Margin Pressures Will Hold Back eBay Inc Stock

Digital retail marketplace eBay Inc (NASDAQ:EBAY) recently reported first quarter numbers that missed the mark, and EBAY stock dropped roughly 5% as a result. Revenues missed expectations, while earnings came in as expected. That may seem somewhat shocking.

Seemingly every other tech company, from Facebook, Inc. (NASDAQ:FB), to Advanced Micro Devices, Inc. (NASDAQ:AMD), to Twitter Inc (NYSE:TWTR), reported much better-than-expected quarterly numbers. As such, EBAY’s miss stands alone against the backdrop of a bunch of beats.

But to me, it isn’t that shocking.

I’ve warned before that EBAY stock was susceptible to a large pullback. The stock has simply sprinted ahead of fundamentals. Everyone was buying into the turnaround story that EBAY was going to morph into a digital retail marketplace of increasing relevance.

But that isn’t happening.

EBAY continues to lose relevance where it matters — young consumers. Meanwhile, in order to stay relevant among older consumers, the company is having to spend an arm and a leg on marketing and product improvements. That is killing margins and weighing on earnings growth.

It is also weighing on eBay stock, and this pressure won’t ease anytime soon. I don’t see the pain in this stock ending until the price tag falls into the mid-$30s.

Here’s a deeper look.

Quarter Highlights Growth and Margin Concerns

EBAY’s first quarter numbers highlighted the two biggest concerns about this company going forward.

The first is erosion in what looks like a top-line narrative that has peaked. Revenue growth in the quarter was 7%, which is on trend with revenue growth rate over the past several quarters. But that growth is being driven by pricing increases, not higher usage on the platform.

Active buyer growth dropped to 4%, versus 5% over the past several quarters. Meanwhile, sold-items growth was just 1%, and that continues a multi-quarter slowdown in sold-items growth. Over the past several quarters, that growth rate has fallen from 4% to 3% to 2% to 1%.

What does this tell me? There is a ton of merit to Piper Jaffray’s Spring 2018 Taking Stock With Teens Survey, which found that eBay’s mind-share among teenagers fell to a record low 1.8%, down 120 basis points from 3% in the Fall 2017 survey.

Clearly, young shoppers aren’t migrating to eBay. Meanwhile, the older-shopper demographic is largely tapped out.

That older demographic is also being teased with the opportunity to buy and sell goods elsewhere on the internet. Consequently, EBAY is having to spend an arm and a leg to keep those users on its platform. Despite strong revenue growth, the sales and marketing expense rate rose 120 basis points year-over-year, while the product development expense rate rose 70 basis points.

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This is pressuring operating margins, which were 30% two years ago and are now expected to be just 28% this year.

eBay Stock Is Priced for Perfection

The problem with EBAY stock is that it’s priced based on perfect dreams that simply won’t materialize.

At best, revenue growth stays in its current 7% range over the next five years, despite signs of slowing growth and capped-out usage. Also at best, margins stabilize at their current 28% level, despite signs that the company is going to have keep spending to keep revenue growth positive.

That combination implies $13.4 billion in revenues in five years and nearly $3.8 billion in operating profits. Taking out $200 million for net interest expense, 21% for taxes, and dividing by a presumably lower share count of 850 million, that equates to roughly $3.30 in earnings per share in five years.

A market-average 16-times multiple on those earnings implies a four-year forward price target of $53. Discounted back by 10% per year, that equates to a present value of right around $36.

Bottom Line on EBAY Stock

The company is quickly losing relevance and having to spend a ton in order to combat that declining relevance. Because of this, EBAY stock is worth, at best, $36 today.

As of this writing, Luke Lango was long