How eBay Taught Me a Lesson

One of the well-deserved perils of writing a column like this is that occasionally someone will come along and, because of something you’ve written, call you–pardon my French–a “dumbfuck.” As it happens, I’m not plucking that word at random from the ether, because in Dumb Money, a forthcoming book about his adventures as a day trader, Joey Anuff (the editor of Suck) calls me precisely that. (The book, by the way, is terrific, and you should buy it when it comes out this spring.)

The source of Anuff’s ire was an item I did in one of my “Weekend Cocktail Chats” in the fall of 1998, just after eBay went public. The item mocked the online auction site as yet another fly-by-night Internet company with no hope of profitability and a market capitalization that bore no connection to reality. Although Anuff eventually became a day trader, eBay seems to have been the one company that he truly loved and invested in out of a real faith in its business, and so my ill-advised and ill-informed scorn made him a bit more annoyed than an item mocking, say, U.S. Steel might have.

I bring this all up because eBay reported earnings yesterday, and the report illuminated what now seems to me to be essentially indisputable, which is that the economics of eBay’s business are tremendous and its future is very bright. (This, of course, makes me wonder why I wasn’t able to see then what I see now, and what Anuff saw then.) Because eBay is essentially just facilitating interactions between buyers and sellers and not building or even really selling anything itself, its gross margins (that is, the cost of actually providing its “goods”) are almost guaranteed to remain high. Although the company obviously needs to invest heavily in technology to be able to handle its ever-increasing volume of items for sale, there are no obvious limitations on how big its virtual marketplace can grow, making it, in that sense, almost infinitely scalable. And the bigger it gets, and the more people grow comfortable with it, the wider the variety of goods people will buy and sell on it.

eBay’s real strength, though, is that it is the quintessential example of the so-called network effect, which says that the value of any network to its users increases sharply–perhaps even geometrically–as the number of users of that network increases. The network effect is often bandied about as characteristic of many businesses on the Net, but in fact there is no “network” on the Net like eBay’s. Sellers want to go where there are the most buyers, and buyers want to go where there are the most sellers, and therefore the positive feedback loop here seems practically unbreakable. For that very reason, eBay is also one of the rare examples in which the much-vaunted “first-mover” advantage also seems to have been real, although if eBay had not executed as well as it has, being first would not have been enough.

There are a couple of quirks to this story. For all the power of the network effect, eBay has seen its domination of online auctions eroded by the entry of Amazon and Yahoo into the market. I’m still not sure why (whenever I buy something on auction at Amazon, I can never figure out why the person isn’t selling the item on eBay, where I feel certain I would have been outbid). But Amazon and Yahoo do have powerful customer bases of their own, and have set up their interfaces so that auction items find their way to regular customers fairly easily. Also, Amazon lets you buy a lot of items with a credit card, and eBay has also faced price competition. Still, it now controls 60 percent of the market, and that’s actually up from 50 percent.

The other quirk is that over the past year, eBay’s stock price has not really moved much (although it did jump 12 percent in the wake of this latest earnings report). The stock is down 35 percent from its 52-week high, and it’s up only 2 percent since last March. One way of reading this is to say that investors finally woke up to the fact that eBay is still making just four cents a share, not much different than it was in 1998. But another way of reading this is that there were enough investors like Anuff at the beginning who understood eBay’s business and understood why they should own its stock that the company became fully valued not long after it went public. In other words, it may be that in eBay’s case, the stock market was fairly efficient, arriving at the “right” price in a matter of months rather than years (as arguably was the case with stocks like Coca-Cola or Microsoft). That doesn’t mean eBay’s stock won’t go up (or down) from here, especially since volatility is now a way of life for Nasdaq stocks. But it probably means that expecting eBay to become a proverbial ten-bagger (rise 1,000 percent) from here is a mistake.

The interesting thing about eBay for me is the way it crystallizes my changing view of Internet companies, and Internet stocks, over the past two years. What once appeared to be a bubble driven by hysterical investors now looks much more to me like as good an attempt as possible at quantifying the value of an economic opportunity that, taken as a whole, still looks practically limitless. (Of course, to almost everyone else, it looks like a bubble.) And while discussion of the Net remains swamped with hype and buzzwords, there clearly are companies, like Yahoo and AOL and eBay, that demonstrate that you can take advantage of that opportunity and still make a profit. I’d say I knew it all along. But my bank account won’t let me.