eBay Inc (EBAY): A Strong Play Amid Weak Guidance

eBay Inc (EBAY): A Strong Play Amid Weak Guidance

Bernstein Research analysts Carlos Kirjner, Peter Paskhaver and Garrett Marks rate Ebay as Outperform as they think eBay Inc (NASDAQ:EBAY) stock is still an attractive investment, despite the highly ambiguous and arguably weak 2015 and 1Q14 guidance.

In this report we discuss why we think eBay Inc (NASDAQ:EBAY) stock is still an attractive investment, despite the highly ambiguous and arguably weak 2015 and 1Q14 guidance. Coming out of 4Q13 results, we have a series of somewhat contradictory data points and here we weigh and analyse them.

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On one hand we have the stronger-than-expected 4Q13 results, the announced $5.6 billion stock repurchase authorization, and Carl Icahn’s proposal to spin off PayPal, which most certainly does not change the fundamentals but may provide some short-term support for the stock.

On the other hand we have an OK-but-not-great revenue guidance for 2015, revenue guidance for 1Q14 and 2014 implying back-loaded revenue acceleration despite the lessons of 2013, and 2015 adj. EPS guidance that could be interpreted at best as highly ambiguous sandbagging. At worst, the margin compression implied by the 2015 guidance may signal a fast deteriorating business requiring a significant increase in marketing and other spend, which could be in the $200 to $300 million range, to deliver roughly in-line revenue growth.

At this point we find it impossible to decide analytically how much of the margin compression implied by guidance is a reflection of management’s conservatism in an attempt to be in a “beat-and-raise” mode versus a plan to increase discretionary R&D and marketing investment. What’s more, since the description of where and how eBay Inc (NASDAQ:EBAY) is planning to invest was quite generic, it is hard to evaluate if the future potential growth supported by the presumed investment would be worth the near-term margin compression, “Amazon style.” Our current view is that eBay won’t get much credit for potential growth from increased investment, unless there is a better story behind it.

On balance, we think the near- to medium-term downside in the worst case scenario is limited and significantly smaller than the upside potential. In addition, some of the ambiguity regarding the level of conservatism of guidance may subside in April, when eBay reports 1Q14 results. For now, we maintain our outperform rating and target price of $65.

eBay’s 4Q13 results suggest that both MarketPlaces and PayPal are healthy

Setting aside guidance and focusing on the actuals eBay Inc (NASDAQ:EBAY) delivered, our view is that eBay’s 4Q13 results and the underlying metrics were reasonably good and better than many had feared: MarketPlaces and PayPal delivered transaction revenues and margins in line or ahead of what we had expected. We think the decline in PayPal’s take-rate and the pressure on transaction margins were due primarily to a mix shift as Merchant Services grew faster than on eBay TPV.

PayPal’s active users grew 16% YoY, while payments per user grew 7.5% without material negative effect on the average payment size, suggesting competition had no or really small impact on PayPal metricsdespite widespread fear, uncertainty, and doubt as we approached the quarterly report.

We expect MarketPlaces GMV and top-line growth to decelerate to the mid-to-high single digits, yielding 2015 total revenues of close to $10 billion. However, we think contribution margins could remain at 40% or higher. Our estimates imply continued deceleration of GMV ex-vehicles, domestic and international, fixed price and auctions. In 2015, we expect fixed price GMV ex-vehicles to grow 15% (vs. 18% in 4Q13) and auction GMV ex-vehicles to decline 9% (vs. -5% in 4Q13).

Setting aside potential incremental investments suggested by guidance and management’s commentary, the impact of the acquisition of BrainTree, based on our previous expectations and the 4Q13 results, we would expect PayPal to deliver 2015 revenues of $9.49 billion, transaction margins greater than 63% and contribution margins above 24%. We believe transaction margins above 62% are well within reach, even if we do not take into account material upside from a potential rewrite of the debit interchange cap rules by the Federal Reserve, which may happen in 2014. In 4Q13 PayPal has shown us once again thepotential for leverage. Historically, about 45% of PayPal’s transaction gross profit dollars flow to contribution profit, and if we were to assume the same cost structure remains in place for 2014 and 2015, we would get contribution margins between 24% and 25%. Our PayPal 2015 revenue estimate is a hair below $9.5 billion, which is the low end of management’s (new) guidance, suggesting our estimates and forecasts are on the conservative side.

