Monday, July 10, 2006

Ebay: Hype over G-Checkout or Is It Hype Over Skype?

The Common Stock of online auctioneer, eBay Inc. (EBAY-$26.62) closed at a new 52-week low on Friday as Wall Street analysts suggested in published research reports that Google Inc.’s (GOOG-$420.45) new online payment service, Google Checkout, could prove to be a legitimate long-term threat to PayPal, currently the Internet’s leading payment service.

Dubbed the ‘PayPal Killer’ in the press, Google Checkout does offer two advantages over PayPal. Speed of checkout is faster for consumers and the service charges merchants 2.0% plus $.20 per transaction, which is less than PayPal’s processing fees (which range between 1.9 percent and 2.9 percent of the purchase amount plus 30 cents per transaction).

Traditional payment methods such as checks, money orders and credit cards processed through merchant accounts, all present various obstacles to the online commerce experience, including lengthy processing time, inconvenience and high costs. PayPal’s Value Proposition is that the proprietary global payments platform offered by PayPal enables any individual or businesses with an email address to securely, easily and quickly send and receive payments online.

PayPal’s account-based system is available to users in 55 markets, including the United States. As of December 31, 2005, PayPal had approximately 96 million total accounts, comprising approximately 19 million business accounts and 77 million personal accounts.

In a report issued last Thursday, Citigroup analyst Mark Mahaney cut his long-term earnings growth forecast for eBay from 22 percent a year, on average, to 20 percent a year. Citing competition from Google Checkout as his main reason for cutting his projected growth rates, Mahoney slashed his target price for eBay to $40 from $51 per share, too.

There is some merit to Mahoney’s investment thesis; for the three-months ended March 31, 2006, PayPal contributed 23.6%, or $328.15 million, of eBay’s $1.39 billion in total net revenue (up from 22.0% in the prior year period).

In an ever-changing competitive technological landscape, G-Checkout is not the first e-commerce competitor that has threatened PayPal’s dominance. PayPal competes with existing online and off-line payment methods, including, among others:

  • Credit card merchant processors that offer their services to online merchants, including Cardservice International, Chase Paymentech, First Data, iPayment and Wells Fargo; and payment gateways, including CyberSource and;
  • Money remitters such as MoneyGram and Western Union, a subsidiary of First Data;
    Bill payment services, including CheckFree;
  • Processors that provide online merchants the ability to offer their customers the option of paying for purchases from their bank account, including Certegy, PayByTouch and TeleCheck, a subsidiary of First Data, or to pay on credit, including Bill Me Later; and,
  • Issuers of stored value targeted at online payments, including VisaBuxx, NetSpend and Next Estate.

When Google first released its Checkout offering last week, eBay made statements to the effect that it was not worried about Checkout, reassuring investors that it was not a PayPal competitor, for Checkout was targeting a different market. [For example, G-Checkout cannot be used to make payments from person to person.]

eBay’s recent actions proved the contrary. Citing Checkout as a new service “without a substantial historical track record of providing safe and reliable financial and/or banking related online transactions,” the Company has banned Checkout as a payment method for Ebay users.

We do applaud Ebay, however, for being innovative in leveraging its core advantage in e-commerce. On May 25, 2006, Ebay strengthened its dominance in e-commerce when it formed an alliance (with the Internet's most trafficked Web site) Yahoo Inc. that will make PayPal the preferred third-party provider of its online wallet.

The 10Q Detective does question, however, Wall Street’s trepidation over Google’s (purported) growing dominance of the Internet? An analysis reveals that its non-research products grab more headlines than market share:

  • Google Talk. The ten-month-old instant-messaging system ranks No.10 in the world, with just two percent as many users as market leader MSN.
  • Google Maps. Although it ranks No.2 worldwide, viewership is 20% less than market leader MapQuest.
  • Blog Search. This nine-month old web log service was expected to bury market-leading Technorati. It gets less than one-fifth as many users.
  • Google Finance. Three-months after its launch, the site ranks No.40 in the U.S.—despite strong initial buzz. Yahoo! Finance remains No. one.
  • Orkut. The social-networking site gets less than one percent as many U.S. visitors as [Source: BusinessWeek, July 10, 2006, “So Much Fanfare, So Few Hits.”]

