eBay June Quarter Preview: Still Heavily Undervalued (EBAY)

| About: eBay Inc. (EBAY)

Caris & Company analyst Tim Boyd previews the announcement of eBay's results for Q2, ended June 30. Excerpts from his note follow:

We estimate Jun06 at $1,430MM in net revenue and $0.24 in pro forma EPS vs. Street consensus for $1,409MM and $0.24, respectively. We have modestly reduced our revenue estimate for the quarter, previously at $1,441MM. Our EPS estimate remains unchanged. The adjustment in our top-line estimate reflects a heavier-than-expected mix shift in favor of Store Inventory Format listings. This shift will likely lead to less non-payment transaction revenue per listing, which we were previously forecasting at $1.79 (down 6% Y/Y) but now believe will come in at $1.70 (down 9% Y/Y). The drop in this key metric was, however, offset to a large extent by much-stronger-than-expected growth in total listings, which we had formerly estimated at 572MM (up 30% Y/Y) but now see at 595MM (up 35% Y/Y).

Although the new revenue estimate of $1,430MM is 1.5% above consensus, we do not view it as aggressive. Management’s June quarter revenue guidance range of $1,370MM to $1,415MM is based on a EUR/USD exchange rate of 1.20, and we estimate that the weighted average EUR/USD rate at which eBay has repatriated its European revenues is approximately 1.2550 – about 4.5% higher than 1.20. Taking into account the relative weakness of the USD relative to all foreign currencies to which eBay is exposed, we estimate that management’s guidance may be understated by as much as $30MM. Conservatively adding $15MM to both ends of the guidance range yields an FX-adjusted range of $1,385MM to $1,430MM, the midpoint of which is virtually in-line with Street consensus of $1,410MM.

Now consider the following: since 1Q04, eBay has never failed to exceed the upper end of its revenue guidance range and has, on average, exceeded the upper end of the range by 3%. Even in the March 2006 quarter, in which FX rates negatively impacted eBay’s top line to the tune of $50.2MM (likely the biggest negative FX impact in the company’s operating history), the company managed to post 1% upside to the high end of its guidance range. The key point here is that eBay has a history of providing highly conservative revenue guidance. Based purely on this history, it would be surprising if the company failed to post at least $1,430MM (i.e. 1% upside to the top end of their current, i.e. non-FX adjusted, guidance range) in revenue, an observation nicely buttressed by June quarter listings growth that has significantly outpaced our expectations and should offset much if not all of the decline in revenue per listing.

As part of its earnings release, eBay will break out the Y/Y impact of FX rate fluctuations on its top-line results. This allows for a calculation of a Y/Y growth rate that is in constant dollar terms. We estimate that Y/Y, FX rate changes will cost eBay $2.5MM on their June quarter top line, which means that the difference between eBay’s reported growth rate and their FX-adjusted growth rate should be negligible. This would be in stark contrast to both the March 2006 quarter and June 2005 quarters, in which FX rate fluctuations wielded a far bigger influence.

Carris ebay 1

The above exhibit highlights a key Bear issue on EBAY shares: in constant-dollar terms, eBay’s Y/Y revenue growth rate is set to decelerate considerably in 2Q06 (to 32% from 40% last quarter). A key aspect of our Long thesis, however, is that 2Q06 is likely to be a trough quarter in terms of fundamentals. Several nascent growth initiatives (such as eBay Express, PayPal Merchant Services, enhanced monetization of eBay’s vast portfolio of advertising inventory, and several facets of the eBay/Yahoo! strategic partnership) are set to gain traction in 2H06 and should:

1. Halt or at least significantly slow the rate of revenue growth deceleration throughout the balance of 2006. 2. Drive re-acceleration in growth beginning in 2Q07 as eBay anniversaries a very tough 2Q05 comp.

We believe that the #1 reason why the shares have declined so much both intra-quarter (down 33%) and YTD (down 37%) is that the market fears an extended period of rapid deceleration in revenue growth. In approximate terms (and based on historical PEG ranges for large-cap Internet stocks), the market’s current valuation of EBAY shares suggests a long-term GAAP EPS CAGR of 18% -- this is materially lower than our 26% estimate and suggests that eBay’s top-line growth rate will be cut nearly in half by 2010.

