Buy eBay Stock Before the PayPal Spinoff (EBAY, PYPL)

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All eyes are on giant auction company eBay (EBAY) as it prepares to begin a new phase of life without its most illustrious subsidiary, PayPal (PYPL).

Buy eBay Stock Before the PayPal Spinoff (EBAY, PYPL)In what is about to become a famous victory for hard-hitting activist investor Carl Icahn, who owns a 3.8% stake in EBAY stock, eBay’s board has officially approved to break eBay into two separate units: Marketplaces (eBay’s traditional business) and PayPal.

Carl Icahn has all along maintained that separating the two segments would unlock substantial value for eBay shareholders. EBay’s management, however, took a different view of things and has for long resisted calls for a breakup by countering that PayPal had benefited greatly from the massive investments eBay had been pumping into the payments unit — which implied that PayPal would falter on its own.

However, in April, an agreement was reached in which eBay would continue to support PayPal after the July 20 spinoff with, among other things:

  • A $5 billion sendoff cash handout
  • An agreement that at least 80% of eBay’s Marketplaces gross merchandise volume (GMV, which is the value of businesses handled by the segment — worth about 24% of PayPal’s payments volume) to be handled by PayPal for the first five years after the split.
  • Desisting from creating a rival payment platform to compete with PayPal. PayPal, however, seems to have gotten plenty of leeway and will have the liberty to strike deals with eBay rivals including Amazon (AMZN) and Alibaba (BABA).

Meanwhile eBay stock is up 5.8% YTD and 18.6% over the past 12 months.

Unlocking Shareholder Value

Numerous studies have shown that corporate spinoffs more often than not create substantial shareholder value.

A 2008 piece by Investopedia highlights, among other things, a 2000-05 Lehman Brothers study that shows both spun-off companies (45%) and their parents (40%) beat the market by quite a sizable margin during the first two years after breaking off, as well as an older study published in the Journal of Financial Economics that determined that spinoffs and parents beat the S&P 500 by a 30% and 18% margin, respectively, during the first three years after breaking apart.

On this premise alone, it makes plenty of sense to separate PayPal from Marketplace.

PayPal has consistently grown at a faster clip than Marketplaces over the last decade. For instance, PayPal’s first-quarter revenues grew 14% to $2.1 billion, while eBay’s Marketplaces revenue declined 4% to $2.07 billion. That’s pretty much representative of the past couple years.

Marketplaces has been seeing declining revenue primarily due to intense competition in the e-commerce space, which has caused GMV as well as eBay’s take rate (commissions charged on transactions) to fall. EBay’s GMV declined 2% during the quarter to $20.2 billion, while its take rate on Marketplaces transactions declined slightly to 8.28%. Marketplace’s take rate, however, remains far higher than PayPal’s, which clocked in at 3.43%.

A fair valuation of PayPal as standalone unit remains a matter of conjecture, though I believe that Needham’s Kerry Rice’s recent $49.6 billion estimate is within the ballpark.

EBay’s consolidated net income margin for the first quarter clocked in at 14%. PayPal sports an operating margin of 21% compared to 37% for Marketplaces thanks to its higher take rate. Using these figures, PayPal’s annualized net income comes in at $906.6 million. A $49.6 billion valuation would give PayPal shares a rather rich price-to-earnings ratio of 54.7 — almost double the current readings by Visa (V) and MasterCard (MA).

To justify such a rich valuation, many analysts argue that unshackling PayPal from eBay will unlock its true growth potential.

PayPal also is viewed as a more complete online payment platform since eBay has succeeded in integrating Braintree, a mobile payments platform that it acquired in 2013 for $800 million. Prior to the acquisition, Braintree was doing about $12 billion in total payment transactions, of which $4 billion were mobile payments.

Now let’s take a worst-case scenario where eBay’s stock falls by a margin that fully reflects the loss of income after the spinoff. (I won’t adjust this figure to reflect Marketplaces’ lower growth rate, as I think it’s highly unlikely things will pan out this way.) If eBay stock, which currently trades at around $61, was to trade down to reflect this reality, it would trade at $38.91.

EBay shareholders will receive one PayPal share for every eBay share they hold. Working with the Needham valuation of PayPal yields $40.83 per PayPal share. This implies that your eBay shareholder will now hold one eBay share worth $38.91 and one PayPal share worth $40.83, working out to a combined worth of $79.74.

Congratulations — you’ve just earned a net gain of more than 30%.

Should You Sell eBay Shares After the Spinoff?

At first glance, it seems as if EBAY stock will be toast following the spinoff. EBay will have to shoulder the entire company’s $7.5 billion debt and part with $5 billion in cash, leaving it with just a little more than $4 billion on its books.

But there is case to be made about holding eBay stock.

For one, the shares will quite likely find a floor well above the $38.91 figure we have worked out above. Credit Suisse projects that eBay, post-spinoff, will grow its GMV at 10.8% — significantly faster than the 9.7% clip it recorded in 2014.

And eBay can now channel the investments it was pumping into PayPal to more promising ventures such as the ‘‘multiscreen product experience.’’

If eBay’s GMV and operating leverage can continue improving, eBay stock could end up having significant upside.

As of this writing, Brian Wu did not hold a position in any of the aforementioned securities.

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