On a valuation basis, the Common Stock price of eBay looks attractive, selling for only 20.9 times forward 2007 earnings of $1.27 per share (PEG of 1.01x). Competitors Google and Amazon (AMZN-$36.11) sell for forward 2007 EPS estimates of 33.3 times (PEG 1.48x) and 43.0 times (PEG 3.19x), respectively.

Before running out on Monday morning to BUY eBay stock, however, our readers should note that the 10Q Detective has unearthed some accounting concerns, that may cause analysts to rethink their earnings’ models—and appropriate valuations of eBay.

The 10Q Detective believes that analysts need to revisit the acquisition of eBay’s communications business. On October 14, 2005, the Company completed its purchase of Skype Technologies S.A., a Luxembourg-based global Internet firm that was established in 2003. Skype provides software that, among other things, enables free VoIP calls between Skype users online. Skype’s premium offerings, which are currently Skype’s primary source of revenue, provide Skype’s users with low-cost connectivity to traditional fixed-line and mobile telephones. Skype currently offers its software in 23 different languages.

We applaud the rationale for the purchaseenabling eBay to create new potential channels to monetize e-commerce activity. Communication via Skype allows buyers and sellers in highly involved, expensive or complex categories of goods or services, to benefit from being able to communicate directly with each other in an instantaneous and private environs.

Additionally, corporate continues to leverage synergies between Skype and its other businesses. On its 1Q:06 conference call, management noted that the Company now regularly promotes Skype across all of its eBay and PayPal sites. Tapping into Skype fee-based offerings, users can utilize PayPal, which allows for efficient online payments and increased growth in users for PayPal as well.

Nonetheless, given the total purchase price of approximately $2.6 billion (which included cash of $1.3 billion and 32.8 million shares of Common Stock valued at $1.3 billion)—we believe that eBay overpaid for Skype—the purchase price could actually reach approximately $4.1 billion if potential earn-out payments are met.

As of March 31, 2006, Skype had 95 million members in 225 countries and territories. Skype is considered a market leader in VoIP offerings in virtually all countries in which it does business.

For the three-months ended March 31, 2006, Skype’s telephony services contributed $35.2 million to top-line sales in the first quarter of 2006. [Prior to the buyout, Skype reported revenue of $3.3 million for the FY ended December 31, 2004.]

Goodwill of $6.1 million and intangible assets (net) of $823.2 million represent approximately 58.7% of the $11.79 in total assets on the balance sheet. Skype contributed approximately $2.3 billion and $280.3 million in goodwill and intangible assets (net), respectively, to this total.

Ebay has allocated a preliminary estimate of $280.3 million to amortizable intangible assets (consisting of registered user base, access and termination agreements, existing technology and trade names with useful lives not exceeding five years).

Applying a fair-value based impairment test for assets, based on the Company’s last impairment test as of August 31, 2005, corporate determined there was no impairment. Additionally, there were no events or circumstances from that date through March 31, 2006, indicating that no further assessment was necessary.

FASB Statement 142 does a nice job in answering the question—When is Goodwill Impaired? “Financial statement preparers will compare the fair value of goodwill to its carrying amount. If the fair value is less than its carrying amount, goodwill is considered impaired and the company must recognize a loss on the balance sheet.”

The VoIP market climate has changed considerably since eBay did its Skype deal. First, the market is far more competitive now. As such, Skype is facing pricing pressures from cable companies that can offer multiple services such as cable television, voice and broadband Internet service. Additionally, these competitors are offering VoIP or other voice services as part of a bundle, in which they offer voice services at a lower price than Skype can for new subscribers.

