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Did eBay make the right call?
Stock Spotlight: eBay is betting Internet phone technology will change the way people buy and sell.
September 23, 2005: 11:54 AM EDT
By Grace Wong, CNN/Money staff writer
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NEW YORK (CNN/Money) - eBay hopes to dial up a new round of growth but many investors are skeptical.

The online auction company is paying a hefty $2.6 billion for Skype, a Luxembourg company that allows users to make phone calls over the Internet using so-called voice-over Internet protocol technology, or VoIP. eBay (Research) stock has tumbled about 7 percent since rumors of the deal first surfaced earlier this month.

San-Jose, Calif.-based eBay is taking a big gamble on Skype. Still, analysts say it's a smart move since eBay faces the twin challenges of decelerating growth in maturing markets like the United States and growing competition from search engines and other online retailers.

eBay is entering another highly competitive field though. Many phone and cable companies have already launched Internet phone services and Google (Research), Yahoo! (Research) and Microsoft (Research) are all seeking a piece of the business as well. But while eBay may be making a "me-too" purchase, it's also buying arguably the best brand in the industry.

But some analysts wondered whether eBay is overpaying since Skype is not expected to break even until the fourth quarter of next year.

"The Skype acquisition is an expensive price tag in the short run," Dave Edwards of American Technology Research said. "It's challenging to figure out if the Skype business model will be successful, but the company is valuing it on its long-term potential."

So did eBay make the right call for its investors?

eBay + PayPal + Skype = ?

eBay has a track record of making deals that complement its core business. When compared to previous acquisitions like Half.com, Shopping.com and PayPal -- all directly related to online commerce -- Skype looks a bit like a reach.

But analysts say Skype mirrors eBay in several ways. Specifically, Skype has a large, loyal base of users and strong sales growth. And the company's services, which have been popularized largely through word-of-mouth, are focused on the idea of community.

That makes it a natural addition, Meg Whitman, president and CEO of eBay, said on a conference call with analysts after the deal was announced on Sept. 12.

By combining Skype and PayPal, the online payments business eBay bought in 2002, eBay hopes to create the ultimate e-commerce and communication engine for buyers and sellers. For example, the company hopes to give sellers the opportunity to buy a "click to call" option alongside listings so a prospective buyer can contact them directly via Skype.

And Skype, which is expected to generate more than $200 million in revenue in 2006, also offers high growth potential as a stand-alone business.

While most VoIP services work by plugging a standard phone into an adapter, Skype offers software that users download to call other Skype users for free. But Skype also offers a range of paid services, such as the ability to make calls to non-Skype users, and voicemail.

"There are a lot of positive ways eBay can integrate its core businesses into Skype, but at the end of the day, the value is in Skype," said Jim Friedland, an analyst at SG Cowen.

Looking beyond Skype

Finding new revenue streams is important for eBay since it is facing a slowdown in growth in key markets like the U.S. and Germany. Shares of eBay had already plunged more than 30 percent this year before the Skype deal because of these concerns.

Deutsche Bank expects eBay's core auction business in the U.S. to grow 20 percent this year, still healthy but well behind its growth of just a few years ago. And while eBay has moved aggressively into emerging Asian markets, growth there hasn't come on as fast as some on Wall Street would like.

The company reported better-than-expected revenue and earnings for the second quarter, but driving those results were hikes to listing fees and strong operating expense controls, leading some to wonder if the results would continue. "The key question now remains whether the fee increases and improved growth rates are sustainable," said Deutsche Bank analyst Jeetil Patel in a research note.

eBay also faces growing competition from a host of Internet companies that are broadening their focus, Gartner analyst David Smith said. Particularly worrisome: search engines Google and Yahoo!, which have been effective in generating leads to sellers.

But investors shouldn't forget about eBay's other businesses, such as PayPal, which according to Edwards, is underappreciated. And while a slowdown in eBay's major markets is to be expected as the industry matures, there's still significant potential in western European markets like Britain and France, analysts said.

A worthy gamble?

Despite some challenges, eBay is a company you want to hold for the long haul. It has a solid business model, a history of successful acquisitions and proven leadership with Whitman at the helm.

Some analysts think there's a lot of upside in the near-term as well. Citigroup analyst Mark Mahaney believes the price could go as high as $49 over the next year, nearly 30 percent above Friday's market price of about $38.

Furthermore, with a P/E ratio of about 37 based on 2006 estimates, eBay trades at a discount to Yahoo! and Google -- which both trade at more than 42 times next year's earnings estimates.

Of course, Internet stocks tend to be high risk, and eBay is no exception. "There are a lot of question marks on the near-term performance of stock," SG Cowen's Friedland said. "It's going to take several quarters to see exactly what the growth trend is for Skype and how they're going to get there."

But the company has a great track record. And with analysts predicting average annual earnings growth of 30 percent over the next five years, we think eBay is worth ringing up for your portfolio.

None of the analysts in this story own shares of eBay. Deutsche Bank has an investment banking relationship with the company, and Citigroup has provided non-investment banking, securities-related services to eBay.

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M&A activity is heating up in the Internet sector. Click here for more.

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