eBay’s Business: Here Are The Key Drivers And Barriers (Part 2/2)

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This article represents the second in a series of two notes we are publishing on eBay (NASDAQ:EBAY). In the previous article, we assessed the principal drivers in eBay’s business model. In this note, we take a look at the key barriers and challenges impacting eBay, and how they could hamper the company’s business in the future. We’d strongly advise our readers to go through the previous part before going through this article.

The marketplaces’ segment is reeling under the pressure from traffic-related challenges, caused by the security breach and Google’s Panda update earlier this year. The security breach occurred during the first quarter, but went unnoticed until May 2014. As a safety measure, eBay had asked all its users to change their passwords – however, this caused a slowdown as buyers exercised caution in using the site at all. We believe the adverse impact of this breach could subside in the coming quarters, especially since no losses were incurred by users. Additionally, Google’s Panda update impacted eBay unfavorably, due to the unstructured and sparse charcter of many listsings, which accounts for much of the content on the site. Search engines bring substantial traffic on eBay’s sites, with organic search accounting for over 90% of this share.  We note that eBay is undertaking considerable changes to its SEO strategy to accommodate the Panda update.  However, we believe it could take a few more quarters to reap results, since it requires manual work to make the content accessible to search engines.

These traffic-related issues have also hit eBay’s profitability, as the company has stepped up its sales and marketing efforts to curb the recent fall in traffic. We think its profitability could start improving in 2015, once other strategies start to pay off. The recent launch of Apple Pay has also caused significant tension among eBay’s investors – but we believe these fears are unfounded as they threaten only a very small share of PayPal’s revenue base.

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Stacking these barriers against the tailwinds we discussed in a previous note, we think that the market could be under-pricing eBay’s stock. We believe the long-term growth opportunities in both eBay’s marketplaces and payments businesses are strong, and the market seems to be over-weighting these headwinds in the present context. We reiterate our $67 price target for eBay’s stock, based on: 1) significant growth in the payments business, 2) improvement in the marketplaces segment, which generates high cash flows and margins; 3) an increase in shareholder value post the spin-off PayPal; and lastly, 4) more than $2 billion in the share buyback program.

See our complete analysis for eBay

Traffic-Related Challenges Due To Security Breach: The marketplaces segment is facing short-term traffic-related challenges, because of which its revenue growth slowed from 11% in Q1 2014 to 9% and 6% in Q2 and Q3, respectively. The security breach took place earlier this year and prompted the company to ask all users to change their passwords as a safety measure.  This led to a slowdown in buying activity, as some users did not change their passwords and avoided the site out of caution. It is important to note that this breach occurred somewhere in February or March, but went undetected until May. [1] The company’s seller-created listings have been known to be affected with various security issues in the past as well.

We think it could take a few more quarters before eBay is fully able to reverse the negative impact of this security breach. While financial information was not reported to be compromised, user data pertaining to names, passwords, phone numbers, address and birth details was most likely accessed by hackers. [1] Since a large number of online users employ the same password for multiple sites, they had to modify the same across several places, creating unpleasant user experience. While buyers would remember this troublesome experience for a short period; over a longer time-frame, we believe this incidence will pass, and buyers will return to using the site as before.

Mis-management of SEO Issue Has Also Contributed To Decline In Traffic: Another issue that has adversely impacted traffic on eBay’s sites includes changes in Google’s algorithms, that determine result rankings for keywords that users query on its search engine. Search engine queries (both paid and organic) are an important source of traffic for the company — these queries accounted for around 23% traffic (on desktop) on eBay.com during the last three months (according to SimilarWeb estimates). Organic search comprised for over 90% of this search traffic. In comparison, search queries were responsible for near-26% of desktop traffic on Amazon.com during the last three months, with organic search accounting for a whopping 95% of this traffic base. [2]

Google’s Panda update in May 2014 impacted eBay substantially, as the latter was punished for factors including inadequate content of its user-generated listings, poor management of paid search strategies, and other issues. [3] As is widely known, Google accounts for the dominant share in the search engine market — Google sites comprised for around 67% share of the explicit core search market (on desktop only) in the U.S. in October 2014, according to comScore. [4] Hence, the proper management of search engine optimization (SEO) protocols is imperative to benefit from this traffic source. However, SEO presents a peculiar problem for eBay considering there are millions of seller-generated listings on its platform, which leads to a large amount of unstructured data on its platform — rectifying this issue involves manual processes, which could take a few more quarters to show results. We believe it is essential for eBay to develop a more stable and long-term SEO strategy, since search engines are increasingly valuing quality-content as one of the top factors in their algorithms. Therefore, management must achieve a long-term solution to effectively managing data created by tens of millions of sellers to more fully leverage this source of traffic.

