The Better Business: Why eBay Is Underperforming but Still a Buy

Source: Thinkstock

Source: Thinkstock

On Wednesday eBay (NASDAQ:EBAY)—owner of the largest online auction house and online payment system PayPal—reported its second quarter earnings. The company reported strong revenue growth of 13 percent and its earnings per share grew to an adjusted $0.69/share or $868 million, or 9 percent, on strength in all of its segments. This is in spite of the fact that the company’s stock has been relatively weak for the year—down 8 percent while the S&P 500 is up 7 percent. Due to this weak performance the company stepped in to repurchase $1.7 billion worth of stock.

In all these are very strong numbers, and yet the stock trades at a discount to its peers in the e-commerce space—notably Amazon (NASDAQ:AMZN)—and in the S&P 500 more generally. Going forward the company trades at just 15 times next year’s earnings estimates, and the strong growth we have been seeing indicates that the company should have little trouble achieving these results.

Why, then, is the company underperforming, and is there an opportunity?

The underperformance can be attributed to a couple of factors. The first is that investors are simply more interested in owning other stocks in similar sectors. For instance in the e-commerce space investors want to own Amazon shares despite the fact that Amazon’s profits are minimal. Investors are convinced that Amazon will someday convert its 20 percent+ revenue growth into earnings growth, and they would rather invest there. Meanwhile eBay continues to generate strong cash-flows and earnings, that continue to grow, and this gives it capital to both expand its businesses and to reward long-term shareholders with stock repurchases. In this respect Amazon may be the faster growing and dominant player in the e-commerce space, but eBay is by far the superior business from an investment standpoint.

The second reason is that competitors are entering the online payment business and as a result PayPal appears to be less attractive. So while PayPal is growing at over 20 percent per year investors see this growth slowing, and by extension they believe that the company’s total growth will decline. Although this is a well-founded concern we should keep in mind that company’s such as Amazon and Visa (V) are late to the game, and while they may make some inroads into this market they will likely be unable to put a dent into the well-established PayPal brand, and I suspect that it will continue to drive eBay’s growth going forward.

In all if we look at eBay’s businesses they are not just growing, but they are cash-flow machines. Keep in mind that eBay doesn’t sell anything. It merely provides the platform for other companies and individuals to sell things and to make payment to one another, and it collects a fee every time. Thus the company has very few expenses other than customer service and software development. With this in mind, I think eBay should be trading at a premium to the broader stock market, which is filled with companies that have to compete with one another on price and which generate thin profit margins and minimal returns on shareholder equity.

With this in mind I think there is an opportunity in eBay shares, although investors may not realize it until a couple of things take place. The first is that management needs to start paying a dividend that reflects the company’s ability to generate cash-flow. While this might spook some growth investors they have clearly been out of eBay shares for some time, and I think if management wants to see the share price rise it needs to generate appeal for value and income investors. The second is that management needs to put forth a growth agenda for its marketplace business, and ideally this agenda will take aim at Amazon, which is seen as the clear leader in the space.

In doing these things without compromising what makes the stock so appealing at the current valuations, I think we can see the shares begin to dramatically outperform.

Disclosure: Ben Kramer-Miller is long Visa.

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