eBay's PayPal Drives Q2 Earnings, Shares Up

eBay Inc. EBAY shares were up 1.5% post its earnings report, as another strong quarter from Paypal drove up its profits.

Revenue

Gross revenue of $4.37 billion was up 2.4% sequentially and 12.6% year over year, more or less in line with of our expectations of around $4.38 billion and in the middle of eBay's guidance range of $4.33-4.43 billion. Currency accounted for a little over 1.5 points of the year-over-year growth.

The bulk of revenue (84%) continues to come from transactions, with the balance coming from marketing services. Both categories grew double-digits from the year-ago quarter and were also up on a sequential basis.

Revenue Breakup

eBay's has three segments: Marketplaces, which refers to the revenue earned from the sale of goods available on eBay properties; Payments, which refers to revenues generated through Paypal; and Enterprises, which comprise mainly of services rendered following the acquisition of GSI.

The three segments generated 50%, 44% and 6% of quarterly revenue, respectively. The Payments segment grew 5.5% sequentially, the only one with any notable growth. The Marketplaces segment was up slightly while Enterprise declined slightly. Marketplaces, Payments and Enterprise revenue grew 5.5%, 19.8% and 2.7% from year-ago levels.

Both U.S. and International revenue grew low single-digits sequentially. On a year-over-year basis, U.S. and international revenue grew 9.5% and 15.5% to around 47% and 53% of total revenue, respectively.

Volumes

eBay's Marketplaces gross merchandise volume (GMV) was down 0.3% sequentially while growing 12.0% year over year (a relatively steady rate) with the U.S./International mix remaining roughly the same at 39%/61%. Active buyers grew very strongly from both the previous and year-ago quarters. Fixed price volumes grew 19% in the last quarter. Top seller same store sales in the U.S., U.K. and Germany was up 14%.

eBay's Paypal was the major driver of revenue, generating total payment volume (TPV) growth of 5.8% and 28.6% (26% on a currency-adjusted basis) from the previous and year-ago quarters, respectively. TPV strength in the last quarter was on account of the increased Paypal adoption by merchant sites all over the world and contribution from Braintree. Additionally, Paypal's penetration on eBay grew 260 bps to 55.6%, also contributing to the growth.

eBay's enabled commerce volume (ECV) grew 5.4% sequentially and was 26.4% above the year-ago level.

Mobile enabled commerce volume jumped 68% from last year to $12.3 billion.

Margins

The pro forma gross margin for the quarter was 68.6%, down 24 bps sequentially and down 63 bps year over year. The take rate remains roughly consistent with the previous quarter but is down from the year-ago quarter. This is the main reason for the gross margin decline despite such a strong jump in volumes.  Transaction margins improved, as both expense and loss rates declined. Gross profit dollars grew 2.1% sequentially and 11.6% year over year.

Operating expenses of $2.11 billion were up 7.8% sequentially and 14.9% from last year. The operating margin shrank 266 bps and 159 bps, respectively from the previous and year-ago quarters to 20.4%. The main reason for the operating margin decline was higher S&M expenses as a percentage of sales.

Excluding the impact of intangibles amortization on a tax-adjusted basis, pro forma net income was $738.6 million or 16.9% of sales compared to $784.4 million or 18.4% in the previous quarter and $711.0 million or 18.3% in the year-ago quarter.

Including the special item, the GAAP net income was $676 million ($0.53 per share) compared to loss of $2.33 billion ($1.82 per share) in the Mar 2014 quarter and $640 million ($0.49 per share) in the Jun quarter of last year.

Balance Sheet and Cash Flow

The company has a solid balance sheet, with cash and short term investments of $7.37 billion, down $475 million during the quarter. eBay generated $1.49 billion in cash from operations and spent $269 million on capex, netting a free cash flow of $1.23 billion (down from $968 million in the last quarter). eBay also spent $35 million on acquisitions and $1.66 billion on share repurchases.

Outlook

Management expects third-quarter 2014 revenue of $4.300-4.400 billion (down 0.4% sequentially and up 11.8% year over year at the mid-point), which was short of consensus expectations of $4.42 billion. The company expects to generate a GAAP EPS of 51 to 53 cents and a non GAAP EPS of 65 to 67 cents. The EPS guidance is much better than the Zacks Consensus of 60 cents.

For 2014, eBay expects revenue of $18-18.3 billion (upper limit down from $18.5 billion), with GAAP earnings of $0.04 to $0.09 (maintained) and non-GAAP earnings of $2.95-$3.00 (maintained).  

Conclusion

eBay has already taken all the necessary measures to boost the Marketplaces business, beginning with the fixed price format, moving on to wooing big sellers and customers, improving the technology and navigation of its properties, investing in better fulfillment services and especially focusing on mobile customers. Its drive to provide complete online solutions for traditional retailers should further add to this growth.

It goes without saying that major online retailers such as Amazon.com AMZN are not going to make things easy for eBay. Additionally, Google Inc (GOOGL) has been making some plays in the online retail/payments segment that potentially increase competition for the company. Apple AAPL also has the potential to encroach on its all-important Payments business. The advent of China's ecommerce giant Alibaba coming to the U.S. will also increase competition for the company.

While eBay's marketplaces business is back on track and the Payments business is well ahead of the competition, the increasing competition, prolonged investments and execution risks make us incrementally cautious, which is the reason the shares carry a Zacks Rank #4 (Sell).