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eBay Inc. (EBAY)

Q3 2007 Earnings Call

October 17, 2007 5:00 pm ET

Executives

Mark Rowen - IR

Meg Whitman – President, CEO

Bob Swan - CFO

Analysts

Shawn Milne - Oppenheimer

Scott Devitt - Stifel Nicolaus

Jeffrey Lindsay - Sanford Bernstein

Anthony Noto - Goldman Sachs

David Joseph - Morgan Stanley

Ben Schachter - UBS

Mark Mahaney - Citigroup

Heath Terry - Credit Suisse

Victor Anthony - Bear Stearns

Operator

Welcome to eBay's third quarter 2007 earnings results conference call. Today's call is being recorded. With us today from the company is the President and Chief Executive Officer Meg Whitman; Chief Financial Officer Bob Swan; and the Vice President of Investor Relations, Mr. Mark Rowen.

At this time I would like to turn the call over to Mr. Mark Rowen. Please go ahead, sir.

Mark Rowen

Thank you, operator and good afternoon. Thank you for joining us. Welcome to eBay's earnings release conference call for the third quarter of 2007. Joining me today on the call are Meg Whitman, our President and Chief Executive Officer; and Bob Swan, our Chief Financial Officer.

We're providing a slide presentation to accompany Bob's commentary during the call. This conference call is also being broadcast on the Internet, and both the presentation and call are available through the investor relations section of eBay's website.

Before we begin, I'd like to remind you that during the course of this conference call, we may discuss some non-GAAP measures in talking about our company's performance. You can find the reconciliation of those measures to the nearest comparable GAAP measures in the slide presentation accompanying the conference call.

In addition, management may make forward-looking statements regarding matters that involve risks and uncertainty, including those relating to the company's ability to grow its business, user base and user activity. Our actual results may differ materially from those discussed in this call for a variety of reasons, including our increasing need to grow revenues from existing users in established markets, an increasingly competitive environment for our businesses, the complexity of managing a growing company with a broad range of businesses; regulatory, tax, as well as IP and other litigation risks, including risks specific to PayPal in the financial industry and risks specific to Skype's technology and to the VoIP industry; our need to upgrade our technology and customer service infrastructure to accommodate growth at reasonable cost, while adding new features and maintaining site stability; foreign exchange rate fluctuations; and the impact and integration of recent and future acquisitions.

You can find more information about factors that could affect our results in our annual report on Form 10-K and our quarterly reports on Form 10-Q, available at investor.eBay.com. You should not unduly rely on any forward-looking statements and we assume no obligation to update them.

With that, let me turn the call over to Meg.

Meg Whitman

Thank you, Mark. Welcome, everyone to today's conference call. Q3 was a strong one for the company. We delivered record net revenues of $1.89 billion, representing a 30% year-over-year growth rate. Non-GAAP earnings per share was up 59% and free cash flow grew 32%, even as we continued to invest in some of our most important businesses.

eBay International, PayPal Merchant Services, StubHub, Classifieds, and our advertising businesses all performed above our expectations during the quarter. We feel good about our strategy headed into Q4, and the investments we are making in our various businesses. Let me give you some highlights for each of our business areas: Marketplaces, Payments and Communications.

Our Marketplaces business unit delivered record net revenues of nearly $1.32 billion this quarter, with a powerful combination of both GMV businesses, like eBay and StubHub, and non-GMV businesses, like Kijiji and Shopping.com. This portfolio continues to enhance our overall top line and bottom line growth.

The PayPal business continues to deliver incredibly well across the globe, marked by an increase in total payment volume up 34% to $12.2 billion. Revenue grew to $470 million, and we couldn't be more pleased by the trajectory of this business.

I will spend some time in a moment talking about Skype and the announcements we made at the beginning of this month; but to give you some context upfront, this is still a rapidly growing business. Skype added 26 million users in the quarter, bringing the total to 246 million, while revenue also grew by 96% year over year. In addition to achieving profitability ahead of schedule during the first quarter of this year, Skype also turned in higher than expected non-GAAP operating profit this quarter.

Now I will give you a bit more detail on the quarterly results for each of the three business units. Beginning with Marketplaces, let's take a look at our GMV-driven businesses, starting with eBay in the U.S. and in Germany. As you will recall from the last few quarterly calls, we talked about our plans to reaccelerate GMV growth on these sites, so I thought I would spend some time giving you an update on our current progress against this multi-quarter plan; what we've learned from the initial findings, and what we have planned for Q4.

Overall the core business in the U.S. and Germany is a bit healthier, as evidenced by higher conversion rates, an increase in successful listings, and moderately higher ASPs versus a year ago. With the bar for customers' expectations higher than it has ever been, we accelerated the pace of product changes on eBay.com and eBay.de to better meet -- and hopefully exceed -- these expectations.

During the quarter, we made substantial enhancements to the buyer experience, particularly around finding. One part of the new experience is Best Match, which uses more intelligent search and discovery technology to serve more relevant items to shoppers. We've already seen conversion rates are up among the buyers who have been exposed to Best Match. We also introduced Snapshot View, which gives buyers a better way to visually browse through the items that they have found on eBay.

The launch of the new home pages in the U.S. and Germany offer buyers and sellers a simpler, and more personalized front door to eBay. Both the U.S. and German home pages were redesigned to have a much more modern look and simplified usability. Innovative features like My eBay at a Glance and Recently Viewed gives users a snapshot of the most relevant information about their trading activity right on the home page. Early results suggest the new home page is helping our customers get to items of interest much more quickly.

