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EBay Evolves Into a Global Commerce Hub

R.J. Hottovy, CFA

Our positive long-term outlook for eBay (EBAY) is intact following strong third-quarter results, highlighted by double-digit growth in PayPal and Marketplaces active users, impressive mobile commerce adoption rates, and modest margin expansion despite user engagement and other investments across all business segments. We believe the company remains on track to achieve its 2015 targets of $300 billion in enabled commerce volume, revenue of $21.5 billion-$23.5 billion, operating margins around 27%, and adjusted earnings per share near $4.00.

In our view, the current share price understates the long-term potential of new members, many of whom are younger mobile users with lower discretionary income at present, but also a lifetime of potential transaction growth ahead. We believe this opportunity will become more transparent when management provides its initial 2014 guidance in January. Additionally, while planned take rate cuts to stimulate large merchant growth, payment platform innovations, and offline channel expansion investments could weigh on operating margins over the next few quarters, we believe these actions will solidify eBay's network effect--the foundation of our wide moat rating--as well as its enormous channel diversification monetization opportunity in the years ahead.

Not Just Auctions Anymore
During the past 15 years, eBay has grown from a small U.S. online auction marketplace into a central commerce hub. PayPal's role as a leading online payment standard and emergent mobile presence, new innovations in the Marketplaces segment, and complementary acquisitions have reshaped eBay into a major e-commerce player for years to come. Amazon may hold the title of top destination for online shoppers today, but we believe eBay will remain an important participant in online commerce growth thanks to its growing portfolio of large retail partners, adjacent Marketplaces offerings, and PayPal's diverse payment capabilities. Additionally, eBay's broader commerce functionality, including mobile shopping applications and payment services, in-store PayPal point-of-sale tests, and PayPal's partnership with Discover, has not been fully appreciated by the market; we believe multiple expansion is possible as this potential is recognized. With one of the most capital-efficient models in e-commerce and a wide economic moat grounded in a solid network effect, eBay's role as a global commerce facilitator should translate into excess economic profits.

As a result of eBay's capital efficiency and relatively stable margins, the stock is most sensitive to changes in long-term revenue growth expectations. We believe eBay's desire to partner, not compete, with other merchants makes it an intriguing player in the evolving world of commerce. EBay has shifted away from its auction business (which represented 34% of Marketplaces volume and less than a fourth of total revenue in 2012) and reinvigorated its Marketplaces growth through new platform innovations and features to accommodate fixed-price transactions (66% of Marketplaces volume and one third of total revenue) through improved search, free shipping, and mobile applications capabilities as well as complementary acquisitions (including local shopping and private sale sites). As a result, eBay has gained traction with third-party partners in categories like fashion apparel, and we expect other categories to see a similar lift over time. Although it will take time for Marketplaces to fully shed its online auction image, we're confident that growth in fixed-price transactions will more than offset the flattish growth in auctions over the next decade. EBay will have to increase technology and marketing investments to maintain a vibrant marketplace. However, these investments should be offset by increased scale, resulting in segment operating margins that hover in the low 40s.

PayPal (about 40% of eBay's 2012 revenue) also benefits from a strong network effect. Buyers are attracted by the security and mass acceptance of PayPal, while sellers are attracted to its lower fraud rates and large user base. These benefits originally were realized on eBay, where PayPal now processes 77% of eBay's global gross merchandise volume. PayPal's opportunity beyond eBay is even greater. PayPal already is accepted by more than 60 of the top 100 online retailers in the United States and processes more than 25% of domestic online retail transactions. With more than half of the world's Internet users coming from developing countries and with low emerging-market penetration rates, PayPal also has tremendous global expansion potential. Payment volume has grown at a 24% compound annual rate the past five years--about 3 times as fast as the online retail market, according to Forrester--and we anticipate this outperformance will continue.

