Why I Think eBay Is Overpriced

After its runup on last week’s earnings announcement, I think eBay (EBAY) stock is overpriced. But then again, it was overpriced before the runup too. Please let me explain.

I do not think eBay is a bad company. Much the opposite, in fact. After all, it has a retail business model that requires no inventory! It is the only legitimate player in its market niche, merchants often depend on its services for their very survival and eBay has found a way to charge fees at every level of the transaction. It is a beautiful arrangement, really. And this is likely what carried it through the dot com crash that destroyed just about every other meaningful peer company.

But today the company is mature, and I think investors have still not yet fully accepted that. I may even go a step further and say that the auction market itself is saturated. There simply isn’t the room for 30, 40, 50% sales growth that eBay enjoyed just a few years ago. Indeed, at this point it seems like sales may actually begin declining. This is a remarkable change in fortune for the post-bubble darling.

The company does remain strong from a profitability perspective – returns on capital as well as margins have stayed at decent levels – but it is a big mistake to confuse a good company with a good investment. I worry that many investors are still expecting too much from the future of the company because the company’s past has been characterized by such ridiculous levels of growth. Bear in mind that the stock has gone nowhere in the last six years. But I still think it could go lower.

I first noticed reason for concern shortly after the company acquired Skype Technologies about four years ago for about $2.6 billion, of which an amazing $2.3 billion was booked as goodwill. Adding insult to shareholders’ injury, as part of the acquisition, eBay also assumed obligations to pay nearly $1.3 billion in incentives to Skype executives should they meet certain targets. At the time of the acquisition, Skype had never turned a profit and was producing only $65 million in sales.

To put this in context, eBay had balance sheet totals at the end of FY2004 of only $8 billion. So in essence, eBay, the company with the dreamy business model and impenetrable moat, was wagering nearly half of its net worth on the future of an unrelated and unproven business. Why?

There are two explanations I can think of, neither of which is good for the eBay shareholder. The first is that eBay management saw that their auction growth (and, by deduction, stock price) was unsustainable and therefore sought to expand the business in other areas. That is the generous explanation. The other explanation is that management didn’t know what the heck they were doing and were simply empire-building. I don’t know which explanation is more likely.

Also, along the way, eBay has issued an enormous amount of new equity to finance everything from nutty acquisitions to outrageous executive salaries (Meg Whitman earned $16 million in her final full year as CEO plus another $14 million in the year after quitting). It is these things that have kept the price of the stock down, NOT a change in expectations for growth.

But yet the market prices expectations. Even if sales continue to grow, if they grow at a rate lower than what the market expects the price of the stock should fall.

eBay’s current stock price, though, implies that sales will continue to grow at a rate higher than 5% well in to the foreseeable future. While this may seem low compared to the astronomical growth the company experienced in the early part of the decade, it is very high on a forward-looking basis. eBay, quite simply, is no longer growing. Gross sales declined 2.2% in the twelve months ended in June and it’s RBP Probability – the likelihood that it will attain the 5% revenue growth necessary to support its stock price is a mere 51%. (See EBAY’s RBP Snapshot)