If one were to look only at eBay’s GMV growth, one might come to the conclusion that this is in fact likely to occur. It is true, after all, that eBay’s GMV growth has decelerated very heavily over the last three quarters. One must take into account, however, the fact that transaction revenue per listing was up 1.3% Y/Y in 1Q06 even while GMV per listing was down 12%. In fact, while GMV per listing has been, on average, down 7% Y/Y during the last three quarters, transaction revenue per listing has been up 4%. The metric that ties this discrepancy together is transaction revenue (ex-Skype) as a percentage of GMV, otherwise known as the transaction take rate. This metric came in at 10.5% last quarter (matching an all-time high), which means that for every dollar of GMV, eBay raked in $0.105 in transaction revenues. Consider the following chart:

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Despite our estimate for a mere 15% Y/Y growth in GMV in the June quarter, we expect eBay’s transaction take rate to rise 110 bps Y/Y to 10.8%. In other words, we expect eBay to generate more revenue per dollar of goods sold on its platform than ever before. Continued deceleration in eBay’s GMV growth would, of course, constitute a big potential negative – after all, there’s a limit to how much profit eBay will be able to squeeze out of each dollar of GMV. We see three key reasons, however, why Y/Y GMV growth is likely to trough in 2Q06:

1. 2Q05 presents a very difficult comp due to a strong growth spurt in high-ASP categories last April thru June. We note Motors in particular – growth in this category was tremendously strong in the U.S., Germany and the U.K. – although Consumer Electronics, Computers and Business & Industrial also put in impressive performances. A corollary of this observation is that the comps for 3Q05 and 4Q05 will be easier.

2. eBay Express should boost growth in higher-ASP categories. Express is eBay’s first attempt to zero in on “new, in-season” items, which sell at higher prices because of seasonal demand (duh). Express is now live but eBay has said that it will begin its major marketing push as the back-to-school season approaches.

3. Material listings growth acceleration in two key emerging markets. eBay may face a lot of challenges in Asia, but you wouldn’t know it from this quarter’s listings growth in China and Korea. China’s growth rate doubled to 140% Y/Y, while Korea’s jumped from 210% to 326%. If eBay can sustain this kind of growth, these markets could begin to move the GMV needle.

Adding to the pressure on EBAY shares was yesterday’s announcement that Jeff Jordan, the President of PayPal, will be departing the company in the fall. A key member of eBay’s management team, Mr. Jordan had been viewed by some as the top candidate to succeed Meg Whitman as CEO. Rajiv Dutta, the former eBay CFO and current Skype President, will take over as PayPal president. Several other positions will be shuffled:

• Alex Kazim, VP of Products for Skype, will become Skype President.
• Henry Gomez, GM of Skype North America, will become Chief Marketing Officer and Director of Country Operations Worldwide for Skype.
• Lorrie Norrington, the President and CEO of Shopping.com, will become the President of eBay International.
• Josh Silverman, VP of products for Shopping.com, will become GM of Shopping.com.

Although the loss of Mr. Jordan is a clear negative, we believe that the depth of eBay’s management “bench” will go a long way toward minimizing any operational impact. We do not believe that the timing of Mr. Jordan’s departure had anything to do with the launch of Google Checkout (although speculation that it did is likely to help sell some newspapers over the next few days). In our view, the announcement of Mr. Jordan’s departure is the first piece of incremental negative news all quarter, i.e. the other three key negative issues that have gotten credit for the massive intra-quarter sell off have been known for some time:

1. Maturation of eBay’s core U.S. auction business. The growth in U.S. auction listings began to materially decelerate in the March quarter of 2004. It has since re-accelerated and re-decelerated several times. Meanwhile, the growth in SIF format listings has skyrocketed.

2. Launch of a Google (NASDAQ:GOOG) online payment system. The “GBuy” speculation began a year ago, and as we stated in our note last Friday, Google Checkout is not likely to threaten PayPal’s off-eBay growth prospects any time soon.

3. Too high a price paid for Skype. The acquisition was a year ago, and little (if anything) has happened since then to justify a more or less positive or negative view on the deal. As we stated in our June 14th note, with the addition of “Skype Me” button functionality on eBay’s core platform, at least we can now start gathering tangible evidence one way or the other.

In that vein, we see EBAY shares as at least 35% undervalued at current levels (our P/E and EV/EBITDA valuation framework suggests a valuation of between $37 and $42), which presents a tremendous opportunity to either open or add to a Long position. In our experience, Internet stocks that sell off heavily intra-quarter tend to rally aggressively on In-Line & In-Line quarters. We are looking for a Beat & In-Line quarter, so we do not expect the stock to remain in this grossly oversold territory for long. To provide some historical perspective, we proffer the following summary of EBAY’s recent quarterly results and how the stock has reacted to them:

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Note that over the last two years, there have been four quarters in which EBAY shares have sold off in the 30 days leading up to earnings. In only one of those instances did the stock fail to rally materially in the following 30 days, and that was in January 2005, right after EBAY had hit a post-bubble-era high of $58.49. The shares were significantly overvalued at that point, just as they are significantly undervalued today. We expect to see the stock rally in 2H06 and we expect 2Q06 earnings to be the catalyst that gets the ball rolling.

EBAY 1-yr chart:

Ebay 1-yr