Buy It Now? EBay’s PayPal issue persists

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E-commerce giant eBay Inc. is the latest company where activist financier Carl Icahn has come calling. Mr. Icahn says he believes it would do well to spin off PayPal, its fastest-growing segment, and let investors, including himself, reap the rewards. EBay management has told Mr. Icahn they have little interest in the proposal, calling it "old news."

Does the prospect of Mr. Icahn's continuing involvement mean you should, in eBay's own parlance, Buy It Now? Or is this one auction where the price of the merchandise goes in the wrong direction?

EBay was fortunate to be able to disclose Mr. Icahn's moves as part of its year-end results Jan. 22, since investor excitement about his activism offset what might have been a run to the exits. While the company met fourth-quarter analyst consensus targets, management issued guidance for 2014 and 2015 that was below Street expectations. At Friday's close of $53.20 (U.S.), they're only slightly down from levels before the earnings release.

Jordan Rohan of Stifel Nicolaus & Co. Inc. cut his "buy" rating to "hold" on the change, saying "we can no longer recommend buying shares of eBay." Even though the stock declined minimally, the cut in guidance made the shares 20-per-cent more expensive than before on a price-to-earnings basis, Mr. Rohan notes.

"With eBay management resistant to activist ideas, and the likelihood of a Paypal spin[off] low without management support, we believe that weaker fundamentals will return to focus soon enough," Mr. Rohan says. The company's Marketplaces business, which include the legacy eBay as well as sites such as ticket seller StubHub and discounter half.com, are posting slower revenue gains than previously assumed. PayPal is generating lower average commissions on its transactions than ever before.

The analysts at Moody's Investors Service, who follow the company's debt, not stock, note that Amazon.com Inc. is not only a major competitor at selling goods, but is rolling out a "Pay with Amazon" service at other online retailers, right next to the PayPal and credit-card buttons. Banks and other finance companies are rolling out person-to-person payment services (Bank of America, Chase Bank and Wells Fargo have partnered on a service called "clearXchange.")

Despite PayPal's increasing competition, however, analysts' efforts at valuing eBay suggest that Mr. Icahn is right when he says the payment service is the company's "gem."

Neil Doshi of CRT Capital uses enterprise value – the company's market capitalization plus net debt – and compares it to EBITDA, or earnings before interest, taxes, depreciation and amortization. EBay's Marketplaces businesses, which he estimates will generate $4.2-billion in EBITDA in 2015, get a multiple of seven, for a value of roughly $30-billion. PayPal, which he figures will generate just $2.6-billion in EBITDA in 2015, gets a multiple of 14, twice as large, and a resulting value of $37-billion. (EBay bought PayPal in 2002 for $1.5-billion, so, nice job!)

One of the reasons the company wants to hold onto PayPal is the very real synergies between it and eBay – the payment service gets 30 per cent of its new customers and 50 per cent of its profits from people who use it on eBay for their purchases. But Mr. Rohan of Stifel says the rebuff of Mr. Icahn is "really disappointing" because one of the options is to do an initial public offering of 15 per cent of PayPal. That would provide a market valuation of the segment, raise cash that could be used for share buybacks and set the stage for a split down the road.

So, is eBay going to muddle along with its best asset locked away, producing subpar returns for shareholders? Perhaps. But there's an opposing bull case.

Mark Mahaney of RBC Dominion Securities raised his target price from $59 to $64 on the recent results. He says the reduced expectations "made the stock safer to buy."

He's focused on the company's "gross merchandise volume" – the dollar value of the goods sold on eBay's sites, regardless of the commission the company takes – and how it increased 14 per cent year-over-year in the fourth quarter, better than expected. The number of users of the Marketplaces sites and PayPal grew 14 per cent and 16 per cent, respectively.

Mr. Mahaney had made eBay a top-3 pick among large-cap Internet stocks for 2014 "because we saw valuation and sentiment as washed out and viewed fundamentals as largely intact. We believe [fourth-quarter] results helped validate that call. We continue to believe the company has enough momentum in its current markets, growth potential in those markets, new investment initiatives in place, and execution competence to consistently deliver at least low-double-digit [earnings-per-share] growth."

Gil Luria of Wedbush Securities has a $70 target price, 20 times his 2015 earnings estimate. (He notes that's still a 10-per-cent discount to his estimated valuation of Visa Inc. and MasterCard Inc., two PayPal comparables.)

Mr. Luria believes Mr. Icahn's activism will help drive share buybacks – eBay has already announced $5-billion in new future purchases that could cut the share count by 7 per cent. That, coupled with the new "beatable hurdle" of guidance, he says, means 2014 will be eBay's "comeback year."

In a way, one can argue, it's a winning situation for shareholders. The bulls could be right. If not, and eBay struggles in 2014, Mr. Icahn is likely to get even noisier, with the company forced to consider larger buybacks or at least a partial PayPal spinoff. The prospect of an agitated Mr. Icahn, coupled with some very real strengths in the company, suggest investors with a longer-term horizon might consider making a bid.