In the U.S., we launched a new bid history page, which gives users more information about bidding activity and also gives buyers the ability to bid directly from the page. The German team launched a fun feature that allows sellers to upload videos of their items they are selling, and they also developed a micro site that shows hot eBay trends and real-time statistics on the items with the most bids.

Finally, in both markets we launched a very simple selling flow designed for new sellers. This is a one-page listing flow designed to make it faster and easier for new sellers to list their items. We've been presenting this as an alternative option for sellers, and early results suggest that users are having good success listing their items more quickly.

In addition to the product changes we made this quarter, we're also focused on improving the breadth and quality of inventory through a variety of pricing promotions. The intention was to give immediate fee reductions to our sellers and encourage them to adopt features that are particularly beneficial to our buyer community, like the gallery feature. Our goal has always been to provide the best economics on the web for sellers, and some of the learnings we've had around these pilot concepts will help inform future pricing decisions.

Over the last few quarters we've talked about our ongoing commitment to trust and safety on eBay. Through our focus on reducing phishing scams and increasing the rapid identification of bad sellers, we made significant progress on our efforts to keep the site clean. Effective enforcement of our seller nonperformance policy and high adoption rates of our enhanced feedback system ensures that our members are both receiving and providing the very best buying experience on the web.

With our product changes happening at a rapid pace, coupled with our aggressive stance on trust and safety, we continue to make progress on enhancing the shopping experience for American and Germany eBayers; but there's still a lot more work to do. It's too early to declare victory, but we are confident that the strategic direction is on track.

Looking beyond our two largest markets, eBay continues to perform well around the world, particularly in the UK, France and Australia where GMV accelerated this quarter. We are also very pleased by the strong performance of Italy and Belgium, and the recent business performance in Korea continues to prove that the product and pricing changes we've made there are paying off in a meaningful way.

Lastly, StubHub remains the world's largest ticket marketplace and a great acquisition for eBay. StubHub announced earlier in October that it would soon make its 10 millionth ticket sale in the company's history. To give you some perspective on how significant this really is, 10 million tickets would sell out every game to be played in this year's Major League Baseball playoffs; eight stadiums, four division series, two League Championships, and one World Series, nearly five times over.

Let me spend a minute on the results from our Classifieds business. Our global multi-brand Classifieds portfolio continued its rapid growth this quarter, posting triple-digit operating and financial metrics in many markets. Monthly unique visitors to these sites are up nearly 200% year over year, and more than 135,000 new ads are being added each day.

As we mentioned last quarter, we launched Kijiji in the U.S. to more than 200 cities at the end of June. After just three months, there are more than 100,000 live ads available at any time. We continue to be very excited about our Classifieds business. While it's still relatively small, it is showing extraordinary promise.

As I said last quarter, we would make more changes to eBay in the next several months than we have made in the last several years. As you can see, we are well on our way here. I know that our efforts will give our users a superior buying and selling experience, especially during the busy Q4 holiday shopping season. Speaking of the fourth quarter, we have some exciting plans to support our holiday efforts around the world.

In the U.S., we will continue to invite our community to Shop Victoriously with our innovative marketing campaign during the holiday season. This campaign is generating excitement and activity among our community, as indicated by our most recent on-site promotions, which are on track to become the most active ever consumer promotions that we have run.

In Germany, a well-integrated marketing campaign is also planned, anchored by the popular taglines "Look What I Have." The German marketing team has designed a program that will actively market eBay.de to buyers and sellers through TV, radio and print ads, as well as through outdoor marketing and online promotions.

In the area of pricing, we want to ensure our U.S. sellers our off to a great start for the holiday season, so we are announcing that starting tomorrow insertion fees will be reduced by at least 33% through November 5th. This will apply to all listings on eBay.com and eBay Motors in both the auction style and fixed-price formats, and could mean a savings of up to 50% for items listed under $1. You'll also see many of our markets around the world launch similar tests this quarter.

Also in the fourth quarter you will see us continue to increase our customer support efforts by adding more representatives in our customer care centers and improving the technology they use to cater to our top buyers and sellers worldwide. As we've done all year, we will continue to ramp our trust and safety efforts ensuring our site is, as always, a great destination for this gift-buying season.

Overall, our Marketplaces business continued to perform well, delivering strong revenue and making our vision of providing anyone with the type of online commerce experience they want a reality, no matter where they live or what kind of format they want to buy and sell in.

Now let me turn to payments. PayPal had an excellent quarter. October marks the fifth anniversary of the closing of the PayPal acquisition, and we continue to celebrate the great success of this business. As evidenced by the numbers this quarter, adoption of PayPal continues to steadily increase all over the globe. Simply put, consumers continue to prefer PayPal when shopping online. Recent consumer research found that PayPal was the second most popular way to pay online in the U.S., right behind Visa. In the UK, PayPal was tied with Visa as the most popular way to pay online.

Our Merchant Services business continues to grow rapidly as we see widespread adoption of PayPal by merchants in the U.S. and abroad. We have recently added brand-name merchants like Hasbro, Footlocker and Blue Nile in the U.S., as well as Lindt Chocolates, the famous Swiss chocolate maker; and Telethon, the largest charitable organization in France. In Australia, PayPal Merchant Services payment volume grew more than 145% year over year.

I am particularly pleased to see that PayPal has gained momentum among the airline industry, adding four domestic airlines this quarter, including Northwest Airlines, Southwest Airlines, Midwest Airlines and U.S. Airways. Just these four airlines alone represent $9.5 billion of addressable TPV for PayPal.

