I’ve been looking for some garbage to short in this market. I think it’s been increasingly difficult to find attractive long opportunities in larger companies that meet my hurdle rate. The only real opportunities I see right now are special situations where the underlying company is undergoing some type of corporate event and coincidentally these are in industries I think I understand best. I don’t think the market is overly expensive nor cheap by the way. Over the next little while I’m going to post a mini marathon set of posts that will update some of the ideas recently mentioned on this blog.
First up is eBay.
eBay – Revisiting the spin-off thesis
The stock has done quite well over the short-term since Steven recommended it. I original liked the idea as well, but now that I have a much higher hurdle rate, it simply doesn’t meet my return requirements unless I structure a long position in combination with more leveraged instruments such as derivatives which I’m unwilling to do at these trading levels.
The original thesis was focussed on the pending spin-off of the PayPal unit from the Marketplaces unit which would unlock substantial shareholder value mainly through improved capital allocation, better corporate governance, operational focus, cost rationalization and in general just getting rid of a rather idiotic CEO. I think the CFO needs to go as well.
I think the opportunity still exists partly because of everyone’s frustrations with the mediocre operating performance and the subpar capital allocation. But I also think investors are increasingly fixated on faster-growth opportunities in the general tech space. Ebay is sort of becoming a “dinosaur” compared to some of the more newly emerging, sexy, rapidly growing technology-based industries such as enterprise SaaS and social media. Moreover, from an event-driven angle there was also little guidance given from management (at the time of the spin-off announcement) for how each business would get capitalized, the complexity of where to allocate the corporate overhead, D&A, etc and the typical failure of most market participants in properly valuing 2 divergent earnings streams.
The thesis for the marketplaces segment is based primarily on financial engineering and returning capital to shareholders via leveraged share buybacks. I had modelled ~$4.1B in EBITDA for marketplaces by 2017, which is actually on the back of low single-digits top-line growth and ~300 bps in EBIT margin compression. I’m actually quite bearish relative to consensus on the long-term prospects of the marketplaces business given what I think is a few emerging structural challenges that this business will face in a changing e-commerce competitive landscape. I think the two large concerns I have is the slowing organic growth and the additional marketing and R&D spend that I think will need to be incurred in order to even sustain positive long-term revenue growth rates. The recent security failure might have also turned off a lot of users and damaged brand equity for the long-term; I know I would be pissed if my account and password got hacked. 1) In the recent full conference call, management projected 0%-5% fx neutral top line growth for marketplaces which I think is pretty ridiculous in light of the fact that US and global e-commerce is still growing at around high-single to low double-digits. This tells me that management have mismanaged the business to such an extent that they’re now losing massive market share. Given the international exposure, I think there’s even a possibility for reported revenue growth to go negative, especially if the US dollar continues to surge against major international markets. Given the operating leverage and rather concentrated US cost base of this segment, the downside won’t look pretty. For a typical dominant network, winner-take-all marketplaces business model that should be taking incremental market share this is just a very worrisome possibility. But honestly, after going over some of management’s bullish forecasts in previous analyst days (that have badly missed or have been revised down), 0%-5% could potentially be very realistic. On the margin side I think larger incremental spending will be required since this business increasingly looks outdated (doesn’t seem to be attracting millennials) and irrelevant.
So I feel like there’s quite a bit of execution risk going forward to revitalize this business and better compete against Amazon. I think going forward the only real value proposition for this platform will be for existing “power sellers” that have a long merchant track record and have less of an incentive to move their business. The major business lesson here: Despite having a business with superior economics on the surface: an asset-light, cash-generative toll-booth business (with ~40% operating margins) vs. Amazon’s fulfilment model (with ~1% operating margins), a dominant network effect doesn’t automatically off-set an inferior service. In Tony Hsieh’s book, Delivering Happiness, he talks about the great lengths Zappos went to continually improve their customer service even if it sacrificed near-term profitability; this included things like free shipping for customers, free returns, and an exceptionally trained, passionate customer service team. Zappos was eventually acquired by Amazon and I feel like even in this new information age economy, the level of customer service remains a critical factor to the success of these e-commerce service platforms.
