Wednesday, August 1, 2012

eBay's Free Cash Flow

Here's the free cash flow of eBay (EBAY) from 2007 through 2011:

2007:  $ 2,187
2008: $ 2,316
2009:  $ 2,341
2010:  $ 2,022
2011:   $ 2,310

We'll see how it looks by year-end, but first half free cash flow is so far a bit lower in 2012 compared to 2011 (it's worth noting the decline but chances are it doesn't mean a whole lot).

For quite some time -- a number of years in fact -- free cash flow has been hovering at or slightly above $ 2 billion per year. Considering the way the stock has moved up in the past two years, some might rightly expect there'd been a more discernible upward trend in what is a fundamental driver of intrinsic value (as long recent cash flow trends are representative of future cash generation capabilities...they often are not, of course).

Unlike not too long ago, there are far fewer negative headlines about eBay's challenges so the story has certainly become a better one to tell:

- Revenues are much higher now and continue to grow nicely (revenue should approach $ 14 billion this year vs just under $ 7.7 billion in 2007. Impressive, but hasn't yet translated to free cash flow...at least not yet).
- PayPal, eBay's fast-growing payments business, seems poised to continue steadily making up an increasingly large slice of the company's total business. Some see it as eBay's jewel.
- The core marketplace business, struggling not long ago, is doing better.

I could add more to the list of improved characteristics. Here's the problem: I understand that good businesses will often invest for the future in a way that may reduce current free cash flow (or limit the increase to free cash flow). In other words, they invest in a way now that ultimately leads to increased intrinsic value. Some investments maintain the business; other investments build incremental business for the future. That's certainly fine, up to a point and in certain circumstances, as long as return on capital ends up being attractive. Otherwise, if it doesn't begin showing up in the free cash flow, how is it possible to judge whether the business is substantially more valuable?

Consider this:

In mid-2010*, the company had shares outstanding of 1,330 billion and its stock price was selling for roughly $ 20/share, giving it a market cap of $ 26.6 billion. Subtract the $ 6.7 billion of net cash and investments and you get an enterprise value of roughly $ 20 billion. So 10x free cash flow or so but actually more like 12x if you back out stock-based compensation.**

These days, the company has shares outstanding of 1,309 billion and its price at yesterday's close was $ 44.3/share, giving it a market cap of nearly $ 58 billion. Subtract the $ 6.3 billion of net cash and you get an enterprise value of just under $ 52 billion. So roughly 23x free cash flow but, once again, more like 28x if you adjust for stock-based compensation.

It seems a huge change in enterprise value and a substantial multiple for what seems a comparably modest change in apparent intrinsic value.

Sometimes investments being made now can mask future free cash flow potential. So more value may exist than the recent free cash flow would otherwise suggest. Amazon (AMZN) is an example that comes to mind.
(Estimating Amazon's valuation seems difficult at best. Without a clear view of its cash producing capacity, it's tough to decide what's an appropriate margin of safety. The range of value is too wide. I'm well aware that Amazon is or is likely to become quite valuable, but that's of little use if you can't figure out an appropriate price to pay now.)

I'm not suggesting eBay hasn't increased its intrinsic value or improved its business. It's more along the lines of this: In 2007 (and before that), eBay had a pretty good business. In 2010, the headlines weren't great -- real challenges had emerged in its marketplace business, for example -- but eBay still had a pretty good business. As far as I can tell it's still a good business now.

Sometimes the tide will be coming in; sometimes not. That's the case with any long-term investment.

Oh, and it's not like the the tide can't reverse again. An investor has to distinguish the difference between what are near-term difficulties (at times rather serious) and real damage to the economic moat of a business.

As PayPal continues to become a bigger percentage of the company, it's possible that intrinsic value growth may even begin to accelerate. Some could argue that justifies the higher intrinsic value and, of course, the higher stock price. Maybe. Others might point to improvements to the marketplace business. I'd just say PayPal has been a great business for years even if some patience for it to become big enough to really matter was required. I'd also add that the marketplace business continued to have sound economics even when it was struggling.

So there's been some increase to eBay's intrinsic value but, unfortunately, the price action lately would seem to more than reflect it (with far less margin of safety being the result).

That doesn't mean the stock won't keep going up near term (or even longer), but I never have had an opinion on that sort of thing. My focus is on finding a durable franchise, paying a plain discount, then allowing the long-term effects of compounding take care of themselves. (Until there's evidence of material moat damage, other emerging threats, and sometimes when opportunity costs are high.)

eBay 2nd Quarter 2012 Results
eBay 2nd Quarter 2010 Results
eBay 4th Quarter and Full Year 2011 Results
eBay 4th Quarter and Full Year 2010 Results
eBay 4th Quarter and Full Year 2009 Results
eBay 4th Quarter and Full Year 2008 Results
eBay 4th Quarter and Full Year 2007 Results

I won't be surprised at all if the company becomes much more valuable over time. It just isn't selling at a clear discount to value anymore. What if they hit a bump in the road again? It's better to assume they will from time to time and pay a price that reflects the possibility (likelihood?). There's no downside if they do not hit a bump or two.

Best to pay a price that doesn't require good things to continue happening, one that protects against the unforeseeable. An improving story and increasingly rosy headlines just gets in the way of finding shares of attractively valued businesses.

Adam

I maintain a long position in eBay established at much lower than recent prices. No intention to buy or sell shares near the current price.

Related posts:
eBay's Valuation (follow-up post)
Technology Stocks (prior post)

* In 2010 stock prices had rebounded substantially from the financial crisis lows. I didn't think it made sense to use the extremely depressed share prices that had been heavily influenced by macro factors in this example. So I picked a period where things were at least somewhat settled down. eBay's enterprise value actually briefly dropped to under $ 10 billion back in 2009.
** Obviously, not all free cash flow is created equal. I could certainly pick some things apart here, but at least these comparisons are apples-to-apples. For example, stock-based compensation should not be backed out. It is not a quality source of cash, inflates free cash flow, and, as a result, needs to be accounted for when attempting to value the company. So the free cash flow multiple is, of course, higher when adjusted for stock-based compensation. eBay has bought a rather substantial amount of their stock back since 2007 (nearly $ 6 billion worth) yet have hardly put a dent in shares outstanding (roughly a 5 percent decline in the share count over that time). A larger reduction in share count would have occurred if dilution from options did not offset the buyback to such a meaningful extent. In other words, stock options can be rather quietly expensive for shareholders. It may make sense from an accounting point of view to include stock-based compensation in the cash flow from operating activities but it does not represent quality free cash flow in my book. Even though stock-based compensation is far from a perfect measure of the true cost it is, at the very least, a decent approximation and reasonable starting point.
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