- eBay runs two main businesses: its popular legacy business, eBay Marketplace, and its rapidly growing online payments subsidiary, PayPal.
- The recent hacking of eBay Marketplace presents more opportunity than risk since its password hashes were salted and should therefore present few long-term risks.
- The company is priced well below its competitors based on multiples of free cash flow.
- The stock has never traded below $50 for longer than four days during the past 18 months.
- The options are pricing a bimodal distribution, but it seems like the technical floor of $50 and relatively cheap earnings growth present more upside than options would suggest.
Benjamin Graham wrote in his book The Intelligent Investor that every investor should "apply a set of standards to each [stock] purchase, to make sure that he obtains (1) a minimum of quality in the past performance and current financial position of the company, and also (2) a minimum of quantity in terms of earnings and assets per dollar of price."
eBay (NASDAQ:EBAY) currently fits the bill for Graham's quality and quantity aspects of investing. The company's quality lies in its management team and high barriers to entry in its business, while the quantity lies in a strong balance sheet, free cash flow (FCF), and the firm's positioning for future growth.
I will overview payment processing, management, valuation, and the opportunities in the options market and conclude with my trade.
The Payment Processing Arena
Payment processing is a high margin business with high barriers to entry. It is a business built on trust, which tends itself toward large, dominant players. eBay's two main competitors in the United States are Visa (NYSE:V) and MasterCard (NYSE:MA).
The Federal Reserve Bank of Chicago released a white paper on innovation in payment processing in 2003 that provides a good view into the payments business. Section II gives an overview of the business model in layman's terms.
Is Apple a Threat?
Apple, or any future competitor that has already built a base of trust, could begin tomorrow and charge half the commission of eBay, Visa, or MasterCard, but the firm would never risk crimping its margins. This could hurt PayPal's growth, but its margins would remain untouched.
PayPal's standard 2.9% fee is well entrenched and the concept of real competition in the space is farfetched for the next few years. There are very few trusted firms that could begin a payment processing business and none that have the incentives to undercut the competition.
John Donahoe II: Donahoe began his career at Bain & Company and spent over twenty years there before making his way to eBay as President of eBay Marketplace in 2005; he continued up eBay's corporate ladder until being named CEO in 2008.
Donahoe is a secure, well-renowned CEO. He holds influential positions on boards of directors like Intel and Skype. My only issue with him is that he did not spend the majority of his career at eBay, but he is now 10 years into his tenure and a steady leader, although his knowledge of the payments business may be lacking.
Robert Swan: Swan is currently the CFO of the Company and has held important leadership roles at Electronic Data Systems and TRW as well.
Swan is well acquainted with the lists of the best Silicon Valley CFOs. He has the impressive resume of growing eBay from a free cash flow negative business to the cash flow behemoth it is today.
Pierre Omidyar: Omidyar is the founder and chairman of eBay. He was a billionaire at the age of 31 at the advent of eBay's IPO and has continued to keep a close watch on the Company's culture while staying outside of the day-to-day operations.
I get the impression that he has engendered a strong corporate governance culture that offsets much of the worry I had when I first heard about the eBay Marketplace hacking scandal. Alongside Warren Buffett and Bill Gates, Pierre has signed the giving pledge, where the pledgee signs away 99% of his wealth to charity. He now spends his time running charities and local publications.
Comparable Companies Analysis
eBay generated $4.08 billion in FCF during the 12 months ended March 2013, up 39% from the $2.93 billion generated the 12 months beforehand. Free Cash Flow, by my calculations, is EBIT - CapEx + D&A. Source: Company Presentation.
eBay's market capitalization is $64.5 billion and its enterprise value (EV) is $60.8 billion. eBay is relatively unleveraged and has about twice as much cash and short-term investments as long-term debt. Source: Yahoo Finance
This gives an EV/FCF multiple of 14.9x. Let's see how that compares to its main payment processing competitors, Visa and MasterCard.
MasterCard generated free cash flow of $4.72 billion over the past twelve months and has an EV of $84.1 billion. The company's TTM EV/FCF multiple is 17.8x. Source: 10-Q Filing
Visa's financials fail to present an easy-to-understand FCF figure, but the company guided to ~$5 billion in free cash flow for 2014. Visa's EV of $159.4 billion gives a 2014 EV/FCF multiple of 31.9x. The figure is after-tax and so is understandably lower. However, after a tax treatment of 30%, the 2014 EV/FCF multiple is still 22.3x. Source: 10-Q Filing
Of the two, MasterCard is most comparable to eBay in terms of financial strength, but the firm still fails to compete on every metric. eBay has greater relative free cash flow and its revenue and free cash flow are growing slightly above that of MasterCard. eBay comes out ahead financially relative to the most comparable companies.
The current mispricing in eBay gives an investor a strong risk-reward profile, but playing the stock in the options markets appears to increase the reward while limiting the risk of permanent capital loss.
The options appear to price based on the modified Black-Sholes and the model's assumptions of a normal, bimodal distribution.
In Joel Greenblatt's section of Hedge Fund Market Wizards by Jack Shrager, he names Wells Fargo (NYSE:WFC) during the 1980s as an example of options market mispricing. For that example, he believed the downside was zero but the upside was almost double the market price at the time.
I don't believe that this is a book-worthy example of options mispricing, but I do believe that the scenario presents a good opportunity to think about option pricing. In my view, the percentage chance of the stock trading at $45 at the end of the year is much lower than the percentage chance of it trading at $55.
A variety of factors create this unique scenario. Quality companies and companies with low EV/FCF multiples relative to the market tend to outperform in the long-run. I tend to be a skeptic of technical analysis, but when a stock has failed to trade below a certain level and continued to test it with good results, then I believe that that particular price level means something to traders and investors. In this example, eBay has failed to trade below $50 per share for an extended period of time and the chance of the stock doing so is likely less than a typical option pricing model would suggest.
The hack in months past of eBay Marketplace could present a downside scenario somewhat like Target (NYSE:TGT), but I believe this is unlikely. Hashing and salting was used to keep passwords safe and I doubt eBay would give up its cryptographic methodologies; everyone is looking at the situation from the same cloudy viewpoint. This is a risk I am willing to take; the better entry point was well worth it.
eBay is attractive based on its positioning in a growing, profitable industry with strong barriers to entry. It trades at lower multiples of FCF than its competitors and is attractive on a technical basis due to the resistance at the $50 per share level.
There is currently a unique opportunity in eBay: an opportunity to buy a quality company at a good price. The firm becomes even more attractive through the use of vanilla call options; four- to six-month volatility is cheap on an implied volatility/historical volatility basis and a bimodal distribution seems unlikely based on the above.