Short-term Profitability Challenges: The recent traffic-related challenges have also impacted operating margins. In the below given table, we see that eBay has significantly increased its expenses on sales and marketing to curb the recent fall in traffic. Sales and marketing as a percentage of revenue increased by 100 and 180 basis points annually in Q2 and Q3 2014 respectively. Combined with recent surge in product development expenses, operating margin was seen at 17.9% in Q3 2014, as compared to 20.5% in a similar period a year ago.

Key Metric (as a % of Revenue) Q1 2013 Q1 2014 Change Q2 2013 Q2 2014 Change Q3 2013 Q3 2014 Change
Cost of Revenue 30.7% 31.7% 1.0% 31.2% 31.9% 0.6% 31.4% 31.9% 0.5%
Sales and marketing 18.6% 18.9% 0.3% 19.9% 20.9% 1.0% 19.4% 21.2% 1.8%
Product development 11.6% 11.3% -0.3% 11.6% 11.5% -0.2% 11.1% 11.7% 0.6%
General and administrative 10.9% 10.9% 0.0% 10.8% 10.6% -0.2% 10.7% 10.2% -0.5%
Other expenses 6.9% 6.6% -0.2% 7.1% 7.0% -0.1% 6.8% 7.1% 0.2%
Operating margin 21.3% 20.6% -0.7% 19.3% 18.2% -1.2% 20.5% 17.9% -2.6%

It is interesting to note that even after this recent decrease in profitability, eBay’s operating margin at 17.9% during the most recent quarter looks a much safer bet than Amazon’s operating margin of -2.6% . We expect the company to incur higher expenses on sales and marketing in the coming quarters as well, a factor that will weigh on its profitability. However, over the long-run, we expect the profitability to stabilize as we think eBay will be able to overcome challenges related to security breach and Panda update in the longer run.

Rising Competition In The Payments Business From Apple Pay: The recent entry of Apple Pay in the mobile payments landscape is another barrier to consider for eBay’s investors. This service would enable iPhone users to utilize their mobile devices as wallets for undertaking transactions. The factors that worry investors include: 1) Apple’s ability to quickly introduce innovative new technologies into the market; 2) the network effect that exists with the tremendous popularity of Apple phones and services, and its ability to partner with a large number of merchants and financial institutions; and,  3) the enormous resource of Apple’s other businesses, which can subsidize Apple Pay as it competes with PayPal’s present take rates.

However, we believe these fears could be overblown.  In our assessment, we take into account several factors, including the market size of this payment technology, iOS’s limited market share, and PayPal’s well established presence in this business. According to Citi Research, transactions through this technology could total around $58 billion by 2017. [5] While large, this figure is still small compared to the overall value of mobile transactions, which could reach $721 billion by 2017 globally, according to Gartner. [6] The upcoming spin-off should also assuage some of these concerns as the split from eBay would allow PayPal to freely partner with other Internet giants like Facebook, Google, Alibaba etc.

Seller Policies Have Created Trouble In The Recent Past: The recent tightening of seller policies at eBay has created significant dissatisfaction among sellers. While these changes ensure higher quality control for buyers, they have caused sellers to migrate from eBay to other online marketplaces offered by Amazon, etsy.com, etc. We suspect that thousands of sellers are leaving eBay because of these unfavorable policies, and due to the recent fall in traffic on the site which has caused their profits to drop. eBay does not report these seller metrics publicly. We think this issue could also impact the company’s top-line in the long-run, considering sellers are an essential component of eBay’s value chain, and their mass migration could cause significant decline in product listings and thereby sales.

Our $67 price estimate for eBay’s stock, represents around 20% premium to the current market price.

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Notes:
  1. eBay Suffers Massive Security Breach, All Users Must Change Their Passwords, Forbes, May 21, 2014 [] []
  2. SimilarWeb.com []
  3. eBay is the Biggest Loser of the Google Panda 4.0 Update, Yahoo, June 3, 2014 []
  4. comScore Releases October 2014 U.S. Desktop Search Engine Rankings, comScore, November 18, 2014 []
  5. What Apple Pay Means For eBay And The Future Of Mobile Payments, Forbes, September 9, 2014 []
  6. Gartner Says Worldwide Mobile Payment Transaction Value to Surpass $235 Billion in 2013, Gartner, June 4, 2013) Factoring in the limited market share of iOS devices within the global smartphone market (~12% as of Q3 2014) and PayPal’s take rate, Apple Pay’s threat on PayPal’s revenue base is very low. ((Android hits 83.6 percent marketshare while iOS, Windows and BlackBerry slide, The Inquirer, November 3, 2014 []