eBay Has Left Premium Valuation Days Behind (EBAY)

From Stifel Nicolaus analyst Scott Devitt on his decision to reduce his target price for eBay (EBAY) from $45 to $39 per share:

* eBay shares are off by 25% since the company announced 1Q06 results. The shares now trade for 20x 2007 free cash flow and 24x 2007 cash EPS, based on our estimates. We are lowering our target price from $45 per share to $39 per share to reflect our updated thoughts on the company and the lowered valuations afforded consumer Internet businesses in a slowing macroeconomic growth environment. Our new target equates to 27x 2007 free cash flow and 31x cash EPS. The days of premium valuation are behind eBay in our view but we believe the stock continues to be a core holding within the Internet Consumer Services sector.

* For the company to achieve our revised target price, we need to see a quarter of stabilized trends from GMV, international revenue growth, and the Stores/Express modifications, all else being equal. To attain levels much above $40, something needs to perform above expectations at PayPal, Skype, or eBay China.

* Our expectations for eBay on a three-year basis include U.S. transaction revenue growth of 18%, international transaction revenue growth of 28%, and PayPal growth of 38%. We assume Skype grows north of 60% but do not include any operating income contribution from the business over the next three years. In aggregate, we believe eBay can grow its revenue by a 25% CAGR over the next three years with similar rate of free cash flow growth. Based on our expectations, our target price equates to a 1.1x PEG ratio on our 2007 free cash flow estimates (1.25x excluding the tax benefit of stock options).

* Cash Flow and Capex. Our free cash flow estimate of $1.7 billion incorporates $500 million of capital expenditures in 2006. The company has stated that it expects to spend 7%-8% of revenue on capital expenditures in 2006 or $400 million to $470 million. On slide 308 of the analyst day presentation, the company notes its expectation of $2.3+ billion in operating cash flow and $1.7+ billion in free cash flow, which implies $600 million in capital expenditures. However, the company continues to state that it expects 7%-8% of revenue. In 1Q06, eBay spent $133 million on capitalized items.

* The U.S. business. In the first quarter, eBay's U.S. transaction revenue grew by 23% excluding the benefit of Shopping.com. The company recently launched eBay Express which should be beneficial to the user experience but could create a continuation of the short-term disruptions that occurred in 1Q related to fixed price listings. We estimate that an eBay Stores (fixed price) transaction generates 94% of the revenue of an auction and 85% of revenue after accounting for the 45% conversion rate on in the auction category. In 2Q06, we estimate that eBay U.S. listings are up by 20% quarter-to-date with the majority of growth coming from fixed price listings (6% auction growth).

* The International business. In short, Europe is doing well and Asia is not. In 1Q06, international transaction revenue grew by 32% on a constant currency basis. In 2Q06, we estimate that international listings are up by 38% driven by strength in Germany. The UK and Germany account for 65% of total international transaction revenue according to our estimates. In China, eBay seems to be lagging Taobao and, according to some reports, falling further behind as time passes. China is important to our long-term investment thesis although we believe our lowered target price could be achieved without any improvement in the country.

* PayPal. PayPal continues to be eBay's best performing asset with constant currency growth of 47% in 1Q06. PayPal now generates more than 30% of its payment volume from its merchant services offering, which is quickly becoming the alternative payment platform on the Internet. With long-term perspective, we continue to believe that PayPal will work as a replacement for credit cards offline as well.

* Skype and The Power of Free. Skype now has more than 100 million users, 6 million concurrent users (2x the acquisition level), and accounts for 7% of international calling minutes. We continue to take a wait-and-see approach with Skype but believe the company is executing well against its goals set out when the deal was announced. For us, the opportunity at Skype goes beyond the replacement of PSTN lines to the replacement of cell phone technology via wireless networks with a long-term horizon. The size of the voice communication industry, landline and cellular, is significant enough for us to be comfortable with Skype's existing pricing strategy.

* Competition. We continue to believe that eBay issues are more related to the slowing growth rate of ecommerce than to emerging transaction and / or payment platforms from Google, Yahoo!, Microsoft, etc. In our view, eBay offers a value proposition to buyers and sellers that is difficult to replicate, it offers very competitive prices to buyers and offers sellers the highest volume / velocity marketplace in which to sell goods on the Internet. eBay also manages the entire process for merchants including distribution / traffic, storefront, payment processing, and fulfillment tools. We believe the unbiased eBay merchant would acknowledge that while ASPs may be slightly higher outside of eBay (driven more by the fixed price format than anything else), the gross profit dollars that the eBay marketplace generates for merchants is unmatched by other online marketplaces. In an environment of absolute price transparency on the Internet, why would a consumer pay more for an item outside of eBay from an opaque merchant (no feedback) than that same consumer would within the more trusted eBay marketplace? Also, now that eBay manages a 15 million keyword program, how is it possible for a small merchant to successfully (and profitably) drive traffic to its own sites while competing against not only eBay for traffic but also Amazon, Wal-Mart, etc.?