Seth Klarman's Baupost Group, a strictly value-oriented firm, revealed a new position in eBay in its 13-F filing.
The Information reports that two PayPal CEO candidates informed them that the CEO pitch includes the eventuality of a spin-off, maybe as early as 2015.
Amazon's move into the unprofitable, niche card-reader business presents no competitive threat to PayPal's core business.
My previous article on eBay (NASDAQ:EBAY), which can be viewed here, presented the view on June 6 that eBay was unlikely to fall very far below $50 because it was a high-quality business trading at attractive levels at a key resistance level. Even though the stock has since moved over $55, it continues to look like a good investment even though its fundamentals are slightly less attractive. The recent news flow suggests the market agrees with my viewpoint.
If you held those October 55 calls I suggested in my last article then you're up a little over 2x, but it's been a bumpy ride to get there, so I won't elaborate on how I thought it was a masterful trade. eBay is a great buy today.
Baupost Group's Second Quarter Entry Point
Seth Klarman's flagship value fund has generated over ~$20 billion in profits for its investors and sticks to a strict value strategy. During the strongest bull market in U.S. history from 1995-1999, Baupost ignored the noise in technology stocks and still generated strong returns while buying put options the entire way up.
The firm manages $27 billion but owned a little over $6 billion in U.S. equities on 6/30, if that helps provide a window into Klarman's views on valuation in the U.S. markets. Still, Baupost saw the quality of the respective eBay and PayPal franchises at the right price and opened a $222 million, or 3.6%, position.
An entry point alongside a firm as storied as Baupost reaffirms my confidence in the position as a value play at a great cost basis. The competitive risks were the biggest question mark for me, and now I feel more comfortable because Baupost stresses quality value investments that have a low chance of permanent capital loss.
PayPal Spin-Off Reportedly in the Works
This section will contain a bit more social science than fundamental analysis. I understand that some dislike the approach, but companies are run by people and people are driven by social science in large part. Michael Milken did say that the best investor is a social scientist.
The Information reported that eBay had told suitors for the open PayPal CEO position that spinning off the subsidiary is an eventuality, something I strongly believe. Donahoe then came out saying that their plans haven't changed but all strategic alternatives would be considered, but the story was not denied.
CEOs can't flip-flop at the risk of losing their credibility. PayPal is the future of eBay; a rough estimate that I've seen thrown around is that the subsidiary makes up about 2/3 of the parent company's value on the low end, and I think that's accurate. In order for eBay to recruit a top-tier talent as CEO, they essentially have to promise them that PayPal will spin off from eBay, maybe sooner rather than later, so that they can assure their autonomy.
The health of the firm's most valuable business is critical to the firm's future success, and a stand-alone entity with a strong, technologically sound CEO sets PayPal up for success better than if it were under the eBay umbrella. I think Donahoe knows his hands are tied, and he must eventually spin off PayPal in order to make the payments giant more agile. If PayPal flops due to its perceived inflexibility under his watch, he knows he will be to blame.
This Bloomberg interview with ex-eBay and ex-Square executive Keith Rabois and Emily Chang provides some good colour on how an investor should think about the behind-the-scenes. I don't agree with everything Rabois says, but he is knowledgeable about payments and has insight that I would never have as an individual investor.
The interview is especially interesting because Rabois ends up talking at length about Square, which is distinctly related to my last item of business: competition from Amazon.
Amazon Entered the Unattractive Personal Card Reader Business
Rabois clearly has an equity interest in Square and wants to talk his own book, but I think the overall impression he gives of the company is quite negative.
Chang eventually asks up front, "Can Square ever be profitable?" Rabois responds that Square has 34% margins, which are "higher than a lot of the companies on your show". What Rabois fails to acknowledge is that those 34% margins are gross margins, and Square is a highly unprofitable business.
eBay's stock dropped on news that generally stated that Amazon had entered mobile payments and was competing on pricing with PayPal. In reality, the news was that Amazon (NASDAQ:AMZN) had entered another largely unprofitable business (surprise surprise), so this was in fact noise. As soon as I saw headlines of "price competition" in payments, I knew that Amazon had not entered PayPal's lucrative mobile payments market but had rather begun its own point of sale card reader business.
The first rule of payment processing is that under the current regime, rates are standard at 2.9% + $0.30 for smaller transactions. Here are Google's rates (NASDAQ:GOOG) (NASDAQ:GOOGL) and Amazon's rates if you would like to double check. You cannot charge lower than these rates if you want to process your payments on the current 'rails' or processing infrastructure, which are operated by Visa (NYSE:V) and MasterCard (NYSE:MA) through the ACH, or Automatic Clearing House. In order to process payments as PayPal does, a corporation needs an ACH origination bank. If you were previously uninformed of this arcane system, Wells Fargo is PayPal's ACH origination bank.
Yet, this arcane system has many benefits to modern society. The Durbin amendment was going to dismantle the old system, but that choice would have been ignorant, as cash economies have implicit costs that taxpayers must bear. The two main reasons are that cash is very expensive to keep up and being forced to transact in cash reduces the will to spend. Tax evasion is also blunted by electronic payments, but the effects are not hugely significant.
Privatizing a little profit for what really is good for society (even though it may not seem like it) is likely best for everyone in terms of cost-benefit. eBay, luckily enough, gets a chunk of this privatized profit with its huge moat, and that is a big part of what makes the company high quality. (Many thanks to SunTrust's Andrew Jeffrey for this insight on the esoteric payments industry).
eBay is still a great buy. A well-known value investing firm initiated a position, the company's best asset should get spun off in the next 12-18 months, and Amazon's movement into payments is little more than a side show.