eBay: A Good Long Term Investment?

The secret to compounding gains in the stock market is finding a solid company with good economic prospects and buying it at reasonable prices. When you find that company, you just have to wait until the price catches up with its real value. It would also be good if management is superb at capital allocation to maximize value creation.

eBay Inc (NASDAQ: EBAY) has good economic prospects given the strong demand in internet and mobile transactions. In fact, it generates consistent free cash flow and has strong financial position. Management has also been good at capital allocation. Over time EBAY will continue to give solid returns to the investor.

 

eBay Inc. was formed on September 1995 as an online auction website by Pierre Omidyar. Shortly after receiving funding from venture capital firm Benchmark Capital, it went public on September 1998. It eventually moved from collectible items to any saleable item auction. By late 2000, it has already expanded worldwide. It has also bought similar auctions site like IBazar and brand4friends. It also bought famous companies like Paypal in 2002 and Skype in 2006. It divested 70% of its stake in Skype last year. It has two business segments:

The company has effectively conquered its major competitors in the auction space. It is also a strong player in the online sales. Paypal is also one of the leading players in the online payments arena. It has an enduring moat that is not easy to penetrate. These strengths resulted in consistent profitability and solid cash flows for the company. I believe will continue in the coming years.

 

Over the last 5 years, annual sales growth averaged by 11%. In turn, net profit has grown by 22% annually during the same period. Pre-tax profit margins have remained stable at 20%. This also translated to a return on capital of 20%. These figures are high by industry standards. Industry earnings growth has annual average of 11% and return on capital at 17%. This goes to show that the company possessed a solid advantage over its competitors. Management has done a good job at allocating capital. It reinvested all of its earnings back to the business. This has increased its shareholder’s wealth by 18% a year for the last 5 years. Meanwhile it has also bought back shares valued at $3.2 billion during the same period. It has definitely enhanced shareholder value as shares were undervalued.

 

The company generates free cash flow of $2 billion a year assuming no growth. It has net cash of $3.8 billion based on the latest filing. I believe management can use this cash to further enhance its business. I also believe that divesting its non-core assets such as Skype (i.e., eBay still has 30% stake) and others should beef up its cash position for value-accretive acquisitions.

 

Moving forward it still has a lot of room to grow. You will notice that its payments segment has increased its contribution to revenues. For the latest quarterly report, Paypal has posted double digits growth. Active registered users have also shown double digit increase. This trend would most likely continue in the future. 

 

Analysts are expecting earnings per share of $2.29, an increase of 12% compared to prior year’s performance. This growth is higher than industry, which is expected to post 11% for the year. On a longer term, the 5-year average earnings growth is pegged at 13%. This is relatively good earnings expectations as it is difficult for a large company like eBay to post this kind of earnings growth.

 

At current prices, the stock is trading at 14 times 2012 earnings. Adjusting for net cash, this yields to 13 times earnings. This valuation may not appear cheap but still reasonable. It is just trading slightly higher than its 5-year lowest historical price to earnings average of 10 times. Historically, it traded as high as 100 times earnings. In contrast to its peers, the company looks cheap. Amazon (NASDAQ: AMZN) is trading at 138 times 2012 earnings. Other auction sales site like Liquidity Services (NASDAQ: LQDT) is also valued higher at 42 times earnings. It seems that Mr. Market is getting irrational again. Why is the stock valued lower when it has consistent profitability and has a solid financial position? The answer is that investors are worried that its European market will have a bigger impact on its profitability. Moreover the market is worried that its market place business is declining.

 

Given its better than expected better than expected earnings report, investors are more convinced that the company is worth higher than its current price. Its shares have returned 8% for the year based on the good results alone. I believe that the current prices present a considerable margin of safety for investors.