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EBay Worthy of a Bid

Matthew Coffina, CFA
R.J. Hottovy, CFA

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by R.J. Hottovy who is the director of our consumer team and we're going to talk about eBay and their recent Analyst Day. EBay is the second-largest position in StockInvestor's real-money Hare portfolio, but even if they weren't, this is a company I'd consider buying today. EBay has a rare combination of a wide economic moat, indicating a very strong competitive advantage, as well as a positive moat trend indicating that the competitive advantage is getting stronger over time, and exemplary stewardship.

R.J., thanks for joining me.

R.J. Hottovy: Thanks, Matt.

Coffina: Could you tell me a little bit more about eBay's economic moat, the reason that it's so strong and the reason that it's strengthening over time for our viewers who may not be as familiar with the story?

Hottovy: Yeah, absolutely. I think it comes down to, this is one of our classic network-effect stocks, where essentially the more users that are on eBay, the more valuable it becomes for all users. This has traditionally been in the auction business, where the company was able to attract a wide network and a wide amount of buyers and sellers. But I think that a lot of the same things that made their auction business so successful is now translated into third-party sales on its Marketplaces. The network effect also pertains to their PayPal business where as more and more people have been accepting and using PayPal, it becomes more useful for merchants to facilitate that ability. And so, I think it really comes down to this is one of our best examples of a network effect, which tends to be one of the stronger sources of competitive advantages that we find across our entire coverage universe.

Coffina: So, the Marketplaces segment in particular really seemed to be slowing down a few years ago, but ever since John Donahoe came in as CEO in 2008, growth has really accelerated there, and then PayPal has also been really strong. But specifically with respect to the Marketplaces segment, what is eBay doing right?

Hottovy: I think you're absolutely right. They've done a great job transforming that business. Traditionally this company had been known as online auction house, and I think they've done a great job reinvigorating the image of its Marketplaces business. I think it comes down to a number of just, for lack of a better phrase, "blocking-and-tackling-type" initiatives. One being, just improving the overall search capabilities and just making the user experience that much more friendly for anybody who is on eBay. They have also increased the number of free shipping offers that are out there. They've done a great job just cleaning up the site in general. They have a lot of mobile-device capabilities that I think are starting to resonate with smartphone users.

And they've made a lot of smart acquisitions too in the last couple of years, whether it'd be allowing local companies, whether it'd be small mom-and-pop shops to integrate their inventories with the eBay system or allow for same-day delivery or even private-sale sites. I think a combination of all those factors has not only made it a more attractive destination for a lot of third-party merchants, a lot of fashion houses are using eBay more and more as a distribution outlet. But it's also become a more relevant destination for shoppers these days as well, and again, just underscoring the network effect that is the linchpin of our wide economic moat for this company.

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Coffina: And how do you think eBay compares with other e-commerce companies, and I'm thinking of Amazon in particular?

Hottovy: Yeah, Amazon is certainly a fierce competitor. And I have to say that Amazon right now is growing a lot faster than eBay is, and traditionally is the first shopping destination for most online shoppers at this point, too. But I think the one thing that gets lost a lot of times and one of the things that is misunderstood by a lot of people out there is that eBay is more of a facilitator of commerce--approximately 100% of its merchandise comes from third parties. And the company is really looking to be a partner with a lot of the retailers, whether it'd be brick-and-mortar stores or other online retailers. They are really looking to be a partner with their capabilities, particularly with respect to some of the mobile apps they have, with some of the payment capabilities they have, whereas Amazon is directly competing with the people that are on eBay's Marketplaces. Amazon has 40% of their sales come from third-party users at this point, as well. But it really comes down to I think eBay is a facilitator, where Amazon just wants to be the largest online retailer. Amazon can make some extra profit having third-party sales, but eBay is more of a champion and more of a partner with these retailers, and I think that's what makes eBay different. At the end of the day, the two companies have different business models.

Coffina: eBay's biggest growth driver is PayPal. I think there have been some concerns recently about PayPal's margins, specifically with respect to some network access fees. MasterCard, which is another Hare holding, has been considering charging digital wallet providers. Also PayPal has this partnership with Discover Financial Services, another Hare holding, regarding offline sales. It seems from the Analyst Day that some concerns were alleviated about the margin pressure on PayPal. So can you tell me some more about that, what you learned at the Analyst Day, and what it means for PayPal's margins?

