eBay Inc. (NASDAQ:EBAY) is one of the most famous two-sided marketplaces, which is connecting buyers and sellers. And while many other companies relying on network effects are rushing from all-time high to all-time high, eBay has only been a mediocre investment in the recent past for various reasons.

(Source: Pixabay)

But, despite the network effect in place, eBay was struggling in the recent past, and the company might be a good case study to learn a little more about network effects – why they are so powerful and where problems and limitations of the network effect and 2-sided marketplace can be found. In this article, we will look mostly at eBay, but also at companies which are a potential threat to eBay – Amazon (NASDAQ:AMZN), Alibaba (NYSE:BABA), Facebook (NASDAQ:FB) or Etsy Inc. (NASDAQ:ETSY), for example.

History

eBay was founded in autumn 1995 and went public in September 1998. It was not only one of the companies founded during the so-called dotcom bubble, but – like Amazon – it is one of the very few companies and stocks that actually were a success and didn’t collapse after 2000. Today, eBay is a global commerce platform, which includes the eBay Marketplace, StubHub (which eBay is about to sell to viagogo for a purchase price of $4.5 billion) and classified platforms, which include brands like mobile.de, Kijiji, Gumtree or eBay Kleinanzeigen. From 2002 till 2014, PayPal (NASDAQ:PYPL) was a subsidiary of eBay and contributed to the revenue and earnings. In September 2014, it was announced that eBay would spin PayPal off into a separate company. This was a move demanded by Carl Icahn.

When looking at the performance of eBay since the IPO, the stock increased 4,260% in the last 22 years, which is a really impressive performance, and the stock was easily outperforming the S&P 500, which increased 225% in the same timeframe. For a very long time, eBay was also outperforming Amazon as an investment, but in the last few years, the stock performance of eBay lost ground to Amazon, which has increased 14,490% in the same timeframe.

ChartData by YCharts

But when looking at the performance of the last few years, eBay’s performance is not so impressive anymore. During the last five years, eBay could increase about 60% – similar to the performance of the S&P 500, while Amazon could increase 472% in the same timeframe.

ChartData by YCharts

When looking at other metrics than the stock performance, we also see eBay having problems to grow. Since 2007, eBay could increase its gross merchandise volume 5.66% annually on average, but in the recent past, the growth of GMV was slowing down. In the past five quarters, the gross merchandise volume in the United States declined every single quarter, with the year-over-year decline being especially steep in the last quarter (8% decline). In the last quarter, the international GMV declined as well (about 1% decrease YoY), while in the previous quarters eBay could at least report a mid-single digit YoY increase.

(Source: Own work based on 10-K and earnings releases of eBay)

When looking at the trailing 12-month number of active buyers during the last few quarters, we also see a slowdown. In the fourth quarter of 2019, the number grew only 2%, while the reported growth rate was at least 4% in the previous quarters.

(Source: Own work based on earnings releases of eBay)

We mentioned above that eBay is one of the classical examples of a 2-sided marketplace and that these companies usually have a wide economic moat around the business, which is protecting the companies against competitors and leading to stable revenue growth and high levels of profitability. In the next sections, I am showing why eBay should profit from network effects. But I will also show where the network effect has its limitations and what that implies for eBay’s business and performance.

The Network Effect

eBay is a classical 2-sided network characterized by the fact that there are two different classes of users which come to the network for different reasons, and each side offers complementary value for the other side. It is also a 2-sided network that is easy to understand: it just connects sellers that want to sell a certain item on the one side as well as buyers that want to purchase a certain item on the other side. eBay is basically offering the marketplace where buyers and sellers can be matched.

So far, we have just described a simple business model. To understand why it is such a powerful and durable business that is difficult to attack, we have to go a little deeper. While an ordinary company which is selling an item or a service can offer value to its customers from the very first day as the service or item is valuable in itself, a marketplace is only creating value over time when a high number of sellers and buyers are trying to offer and purchase products. To use an extreme example: if there is just one buyer or just one seller active at a marketplace, this marketplace won’t have any value at all, as it is not possible to sell or buy anything. And even with only a few buyers and sellers being active, it is rather unlikely that one seller is offering exactly the item a buyer is searching for. Only after time and with an increasing number of active users, the marketplace becomes valuable to both sides, and every new buyer offers additional value to the sellers, and every new seller offers value to the buyers.