In preparation for Q4, we're excited about the plans that PayPal has for consumers doing the holiday season. We've created an integrated marketing campaign designed to bring great value to consumers through exclusive promotions and an assortment of special offers from PayPal merchants. We look forward to welcoming additional merchants to the PayPal family in Q4, including more airline partners.

Continuing the strong momentum for PayPal remains a strategic focus for the company. Our goals are to increase PayPal ubiquity, sustain the existing core growth, and enhance the user experience, allowing us to remain the world's preferred online payment service.

As for our communications business, I know most of you saw the announcement we made at the beginning of the month regarding the departure of Skype's CEO Niklas Zennstrom, as well as the accelerated earn out payments and impairment charge. Clearly, we are disappointed in the impairment charge. However, we remain confident about this business in the longer term.

Since our acquisition of Skype two years ago, Skype has added more than 188 million users and enabled more than 60 billion minutes of conversation globally. In the third quarter, Skype delivered revenues of $98 million, representing a growth rate of 96%. With its world-class voice calling and video capabilities, it continues to distance itself from its many competitors.

As a part of the announcement we made earlier this month, we also said that we are in the process of looking for a new CEO. I'm pleased to report that we are making progress here. The strength of the Skype brand has generated tremendous interest, and we are delighted by the strong internal and external candidates we're considering. From this very qualified group, we hope to make a selection very soon.

Over the next several months, we will work to improve the way we engage and delight Skype users. For example, yesterday's announcement about the MySpace/Skype partnership is the next phase in our plan to make Skype available across multiple platforms. We also want to fully develop our nascent ecommerce services, like Skype Prime and Skype Find.

Additionally, delivering the synergy with eBay and PayPal that we had always envisioned will be a renewed priority. We are also looking forward to the next generation of the SkypeClient, which has some fantastic features and will debut next year.

Skype is a great business with a lot of potential. With the earn out component no longer a factor, we will be better able to prioritize our resources, refocus the team and strengthen execution to ensure that Skype users will continue to enjoy and benefit from this fantastic technology.

So overall, the third quarter of 2007 was a great start to the second half of the year. We've made good progress against this year's strategic plan, highlighted by significant product changes and strong financial performance from our portfolio of businesses.

Before I close, let me say a word about 2008. As Bob stated at this time last year, we won't be giving 2008 guidance until our Q4 earnings call in January. This is because it's extremely difficult to give you an accurate forecast before the most important quarter of the year for us is completed.

That said, as we head into 2008 we will continue to focus on accelerating GMV growth in eBay's largest markets. Our learnings from 2007 have given us confidence to move faster and more aggressively on product enhancements, pricing changes, customer support and trust and safety investments, as well as customer loyalty programs. All of these changes are designed to improve the end-to-end user experience for both buyers and sellers, and can therefore change the trajectory of GMV growth.

This strategy benefits PayPal significantly, as the growth of the core eBay business is also extremely important to PayPal's financial architecture. All of this will take investment and focus in 2008, but we are convinced it is the right thing to do. It's important to note that these investments will all go right to our users in the form of a better experience, better support, and better pricing strategies designed to maximize value for our sellers.

We will also invest in our newer, faster-growing businesses like Skype, PayPal Merchant Services, Classifieds and advertising. While these businesses are currently lower-margin businesses for the most part -- with the exception, of course, of advertising -- they are still relatively new and hold great promise for revenue growth and operating margin expansion in the future. We also plan to significantly increase our focus on leveraging our cost structure and driving productivity. We've always been disciplined about our cost structure, but in 2008 you will see a greater emphasis on both operating smarter and more efficiently.

In closing, I continue to be extremely impressed with the achievements of our entrepreneurial community of global users, and our now nearly 15,000 employees around the world. We are on an exciting journey, and I believe that we will continue to make history together.

Now I will turn it over to Bob for a closer look at the numbers.

Bob Swan

Thanks, Meg. Today I'll discuss our Q3 financial performance, along with our outlook for the fourth quarter of 2007. During my discussion I will reference our earnings slide presentation, which accompanies the webcast. Overall, we're very pleased with the financial results we posted in Q3. Our results reflect strong top line growth, even stronger non-GAAP earnings growth, and excellent free cash flow. We continued our share repurchase program in the quarter, buying back $500 million of eBay shares in Q3, and $2.8 billion since we launched our initial repurchase program in July of last year.

Although we're disappointed with the impairment charge we took in the quarter, we still believe that Skype has great potential.

With strong financial performance in each of the first three quarters of the year, we approach the remainder of the year focused on the execution of our business plan and confident in our ability to deliver strong full year revenue and earnings growth.

In total, our combined businesses generated record net revenues of $1.9 billion, a 30% increase over last year. Organic revenue growth, excluding acquisitions and FX was 23%. The growth was driven by an acceleration of Marketplaces international GMV-based revenues, another extremely strong performance from PayPal Merchant Services, almost triple-digit growth from Skype, and continued traction in some of our non-GMV businesses, such as advertising and classifieds.

Non-GAAP EPS was $0.41 for the quarter, a 59% increase from last year and $0.08 above the top end of our guidance range. This was primarily driven by operational out performance, which we mostly reinvested back into the business, a lower tax rate, including $0.04 from a one-time tax asset, and translation benefits resulting from a weaker U.S. dollar.

In the third quarter, we generated $510 million of free cash flow, an increase of 32% above last year's level. This outstanding growth was driven primarily by earnings expansion, coupled with a year-over-year reduction in CapEx as a percentage of revenue.

