Friday, January 29, 2010

Amazon vs eBay

When Amazon (AMZNreports earnings it seems lately nothing can go wrong.

Free cash flow (FCF) at Amazon was $ 2.92 billion and grew at a 114% clip.

Impressive right?

Yes, but in this case, maybe not quite as impressive as it seems. A good chunk of that growth in FCF came from accounts payables increasing faster than accounts receivable and inventories. Not exactly the highest quality source of FCF, but the company does have a rather brilliant negative working capital cycle in place.

Well, at least they do as long as the growth persists.

Essentially, it's a source of "float" that provides lots of cheap funding for expansion as long as the exceptional growth can be sustained. Of course, if invested consistently well, that funding might lead to future earning power that isn't all that obvious today.
(More than a few seem willing to pay what seems a premium valuation for those prospects.)

Now, I happen to think a more conservative and closer reflection of Amazon's full year operating FCF is net income + depreciation - capex = $ 902 + $ 378 - $ 373 = $ 907 million.

That's more than a $ 2 billion difference in FCF and much of it comes down to the working capital model. It is the increases to accounts payable (relative to more modest increases to accounts receivable and inventories) and also additions to unearned revenue (relative to amortization of previously unearned revenue) that make up quite a bit of that gap.

At the current price of $ 129/share, Amazon's Market Cap is ~$ 59.4 billion with an Enterprise Value (EV = Market Cap - Net Cash and Marketable Securities + Debt) of ~$ 53.2 billion.
(Amazon has ~$ 6.2 billion in net cash on the balance sheet.)

So the EV/FCF for Amazon = 58.7x
(vs 18.2x using the reported number)

Look at Amazon's performance over the past 3 years using net cash provided by operating activities minus capex to calculate FCF. Over those 3 years, Amazon averaged FCF of $ 1.82 billion/year.

So using that number the EV/FCF for Amazon = 29.2x

That may or may not seem too expensive for a stellar company, but here's why I think that FCF calculation doesn't reflect economic reality. It's not just that much of the so-called FCF is coming from a great working capital model and unearned revenue that shouldn't really be considered quality operating FCF.

There's also a boost from the company's stock-based compensation.*

If you adjust for these things EV/FCF is, once again, north of 50x.

Now lets try the same calculation for eBay (EBAY), who is currently treated like the "George" compared to Amazon's "Elaine".
(George being the serial underachiever on Seinfeld. Well, at least until becoming transformed in the classic 86th Seinfeld episode: "The Opposite". In that episode, successful Elaine becomes like George and vice versa.)

eBay's average 3 year FCF = ~ $ 2.3 billion

At the current price of $ 23.30/share, the market cap of eBay is approximately $ 30.8 billion and an EV = ~ $ 25.9 billion.
(eBay has ~$ 4.9 billion of net cash on the balance sheet)

So the EV/FCF for eBay = 11.4x

Unlike Amazon, the cash flow of eBay is not boosted by changes in working capital (actually eBay's FCF is reduced somewhat by changes in working capital). Like Amazon, it is boosted by stock-based compensation. Adjusting FCF lower to account for stock-based compensation raises the EV/FCF multiple to more like 13.4x.

Here is eBay's most recent results.

Amazon's operating FCF is currently increasing faster than eBay's (who knows going forward). Using my math, they actually grew it at around 50% year-over-year (not 100% plus, but still impressive). I wouldn't bet that growth rate is sustainable for very long but, who knows, maybe it is. At its current FCF multiple, eBay doesn't need to increase FCF much to justify its valuation. In contrast, to justify its multiple, Amazon has to increase FCF rapidly for a long time. The question comes down to how much confidence one has in the future prospects and what's the appropriate margin of safety.

I like the long run prospects of both businesses but am only comfortable with eBay's stock. This comes down to margin of safety. To figure out what price represents a comfortable margin of safety, the per share intrinsic value must be estimated. Well, someone else may know how to figure that out for Amazon but I don't.**

Amazon seems to be executing brilliantly (even if it's far from easy to judge -- at least for me -- the company's value), while eBay has been working through problems in its Marketplace business. Well, problems are all relative. Even during eBay's struggles, the company sustained very solid free cash flow. The recent results seem to indicate eBay has made some good progress in their Marketplace business while PayPal continues to perform very well.

So, to some degree, Amazon's premium valuation compared to eBay may be warranted, but it at least appears a bit extreme. If nothing else, the premium requires that the company continue doing very well for quite some time to produce even a satisfactory investing result.***

Now, what happens if Amazon ends up like Elaine in that Seinfeld episode and becomes George? Having Amazon's valuation normalize would certainly hurt.

All eBay has to do is keep on being George.

Even if eBay continues to be the seen as underachiever with unexciting growth prospects, it at least seems not much has to go right.

Considering the valuation, it appears that the company need only continue to generate solid free cash flow, solidify its moat, and use its excess capital wisely. No small feat (and far from a certainty) but, if nothing else, not much of its current value looks to be based upon a promising future not quite yet realized.
(Of course, it's also possible that the prospects for eBay -- real or perceived -- might even improve. A bonus when a premium isn't paid in the first place.)

Interestingly, Amazon also announced their intention to buy back up to $ 2 billion of the stock.



Long position in eBay

* FCF -- if calculated using net cash provided by operating activities minus capex -- for both Amazon and eBay is reduced when you adjust for stock-based compensation (which is added back in operating cash flow since it is a non-cash expense). Stock-based compensation may be a non-cash expense in an operational sense, but cash would have to be used by each company buying back shares to maintain share count (cash paid to buy shares minus what was paid to the company depending on the exercise price). That's a real cost to shareholders. Basically, if stock-based compensation is ignored, both companies boost free cash flow only in appearance. Now, the stock-based compensation number is not a perfect way to estimate the real cost, but the bottom line is FCF should be adjusted lower in order to make a more meaningful if rough estimate of the true economic per share impact on shareholders. There's a number of ways to make an informed though imprecise adjustment but, no matter how one decides to estimate the cost, it plainly can't be ignored.
(The lack of precision comes down to the number of variable involved and the inherent limitations of accounting.)
** Especially when it comes to managing the downside risk of an investment, it's best to only buy what one understands. That's necessarily unique to each investor and dependent on individual knowledge, expertise, and limitations.
*** Not via the skillful trading of price action but via increase to per share intrinsic value. I don't doubt both of these businesses might actually end up being quite valuable down the road. One just seems to have a less difficult to estimate margin of safety at this time. As far as price action goes, premium valuations can proceed to become even more so (and, similarly, a discount to value can become an even bigger discount and stay that way quite a while). In the short run and even much longer, just about anything can happen as far as stock price action goes. No view is offered here on that front. Figuring out how market prices might fluctuate near-term and beyond is difficult at best. I'll leave that game to others. In contrast, figuring out how price compares to intrinsic value is, at least occasionally, more doable. Not easy but doable. Well, at least it can be for certain assets one understands. If value is consistently judged well, and a nice discount is always paid to that estimated value, reasonably good outcomes and fewer mistakes become more likely. 
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eBay 2008 10-K