And once such a large marketplace exists, it is difficult to attack as a new marketplace has to draw in buyers and sellers at the same time and, therefore, has to offer value to both groups at the same time. Once a marketplace like eBay with an active base of 180 million buyers is in place, it is very difficult for new marketplaces to convince sellers and buyers not to use eBay but another marketplace with a fraction of active buyers and sellers instead. Buyers won’t use a marketplace without sellers, and sellers won’t use a marketplace without buyers as it has no value for the other side. A competitor can even offer a better app, a more user-friendly marketplace or a better service – it probably won’t matter as the most important value proposition for buyers and sellers is the network of buyers and sellers. And such a large and dense network is almost impossible to offer for young companies in the early days.

And considering these aspects, it is not surprising to learn that eBay is on the 44th spot on the list of most valuable companies in the world (according to Interbrand). Until 2014, Interbrand saw the brand value increase every single year, but since then, Interbrand saw the brand value declining every single year. And this brings us to the next important section of our article – why eBay seems to be in trouble despite its network and how such networks can be attacked after all.

Competitors

We mentioned above that it is difficult to attack a network like eBay with about 180 million active buyers as it is quite difficult for competitors to create a similar marketplace from scratch. Nevertheless, eBay seems to have problems to achieve growth and several metrics – like GMV, revenue or active users – are either declining or growing only in the low single digits. And there are two different reasons for these problems: eBay is facing competitors that already have a large and dense network in place and additionally, eBay is facing a phenomenon called “multi-tenanting”.

Multi-tenanting

Let’s start with multi-tenanting, which is one of the major weaknesses of marketplaces and is undermining the defensibility and is often mentioned in the articles and whitepapers of Nfx. Multi-tenanting basically describes the problem that sellers can offer their products not only at eBay, but also at other marketplaces, and buyers can also search on different marketplaces for the products they want to purchase. If you can’t use two marketplaces at the same time – because it would be too expensive or too time-consuming – marketplaces like eBay could defend themselves against competitors. As long as a marketplace can’t “lock in” its sellers and buyers in a way that doesn’t make using other marketplaces unattractive, a company (or its marketplace) will face competition.

Rising marketplace: Etsy

And therefore, eBay is facing competition from new companies, which can enter the market due to the above described multi-tenanting effect as the existing users of eBay can also try out new marketplaces without facing huge additional costs. A good example would be Etsy, which has about 44.8 million active buyers already (reflecting a 20.7% increase YoY) and 2.6 million sellers (reflecting a 26.9% YoY growth).

(Source: Etsy Investor Presentation)

And Etsy can not only increase its GMS with a high pace, the company is also increasing the GMS per active buyer a little bit. In the last few quarters, Etsy could increase the GMS per active buyer about 2% to $101.50 in the third quarter of 2019. According to Etsy’s guidance, the GMS for 2019 will be about $5 billion, and this is still only a fraction of eBay’s gross merchandise volume, which is about $90 billion. But 44 million active buyers are quite a lot, and Etsy can, therefore, be a threat to eBay. The strategy to handle such threats could be to just buy the competitor, but with a current valuation of $6 billion, Etsy might be too expensive for eBay to buy. Facebook (FB) could successfully purchase Instagram, but at a point in time, where Instagram had only about 1 million users.

Existing networks: Amazon, Alibaba, Facebook

And that would not solve the problem for eBay as it is not just facing competition from Etsy, but also from companies like Amazon, Alibaba, or Facebook. The problem is that these companies already have a huge customer base and a huge network. Amazon might have about 110 million Amazon Prime members just in the United States. Facebook has about 1.6 billion daily active users. And Alibaba’s marketplace Taobao has about 700 million monthly active users, but is probably not the biggest threat for eBay, and therefore, we will rather focus on Amazon.