I assume the new marketplaces management will increase the pace of buybacks and leverage up to 2.5x net debt to EBITDA by 2017. Working from EBITDA to FCF per share, I modeled out nearly $2B in fully-capex’d FCF by 2017. If marketplace can raise debt over the next 3 years at an average after-tax cost of 3.5%-4%, leverage up to 2.5x by 2017, and assuming they pay full repatriation taxes on existing foreign cash, I think they can repurchase ~22% of the total current float over the next 3 years. They should be over a comfortable interest coverage ratio of over 5x as well. Originally I expected closer to 30% of the float to be repurchased but since they’ve announced that they’re capitalizing PayPal with $5B in cash, I think this is less likely. Given the number of large actavist funds in this name (Jana, Third Point, Glenview, Icahn), and the leveraged share buybacks that have already taken place over the past year (~$4.6B in share buybacks) I’m rather confident that they will shrink the equity accretively in this low rate environment – I just don’t know to what degree (2.5x is what I’m assuming or 4x that some have suggested). For a still rather high-margin, cash generative business with a network effect moat, (although structurally challenged I believe) I value marketplaces at a range of multiples of 14x-16x (or a ~6%-7% fcf yield) my estimate for $2 per share by 2017. On these numbers, marketplaces is basically worth $28-$32 per share 3 years from now. Unlike most of the Street that values marketplaces on an EBITDA multiple, I believe we have to take into account a more efficient capital structure that involves leveraged share buybacks.
However, if top-line growth rates dip to negative territory and FCF growth decelerates even faster, the entire leveraged buyback thesis falls apart. On the upside case, it’s very possible that Alibaba will eventually acquire eBay and fix its problems. I think Jack Ma has real ambitions to expand outside of China. I would just assign a 0 value on the GSI segment (which is now getting sold) since it’s immaterial and was a horrible acquisition. On a side note, Donahoe has repeatedly said that it was a great acquisition – I wonder why the sudden change of heart?
For the PayPal unit, here’s an excerpt from my last letter to my investors:
“… Although we acknowledge that Apple Pay can potentially become a major contender in the payments industry, we remain skeptical of a wide spread merchant and consumer adoption of Near Field Communication (NFC) technologies, along with the issues of convenience and security being adequately addressed. Apple Pay is currently only in ~220,000 merchants in the US, which is ~2% of the total addressable market. Furthermore, we believe that their competitive focus will remain in the offline, mobile Point-of-Sales (PoS) space which is currently a miniscule part of PayPal’s existing business. In fact many market players, including PayPal, have failed to gain much market traction in the mobile offline payments industry over the past several years. This is partly due to the high barriers of entry including scale and security requirements, but more challengingly the need to get the different parties with differing economic incentives in the payments ecosystem including customers, merchants, financial regulators, banks, and the payment networks to facilitate wider spread adoption of PoS mobile payments. If Apple Pay can indeed generate considerable traction and wider spread adoption of PoS mobile payments, we actually believe that this will ironically be a net positive for an independent PayPal; it can it open up a large offline payments opportunity as a free option, currently not being priced into shares, in our view. As per the unit economics, Apple Pay currently takes $0.15 for an average $100 PoS transaction versus PayPal’s ~$1 – a stark differential. Although PayPal may have to sacrifice some existing unit economics in order to create substantial value in PoS mobile payments, we believe given PayPal’s strong brand equity and franchise value, PayPal can eventually generate sufficient scale to participate in this opportunity.