Now let's take a closer look at our segment results for the quarter. Overall, our Marketplaces business had a very good quarter, with strong top-line growth and profitability. The Marketplaces segment achieved net revenues of $1.3 billion, an increase of 26% over the year-ago period. Global GMV was $14.4 billion in the quarter, a 14% increase over last year. Approximately 51% of revenue and 53% of GMV came from our international markets.

Now let's walk through some of our key operating metrics. eBay Marketplaces added nearly 7 million confirmed registered users in the quarter, bringing the total user base to 248 million. New listings totaled 556 million in the quarter, a decline of 5% versus Q3 last year, with core listings down 3% and store inventory listings down 14%. New listings totaled 254 million in the U.S. and 301 million internationally.

U.S. GMV grew by 10% over last year to $6.7 billion, a similar increase to last quarter. Core listings increased modestly, while much of the growth was fueled by increases in conversion rates and ASPs due to higher quality inventory listings on our site.

International GMV grew by 17% year over year to $7.7 billion. Excluding benefits from foreign exchange, international GMV grew by 10%; a 2 point acceleration sequentially on an FX-neutral basis, primarily driven by strong a conversion rate and ASP improvements in our German business. France and Italy, which are at earlier stages of development, continue to be strong contributors to our overall European performance.

In Asia, we're pleased with the progress we're making in Korea, as year over year revenue growth accelerated nicely in Q3 following last quarter's acceleration of GMV growth. We are increasingly confident that these results demonstrate the initiatives we've introduced in Korea over the past year or so are resonating with consumers in that market.

In Australia, listings and GMV growth rates accelerated nicely and in China, our joint venture with Tom Online is off to a good start, as our new site went live in Q3 and listing levels are already higher than they were prior to the joint venture.

Let me give you some additional color on the wide gap between the 5% decline in new listings and our 26% growth in Marketplaces revenue. The influences causing the diversions are twofold. First, GMV grew significantly faster than new listings. Second, revenue continues to grow much faster than GMV. The gap between listings and GMV growth is driven by several factors. First, we no longer include listings from our joint ventures in China and Taiwan; this, plus our recent acquisition of StubHub accounted for approximately 5 points of the difference. Second, improved ASPs and conversion rates accounted for approximately 10 points of the difference. Third, FX drove the remaining 4 points of divergence to total GMV growth of 14%.

The gap between our GMV and revenue growth is also driven by several factors. First, continued strength in our non-GMV businesses such as Shopping.com, Rent.com, classifieds and advertising, contributed 4 points of growth on a year-over-year basis. Classifieds continues to exhibit hyper-growth characteristics, and advertising continues to gain significant momentum on our sites. Overall, our advertising and other revenue within Marketplaces increased 67% over last year, accounting for 4% of Marketplaces revenue in the quarter.

Second, StubHub, which receives a higher take rate than our eBay Marketplaces, as well as our joint ventures in China and Taiwan where we no longer recognize local GMV or revenue due to our minority interest, drove approximately 5 points of the differential. Finally, the revenue shift in vehicles to non-GMV based formats such as classifieds and dealer subscriptions, as well as pricing actions we've taken in the last 12 months drove the remaining 3 points of growth.

So in summary, our Marketplaces business performed well this quarter. We continue to invest in significant enhancements to the buyer experience, and we'll continue to conduct pricing tests on our various sites as we go forward to better understand how we can optimize growth rates in our marketplace.

Now let's turn to our payments business. PayPal posted another strong quarter with total revenue coming in at $470 million, a 35% increase versus the same period last year. This quarter's performance once again underscores the progress we're making in our efforts to accelerate the ubiquity of PayPal on the web by increasing penetration on eBay and expanding our global footprint beyond eBay.

Total payment volume in the quarter was $12.2 billion, representing 34% year-over-year growth, the second quarter in a row of growth acceleration. TPV grew by 27% in the U.S. and 49% internationally. TPV growth continued to benefit from our ongoing geographic footprint expansion, with international TPV accounting for 34% of the total, compared to 31% in 3Q'06, primarily driven by the tremendous strength in Merchant Services.

In terms of key operating metrics, PayPal added nearly 11 million new accounts in the quarter, ending Q3 with 164 million total accounts. On our eBay platform, PayPal's global TPV grew by 18% year over year. TPV growth was fueled by increases in GMV, coupled with an increase in global penetration rates to 61% of addressable GMV, up from 58% last year.

The on eBay platform, PayPal's Global Merchant Services business recorded another phenomenal quarter, generating $5.4 billion of TPV, representing a 61% year-over-year growth and marking a second straight quarter of acceleration. We continue to attract top online retailers to our platform, and we're extremely excited about the traction we have gained. We also launched PayPal PayLater in the quarter, a new transactional credit offering that we believe could accelerate future volume.

PayPal's Q3 transaction expense was 1.15%, 8 basis points higher than the year-ago period, and 3 basis points higher than last quarter, primarily due to growth in new PayPal customers, who initially tend to favor credit card over bank and store balance transfers.

PayPal recorded a transaction loss of 25 basis points this quarter, a 10 basis point improvement from the year-ago quarter and 4 basis points lower sequentially. However, 9 basis points of the loss rate improvement was due to a change in estimates related to chargeback loss recoveries.

In summary, PayPal had another great quarter and it continues to be one of the key drivers of our companywide growth. We continue to make significant investments in order to extend our leadership position in the online payment space, and we believe the strong growth we've experienced in recent quarters confirms that these investments are beginning to pay off.