When looking at companies like Amazon or Alibaba, there is a huge advantage. Both are selling products that already have a large number of customers using the site, and the buying side of a 2-sided network already exists. Millions of customers are using Amazon in order to buy products, and while this is not enough to create a similar 2-sided marketplace as eBay, it is much easier as if a company had to start from scratch. The huge number of buyers is a huge incentive to sell at Amazon, and it is therefore much easier to attract sellers to the marketplace. Amazon launched its marketplace already in 2002 – seven years after eBay – and might therefore be the major competitor of eBay. In the last quarter, Amazon generated about $17.4 billion from “Third party seller services”, which is not only reflecting a growth of 30% YoY (while eBay is struggling to grow its GMV). According to the press release, third party sellers sold more than a billion items during the holiday season (including more than 100 million items shipped with Prime Free One-Day Delivery). And in 2018, the gross market volume generated by Amazon Marketplace (third party sellers) was about $160 billion and therefore about twice as high as eBay’s GMV.

Facebook might also be an additional example for a company that can pose a threat to eBay. Although people are not using social networks like Facebook primarily to buy or sell items, the company has already an impressive network it can use. With 1.6 billion daily active users and almost 2.5 billion monthly active users, it is easier to start a 2-sided marketplace like eBay.

(Source: Facebook Investor Presentation)

In 2016, Facebook re-launched its marketplace after the company had already tried to launch its marketplace several times in the past without being successful. And with more than 700 million monthly active users as of March 2018, it seemed to be more successful this time. And aside from Facebook, there are many more companies with similar social networks in place like Tencent (OTCPK:TCEHY) with more than 1 billion monthly active users for WeChat, which could pose a threat to eBay at some point in time.

Summing Up

Considering the network effect of eBay, one might expect that eBay should report metrics of high stability and consistency. But when looking at the last decade, the numbers show a different picture. A stable gross margin can show consistency of the business and maybe some form of pricing power (and both are indicating a wide economic moat). In case of eBay, the gross margin is actually quite stable – the improvement between 2014 and 2015 stems from the PayPal spin-off. The return on invested capital (ROIC) is another metric indicating if a company might have an economic moat (and companies with a strong network in place usually have a wide moat). On average, eBay has an RoIC of 12.71% during the last decade, which is acceptable, but the numbers show extreme fluctuations from year to year.

(Source: Own work based on numbers from Morningstar)

While margins and RoIC are acceptable, revenue, earnings per share, and free cash flow show a different picture. When looking at revenue, we can see an uptrend, but after the PayPal spin-off (which explains the decline between 2014 and 2015), eBay could increase its revenue only 5.88% on average (compared to 18.25% on average in the years 2010 till 2014). And especially in 2019, revenue could only be increased 0.5%. When looking at earnings per share, we see wild fluctuations during the decade without any real trend. In 2016, earnings per share (on a GAAP basis) were as high as $6.35 and in 2017 as low as ($0.95). For 2019, eBay could report a non-GAAP EPS of $2.83. In the years until 2014, free cash flow could increase with a steady pace, but in the two years after the spin-off, the free cash flow dropped and is now fluctuating between $2 billion and $2.5 billion.

(Source: Own work based on numbers from Morningstar)

Considering the slowdown in growth rates, it makes sense for eBay to start paying a dividend and distribute money to shareholders. It also makes sense to buy back shares, but eBay should not forget to invest in its business. Just buying back shares can be dangerous – even with network effects in place, but especially when facing competition like eBay is facing right now.

Conclusion

I am certainly not saying that eBay is a bad investment, but during the last five years, it performed pretty similar to the S&P 500 and, therefore, not a great investment. And especially considering the 2-sided marketplace and the competitive advantage that often stems from such networks, eBay as investment was a disappointment. While other companies built on strong network effects outperformed the market in the last few years, eBay was facing some competitors, which created serious troubles for eBay, and the challenges will probably continue.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2020-02-17