PayPal’s ~$216 billion in Total Payments Volume (TPV) is currently ~20% of the $1 trillion online commerce total volume – second to only AliPay – and only ~2% of $10 trillion in the total commerce opportunity. The online eCommerce market is a long-term secular growth market and should continue to grow faster than brick-and-mortar TPV. We believe that post-spin, independent PayPal will have ample strategic options to aggressively pursue the total eCommerce opportunity – both online and offline. PayPal can position itself as either platform agnostic like it has for the most part historically, or it could potentially form strategic partnerships with either Apple, Google, Facebook, Samsung or even Amazon, among other large market players once it is separate from core eBay. We believe there was likely internal conflict and misaligned incentives between past PayPal executives and the C-suite, leading to poor strategic decisions for PayPal’s positioning in the marketplace. An independent PayPal will likely become a more nimble, focussed, disruptive “Silicon Valley-like” entity, with future business performance properly aligned between management and employees. The bottom line is that we believe spinning-off PayPal is the right strategic decision and will better position PayPal to tackle a rapidly changing global payments competitive landscape.”
In sum, I think an independent PayPal makes a lot of sense. In order to attract some of the brightest talent needed in Silicon Valley today, I think an independent stock currency is required for stock-based compensation. Base Case: PayPal earns nearly $3B in operating income by 2017. I assume a bit of margin compression (~200 bps) if they go after the offline payments opportunity and continue to deploy large amounts of R&D spending. So net-net the lower incremental margins from the offline opportunity should outweigh their existing scale benefits. I also think there’s a bit of risk from PayPal’s projected ~20% top-line growth rate – if we assume eBay’s top-line is slowing down to LSD-MSD, then by default PayPal’s related transactions on the eBay platform (around one third of PayPal’s business) should be slowing down dramatically as well.
On a 25x-30x net operating profit after-tax (NOPAT) multiple, PayPal is basically worth $50-$60 per share 3 years from now, or nearly double eBay’s value. I’m not quite sure what management plans to do with the $6.3B in incremental fcf that they’ll generate over the interim years so I very conservatively assume that it just builds up on their balance sheet. There’s definitely a bit of upside if the actavists push new PayPal management for better capital allocation as well. PayPal will be capitalized with no debt and $5B in cash to help fund the credit part of their business but I think realistically they’ll just need half of that amount. PayPal’s $9B in excess cash by 2017 will be basically worth ~$7.5 per share.
So let’s add all the pieces up to arrive at intrinsic value: 1) eBay marketplaces: $28-$32, 2) PayPal: $50-$60, 3) PayPal’s excess cash: $7.5, and 4) a 9x multiple on corporate overhead’s negative after-tax income: ($13.5). If we add it all up the stock is worth $72 – $86 by 2017. If we take the mid-point of the intrinsic value range and if the post-spin catalysts materialize as expected, the stock should generate a near 18% 2-year IRR under my base case from today’s $57 price tag. Unfortunately this is way below my hurdle rate, so I’m officially closing this position for the blog. How I’m going to play this situation out is to observe the stock up to the spin-off event and see if I can get more clarity on post-spin capital allocation and if there’s any post-spin forced selling. I’m not long now, but at least I’ve done the necessary work should Mr. Market present an opportunity. I’m also much more interested in the PayPal piece. For bigger funds that have a lower hurdle rate, the opportunity might be worth it if you’re confident that capital will be adequately allocated in both pieces and if you think marketplaces isn’t in a long-term structural decline.
One last note on management that I want to get out of my system. These guys (management) are honestly amateurs when it comes to capital allocation and corporate governance. If I were to grade them alongside the management teams that run my portfolio companies on a relative scale from 1-10, these guys would be sitting on a negative digit. I have absolutely zero confidence in existing management to execute on what is necessary to build long-term shareholder value. I recall reading a transcript with the CFO basically saying in like a proud way that the ~$15B of cash that they’re holding on their balance sheet is generating a lot of interest income. Well, no shit. If you give me $15B I can sit on my ass and buy long-term US treasuries too! These guys seriously need to go. The high executive turnover, constant flip-flopping on major strategic issues and operational missteps is suffice evidence. Next time don’t hire a management consultant to run a once leading, global technology company.
 NFC only works on the newest iPhone 6 models, which is ~70 million users as of the end of 2014; Apple has large existing installed base of ~500 million iPhones