Now let's turn to our communications business. Skype enjoyed healthy growth in the quarter, posting total revenue of $98 million, an increase of 96% over the year-ago period, while delivering a third consecutive quarter of segment profitability, excluding the impairment charge, which I will discuss in a moment. Skype's total registered users grew to nearly 246 million, representing an increase of 81% over last year. Geographically, all three major regions: Europe, North America, and particularly Asia, exhibited robust growth.

We remain less pleased with user metrics, with Skype Sky minutes at 6.1 billion during the quarter, down 8% compared to last year, and Skype out minutes at 1.4 billion, an increase of 25% versus last year. As we announced several weeks ago, we agreed to pay approximately $530 million to settle all future obligations under our earn out agreement with certain Skype shareholders.

In the third quarter, we took an impairment charge for the $530 million earn out, plus an additional $900 million to writedown Skype goodwill on our books. Reflected in this writedown is the fact that Skype has yet to achieve some of the milestones we had hoped for at the time of acquisition. But, we still believe that this young and fast-growing company has great potential. We will continue to focus our efforts on engaging our rapidly-growing Skype user base and expanding our product and feature set.

Now let's take a look at how business unit performance translated into non-GAAP financial results. As I indicated earlier, eBay delivered record net revenues of $1.89 billion, up 30% year-over-year. Acquisitions we made over the last four months contributed nearly 4 points to our top line growth, and FX contributed an additional 4 points. This top line growth, coupled with a lower share count from our share repurchase program and lower tax rates driven by our increasingly global footprint, including the onetime benefit I discussed earlier and a weaker U.S. dollar drove EPS expansion from $0.26 to $0.41, a 59% increase versus Q3 '06.

Operating margin came in at 31.4% in Q3, 70 basis points below last year's level. The decrease in operating margin was attributable to a negative mix shift as PayPal and Skype, our lower-margin businesses, grew fastest; as well as additional investments across all of our businesses, partially offset by operating leverage, productivity improvement and foreign exchange.

Let's take a look our operating expenses in a bit more detail. Sales and marketing expense was 24.5% of revenue in the third quarter, a 50 basis point improvement from the year-ago period, as we leveraged our technology and benefited from a positive mix shift from faster-growing PayPal and Skype.

Product development expense was 7.6% of revenue, 60 basis points higher than a year ago. The increase is primarily related to product enhancements at PayPal, as well as enhancements to the buyer experience in Marketplaces.

Lastly, G&A expense was 13.6% of revenue, down 110 basis points year over year as we continue to leverage our existing G&A infrastructure. Collectively, these factors translated into $593 million of non-GAAP operating income, up 28% on a year-over-year basis; and non-GAAP net income of $564 million, up 53% from last year.

We ended the third quarter with nearly $4.4 billion in cash, cash equivalents and investments, an increase of $600 million from the end of last quarter. We generated $620 million of operating cash flow in the quarter, while CapEx was 6.3% of revenue, resulting in $510 million of free cash flow generation.

Proceeds from stock option exercises, equity gains and other items added approximately $600 million, and we repurchased approximately $500 million worth of eBay shares in the quarter.

Let me remind you that the $530 million payment related to the Skype earn out took place in early Q4, so it didn't impact our cash flow statement in the third quarter.

With that, let me turn to our non-GAAP guidance for Q4 and the full year. Now that we have a strong third quarter behind us and some decent momentum heading into the all-important holiday season, we're raising our guidance for 2007. We're increasing our revenue guidance to a range of $7.6 billion to $7.65 billion, an increase of approximately $250 million from our previous guidance, partially due to good execution in the third quarter, and partially due to FX benefits.

We're increasing our non-GAAP EPS to a range of $1.47 to $1.49, $0.12 higher than our previous guidance at the midpoint. Our increase in EPS guidance includes $0.03 of Q3 operational out performance, of which we reinvested $0.02 back into the business; $0.05 from a more favorable than previously expected full-year tax rate; $0.04 from a one-time tax benefit in the third quarter; and a $0.02 benefit in the back half of the year from foreign exchange.

We continue to expect full year '07 operating margins of approximately 33%, and we are raising our free cash flow forecast to $2.05 billion on full year CapEx in the range of 6.5% to 7.5% of revenue. Our revised guidance assumes a full-year non-GAAP tax rate of 21% to 21.5%.

Specifically for Q4, we expect net revenues in the range of $2.1 billion to $2.15 billion, representing a year-over-year increase of 22% to 25%. This expected deceleration from recent quarters is primarily a function of more difficult year-over-year comparisons. We expect non-GAAP EPS to be in the range of $0.39 to $0.41, equating to a year-over-year growth rate of 30% at the midpoint. Fourth quarter guidance assumes a U.S. to dollar euro exchange rate of $1.38.

As Meg mentioned earlier, we won't provide earnings guidance for 2008 until next January. However, I want to give you a glimpse into how things are shaping up in our view. On the positive side, we're building some decent momentum as we exit 2007 and head into 2008. We believe we're starting to see some benefits from the investments in our core business.

In addition, the rapid growth trajectory we've experienced in PayPal and Skype will likely continue. We believe our newer formats, such as Classifieds and StubHub, as well as newer methods of monetizing our traffic such as advertising will continue to gain momentum next year. Finally, we believe we'll continue to benefit from economies of scale and productivity improvements.

