eBay (NASDAQ:EBAY) results were out last night. Overall the results were solid and progressive.
But shares were down 8% in After-Hours trading... Why?
eBay shares have had a big run up this year. The shares traded at $25 for the first half of the year and then jumped nearly 30% to $32. The market became over optimistic on eBay's strategy. The company is currently trying to shape itself into a more "Amazon-like" market and sharpen up its online image but progress is very slow. The market obviously loves this story, particularly since eBay trades at good value on a fundamental basis and because eBay has a credible shot of living with Amazon (NASDAQ:AMZN) in the online market space.
But whilst the story and aspiration are great, evidence of execution is far less so. If you listen to the earnings call, there is lots of talk about small, incremental user testing of its new site using "structured data" but little of substance on a launch date and results of said tests. Managing change can be risky particularly when it involves changing well-established daily routines that buyers and sellers are fluent in. If it ain't broke, don't fix it.
While these early results give us continued confidence in our strategy, our new pages are currently being exposed to a very small fraction of our traffic. The majority of our business today comes through our organic, on eBay search funnel. Over time we expect to start introducing these new experiences to our organic traffic. Now while we're moving at an urgent pace, you can expect us to take an intelligent approach to this transition to ensure that we don't disrupt our customers along the way.
Devin Wenig, President and CEO of eBay Inc
The impatient money has decided to book a great gain and leave the table but that doesn't mean they won't come back.
eBay is Still Great Value
eBay trades at a discount to its market price. Prior to last night's news, I pegged eBay Free Cashflow ((NYSE:FCF)) at $2.2B. Assuming a perpetual 3% growth rate and 8% discount rate I was getting a Discounted Cashflow Value of $42B. eBay has a solid balance sheet with Total Liabilities as of June 30th $4B more than Current Assets. My fair value estimate was $38B and the market cap was $36B. About a 5% discount. Not a wide enough margin of safety given my valuation is quite rough and ready.
My obsession is Free Cashflow and eBay is delivering on this front. Q3 2016 FCF was up 34% to $617B on Q3 2015 Free Cashflow. Over Q1-Q3 of 2016 eBay has booked $1.7B in just 9 months. In Q4 2015, eBay booked nearly $1B in FCF and this seems likely to recur since eBay management guided that Q4 2016 Sales will be in the same range as Q4 2015. As such a very credible bet exists that eBay will hit FCF of $2.7B for 2016. My discounted cashflow estimate of $2.7B to grow perpetually at 3% on a hurdle rate of 8% is $51.5B.
On the balance sheet side (my second obsession), Current Assets are again $4B in deficit to Total Liabilities.
So my fair value estimate is $47.5B. Given eBay's closing market cap of $36B I believe the stock is 25-30% undervalued. I like this margin of safety. My valuation could well be wrong but at least it can afford to be 25-30% wrong. I like those odds.
Rationalizing the eBay FCF resilience
My valuation is very much built on sustainability of the Free Cashflows into the future and growing those Free Cashflows. I believe a DCF model is very appropriate for eBay because it has a massive moat. It is very difficult for competitors to emulate the eBay buyer-seller network. It has taken eBay nearly 2 decades of graft to get where it is. And an upstart would have to spend massive marketing on not just attracting buyers but also sellers. Creating a marketplace is not a normal business. You don't just spend marketing on attracting customers (or buyers) like normal businesses. You need to also attract the sellers to make the market place work.
Some may point to Amazon as a potential disruptor to eBay, but Amazon has always been a competitor and this hasn't stopped eBay. I just cannot see what will disrupt eBay's FCF into the future. I believe its revenue base is very sticky and highly diversified.
As a relative comparison, it's worth thinking about the Intel (NASDAQ:INTC) business which also has a big Free Cashflow yield. Intel had a big fall yesterday on its earnings but I had limited interest in buying. Intel is engaged in a continuous battle of "creative destruction capex" to keep relevant. eBay doesn't have that problem in my opinion. Its business will continue chugging out FCFs with very little capex. The Intel Capex to Operational Cashflow ratio is about 50%, whereas eBay's is about 25%. I'd need to see Intel fall further to buy it.
Finally eBay's Free Cashflows are not going to be dramatically unhinged by a big move in interest rates, currencies or oil prices. Sure there will be some impact but it will be immaterial to the eBay business. The Free Cashflows of eBay are not a temporary mirage or subject to major cyclical volatility (in fact, I believe more people shop on eBay in a recession). Sure the market may get over or under excited from time to time about future prospects but just keep an eye to the cashflow to derive value.
It's one thing having lots of FCF but not much use to the investor if the company doesn't return it to me or invest it better than I can. eBay is buying back stock at a massive rate. It has repurchased $2B worth of shares YTD. $2.5B worth of buyback seems reasonable for 2016. Looking at estimated FCF of $2.7B for 2016, we can see eBay is returning most of its Free Cashflow to shareholders. The buyback yield stands at a very respectable 7%.
eBay has also signed an agreement to sell its stake in MercadoLibre (MELI ... the "eBay" of Latin America). Here's more from the earnings call on the sale:
It will be about $1.2 billion of gross proceeds and about $700 million to $800 million of net gain. If the shoe exercises, that'll be an addition to that. This is a Q4 event and we're working through the U.S. and international tax implications of this.
So investors can expect at least another $1.2B of cash in Q4 net of taxes. eBay will continue to hold a small residual stake in MercadoLibre but at the option of Mercado. The CEO made it clear that a dividend will not be initiated from this windfall.
Given its history of success with Paypal, Mercado Libre, StubHub, Classifieds and its return of Free Cashflow to shareholders via buybacks, I believe eBay is an excellent partner to invest with and an excellent steward of capital.
And let's not forget that if eBay can pull off its structured data strategy then there could be a lot of organic upside in the next year or two. If it doesn't so what. eBay will still generate lots of Free Cashflow. Downside is limited. This is the type of investment I like.
I have been following eBay for a while now and have been kicking myself that I didn't invest around Brexit time. The exercise of writing on Seeking Alpha about eBay has been a real pleasure for me because I now realize eBay is a far better prospect than I was giving it credit for. A rarity. I suspect I will open up a position soon. I love sustainable, high yielding FCF businesses like eBay. I am even more impressed by the high level of FCF return to shareholders. My only decision is do I wait for Microsoft (NASDAQ:MSFT) and Paypal (NASDAQ:PYPL) to report tonight. I am big fan of both these names too.
Disclosure: I am/we are long PYPL, MSFT.
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.