; recent price, $69) has evolved into the world's largest online marketplace. Standard & Poor's Equity Research believes its shares represent a compelling investment opportunity, based upon eBay's leadership in what we consider the attractive areas of Internet auctions, retail and payments, and its proven ability to expand into new categories, geographies, and services. We also think the shares are appealingly valued, based on our intrinsic analysis. The stock carries our highest investment ranking of 5 STARS, or buy.
eBay was launched in 1995, to establish an efficient marketplace for individuals to trade goods. The site enables users to list items for sale, browse through goods organized by categories, bid in auctions, and make immediate purchases. eBay also owns and operates discount retailer Half.com and online payments business PayPal.
Despite being a for-profit venture, eBay has never been solely focused on just transactions and profits. In our view, it has always tried to pay special attention to its users. This has contributed to significant customer loyalty and valuable word-of-mouth marketing. eBay actively promotes user interaction and relationships, and user feedback serves as the foundation for the ratings of both sellers and buyers.
VIRTUOUS CYCLE. eBay has been buoyed by the so-called network effect -- the concept that a network becomes more valuable as its number of constituents and usage increases. Initially, users were attracted to eBay because it offered hard-to-find inventory via a unique online platform. Perhaps a family member or friend recommended the nascent Web site. Soon, eBay's growing population of would-be buyers attracted a larger number of sellers, which in turn led to even more prospective sellers and additional vendors.
This virtuous cycle continues to this day and raises the value of the eBay network. As of December, 2003, eBay had 94.9 million registered users, up 54% from the prior year. Despite its already significant customer base, quarterly growth in registered users actually trended higher in 2003.
eBay's well-known brand and large and active user base constitute a significant competitive advantage, in our view. The online-auction site is still the company's flagship business, accounting for $4.4 billion of gross merchandise sales in the fourth quarter of 2003. We estimate that eBay accounts for a majority of all Internet auction listings and gross merchandise sales.
However, eBay has broadened its business to become a mainstream shopping destination. It was able to successfully evolve in this way, in our opinion, by expanding its inventory and purchasing options. For example, eBay had only a single billion-dollar, gross merchandise sales category in 2001 -- eBay Motors. Now it has six. Newer categories are also showing notable growth -- including business-to-business segments like construction, industrial supply, and wholesale.
PAINLESS PAYMENT. eBay's enhanced purchasing options are also making it more appealing to mainstream users, in our view. Soon after its July, 2000, purchase of Half.com, eBay began offering "Buy It Now" instant-purchase capability on its flagship site. Fixed-price transactions accounted for 28% of gross merchandise sales in the fourth quarter of 2003. We believe they have resonated with buyers who don't care to wait for an auction to end.
eBay also offers enhanced payment options via PayPal, which enables any user with an e-mail address to send and receive online payments. These transactions are relatively inexpensive (free to the buyer, though the seller pays a fee) and fast.
The effectiveness of these pricing, purchasing, and payment advancements is notable, in our view. In 1999, collectibles made up 60% of gross merchandise sales, and practical (noncollectible) items 40%. After the deployment of these additional choices, 87% of 2003 gross merchandise sales came from practical items, with only 13% from collectibles. eBay's share of the U.S. online retail market has risen from about 16% in 2000 to 22% in 2003. With these advances and international expansion, eBay has estimated its market opportunity at some $1.9 trillion, which we think could prove conservative.
GROWTH PROJECTIONS. eBay seeks to build on its leading position in online trading by broadening its platform across new product categories and geographies, by enhancing features and functionality such as payments, and by fostering customer affinity. It has a presence in 28 countries, up from only 8 in 2000 and 1 in 1999. It has the leading e-commerce Web site in 12 countries and is the top online-auction destination in 16 nations. From 2001 to 2003, average annual growth was 78% in international users, 114% in gross merchandise sales, and 141% in transaction revenues.