We'll also face some operating margin headwinds entering 2008 as the competitive environment continues to intensify and our investments in growth opportunities accelerate. First, while the Marketplaces business will have a very strong 2007, we need to accelerate the pace of change. Our efforts around products, trust and safety and pricing are helping, but we'll need to do more, do it better and do it faster in 2008 in order to accelerate GMV in our largest markets. This will require investment.

Secondly, the rapid growth of PayPal and Skype, our lower margin businesses, will continue to put pressure on operating margin as the mix of our business continues to evolve and diversify.

Third, PayPal Merchant Services and PayPal PayLater have great opportunities ahead, and we'll likely accelerate investment there in order to build ubiquity and adoption.

Finally, we believe we may have monetized Skype a little too early and a little too much these past few quarters, and we'll be likely to reinvest some of those profits to stimulate user activity in 2008.

In summary, we believe our Q3 results mark another quarter of strong performance, and we're focused on execution as we approach the most important shopping period of the year. Once we have the holiday season behind us, we'll know much more about our approach to 2008, and look forward to updating you in January.

Now we'd be happy to answer your questions.

Question-and-Answer Session

Operator

Your first question comes from Shawn Milne - Oppenheimer.

Shawn Milne - Oppenheimer

Thank you, and thanks for taking my question. Meg, you talked a little bit about the early success in Best Match. Can you talked about the rollout plan? It looks like what we've seen so far has been more commodity or UPC-based categories, and if you can just give a little more color around what you're seeing in conversion rates, that would be very helpful. Thank you.

Meg Whitman

Best Match, you're right. We have started in categories that have good catalogs associated with them. Whether that's books, movies and music, consumer electronics, things that have basically ISDN numbers associated with them. Those tend to be more commodity-oriented items than unique items like collectibles or used products.

What we've seen is that we can get people to the item they're looking for faster, make it easier for them to look at a smaller number of listings as opposed to page after page of listings, and we are seeing some positive early results in conversion rates. So we will continue to roll that out across categories as we head into 2008.

I don't believe there's going to be much more rollout in 2007 because we pretty much put a moratorium on the site for the holiday season. But we're encouraged, and you'll see the pace of change accelerate more rapidly in the first quarter of 2008.

Operator

Your next question comes from Scott Devitt - Stifel Nicolaus.

Scott Devitt - Stifel Nicolaus

Thank you. I'm trying to better understand the long-term margin structure at PayPal, given that Merchant Services is now about 44% of the total payment volume. I'd be interested if you could provide some more details on Merchant Services specifically? What I'm interested in is possibly the domestic/international split of the payment volume, possibly the operating margin structure of Merchant Services versus PayPal on eBay.

Then if you could just expand on your disclosures in the last 10-Q related to direct contribution margins for PayPal. It seems like that's gone from 26% last year to 18% from the last disclosed numbers. Again, just trying to understand the margin structure of that business as Merchant Services grows over time. Thank you.

Bob Swan

What we've seen over the last several quarters in the acceleration of PayPal growth is primarily driven by the traction we continue to get from Merchant Services, both here domestically and specifically, internationally. So Merchant Services is becoming a much bigger piece of the overall PayPal business.

We said a year or so ago the long-term operating margins for our PayPal business we believed would be in the 20% to 25% range. What that entails is continued accelerated growth in Merchant Services and improving penetration on eBay, over time.

What we've experienced in the short term with rapid growth is our customers have a tendency to use credit cards in their initial early adoption of PayPal. The less we know about consumers, all else equal, the higher the fraud losses. So in high growth periods -- which Merchant Services are in -- our transaction expense and our fraud losses have a tendency to be higher. That's what we've been experiencing over the course of the first couple quarters this year in the transaction margins on PayPal.

We believe over time, as customers mature in their uses of PayPal, what they have done is adopted more ACH methods of payment that enhances margins. As we learn more about them, our fraud models are more effective in detecting potential fraud.

So all that means is we feel great about PayPal's growth. We feel even better about the traction we're getting in Merchant Services. Long term, operating margins in PayPal we believe to be in the 20% to 25% range.

Operator

Your next question comes from Jeffrey Lindsay - Sanford Bernstein.

Jeffrey Lindsay - Sanford Bernstein

Can we get a little bit more detail on the increase in product development costs? Specifically, what was the nature of the rise from 7% to 7.6%?

Secondly, possibly a related question. Do you have plans to possibly go to an open platform to improve R&D cost performance?

Bob Swan

I'll take the first part. In terms of product development, we've been talking about continuing to accelerate our product efforts, and Meg walked you through a lot in the introduction, particularly on the Marketplaces or eBay side during the course of the quarter. This has been a constant theme for us to put a little more into product, and a little bit less into marketing to improve the user experience. So the results of a lot of that investment went via the site in this quarter.

In addition to that, PayPal, we've continued to invest in building out its global product footprint and make its underlying infrastructure a little more agile to support its increasing growth. The combination of those two things are what's driving up the R&D expenses as a percent of total.

Meg Whitman

Interestingly, our development capacity has actually expanded faster, because not all of the development capacity has been added here in the United States. So while 7% went to 7.6%, our capacity actually increased much more dramatically. I think we're really pleased by the way we're handling product development expansion across the company.

With regard to open platforms, we have had, I would say, moderately open platforms on eBay for many years. We have had a robust suite of APIs. But there is more work to do around these open platforms. The thing that obviously we always have to be focused on is on the PayPal side, we handle people's money. So our tolerance for risk, our tolerance for fraud, is lower than it is in almost any of our other businesses.

