eBay Is An Outstanding Company That Is Undervalued

May.19.14 | About: eBay Inc. (EBAY)

Summary

eBay has a very profitable business model, generates a lot of free cash flow each year and has great economic moats.

The stock has remained relatively flat since early 2013, while the company's free cash flow has increased substantially during the same period.

The stock is undervalued relative to its intrinsic value (the company's business value).

Billionaire investor Carl Icahn also invested in eBay. He normally invests in undervalued stocks that have good growth potential.

eBay (NASDAQ:EBAY) is one of my favorite companies for long-term investing, because the company has a great business model that generates a lot of free cash flow each year, the company has two outstanding businesses (eBay marketplaces and Paypal), and great economic moats that can protect it from competitors.

The stock market is not always rational or efficient. Every once in a while, we can find great investing opportunities from great companies such as eBay, Apple (NASDAQ:AAPL) and Yandex (NASDAQ:YNDX) that are mis-priced by the market. For example, I published an article about Apple a few months ago when the stock was substantially undervalued. It was trading at $455 billion in market cap at the time of writing and is currently worth $514 billion. In other words, we can often find great companies that are undervalued in the stock market, invest in them for the long-term, and sell them when they become substantially overvalued or when they no longer have good economic prospects.

At this moment, I believe that eBay is a great company that is undervalued and that it could be a great buying opportunity for investors who like to invest for the long-term. A great company is one that 1) we can understand, 2) with good economic moats, 3) with great long-term economic prospects, and 4) with an able and trustworthy management team. Great buying opportunities occur when the stock is undervalued, which means that the stock is below its intrinsic value-the company's business value.

eBay Has Several Great Business Segments

eBay has three main business segments: Marketplaces (eBay websites), Payments (Paypal and Bill Me Later) and Enterprise (formerly GSI Commerce). While all of them are great businesses, eBay marketplaces and Paypal are the two main ones that generate the most revenues for the company (see image below). Also note that eBay is earning more revenues from the international market than the U.S. (e.g. 53% of eBay's total net revenues came from the international market for Q1 2014).

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Source: eBay 2013 Annual Report

While I will not go into the details for each of eBay's business segments (this is available on eBay's Q1 2014 Report and Q1 2014 conference call), I want to share with you several economic trends that I believe will drive eBay's revenue and free cash flow growth in the next decade.

Before we start, we must first understand that eBay generates revenues primarily from the transactions enabled on eBay websites and the payments processed through Paypal. Unlike Amazon (NASDAQ:AMZN), eBay's Marketplaces business does not carry inventory and does not run fulfillment centers (except for the company's Enterprise segment). eBay merely acts as the middle person/platform that enables transactions between buyers and sellers around the world. For eBay's Marketplaces business, the company charges the seller listing fees and final value fees plus other optional marketing fees. This means that eBay's business model is much more profitable than Amazon's, because it does not have inventory and fulfillment center costs.

In addition, Paypal is very profitable, similar to Visa (NYSE:V) and MasterCard (NYSE:MA). Paypal earns money by deducting a commission fee (e.g. $0.30 per sale + 2.9% of the sales amount) from the final sale amount.

Growing Enabled Commerce Volume

eBay's most important performance metric is Enabled Commerce Volume [ECV] (aka commerce volume). The company's earnings are largely dependent on the amount of commerce volume it generates. ECV measures the total amount of commerce volume generated from eBay's Marketplaces and Enterprise segments and the payment volume generated from eBay's Payments segment.

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Source: Q1 2014 Earnings Slide

eBay's commerce volume has been consistently growing over the past several years. This is due to the increase of active users and sellers/merchants, eBay's expansion in mobile platforms and in the international market, as well as the rapid growth of Paypal. Since eBay is continuously expanding more in the international market, mobile platforms and payment services, I believe that its commerce volume should grow at a double-digit rate- between 10% to 20% each year- for the next decade.

Cross-border Trades as a Competitive Advantage

eBay websites allow cross-border transactions between buyers and sellers from different countries. This is eBay's biggest competitive advantage (in addition to Paypal) because it encourage more merchants to use eBay. For example, merchants in Hong Kong can often make iPhone cases at a lower cost than anyone else and can sell them to U.S. buyers via eBay. On the other hand, buyers can often find cheaper items on eBay-such as iPhone cases-through auctions or fixed-priced purchases. Hence, I believe that cross-border trades will continue to help eBay attract more commerce volume and revenues from the international market.

