EBay Undervalued, But PayPal Spinoff Not the Answer

Despite the competitive retail landscape this holiday season, we believe  eBay's (EBAY) fourth-quarter results reinforce our positive long-term outlook, particularly the impact that mobile devices had on active user growth and volume trends across the PayPal and Marketplaces segments. Although management acknowledged that it had not monetized volume growth as much as it had anticipated when it laid out its previous targets at the March 2013 analyst day--a key reason behind the reduction in its 2015 targets--we believe eBay is taking prudent steps to maintain and stimulate buyer and seller growth at a time when offline and online commerce are rapidly converging.

We believe consumers' increasing acceptance of online and mobile commerce (as well as  Amazon's (AMZN) continued success) could serve as a wake-up call for many traditional retailers, which may look to eBay as a partner because of its wide variety of delivery (including eBay Now), payment, fulfillment/ship-from-store, and other commerce solutions. For this reason, we believe an increase in near-term investments, including a number of core, omnichannel, PayPal reach, and cross-border enhancements, will help to solidify eBay's network effect and our wide moat rating. We had already assumed more conservative Marketplaces revenue than management's previous guidance and plan to tweak our base-case assumptions to reflect near-term investments, but the changes will not be enough to move our $63 fair value estimate.

The other notable development from the fourth-quarter update was that activist investor Carl Icahn has made a nonbinding proposal to spin off PayPal into a separate company. Although we share Icahn's view that the market is underestimating eBay's longer-term potential, we agree with management that the Marketplaces and PayPal business units possess meaningful customer acquisition, data, and growth initiative funding synergies, and we would consider a separation of the businesses to be value-destructive.

As in recent quarters, we believe active user growth was the key takeaway for investors during the fourth quarter, with Marketplaces users growing 14.1% to 128 million (the fifth consecutive quarter of double-digit growth) and PayPal users growing 16.2% to 143 million active accounts (representing more than 16 straight quarters of double-digit growth). New active user growth helped to drive enabled commerce volume of $61 billion during the quarter (an increase of 22% year over year) and validates recent investments to the Marketplaces and PayPal customer experience, cross-border capabilities, and the Bill Me Later platform. It also suggests that channel-diversification efforts continue to gain traction and highlights the significant potential that mobile commerce offers; management reported that mobile commerce volume increased 88% for the full year, supported by 14 million new mobile Marketplaces and PayPal users (roughly 40% of all new Marketplaces and PayPal users). We continue to believe that new mobile users are heavily skewed toward younger customers with lower disposable income, often from emerging markets. We believe this demographic will help to attract new merchant partners to eBay's various marketplaces and enhance its network effect. In turn, we expect mobile users to increase purchase frequency and average transaction/payment volume over time (backed by the aforementioned core business, omnichannel, payment technology and cross-border investments), supporting our five-year revenue growth forecast (2014-18) in the low teens. 

Management's initial 2014 guidance, including full-year revenue of $18.0 billion-$18.5 billion and adjusted EPS of $2.95-$3.00 (excluding stock-based compensation, amortization of intangibles, and acquisition-related expenses), strikes us as achievable based on current macroeconomic and industry trends as well as management's investment plans. We also believe management's updated 2015 targets, which now include more than $300 billion in enabled commerce volume (with mobile commerce volume growing at a 65% clip), revenue of $20.5 billion-$21.5 billion (down from $21.5 billion-$23.5 billion), adjusted earnings per share growth of greater than 10% in 2015 (suggesting at least $3.30), and more than $11 billion in cumulative free cash flow for the three-year period ending in 2015, appropriately highlight the company's opportunity in mobile commerce balanced with investments near-term investments designed to solidify eBay's position as a preferred commerce partner.

With the shares trading at approximately 18.5 times the midpoint of management's 2014 EPS forecast (or 16.5 times forward earnings after stripping out the nearly $6.60 per share in net cash and equivalents on the balance sheet at the end of the quarter) after a modest uptick following the disclosure of the Icahn proposal, we still find eBay's risk/reward proposition to be compelling. While we don't expect Icahn's proposal to succeed, we think increased market awareness of how combined the eBay-PayPal platform enhances its network effect and strengthens its position in the rapidly evolving world of online, offline, and mobile commerce could serve as a positive share price catalyst over the near term. We also believe Icahn's proposal may have caused management to increase its emphasis on shareholder returns, evidenced by the $5 billion increase in its share-repurchase program announced in conjunction with the fourth-quarter results.

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