Dueling Fools
eBay Bubble?
March 17, 1999

eBay Bear's Den
by Paul Larson ([email protected])

While I run the risk of being called "Wise" by my Foolish associates (the ultimate slam) for agreeing to argue the bearish side in this Duel, I won't hesitate to say I think eBay has a much tougher road ahead of it than many seem to be thinking around here these days. The eBay site, as it stands now, is ripe for fraud, and there are some serious roadblocks to the spectacular growth the Bulls are betting on. More importantly, today's exorbitant valuation placed on the stock has all the good news (and then some) already priced into it.

Let's first look at some of the problems the company faces as it attempts to grow in the coming years. One of the largest problems I see with the operating model is simply fraud. There have been several well-publicized cases of sellers using the site, collecting money from the winning bidders, and never delivering the goods. All one needs to start selling on eBay is a valid email address, yet email addresses are extremely easy to come by and change. Even if only one in a thousand participants is dishonest, that one running around unchecked is enough to undermine the integrity of the entire process.

Then there's also the problem of shills. That is, a seller may bid on his own merchandise (using a different account) in order to prop the price up of any given item. A savvy seller may even use several associates that all shill bid on the seller's behalf. What's to stop a half dozen hackers from maximizing each other's bid prices while propping up their "feedback" the entire time? The short answer is there is very little that can be done to prevent this at the current time. Deadbeat bidders, folks who bid on items but don't pay for whatever reason, are also a significant problem users of the site have to worry about.

eBay may be the largest community of buyers and sellers on the Internet, but, like any other big city, eBay has its own unique problems. If eBay is the New York of the online auctions, it is a virtual city where the garbage haulers only remove the trash sporadically and the police claim the crime is not their problem.

I'm sure Rick has already told you about the company's great margins, but I suspect those margins will fall as the company incurs increased costs to more effectively police its site. The laissez faire method of managing the auctions, while extremely profitable, just isn't going to fly if the company wishes to grow to the next level.

Another fundamental problem with online auctions is that buyers don't get to physically inspect the items they are bidding on. I've got to wonder what percentage of buyers may receive merchandise they aren't exactly pleased with. Does that CD have a scratch? Beanie Baby smells like smoke? There is very little recourse a buyer has if a product's quality isn't quite up to snuff. If an item is new, the quality can be relatively assured. But when the vast majority of the items are used, verifying the quality of the products is virtually impossible. This is a fundamental problem all the online auctioneers face that is never going to disappear.

Speaking of other online auctioneers, eBay is far from alone in the field. While eBay's size gives the company an advantage against the upstarts, the competition may be just enough to cause the company to reduce its listing prices. The barriers to entry in the online auction market are extremely low, and the success of the current operators has numerous well-funded companies aiming to get a slice of eBay's pie. What's to stop AOL, Amazon, or Yahoo! from getting in on the action? Yahoo's already trying, and others are sure to follow.

No bearish argument about eBay's stock would be complete without a mention of valuation. Here are some numbers to ponder:

Trailing Annual Sales:    $47.4 million
Trailing Net Income:    $2.4 million
Consensus profit estimate, year 2000:    $21.8 million
Market Capitalization:    $18,748.6 million

All these numbers are as of this writing, and will probably wildly change in the next few days. Nevertheless, let's assume eBay, as a mature yet lean and profitable company, commands a 40x earnings multiple at some point down the road. In order for the company to grow into that valuation eBay will have to expand its trailing earnings 195 times. Even I, the one supposed to be playing the Bear here, can see eBay's earnings easily doubling, quadrupling, and even octupling over the coming years. But grow by a factor of nearly 200? That's one gargantuan assumption, Fool.

Here's another way to look at it. If eBay were to quadruple sales in the next year and triple sales the year after that, the company will have revenue just shy of $570 million in March of 2001. At today's valuation, that's still roughly 33x generously estimated forward revenue. Assume the company's net profit margin expands to 10% and you are only left with $57 million in earnings. Plug the numbers into a calculator and you will see the stock is trading at well over 300x these quite generous forward projections.

To make a long story short, eBay has an expensive valuation any way you cut the numbers. But unlike the $200,000 price eBay community members bid a Katie Couric autographed jacket up to, the price on eBay's stock is no joke.

Profitable leaders in new and exciting industries always deserve a premium, but the Bulls will need several years of absolutely explosive growth in order to even come close to justifying today's price. Is such a feat possible? Of course. Is the growth going to be of the magnitude the market is currently assuming? I have my doubts.

Whether buying something at eBay's site or looking to buy the stock, the message is the same -- Caveat Emptor.

Next: The Bull Responds