Wednesday, October 20, 2010

eBay: Going Once...

The bidding for eBay (EBAY) shares has heated up since my June article "eBay: Buyout or Breakup?" and my purchase at $19.85 a share that same month.  Since then, the company has added over $10 billion to its market value (or about 40%).  Based on price alone, the investment case is far less clear today.

There is plenty of good news in the the third quarter earnings report.  Earnings beat expectations.  PayPal accounts and float increased significantly.  Free cash flow clocked in at $580 million for the quarter.  There were no stupid acquisitions.  Guidance was raised.  Things that make investors giddy.  The after-hours action in eBay shares proves it.

Did I mention that eBay generates tons of cash?

The company generated just over $2.3 billion in free cash flow in 2008 and a nearly identical amount in 2009.  This year's total will almost certainly be in the ballpark, not much higher and perhaps a bit lower (thanks to some working capital changes).  You can practically set your watch using their cash flow statement.  In the first 9 months of 2010, total free cash flow sums to $1.4 billion.  Not surprisingly, eBay is flush with cash (over $6 billion at quarter end) and zero debt.

In addition to a beautiful balance sheet and copious amounts of cash flow, eBay continues to own a a stake in Skype.  Why?  Who knows.  Apparently it's worth billions to someone.  I just wish eBay would take that someone up on the offer.  Dear eBay, please SELL Skype once and for all.

If there was ever a "non-core" asset, this is it.

In any case, at the current price, Mr. Market is putting a $36 billion market value on eBay (assuming overnight gains hold).  $10 billion ago eBay was clearly undervalued.  Today, it seems to have entered fair value territory.  For all the talk of growth, the cash generating fundamentals of eBay are little changed.  I'm not complaining.  And to be fair, when a company generates this much cash, it's difficult to move the needle.

Paypal's growth is impressive, but it is still a relatively small business within eBay.  While most investors point to a lack of growth in the Marketplace business, this is the division generating most of eBay's free cash flow. And growth in PayPal hasn't translated into huge free cash flow gains.  Mostly it has offset pressures elsewhere.

None of this is particularly worrisome given the absolute level of cash that eBay generates.  And a free cash flow multiple of 12 to 14 times is not exactly a ridiculously optimistic valuation.  Nonetheless, there are reasons for concern.

Shareholders should take note of the increase in shares outstanding since 2008.  If not for a $300 million repurchase in the most recent quarter, the share base would have risen again.  Even with the share repurchase, diluted shares outstanding barely fell.  This creeping dilution (and the addiction to options that cause it) is not insignificant and means that the fcf multiples above are overstated.

Below $20 a share, it was a risk worth taking because the valuation was compelling.  But now?

The media seems quite thrilled with the eBay's announcement that it plans to repurchase $2 billion worth of its own shares.  But as I've said many times before, not all share buybacks are created equal.  Some merely attempt to mask the effects of options and other dilutive actions, while others actually amount to a return of cash to shareholders.  When companies buy back billions in shares and the actual number of shares outstanding doesn't change, then shareholders are not better off.  Management is simply putting an explicit cost on the implicit cost of dilution.  The dilution that would have happened had without the repurchase.  But it is a distinction without a difference.  Shareholders are poorer either way.

Should eBay shareholders get excited about the company's recently announced repurchase program?  Here's the full quote from the Q3 press release:
The company repurchased approximately $300 million of its common stock in the third quarter. In addition, the company’s board of directors authorized an additional $2.0 billion stock repurchase program for the purpose of offsetting dilution from the company’s equity compensation programs.
Did you catch that?  I guess we're left to wonder how long that $2 billion will "protect" us.  The company is practically bragging about having cut a hole in our pocket.  Guess who's holding the bucket?  All those option holders.

Newsflash: this isn't a buyback to be proud of OR to cheer about.  Going twice...

In addition to this, I am mystified by the decision of eBay's management to issuance of "up to $1.5 billion" of debt. With $6 billion in net cash?  They say the funding would “enhance the company’s flexibility to invest in its business and make strategic acquisitions.”

Oh no, here it comes! 

Now I know most of eBay’s excess cash is overseas (thanks to huge international sales), but borrowing money (even at these rates) seems like a perfect waste of time.  Perhaps the finance department is so bored with collecting and counting all the aforementioned cash that they've decided to borrow some money just to make life interesting. 

Let's all hope they don't start throwing money at acquisitions in the pursuit of growth.  Acquisitions?  Really?  Given your track record?  Are you trying to kill the golden goose again?  We've seen that movie before.  Wasn't it called "Pie in the Sky(pe)"?  Stop it.

eBay also needs to cool it with the options.  They aren't a sexy startup that burns cash and is run out of a garage.  They can/should use actual cash instead of options instead of the sleight of hand that they are hoping nobody sees.  Pay no attention to that man behind the curtain!

They also need to accept that they are a maturing business with enviable cash generating properties.  Excess cash should be paid out via dividends and real, honest-to-goodness stock repurchases.

Until there's some evidence of this, I'll be reducing my eBay holding.  I'm bringing the gavel down after 5 months and 40 percent.  SOLD to that eBay man behind the curtain... I can seeeeee you!

Disclosure:  Long eBay.

1 comment:

  1. Nice article- I'm not a fan of the industry but I like your description of not all share repurchases being created equal... interesting that management has actually explicitly stated the buybacks are used to offset dilution. I'd sell out completely of this one myself (probably wouldn't have bought in the first place... haha).