eBay (eBay) had a busy night on Wednesday as the company reported quarterly results and disclosed that Carl Icahn has a stake in the firm and has made requests for change (press release available here). Shares have been range bound over the past twelve months (see the chart below), and Icahn clearly sees an opportunity to get the stock out of its current rut. As a consequence, shares have spiked over 7% after hours on this news. In this article, I will first go over eBay's results and then Mr. Icahn's suggestions before coming to a conclusion about the company's fair value.
First in the quarter, eBay reported EPS of $0.81 on revenue of $4.53 billion. While earnings beat by a penny, revenue missed by $30 million, though it did still grow 13.5% year over year. Earnings growth was 16% thanks to higher revenue and transaction volume. eBay operates two main businesses: its online marketplace and PayPal. While the marketplace is a major part of the business, PayPal is seen as the driver of long-term growth as consumers continue to move towards electronic payment systems. Importantly, the company is performing well in mobile as PayPal is built to be used on phones with volume up 88%. Over 22% of wBay's combined marketplace and PayPal volume is done with mobile devices.
PayPal grew revenue by 19% both in the quarter and all of 2013 with total revenue of $6.6 billion, and the service now boasts 143 million active accounts and 3 billion annual transactions. Marketplace growth was slower but still strong at 12% both annually and in the quarter for an annual total of $8.3 billion. While eBay's marketplace has faced stiff competition from the likes of Amazon (AMZN), there is no reason to be gloomy about its performance with double digit growth. Put simply, Marketplace continues to grow, albeit slower than other e-commerce sites, while PayPal performs more strongly thanks to a secular shift towards electronic payments as more business is done over the internet.
This quarter was even stronger when you realize that eBay actually had a higher effective tax rate this quarter (20%) versus last year's quarter (18%). This EPS beat was driven by stronger volume rather than accounting maneuvers. eBay also continues to be a cash flow machine as it generated $1.7 billion in operating cash flow, and impressively, free cash flow was $1.4 billion. For all of 2013, free cash flow totaled $3.7 billion.
Thanks to strong cash flow, eBay carries $12.8 billion in cash and cash equivalents, which accounts for 17% of its market capitalization. Thanks to this free cash flow and strong balance sheet, the company has increased its share buyback authorization by $5 billion. Combined with the $640 million outstanding on the previous authorization, eBay can now buyback $5.6 billion worth of stock or over 7.5% of the float. eBay should generate over $4 billion in free cash flow in 2014, so this buyback will eat about $1-1.5 billion of the company's excessive cash hoard.
Management is looking for a strong 2014 with non-GAAP earnings of $2.95-$3.00 on $18-$18.5 billion in revenue, which gives shares a forward multiple of 19.5-20x after accounting for the pop on the news release. Now, analysts had been looking for $3.12 on $18.5 billion in 2014, so while eBay's projections for 15% annual growth look strong they do miss the street's expectations. It is important to recognize that shares were range bound in 2013 in large part because management at times gave overzealous expectations that it failed to meet. It follows then that management sets a more conservative bar for 2014 so that it can beat numbers.
Moreover with the Icahn news likely to overwhelm talks of lackluster guidance, this quarter was the perfect opportunity to sand-bag a little and make it easier to beat in the coming months. With that said, let's turn to Mr. Icahn who has amassed a 0.82% stake, which is worth roughly $500 million. Icahn has nominated two directors to the board and has offered a non-binding proposal to spin-off PayPal's business. eBay struck a somewhat conciliatory tone at first saying it "welcomes the opportunity to listen to the perspective of all of its shareholders, including Mr. Icahn. His Board nominations will be passed on to the Boards Corporate Governance and Nominating Committee, which will consider them in the ordinary course of business."
However, eBay says it has in the past undertaken strategic reviews of the business and determined that investors are better off with PayPal part of eBay and opposes the idea of a spin-off. Now, Icahn clearly has plenty of dry powder as a $500 million position is relatively small for him, so he could easily try to take a bigger stake to force a spin-off, though he would still need significant support from other shareholders, which remains uncertain.
Now, Mr. Icahn's position does make sense as Visa (V) and MasterCard (MA), which are PayPal's major competitors, trade around 25-30x earnings and 10-12x sales. Depending the valuation metric you used, PayPal as a stand-alone entity is worth $55-$75 billion. At the high end, it is worth more than what the entire company is trading at. With the marketplace still growing revenue and profitability, it clearly has positive value, even $25-$30 billion with a rock bottom valuation.
As separate entities, eBay and PayPal would be worth 10%-40% more than where shares are currently trading assuming they traded at similar valuations to peers. In other words, it is easy to see why Icahn wants the company to separate. With his small stake, it will be difficult to get traction for his plan, and a spin-off would likely be more than 12 months away. Frankly, I would not bet on it. However, I still would be a buyer of eBay under $60 thanks to its discount to its fair value when you combine the value of each segment. As a combined entity, eBay should still trade to at least $70-$75. With strong performance, Icahn's involvement, and a discount to fair value, eBay makes sense as a long right here.