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Online Extra: eBay: From Pez to Profits


I remember my delight when I first discovered eBay (EBAY), the online auctioneer. A lover of yard sales, flea markets, and anything cheap, I relished the ability to find a used food processor in Alabama for $5 and an inflatable raft in California for $7.50.

I also vividly remember my reaction the day that eBay offered its shares to the public: "They're actually going to try and make a business out of this?" It was, after all, designed initially by founder Pierre Omidyar as a way to help his fianc?e sell her collection of Pez dispensers. While I loved buying things on eBay, I laughed at its chances of profitability for a glorified Pez-dispenser distributor. Other investors apparently didn't join in my cynicism. On opening day, eBay's shares almost tripled.

As the Internet bubble inflated, it became pass?e to criticize business plans of New Economy companies. But now that the bubble has burst, it's easy to scoff at some of these enterprises. One company has emerged, though, with a real, honest-to-goodness profitable business on the Internet. Yep, it's that Pez dispenser company.

CRITICAL MASS. Of course, eBay is a lot more than that. It's the world's largest yard sale and gets a cut on each transaction. All those Internet axioms that have proven to be so untrue for everyone else give eBay its edge. Because it was the first mover in its arena, it quickly got critical mass, built a sense of community, and was allowed to charge for something that costs it next to nothing to provide. The biggest criticism of its business model is that it could be so easily imitated. In fact, Yahoo! (YHOO), Amazon.com (AMZN), and countless others tried to mimic it. They all failed.

That's because in the world of Pez dispensers, critical mass counts. If you want to sell something, you want to go to the place where you'll find the most buyers. Because eBay built its storefront first, it quickly achieved critical mass. Even when Yahoo! offered sellers commission-free auctions and Amazon offered buyers quality guarantees on merchandise purchased through its auctions, the crowds failed to come. eBay had already won the war.

Last year, the company was profitable any way you want to measure it. It pulled in a total of $431 million in sales and $48 million in operating profit. "At investor conferences in 1999, they would challenge me on why eBay was so profitable," says Chief Executive Officer Meg Whitman. This year, both revenue and earnings should come close to doubling. There's scant criticism about that now.

HARD TO MEASURE. For investors who bought at the IPO, eBay was a great buy. But now it has become very hard to measure the stock's correct valuation. As a profitable, relatively mature company, one can argue that it should be measured on old-fashioned profitability metrics. But if you look at eBay's price-to-earnings ratio, which was 191 at the end of April, it's clearly one of the more expensive stocks in the market.

But it suddenly looks cheaper when you look at the company's forecasts over the next three to five years. Chief Financial Officer Rajiv Dutta says eBay will take in $3 billion by 2005, nearly a third of which will be operating profit.

Sound like idle fantasizing by yet another Net executive? Not to analysts who cover the company. "eBay's results and bullish outlook merit significant attention from investors and clearly distinguish the company from others in the broad technology/Internet marketplace," says W.R. Hambrecht analyst Derek Brown, who rates the stock a strong buy. Of the 20 analysts who cover the company, 16 have strong buy or buy recommendations, and only 4 have hold ratings. There's not a single sell recommendation throughout Wall Street.

UNGRABBED CROWN. That's not to say that the company can anticipate only smooth sailing on its way to its $3 billion sales goal in 2005. It's biggest hurdle is international expansion. eBay Japan is already the largest auction service in that country, but the crown has yet to be grabbed by anyone in Europe, despite fierce competition there.

Expansion in other countries might be even more difficult. In Korea, the world's sixth-largest Internet market by usage, a local startup called Internet Auction quickly became the market leader. eBay solved that problem by buying Internet Auction for $120 million in January. But with only about $500 million in cash reserves, eBay can't buy every market leader in every country.

Another obstacle to eBay's long-term goals is that its take-rate, the commission it charges on each transaction, is actually declining. It was 7.6% in the fourth quarter of 2000 and 7.4% in the first quarter of 2001. The drop is a direct result of higher-priced items being auctioned on eBay. The more expensive an item, the lower the commission.

STICKY SITUATION. On the one hand, this is good news because it shows that eBay is succeeding in its goal of becoming a marketplace for high-cost merchandise. Indeed, the average price of an item for sale on the site jumped from $20.35 to $22.50. But it also presents a sticky situation in terms of revenues for the company. In addition, eBay charges lower commissions internationally, where much of its future growth needs to come from.

In the short term, eBay is doing quite well. It met its first-quarter expectations when it declared earnings of 11 cents a share, or $30.6 million, in profits. Last year's first quarter saw only $4.4 million in profits. That puts it on course to earn 36 cents per share in 2001, and 64 cents per share in 2002, with $179 million in profits next year. While that's admirable, especially for a dot-com, eBay still has a lot of growth to do to catch up with its own expectations. By Sam Jaffe


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