PayPal is another important element to eBay's rise. It has seen notable growth in accounts, active accounts, payment volume, and revenue since its acquisition in October, 2002. In the fourth quarter of 2003, 91% of eBay listings offered PayPal, and 65% of the Web site's transactions were consummated using the service. eBay wants PayPal to become the standard payment method on eBay.com and in its international markets. It's also working to make PayPal more prominent on non-eBay Web sites.
Reflecting these initiatives and conditions, we believe eBay will be able to deliver revenue increases of 40% in 2004 and 30% in 2005. Over the next three years, we expect sales growth to average some 32% annually. We believe eBay has formidable resources to deploy on marketing, technology, and strategic acquisitions. It recently had a market cap of over $44 billion, and cash and investments of $2.8 billion -- and no debt -- as of December, 2003.MODEL ADVANTAGE. Another key advantage, in our view: Its technology platforms and infrastructure are difficult to replicate. Internet giants Amazon.com (AMZN
; 3 STARS, or hold; $45) and Yahoo! (YHOO
; 3 STARS; $46) have learned about the challenges of competing with eBay. Amazon's foray into online auctions failed. Yahoo shut down its European auction sites in 2002 and agreed to a marketing relationship with eBay. (Yahoo has had some success with online auctions in Asia.) We believe the first-mover advantage has been pivotal in online auctions, and eBay has capitalized accordingly.
One of eBay's key strategic assets, in our opinion, is its business model. Unlike many of its competitors, it isn't a retailer and doesn't have expenses related to back-end functions such as order processing, fulfillment, and shipping. Perhaps most important, it has absolutely no inventory costs and minimal associated risk. As a result, eBay boasts what we believe are robust margins and significant free cash flow that enable it to reinvest in existing operations and pursue new growth initiatives.
We expect eBay's annual pro forma operating margin to widen from 33.5% in 2003 to 35.6% in 2004, and to 37.2% in 2005. Net margins should improve from 23.7% in 2003 to 25.2% in 2004, and to 26.4% in 2005. These margins are well in excess of those of nearly all of its competitors.
DETERMINING VALUE. Our estimates of Standard & Poor's Core Earnings are 35 cents a share for 2003 and 67 cents for 2004. These forecasts reflect estimated stock-option expense under accounting regulation SFAS 123 of $215 million (33 cents per share) in 2003 and $236.5 million (35 cents) in 2004. We expect the impact of stock options as a percentage of net income to continue to decline. eBay does not have any pension-related expenses, because it doesn't maintain a defined benefit plan.
We believe the stock's current valuation is compelling. The shares recently had a p-e of 62, based on our 2004 estimate, considerably above that of the S&P 500-stock index. However, the stock's 2004 p-e-to-growth-rate (PEG) ratio of 1.5 was comparable to that of the S&P 500. And eBay's 2004 PEG ratio was 16% lower than that of the S&P 500 Info-Tech sector index. The stock also trades at notable discounts to Amazon and Yahoo, based on 2004 p-e and PEG. Employing comparative analysis, eBay appears attractive to us, particularly in light of its market leadership, growth prospects, and profitability.
We think the best way to assess eBay's value is through intrinsic analysis. We project it will generate annual growth in free cash flow averaging 53% from 2004 to 2006, declining gradually thereafter. This growth should outpace the rise in revenues due to increasing scale and operating leverage, margin expansion, and relatively low levels of capital spending. We estimate the stock's intrinsic value at $83, based on our
discounted cash-flow analysis.
WORST-CASE SCENARIOS. Our 12-month target price is also $83, a 20% premium to the recent market price. We expect to the shares to notably outperform the S&P 500 over the next 12 months.
Possible risks to our projections, target price, and investment opinion include anything that diverts users away from their customary level of activity on eBay's Web sites, challenges in international markets that are fraught with regulatory and cultural uncertainty, developments resulting in increasing taxation of its businesses, fraud or misappropriation involving the PayPal unit, negative publicity associated with eBay or its properties, or adverse litigation or rulings involving its intellectual property. Analyst Kessler follows Internet retail stocks for Standard & Poor's Equity Research