The same is somewhat true for eBay in that we are a target for account takeovers and other things. But that said, we have watched what is going on in the marketplace with open platforms. We are committed to, over the next couple of years, opening up our platforms more so that we can get other people to do some of the R&D and some of the new, fun niche features that would be welcomed by our users.

So, thanks for that.

Operator

Your next question comes from Anthony Noto - Goldman Sachs.

Anthony Noto - Goldman Sachs

Thank you very much. Bob, on slide 8 of the slides you provided the conversion rate and ASP contribution of 10%. Meg, you talked about rolling out some of these new initiatives that are adding conversion rate. Do you think you can maintain that year-over-year growth rate of 10%, or do you think it's in the low single-digits? Where do you think it goes? The combination of really just implementing some of the technology to drive conversion rates higher as opposed to just pricing mechanisms?

Meg, you're lowering fees through November 5th by about, I think you said, 33%. Obviously your revenue guidance is higher. So I was wondering how you're really funding that? Do you think you get incremental volume against the lower revenue per listing on the front end? Thanks.

Bob Swan

I'll start, Anthony. I think a couple things; first, what we saw happen during the course of the third quarter is continued improvements in conversion rate and ASPs virtually across all of our markets. What we anticipate happening as we go forward into Q4 is the year-over-year comps related to listings will become cleaner. We expect to see some listings growth as we enter Q4. We're expecting conversion rates to hold, and they're holding off some relatively tough comps from fourth quarter last year.

We do however expect ASPs to decline. There's a couple of dynamics that we think will drive that decline. One is the absence of, you may remember last year's fourth quarter had some high ASP consumer electronics products that really drove an increase in ASPs. We don't anticipate that kind of increase in ASPs this year. As a matter of fact, we anticipate them coming down.

Secondly, we're driving more velocity in the lower tranches, and in the lower tranches with lower average selling prices. The combination of those two have conversion rates holding but ASPs likely declining in the fourth quarter.

Meg Whitman

Anthony, let me take your question about lowering fees. We've done a lot of pricing tests over the last 12 months, but this is the single biggest pricing test we have ever run in terms of decreasing insertion fees for a sustained period of time. The truth is, we don't exactly know how this will work. But we expect listings to increase; we except successful items to increase; we anticipate perhaps ASPs will go down, as Bob said. What the result is on revenue, we don't know. We've taken our very best guess and we've factored that into our fourth quarter results.

So suffice it to say that if we hadn't done this pricing test, revenues might have been higher. But we really do not know. Part of this test is actually to get some real-world data on a pretty significant decrease in our insertion fees.

And we wanted to get a fast start to the holidays for our sellers. As I said, it is through November 5th. So this is the same price reduction. I actually think this is going to turn out well for us, but we have factored that into our guidance. I would say we have been appropriately conservative in factoring that into our guidance.

Operator

Your next question comes from David Joseph - Morgan Stanley.

David Joseph - Morgan Stanley

Thank you. Mary and I have just one question. It seems that eBay is pretty well-positioned for the holiday season right now. You've seen the quality of goods improve pretty dramatically on the site. You're improving the user experience. We certainly like the Snapshot, and we're looking forward to the new checkout, though it doesn't sound like you're going to be getting that out before the holiday season.

But it seems that now really the focus is on the bidding activity. You're getting maybe perhaps some inactive buyers back to the platform and have a new and improved experience. To that end, I guess, all eyes would be a little bit on the marketing campaigns that you launched in mid-September. You said that the initial results were somewhat positive. I am wondering if you could provide a little bit more color on that? But also, give us a little bit more of an idea of what other marketing you might be doing to attract or drive activation or activity?

Meg Whitman

Sure. I think you're right. I think we have good plans for the holiday season, not only in the U.S. but also in Germany and the UK, as well as most of the eBay countries around the world. Inactive buyers are certainly a part of that campaign.

With regard to these integrated marketing campaigns, and I would say they're better integrated than they have ever been before , the feedback that we've gotten from our community of users is very good. Our community of users likes these campaigns and that's important, because when they like the campaigns, they tend to be more involved with the site. Most of the marketing just started in mid-September, so it's a little early to tell. But if you look at the early results, I think, we feel pretty good about it.

The marketing campaigns also have some new features; catalogs every month, and also more couponing. Now that most of the listings on eBay.com offer PayPal, we can actually effectively utilize couponing which is a traditional holiday season marketing tool that we've not really been able to use in the past.

So I think we are well-positioned. I think we've got a great campaign in place across our countries, and we'll see how it works out.

Operator

Your next question comes from Ben Schachter - UBS.

Ben Schachter - UBS

Looking at the percentage of revenue, or percentage of GMV that's coming in at fixed price, I'm wondering if there's an optimal number that you're looking at there? Within the context of how you look at the Store versus Core, and how there were some structural disruptions. Is there any chance that you think the percentage of GMV that's fixed price, can that get to a point where there will be structural problems with the business?

Meg Whitman

Our objective is to follow the user. This is a marketplace, and we want to do what the users want to do; what the sellers want to sell, and what the buyers want to buy. But one of the keys to fixed price is our finding product, or Best Match. Because what happened to us last year is we added a whole host of fixed price listings, and the search or find capability was not up to sorting through this vast number of increased and not particularly well-priced inventory. That created some of the user experience issues that we had last year.

So it's actually not about the format; it's about the finding metaphor that has to keep up with fixed price. So I think we're better positioned than we've have been in that regard, and I think we're also very pleased with the Stores vibrancy. We still have well over a quarter of a million stores in the U.S. and that continues to grow. Our ProStores product hit an all-time record last week in terms of the number of stores.