Hottovy: Yeah, thanks Matt. It's a great question and certainly one that investors have been keenly focused on right now. With respect to the digital-wallet network-access fees, what we learned at the Analyst Day was that, one, I'm less concerned about it, because this is something that's going to be impacting all digital-wallet providers out there, and just because of the funding mix that PayPal has--where the consumers facilitate transactions through not only credit cards, but also funds that they have loaded up in PayPal already, as well as automated clearing house methods and other forms of payment--just because that a company like PayPal is less dependent on credit cards, while certainly being a big part of the funding mix, it certainly has a larger percentage of the transactions facilitated by other forms of tender that aren't going to be subject to the digital-wallet access fees.

So in my mind, PayPal is going to see less of an impact from these potential charges coming from MasterCard and potentially Visa down the road as well, compared with rivals like Google and Square. Additionally, one thing that the company stressed during the Analyst Day was the idea of extending credit to consumers where eBay does see a positive impact in the overall transaction margin, the amount purchased by consumers per year. When they do get credit, they get lower funding rates, and eBay sees higher conversion rates. So at the end of the day I think that's a nice offset.

Now with respect to the offline initiative, there have been a number of concerns that as the company moves out and makes PayPal available at the point-of-sale system at a lot of large national retailers, as well as Discover's entire network, that that might have a dilutive impact on margins for the business. In fact, what the company says is that while they may have a lower take rate--and I think what they're doing here is just lowering the take rate to allow merchants to put PayPal in and make it a part of the point-of-sale system--what you find is that there's lower loss rates, so lower fraud coming from the in-store purchases, as well, that more or less neutralizes that lower take rate, allowing it to be about margin-neutral at the end of the day.

One of things that I think surprised a lot of investors at the Analyst Day is that the company actually increased its operating margin target for PayPal. That segment historically generated about 24%-26% operating margins. They were looking for 24% this year and most people thought that number was going to be flat for the next couple of years, but in fact PayPal is actually expected by 2015 to reach 25% or above on that segment alone.

Coffina: So, you've raised your fair value estimate on eBay twice in the last month or so, and now since its $63 a share, up from $53, can you tell me what are the key assumptions behind that fair value estimate?

Hottovy: Sure. There's really been two main drivers behind the fair value increase; one being the mobile opportunity that's out there. I think eBay is one of the best-positioned companies to capitalize on the growing trend of mobile commerce, whether it be through its portfolio of mobile apps or its ability to facilitate mobile payments. John Donahoe had a good anecdote that going forward consumers aren't going to want to see multiple apps for every different retailer that's out there in every different payment form.

They're really going to want one versatile app that they can go to for as many as their shopping needs they can accomplish in one payment form, and I think that eBay is uniquely positioned in that form. I think that mobile payments, which are expected to exceed $20 billion from both payment volumes and merchandise volumes, both in 2013; that number could grow up to $75 billion by 2015, which would represent over one fourth of the commerce volumes that the company is facilitating by that point. I think that eBay's ability to monetize their mobile growth is the first reason why I've increased my fair value estimates.

The second reason is just being some pretty ambitious targets the company has laid out in terms of what it hopes to accomplish in terms of overall merchandise volume, payment volumes, revenue, and operating margins by 2015. We were already ahead of Wall Street estimates for a lot of our 2015 numbers, but the company introduced targets of $110 billion in gross merchandise volume, $290 billion in total payment volumes. That's supposed to result in 2015 revenue between $21.5 billion and $23.5 billion, with operating margins essentially holding flat at about 27%.

Those numbers were ahead of my expectations, but as the company walked through their blueprint to hit those numbers, it gave me more confidence that they can hit them. So, that's really what's driving that [fair value estimate]. Those payment volumes are going to be facilitated by a little bit lower take rate to make the company more competitive and keep its top merchants happy, but at the end of the day the free cash flow implications of that kind of volume growth outweigh that lower take rate and have a positive impact on our fair value estimate.

Coffina: Great. Thanks so much for joining me today, R.J. In conclusion, eBay I think is one of the highest-quality companies in our coverage universe, trading in a modest discount to fair value but certainly worth keeping on your radar screens. For Morningstar StockInvestor, I’m Matt Coffina.

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