EBay's Painful Quarter

The online auction site didn't gain on rivals like Amazon, even in a down economy when it could be benefiting from deal-oriented shoppers

When earlier this year John Donahoe was named eBay CEO, succeeding Meg Whitman, he indicated that planned changes would inflict some pain in the short term (BusinessWeek, 1/23/08). He wasn't kidding. Figures released July 16 suggested that so far, Donahoe's changes, aimed at reviving growth, have done little to reverse a market share loss to rivals such as Amazon.com (AMZN).

For the second quarter, eBay (EBAY) reported profits of $460 million, or 35¢ a diluted share, on $2.2 billion in revenue. Those numbers exceeded analysts' average expectations.

Too Many Changes for Sellers

But the pace of growth continued to decline in eBay's core shopping business. The total value of goods sold on eBay's site grew just 4%, excluding the benefit of foreign exchange, down four percentage points from the first quarter. Its shopping business grew 13% annually, down two percentage points from the prior quarter. Revenue from fees charged when items are listed and sold on its shopping site grew just 9% from last year, down from 14% annual growth in the prior quarter.

Donahoe said during an earnings call that he believes the major changes to eBay's business—a new fee structure, system of rating sellers, and improved search technology, to name a few—will turn around the company's shopping business in the long run. "We are making the bold changes necessary for eBay to compete," Donahoe said. "We feel that we are on the right path, and we are going to stick with it."

Investors signaled disquiet. The shares dropped 14% the next day, leaving eBay down 27% this year. American Technology Research analyst Tim Boyd, who long held a buy rating on the stock until three months ago when he downgraded it to neutral, lowered his rating again on July 17, to sell. "I don't think anyone, until today, considered the possibility that eBay might have negative growth this year," Boyd says. "They are milking more and more from less and less."

Many of the sellers who make their livelihood from listing items on eBay are also dismayed by the changes, saying they're unable to adjust prices and shift strategy quickly enough to keep pace with eBay's rapid-fire moves. "There is a tremendous amount of change that sellers are being asked to shoulder," says Derek Brown, an analyst at Cantor Fitzgerald, who has long had a sell on the stock. "Every two to three months now [sellers] are walking into their living room and all the furniture is rearranged."

Growth Trailing the Market

In a conversation after the earnings call, Chief Financial Officer Bob Swan pointed out that some of the new initiatives increased the selection of goods on eBay and encouraged more shoppers to return to the site. Those in turn should increase total sales and the company's revenue over time. New listings increased 19% in the quarter vs. the prior quarter, and 3% from a year earlier. That's up from 10% quarterly growth and 2% annual growth in the first three months of the year. The number of items sold was up 10% from the prior year. "We believe that change is the right thing to do, and we believe that we have seen some very encouraging signs," Swan says.

Despite a gain in the number of items sold, the average selling price of goods on eBay declined 6%. That means items are selling, but at lower prices. Lower prices hurt sellers and are particularly painful to eBay under its new fee structure, which grabs the most revenue from percentage-based fees on the sale price of items.

Swan also attributed some of the declining growth in eBay's core shopping business to a slowing U.S. economy. Growth was flat in eBay's autos business, which brings in about 20% of the revenue for its shopping sites. Swan also said the softening economy was leading shoppers to buy cheaper items.

True, the economy is taking some toll on eBay's business. But a bargain site like eBay could also have benefited from a weakening economy as increased volume from deal-oriented shoppers makes up for the decline in selling prices.

Moreover, eBay's growth has long trailed growth in the overall e-commerce market. The U.S. e-commerce market is expected to grow 17% this year, according to Forrester Research (FORR). But revenue in eBay's U.S. marketplace grew just 12% from a year earlier.

Raised Revenue Forecast

As ever, a bright spot in eBay's earnings was the performance in its PayPal payments system. The total amount of payments processed by PayPal grew 35%, an acceleration from the annual growth in prior quarters. But even there, the outlook could worsen if growth continues to slow in eBay's core business. About half of PayPal's business is on eBay's sites.

Moreover, PayPal will soon be reimbursing shoppers for items purchased on eBay's site that turn out to be fraudulent. Swan says PayPal's fraud detection methods will flag problem transactions before needing to dole out reimbursements, thus keeping the company from suffering profit losses due to refunds—while increasing buyers' willingness to pay higher prices for items. "We are prepared to put our money where our mouth is," says Swan.

Swan believes changes like these will begin to have a positive impact by yearend. The company raised its forecast for full-year revenue to $8.8 billion to $9.05 billion, up from $8.7 billion to $9 billion. "Our focus is to exit 2008 stronger than when we entered," Swan says. That would surely assuage at least part of the newly inflicted pain.

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