So the net-net-net is I think, you're going to see a higher percentage of our GMV in fixed-price. I think it's the fastest-growing part of the market. We can now cope with it from the finding metaphor point of view.

Operator

Your next question comes from Mark Mahaney - Citigroup.

Mark Mahaney - Citigroup

Thank you very much. One question on Skype and one on Germany. On Skype, you made comments about monetizing Skype too early. Were there specific things that you're referring to there? What were the initiatives that were monetized too quickly? Last quarter I think you had said that German GMV growth was up mid single-digits. Is there a specific update to that, or was it roughly up that same level again this quarter? Thank you.

Meg Whitman

With regard to Skype, when the earn-out incentives were in place, because two of the three metrics were financial metrics -- revenue and gross profit -- there was a lot of incentive to monetize this user base really fast. Whether it was the call setup fee, whether it was the rates that we charged SkypeOut and SkypeIn, I think we dialed that up too fast given that the value proposition for Skype in the early days was, you can talk for free.

So I understand why it was done. I think it was done too early with not as much focus on delighting the user, whether that was simplicity of UI, whether that was customer support. You're going to see us back off some of that monetization a little bit to continue to delight the users.

Bob Swan

In terms of Germany progress during the quarter, we saw GMV acceleration from Q2 to Q3 on an FX-neutral basis. As Meg indicated, we saw some decent growth in listings, conversion rates, and ASPs continued to improve during the course of the quarter. The combination of those three things resulted in acceleration of GMV.

I would say that we also had relatively speaking, some easier comps. Because you'll remember last year we talked quite a bit about the World Cup. The comps on a year-over-year basis were a little bit easier this year. But modest listings growth, improved conversions and ASPs; that is accelerating GMV.

Meg Whitman

One last point on Skype. I think the other thing is we over-monetized a bit, but I also think we dropped a bit too much profitability to the bottom line, because the team wasn't focused on how we could actually utilize this, if you will, excess profitability to drive user engagements. I think that was the nature of an early-stage team that is going to end up needing to spend a bit more money on marketing and user engagement.

So it may be that we over-monetized a bit. I think we probably, better said, dropped a little bit too much money to the bottom line for this stage growth of the company.

Operator

Your next question comes from Heath Terry - Credit Suisse.

Heath Terry - Credit Suisse

I just wanted to dig a little bit deeper on the decision to lower insertion fees. I am curious as to what's really motivating that. You've seen such strong improvement in ASPs and conversion rates following the fee increases. I'm wondering if you're beginning to feel like there's not enough inventory on the site, or there's just not a broad enough representation of product going into the holiday season that we've gotten to the point that we need to encourage more listings?

Meg Whitman

I think there are a couple of factors at work. One is we want to make sure that we have great breadth of inventory --and high quality inventory -- on the site for the holiday season so we wanted our sellers to get off to a fast start. That's why we made the decision to lower prices for such a sustained period of time.

The other thing is we want to see what happens when we take a price decrease of this magnitude. What is the listings elasticity? What is the conversion rate? What is the nature of what we do here? I think the learning over the last 12 months, let me speak for myself personally, is we have a number of different levers to pull. We've got product levers, we've got marketing levers, we've got customer support and trust and safety levers and we have a pricing lever that we have not ever really decreased price. It is possible that by decreasing price, we actually increase the revenues and vibrancy of this market in such a way that this price decrease is more than self-liquidating.

Now, I don't know that that's going to happen. But we were very much in favor of saying let's see what happens when we take a pretty significant sustained decrease in insertion fee in our largest market. Let's see what happens there. It may well be better for sellers, and interestingly there, better for buyers. We may end up with a win-win. But we will see, and we will report back in the first quarter.

Operator

Your final question comes from Victor Anthony - Bear Stearns.

Victor Anthony - Bear Stearns

First on category pricing. I know you've been testing that in the UK, or you plan to do so, I think next week. Wonder if you could talk about what's influencing that change? When do you plan to move that over to the U.S.?

Second, one more question on the rationale for the insertion fees. I wondered how much of that decision was influenced by the competitive landscape, and in particular Amazon? Thanks.

Meg Whitman

On category pricing, actually a number of countries around the world have done category-based pricing. Germany had pricing scenarios on tech and consumer electronics. They have a toys-based category pricing coming in for the holiday season. The UK, you mentioned, has had differential pricing on a number of categories. I think apparel was one.

I think that differentiated category pricing may be in our future. As you think about it, our sellers have very different margins on whether it's a watch, or whether it's a piece of apparel, or whether it's a very competitive consumer electronics; high price or low price. So again, we're learning. One of the great things is we have laboratories around the world that we can test this strategy. So I suspect that category-based pricing may well be in our future.

With regard to competitive dynamics, actually the cost of selling, the total all-in cost of selling on eBay is extremely competitive versus anyone, including Amazon. The mix of fees around the world can be different, where there are virtually no insertion fees and much higher value fees. So one of the things we are testing is what does a reduction in the insertion fee do? How does that play out?

I wouldn't say it was necessarily competitively driven; it was, let's take a look at the entire market dynamic. It's 12 years since we launched this marketplace, and let's really take a big, bold experiment that we've never done before and see what happens to the overall vibrancy of the market.

I think that's it. Thank you very much, and we look forward to talking to you next quarter.

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Source: eBay Q3 2007 Earnings Call Transcript
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