As a result of the above, our 2015 “momentum trajectory” adj. EPS estimate (that is, without the impact of Braintree, incremental investments, and buybacks) would be $3.49, growing 17% from $3.00 in 2014.

Management to shrink share count

We believe eBay Inc (NASDAQ:EBAY) will use a large portion of the $5.6 billion authorization to shrink the share count. We will assume the $5.6 billion are used in the next two years, that roughly $2 billion are used to offset dilution, leaving $3.6 billion to reduce share count. Assuming, conservatively, an average share repurchase price of $57, we get a 2014 adj. EPS of $3.01 and 2015 adj. EPS of $3.64, after taking into account the ($0.03) impact of Braintree in 2014 and assuming it has not impact in 2015 (which we believe is conservative since we think it may actually be accretive in 2015). We will refer to this scenario as our baseline scenario, to evaluate the guidance and the potential impact of incremental investment.

Guidance suggests massive incremental investment

Ebay’s 2014 and 2015 revenue guidance was roughly in line with our expectations before earnings and our current, slightly revised expectations. The 2014 adj. EPS guidance is lower than what we had expected, which was a midpoint between $3.00 and $3.10 (we had estimated Braintree at break-even in 2014).

  • If we take the midpoint of the 2014 guidance at $2.98 adj. EPS and contrast with our baseline scenario of $3.01 adj. EPS, this leaves roughly $50 million in 2014 for incremental PayPal investments, which would bring contribution margins down by 60 bps, to 23%. In other words, with our conservative GMV growth and PayPal take rate evolution assumption, to get down to midpoint of 2014 guidance eBay would have to invest $50 million incremental on PayPal. This seems like a plausible incremental investment level and suggests that 2014 guidance is reasonable.
  • To evaluate the somewhat ambiguous 2015 adj. EPS guidance of “greater than 10%” growth we will size how much discretionaryincremental spend is available if we assume that greater than 10% corresponds to 12%, or 2015 adj. EPS of $3.34 (12% higher than the 2014 guidance midpoint of $2.98 discussed above). This is $0.29 below our baseline case. This gap corresponds to an incremental (to our baseline case) investment of nearly $450 million and, assuming it is mostly into PayPal, a PayPal contribution margin of 20%. Exhibit 16 shows the different amounts of “discretionary incremental investment” available to eBay’s management under different interpretations of the meaning of “greater than 10%.”

This suggests to us that in all likelihood we will see 2015 adj. EPS growth significantly higher than 12%, since $440 million would be a staggering incrementall investment.

We think it is impossible to discern from the publicly available data how large the incremental investment will be. On balance, we believe the downside of an eBay investment remains limited and the upside is quite attractive, and hence maintain our outperform rating and $65 price target.

  • We see the downside scenario as follows: a) eBay Inc (NASDAQ:EBAY) makes a very large (in fact staggering) incremental investment on PayPal (e.g., $300 million) and gets no incremental revenue or credit (through a higher multiple) in 2015. We believe that in this highly unlikely, extreme negative scenario the downside from the current stock price is highly limited as we would get adj. EPS of $3.34, growing at more than12%, which we think would still justify a valuation in the mid-to-high 40s or low 50s (13-15 times), not much below the current price.
  • For our estimates, we will assume eBay will invest $150 million incremental on PayPal in 2015 and $50 million in 2014, and buy back $5.6 billion over the next two years (at an average price of $57). This yields 2014 adj. EPS estimates of $2.98 and 2015 adj. EPS estimates of $3.53, growing 18% YoY. Applying an 18.5 times multiple we reach our new price target of $65. This is not an aggressive upside scenario as we have built inmultiple conservative assumptions.

eBay’s 1Q14 revenue guidance seems quite conservative

When eBay Inc (NASDAQ:EBAY) reports 1Q14 results, we will have a better idea of how conservative management was in setting the guidance and whether the downside or upside scenario is more likely. Given how asymmetric they are, we retain our outperform rating and adjust our 12-month target price to $65.

Investment conclusion

We rate eBay Inc (NASDAQ:EBAY) outperform with a 12-month target price of $65.

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