Aside from cable, Skype must now contend, too, with legacy telephone carriers (like Verizon's VoiceWing consumer VoIP service and AT&T Callvantage), other VoIP providers (like Vonage, Net2Phone, and 8x8), and the Instant Messenger (IM) platform offerings of AOL, Google, Yahoo! and, Microsoft (which bought Internet start-up Teleo).

The Internet Service Providers are not sitting idle. For example, last December Yahoo! extended its VoIP services beyond PC-to-PC applications with the launch of two fee-based Internet telephony services (called Phone Out & Phone In). And in April, AOL answered the VoIP call with its own service, called AIMphone.

In a more crowded market, eBay’s revenue projections for its Skype communications segment seem more undoable with each passing quarter.

According to documents filed with the SEC in September 2005, EBay anticipated that Skype would generate an estimated $60 million in revenues in 2005 and more than $200 million in 2006. Skype posted $24.8 million in sales in the 4Q:05—well below initial estimates; and, as previously mentioned, the goal of $200 million in forecasted communication revenue for FY ’06 is looking like a stretch, too.

Nonetheless, management at eBay continues to put on their happy faces. To quote their CFO, Bob Swan:

“Skype continues to expand its community of registered users at a phenomenal pace. We ended Q1 with nearly 95 million registered users, representing a nearly 200% increase from a year ago and sequential increase of 27%. To put this in context, in Q1 Skype acquired over 220,000 new users per day. The rapid acquisition of new users, along with the expansion of the Skype ecosystem, is enabling increased activity, which resulted in 6.9 billion Skype-to-Skype minutes served in Q1, a sequential increase of 31%. We are extremely happy about Skype’s Q1 performance, and we are on track to achieve our full year revenue guidance of approximately $200 million for Skype.”

Market conditions have changed, too, which has affected valuations:

1. In January 2005, Net2Phone was acquired by IDT for an aggregate consideration payment of $155.8 million. [2006 EV/ Revenue: 1.56 times]
2. In October 2005, Skype was acquired by eBay for an aggregate consideration payment of $4.1 billion. [2006 EV/Revenue: 20.5 times – which excludes any cross-selling potential]
3. On May 24, 2005, the Vonage IPO priced at $17.00 per share. Recent price: $7.67 per share. [Trailing 12-month EV/ Revenue: 3.74 times]
4. Internet Telephony Service Provider, 8 x 8, Inc. (EGHT-$1.01]. [March 2007 EV/ Revenue: 0.65 times]

In conclusion, the current Common Stock price of eBay has already discounted continued market share erosion in the Far East (spec. South Korea & China), sluggish auction growth in the core U.S. and U.K. markets, and the perceived threat posed by G-Checkout.

In our opinion, however, future earnings could be adversely affected if—and when—the Company is forced to write down the value of its Skype investment.


Anonymous said...

You know, I just can't get too excited about whether or not Ebay overpaid for Skype. Whether or not they're forced to write down any assets won't change what the capital structure is today and what cash flow they generate today and tommorrow. It'll affect one earnings statement which will have no relationship to actual cash. You're worried whether they're going to generate $200 Mill in revenues in 2006 for Skype, when the whole company made $4.5 billion over fiscal 2005. I could have told you they overpaid the day they bought it. It's just not material anymore based on an overall valuation to the entire business no matter how well or badly Skype does.

David J. Phillips said...

I disagree with you that "sunk costs" are irrelevant. You correctly point out that any asset impairment writedown will be a non-cash charge against future earnings; nonetheless--a billion dollars is monies that could have [speculation] been used for more relevant purposes [last year] to invest in a project that could have "sustained" future earnings growth.

Anonymous said...

That, perhaps, is the point about "bad" deals from the past: what they say about management's capital allocation skills. This is different from their operating skills and their strategic judgement - but still important in terms of judging their ability to generate future value.

The ideal management team has good skiils in each of the above areas - but not all real-life management teams do.

Anonymous said...

as an investor I dont care if they write off skype..this has been factored in in the stock price. I'm paying nothing for skype and any upside is gravy for me.