Rapid Growth in Mobile Commerce Volume

eBay has been very successful in its mobile platforms. For example, its mobile ECV has grown from 14% of its total ECV in Q1 2013 to 19% of total ECV in Q1 2014 (see eBay-enabled ECV image above). As more people use mobile devices for eBay and Paypal transactions, we can expect that eBay's mobile commerce volume will continue to grow at a faster pace than its non-mobile commerce volume.

eBay's Growing Revenues and Free Cash Flows

Over the past 10 years, eBay's Free Cash Flow [FCF] grew from $992 million to $3.7 billion with a Compound Annual Growth Rate (OTCPK:CAGR) of 15.9% each year (see image below). For the trailing 12 months between Q2 2013 and Q1 2014, its Free Cash Flow was $4.1 billion.

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Note that eBay repatriated (brought back) $9.0 billion of foreign earnings to the U.S. in Q1 2014. This resulted in a "non-cash" tax charge of approximately $3 billion on eBay's income statement, and the company had to report a GAAP loss of ($2.3 billion) or ($1.82) per diluted share (source: Q1 2014 Earnings Release). The non-cash tax charge may distort eBay's performance (net income and diluted earnings per share) for Q1 2014. A better performance metric is the company's free cash flow.

Competition and Risks

Competition is likely eBay's biggest risk as more companies are competing in eCommerce and in payment services.

For online marketplaces, Amazon is eBay's biggest competitor in the U.S. and in the international market. Alibaba-the largest ecommerce company in China-will likely become a huge competitor should it enter the U.S. market. For payment businesses, eBay's Paypal is the leading digital wallet and online payment service. It is much more popular than Google Wallet and other digital wallets. For mobile payment services, Paypal is expanding more in offline stores and will likely compete with Apple should it enter the mobile payment market.

eBay has great economic moats (e.g. cross-border trading, a large selection of products that is comparable to Amazon's, cheaper products, market-leading Paypal, auction-based trading, etc.) that I believe can protect the company from most competition. However, I do not know whether mobile payment will disrupt or complement Paypal.

Why eBay is Undervalued

As mentioned above, the stock remained relatively flat between early 2013 and the time of writing this, while the company's Free Cash Flow grew from $2.6 billion in fiscal 2012 to $4.1 billion for the 12 months between Q3 2013 and Q1 2014. This may suggest that the stock is undervalued because the market has not recognized the company's growing free cash flow.

Intrinsic valuation (a method that measures a company's business value) also suggests that eBay is undervalued. To measure eBay's current intrinsic value, I have used three scenarios: an optimistic valuation with a free cash flow CAGR of 15%, a fair valuation with a CAGR of 13%, and a pessimistic valuation with a CAGR of 10%. My other assumption is that the discount rate is 13% (see image below).

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According to my estimates, eBay's fair intrinsic value should be around $76 billion in market cap or $60 per share, assuming that the company's free cash flow will grow at a CAGR of 13% for the next decade. This means that the stock is undervalued by around 15%. However, if the company's free cash flow grows at a CAGR of 10% for the next decade, the company should be worth around $65 billion in market cap or $51 per share.

If we consider eBay's growing commerce volume and the economics trends that I mentioned earlier, I believe that its free cash flow should grow at a CAGR of 10% to 15% each year for the next decade (its Free Cash Flow grew at a CAGR of 15.9% for the past 10 years).

The Bottom Line

I believe that eBay is a great company for long-term investing, because it has two great businesses-eBay websites and Paypal-that are very profitable, generate a lot of free cash flow, and have great economic moats. The stock is likely undervalued because it has been relatively flat since early 2013, even though its free cash flow has grown substantially. In addition, I have estimated eBay's fair intrinsic value to be around $76 billion in market cap or $60 per share.

On a separate note, billionaire investor Carl Icahn has invested in eBay and owns 27.8 million shares, according to Businessinsider. He normally invests in undervalued stocks that have great growth potential. This also indicates that eBay might be undervalued. Icahn tried to separate Paypal from eBay, but eventually backed away from his proposal. I believe that both businesses are better together because they can increase each others' commerce volume as well as payment volume.

Sources: eBay 2013 Annual Report, Q1 2014 Quarterly Report, Conference Call and Earnings Slides, Morningstar, Yahoo Finance, Businessinsider, SA Transcripts and Intelligent Stocks.

Disclosure: I am long AAPL, AMZN, YNDX, MA, V. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.