By The Valuentum Team
Global commerce and payments company eBay's (NASDAQ:EBAY) low capital intensity and predictable cash flow generation speak highly about its business quality. The company has performed well in mobile as of late, a strong sign for the future of the business as the world continues to be "on the go." Geographic expansion could offer meaningful growth opportunities moving forward as well; more than 40% of total gross merchandise volume (GMV) was still generated in the US as of 2015.
Though we like eBay's fundamental prospects by itself, we maintain our view that a tie-up of Yahoo! (NASDAQ:YHOO) and eBay may be the best long-term picture for the two Internet-based firms. eBay's expected traditional free cash flow generation alone can pave the way for significant economic value creation as debt of the combined transaction is repaid. eBay also "firmed up" its full-year revenue outlook, and it is targeting traditional free cash flow of $2.2-$2.4 billion in fiscal 2016, in-line with the marks of each of the past three years. At the high end of the free cash flow guidance range for 2016, that's a free cash flow yield of ~8.5%. Can you imagine the revenue and cost synergies to be extracted in a Yahoo-eBay tie-up?
eBay was once a core holding in our Best Ideas Newsletter portfolio, but we removed our position shortly after the split with PayPal (NASDAQ:PYPL). eBay currently registers a 7 on the Valuentum Buying Index. We don't think eBay will remain by itself for long, particularly as suitors look at its free cash flow generation as a potential funding source for bigger and better things.
eBay's Investment Considerations
• eBay is a global commerce and payments company. The firm spun off PayPal into a separate publicly-traded company, and this report reflects the value of eBay on a standalone basis. Carl Icahn no longer holds shares in this security.
• eBay is still a powerhouse even after letting go of its prized PayPal. During 2015, the firm processed $82 billion in gross merchandise value from ~162 million active buyers and over 25 million active sellers. It had 800 million listings. eBay's standalone revenue in 2015 was $8.6 billion.
• The company's business continues its resurgence, with active user growth recently reaching levels not seen since 2007. Targeting convenience and customer service via a site redesign has resonated with users. Mobile performance has also been fantastic, with the company processing ~$35 billion in mobile gross merchandise value in 2015.
• Investors can expect revenue growth in the low single digits and an operating margins comfortably above the 30% mark. Free cash flow is targeted in the range of $2.2-$2.4 billion in 2016, which could be a solid increase over 2015 levels. Low capital intensity and predictable cash flows speak to high business quality.
• In fiscal 2016, eBay is expecting FX-neutral revenue growth of 2%-5%, or total revenue of $8.5-$8.8 billion. Strong operating margin between 31%-33% is expected to drive non-GAAP earnings per share to $1.82-$1.87.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. eBay's 3-year historical return on invested capital (without goodwill) is 77.6%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does notconsider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.
Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
In the chart below, we show the probable path of eBay's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. eBay's free cash flow margin has averaged about 27.6% during the past 3 years. As such, we think the firm's cash flow generation
is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At eBay, cash flow from operations decreased about 2% from levels registered two years ago, while capital expenditures fell about 1% over the same time period.
In the first three months of 2016, eBay reported cash flow from operations of ~$641 million and capital expenditures of ~$158 million, resulting in free cash flow of ~$483 million, less than half of free cash flow in the first quarter of 2015.
This is the most important portion of our analysis. Below we outline our fair value assumptions as well as derive a fair value estimate for shares.
Our discounted cash flow model indicates that eBay's shares are worth between $26-$40 each. Shares are currently trading at ~$24 per share, below the low end of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at this time.
Both our top and bottom-line forecasts for 2016 and 2017 are in line with consensus estimates for eBay. We are expecting low to mid-single digit growth in revenue in the coming years, while operating efficiencies should help earnings growth outpace top-line growth. The low capital intensity of the firm's business is one of the drivers of its strong free cash flow generation, a large factor in our high opinion of the company, and we are expecting capital expenditures to remain near 8% of total revenue moving forward.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $33 per share represents a price-to-earnings (P/E) ratio of about 20.7 times last year's earnings and an implied EV/EBITDA multiple of about 12.9 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.3%. Our model reflects a 5-year projected average operating margin of 39.8%, which is above eBay's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 1.8% for the next 15 years and 3% in perpetuity. For eBay, we use a 9.7% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $33 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for eBay. We think the firm is attractive below $26 per share (the green line), but quite expensive above $40 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate eBay's fair value at this point in time to be about $33 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of eBay's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $45 per share in Year 3 represents our existing fair value per share of $33 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: PYPL is included in the portfolio of the Best Ideas Newsletter.