How to Play Last Week's Rumor of an eBay/PayPal Spin-Off
08/26/2014 9:09 am EST
MoneyShow's Jim Jubak doesn’t see the possible spin-off of this online auction house’s payments processing service as motivated by shareholder-friendly efforts but rather by a huge increase in competition, so he’s selling his shares as of today, August 26.
When rumors swept through the stock market last week that eBay (EBAY) was thinking about spinning off its online payments business PayPal, eBay’s shares jumped amidst lots of talk about how Carl Icahn had been right in his fight to get eBay to separate PayPal from its eBay marketplace business. The break up, Icahn had argued, would release the full market value of PayPal that was being buried by its link with the slower growing eBay marketplace.
Interesting storyline but one that’s—essentially—wrong. Any decision to split PayPal and eBay isn’t motivated by some shareholder-friendly effort to realize market value.
Instead, I think it’s motivated by a huge increase in the competition in the e-payments sector. The battle now is all about scale and eBay needs to create a currency—publicly traded PayPal shares—that it can use to build market share through acquisitions in the sector. PayPal—even with 152 million users—isn’t big enough to fend off new competition from Visa (V), Amazon.com (AMZN), soon to be public Chinese Internet giant Alibaba, and Google (GOOG). To compete, PayPal is going to have to acquire new whiz-bang features and break into new market segments in order to build its user base. And, to do that, PayPal is going to need stock that it can use to convince new talent and young entrepreneurs to sell to it rather than its competitors.
In my opinion, it’s an appreciation of the logic of that story—and of PayPal’s strategic need for growth—that fueled last week’s rumors.
The challenge in the e-payments space is stunning. PayPal’s own numbers clearly demonstrate the problems. Even though e-payment is a fast growing market with immense prospects, current numbers argue that it’s already commoditized. Nobody makes much money on a transaction.
For example, in the second quarter of 2014, PayPal (with its 152 million users) processed $55 billion in payments, producing revenue of $2 billion. Pre-tax operating profit on that $55 billion in payments was just $500 million. But that figure doesn’t fully account for overhead for PayPal that shows up on eBay’s income statement. Making some estimate for what percentage of that would go to PayPal if the companies operated independently—about half, the Financial Times suggests—results in a profit for PayPal of less than 0.5% of payment volume.
That margin looks tight enough, but it is, in fact, even tighter since much of it comes from things other than simply processing payments. For example, PayPal provides credit to users for purchases based on their account history. (PayPal plans to buy the $1 billion loan portfolio for its co-branded credit card from GE Capital in 2016.) Businesses that use PayPal to sell and then collect from customers can get a loan for working capital based on projections of future sales. (In essence, this is an e-payment return to the good old days of “factoring,” when a company could get a loan backed by sales made but not yet received.)
Looking at numbers like these, it’s not clear why everybody is rushing to either start or fund an e-payments business. The Financial Times counted 800 e-payments startups on a major venture capital Web site for startups.
In spite of the growth prospects for the space as a whole, it’s clear to me that almost none of these startups will achieve the scale necessary to make any money in this market. They are instead—if they’re lucky—candidates for acquisition by the big players, like PayPal, Visa, and Amazon that have already built that scale and now face the need to find a way to add more users.
An example of one of these startups and its trajectory is Venmo, an e–payments app that allows friends to transfer money to each other based on their trust and personal history using bank-grade security and a smart phone. No more, “Gee, didn’t you owe me $78.50 for dinner?” Now that money can move to the user’s Venmo account or to the user’s bank. The goal, the founders told Forbes in 2013, was to be accepted like Visa but used like Facebook.
Sure, much cooler than PayPal, or Visa, or Amazon and with the potential to tap into a new customer base.
In August 2012, Venmo was acquired by Braintree, the company that handles payments for Uber, Airbnb, and LivingSocial. Braintree processed $12 billion in payments in 2013 with $4 billion of that coming through mobile devices.
In September 2013, eBay bought Braintree (and thus Venmo) for $800 million.
In this example, I think you’re looking at the growth strategy for e-payments and the reason that eBay will—if they’re smart (and I think they are)—split off PayPal in order to create a new currency for these acquisitions.
If I’m right, what do you want to do with eBay shares? The stock is a member of both my 12-18 month Jubak’s Picks Portfolio and Jubak Picks 50 long-term portfolio. My read is that eBay/PayPal is in for a period of very tough competitive pressure where frequent news stories about big competitors entering the space have a regular depressing influence on the stock. In this atmosphere—and in the time period of the 12-18 month portfolio—I think it’s going to be hard for the shares to make much headway. If you want to hold on in anticipation of another 10%, or so, pop on a confirmed spin-off, I think that’s a reasonable speculation. But I just don’t see this emerging as a solid and appreciated growth story in the 12-18 month time horizon.
So, with this post, I will be selling eBay out of the Jubak’s Picks portfolio as of Tuesday, August 26. I have a 7.47% gain in the stock since I added it to this portfolio on April 22, 2013.
Your decision on what to do with eBay in the longer-term portfolio depends on how you see the battle going in the e-payments space. PayPal does have advantages over Visa and even Amazon in this battle—as a pure play on e-payments, it does have a chance to win a substantial percentage of the acquisition battles. It does have more experience than competitors in adding new products and services in this space. And it has relatively fewer conflicts—internal and external—than Amazon or Visa. I think the e-payments space will grow so fast (more on the projected growth of the sector in a future post) that even a Top 3 finish would be extremely profitable. With that in mind, and in recognition of the scale that PayPal has already achieved, I’m going to keep the shares in my long-term portfolio.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I managed, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund shut its doors at the end of May and my personal portfolio is now in cash. I anticipate putting those funds to work in the market over the next few months and when I do I’ll disclose my positions here.