Additionally, PayPal's offline point-of-sale capabilities (which could eventually reach 7 million U.S. retailers--roughly 90% of all retailers in the country--through the August 2012 partnership with Discover), increasing adoption of mobile commerce (eBay mobile accounted for about $13 billion in merchandise volume in 2012, with PayPal mobile generating $14 billion in payment volume), and other payment innovations (including Zong's ability to verify and clear payments through existing wireless carriers) provide eBay with several new growth channels over the next decade. We also believe PayPal has an opportunity in extending credit to consumers, which has an additive impact on transaction margins, average annual spending levels, funding costs, and conversion rates.

The 2011 acquisition of GSI Commerce made strategic sense for both firms. EBay extends the reach of its merchant services segment (online payment processing for merchants) by adding GSI's e-commerce client base, which includes 180 retailers and brands like Ralph Lauren, Victoria's Secret, and Dick's Sporting Goods. GSI can offer its client base enhanced payment capabilities (approximately 95% of which offer PayPal and/or Bill Me Later), wider geographic reach, and access to any developing e-commerce trends. GSI expects to have more than 30 large merchants on eBay's platform in 2013, with clients' same-store sales growth consistently outpacing the e-commerce market the past several years.

Network Effect, Scale, and Investment Bolster Wide Moat
EBay's auction business is the classic example of a network effect, where the value of the network grows as the people who use the network increase. This network effect has created material switching costs and significant barriers to entry for eBay rivals, forcing several would-be competitors to shut down auction services. The network effect is not nearly as strong in the faster-growing fixed-price transaction business, but we think eBay's scale and technology investments provide competitive advantages in this channel and should preserve the firm's wide moat. EBay's strong profitability--Marketplaces' operating margins are around 40%--allows it to continuously reinvest in its technology to the benefit of third-party sellers. Superior free cash flow generation also enables eBay to invest in ways to continually drive traffic to its website.

With 137 million active accounts globally, PayPal is a leading standard for online payments. PayPal boasts more active accounts than total active general purpose U.S. credit card accounts at MasterCard, Discover, and American Express (75 million, 26 million, and 21 million, respectively), according to Nilson Report data, and was only a shade behind Visa (116 million). Including all U.S. general purpose credit, debit, and prepaid cards, Visa and MasterCard still command a sizable lead in active accounts (334 million and 140 million, respectively) and total volume processed ($2.5 trillion and $1.1 trillion, respectively, compared with $144 billion for PayPal). However, PayPal payment volume continues to grow at a much faster clip (averaging 25% annual growth in the past five years), which could accelerate following PayPal's partnership with Discover to accept PayPal's digital wallet across its existing base of more than 7 million U.S. merchants. Consumers are attracted to PayPal's convenience (multiple options to fund transactions), security (lower fraud rates), and increasing acceptance among merchants (around 10 million active sellers in 2011, including more than 60 of the top 100 online retailers in the U.S.). Merchants are drawn to PayPal for its sizable user base, closed-loop system, and lower fraud rates. Taking this all together, we think PayPal has also established a wide economic moat.

Pursuit of Revenue Growth Brings Some Risk
With traditional growth drivers like auctions nearing maturity, eBay has turned to new platform innovations, acquisitions, and overseas expansion to reinvigorate top-line growth. The company has introduced several changes geared toward fueling growth in fixed-price transactions, including modified fee structures, new search functionality, and a loyalty program. Although the company has had early success with these measures, they could also alienate eBay's loyal auction community and diminish its network effect. We believe eBay's recent acquisitions have been complementary to its core business segments, but integrating so many businesses simultaneously can be distracting to other growth initiatives. International growth brings unique challenges, as foreign governing bodies are constantly amending online commerce laws.

A constantly evolving e-commerce landscape could also be disruptive to eBay's different platforms. PayPal faces increased competition from Login and Pay with Amazon, V.me by Visa, Isis, and MasterCard PayPass. PayPal's lending arm, Bill Me Later, also exposes the company to increased credit risk, as many of its customers are subprime borrowers, as well as regulatory issues.

Additionally, eBay faces indirect competition from online search companies such as Google and Yahoo, which direct consumers to online merchants through natural and paid search.