August 05, 2006

Business Review: eBay

eBay announced a shakeup within its management staff this week, signaling continued change in their business. A review of their most recent SEC quarterly filing illustrates some of the issues facing the company.

During the first quarter of 2006, sales increased a healthy 35%, from $1,031,724 last year to $1,390,419. Gross Margin decreased from 81.9% last year to 80.0% this year. This metric was partially influenced by changes in stock option expensing.

Expenses, after accounting for changes in how stock options are expensed, have increased at a faster rate than sales have increased. Sales and Marketing expense increased by 39% verses last year. Product Development increased by 33%. General and Administrative expenses increased by 40%.

As a result, income from operations decreased by 4% after accounting for stock options. Income from operations, on a comp basis with last year, only increased by 20% on the 35% increase in sales. In other words, eBay is not generating sales fast enough to cover rising expenses.

Their filing indicates other interesting tidbits. PayPal is the fastest growing of the three mature business units at eBay, growing by 44% over last year. However, only 26% of PayPal dollars flow-through to profit. US Sales increased by 30%, and these sales flow-through to profit at a much more impressive 40%. The most profitable unit, International Sales, only increased by 25%, though these sales can be influenced by exchange rates. International Sales flow-through to profit at a whopping 48%. In other words, the fastest growing business areas at eBay generate the lowest rate of profit. This is not good for the future of eBay. Couple that with their purchase of Skype, which lost more than eight million dollars on sales of $35 million, and the profit story isn't great.

Further compounding eBay's growth problems are subscribers. Although net sales increased by 35%, the number of active users, those active over the past year, only increased by 25% verses last year. This may indicate a future problem for eBay. PayPal accounts, measured as active users over the past three months, increased by 32% verses last year, a rate that is less than the rate which net sales are growing.

The data may indicate that eBay is reaching maturity, as a business. Obviously, I don't know the inside workings of eBay, so any comments about eBay reaching maturity are purely speculative. It will be interesting to see if eBay can find additional ways to grow.

In their 10-Q statement, management states that they may need to increase marketing and brand expenses. One of their quotes states that "Brand promotion activities may not yield increased revenues, and even if they do, any increased revenues may not offset the expenses incurred in building our brands. If we do attract new users to our services, they may not conduct transactions using our services on a regular basis. If we fail to promote and maintain our brands, or if we incur substantial expenses in an unsuccessful attempt to promote and maintain our brands, our business would be harmed." In other words, eBay may spend marketing dollars to promote business units, and those marketing dollars may not have a corresponding return on investment, limiting future growth.

eBay's PayPal unit is facing increased competition from Google. And reports indicate that Microsoft has an interest in merging their MSN unit with eBay. The next few months could prove to be very interesting for a previous stock darling that has lost more than fifty percent of its market capitalization over the past eighteen months.

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