Can eBay continue to defy gravity?

From Knowledge@Wharton
Special to CNET News.com
February 28, 2005, 12:00 PM PST

When eBay reported its 2004 financial results on January 19, it looked like business as usual. Annual revenue was up 51 percent from a year ago, and net income jumped 76 percent. But then the company cut its outlook for 2005 and rankled customers with a fee increase. On Wall Street the Internet darling got panned as shares tumbled 19 percent in one day (January 20).

Are these issues short-term growing pains or the beginning of something worse? Is eBay becoming a mature company that won't be able to keep up its heady growth? And what competitors are targeting eBay? Wharton experts say there's no need to get too worried about eBay's prospects right now. In the future, however, things may become more interesting.

Wharton management professor Saikat Chaudhuri says eBay is going through a natural evolution of companies in relatively young markets. First, one dominant player emerges due to first mover advantage as eBay did. Then, a company gains near monopoly status in its new segment such as electronic auctions. Next, large competitors such as Yahoo and Amazon get interested in the market and even smaller rivals adopt similar business practices. And finally, the dominant first mover matures and the rate of growth slows.

"A P2P commerce network would be able to do what eBay does but without the centralized servers, infrastructure costs and overhead."

-- Wharton marketing professor Peter Fader

"I'm not worried about eBay's performance, but the question eBay has to ask is when it will reach the limits of its growth," says Chaudhuri. "It won't be today, but it could be five years from now." Marketing professor Yoram "Jerry" Wind, co-author of a recent book entitled ?The Power of Impossible Thinking?, agrees. "eBay is positioned well, but the longer you go with strong percentage growth the harder it is to keep going," he says.

Worries about eBay were triggered by its fourth quarter earnings results. The company reported pro forma earnings of $226 million, or 33 cents a share, on revenue of $935.8 million, up 44 percent from a year ago. While those results were strong, they fell short of Wall Street estimates by a penny, prompting analysts like Merrill Lynch's Gregory Smith to note "a few chinks in the armor." The outlook for first quarter earnings and 2005 was also slightly cut because eBay is planning to spend $300 million on expanding globally.

On the company's earnings conference call, eBay CEO Meg Whitman said the company faced the same lumpy results over the holiday shopping season that traditional retailers experienced. "We saw some very unusual trading patterns in November and December," noted Whitman. "As a mainstream shopping destination, the eBay marketplace was affected by the same delay in holiday shopping that occurred in much of offline retail."

Can eBay continue to defy gravity? "We believe eBay has shown signs of becoming a victim of its own phenomenal growth success as the law of large numbers begins to impact results," wrote Smith in a report. "Taking a step back, we realize that eBay still has an outstanding business model and overall fundamentals remain intact."

Challenges ahead
While worries about eBay's future are premature, the company has some challenges ahead, say Wharton faculty.

One example: eBay may not have the pricing power it thought it had. A recent price increase in fees for posting photos and other advanced features wasn't handled well, and some customers revolted. Following complaints, eBay issued an open letter to customers and announced it reduced listing fees on items below 99 cents to 25 cents from 30 cents. eBay raises fees annually.

Chaudhuri acknowledges that eBay could have handled its price increases better. "eBay wasn't savvy about it. At other companies like Procter & Gamble there's a more formal process and a scientific way to evaluate the impact of price increases. eBay has been so successful that it didn't expect any pushback."

"eBay is one of the most mature companies in an immature industry."

-- Wharton management professor Saikat Chaudhuri

That kind of flub shows just one of the challenges eBay faces. Another issue is growth. In 2004, the fourth-quarter growth rate for eBay's U.S. auction business slowed to 25 percent from 40 percent in the first quarter. International auction growth, however, picked up the slack, but analysts say that can't last forever. The trick for eBay will be to keep its growth rates while managing Wall Street and customer expectations. "The challenge is to temper investor expectations for boundless growth and to avoid the temptation of overreaching to satisfy Wall Street," says Wharton marketing professor Peter Fader.

Bottom line: eBay is a mature company, and growth has to slow at some point. Not today, maybe not next year--but over the next five years or so, slower growth is definitely possible. "If maturity isn't here it's certainly on the horizon," says Fader.

Slowing growth will also mean that eBay will have to keep its current customers and lure new ones. As they mature, all companies have to fuel repeat purchasing, attract new customers and minimize churn. Wharton experts say eBay to this point has had it easy. Its network, growing base of buyers and sellers and wide availability of products have come with minimal marketing. eBay hasn't had to try all that hard to grow. Wind says eBay's biggest challenge will be to maintain the edge it had as a smaller company. "Can eBay manage its growth internally with its people and processes?" asks Wind. "Or will it become big, complacent and arrogant like most big companies?"

No need to panic
Fader says there's no need to get overly concerned about eBay's fourth-quarter performance, even if it did disappoint a few skittish investors. "I am as upbeat as ever about the prospects of eBay," he notes. "They have a gold mine there." Given eBay's winning streak of strong quarters and solid performance from the day it went public, "at some point, you have to just sit back and trust them."

According to Fader, eBay has entrenched itself as a bona fide distribution channel, and that's really hard to displace, especially because the company maintains its focus on core markets. Whitman cited eBay research showing that 430,000 users depend on eBay for some or all of their livelihoods. "Compare eBay to Amazon, which is really just a bookstore," says Fader. "eBay is a distribution channel that's only growing. Amazon is diluting itself." The company, with its reputation as a one-stop shop for things ranging from old football jerseys to stadium naming rights to automobiles, doesn't have any competition in the near term, he and others add.

The wild card is what eBay will do when its growth begins to slow. Will it branch out into retailing? Will it enter new businesses? eBay has branched out somewhat, but acquisitions such as PayPal, Half.com and Rent.com complement its core auction business. Meanwhile, with each eBay move, the company becomes more secure. "It would be very difficult for any company to replicate eBay," says Wind. "The rating system, the infrastructure, the incredible trust between buyers and sellers are really priceless."

As for customer losses, Chaudhuri says there's no need to worry because customer churn is a natural issue with maturing companies. "Some customers are going to leave anyway. eBay still offers a compelling value to customers."

Future competitors
Although Fader, Wind and Chaudhuri were unanimous about the lack of competition for eBay, all agree that the real threats may not even be created yet. "You really have to look for competition from left field," says Wind. "A bank isn't worried about the bank across the street; it is worried about Wal-Mart."

In the U.S., no competitor provides the network and scale of what eBay provides--although some players such as Overstock.com are nibbling at eBay's market. The real battle will be abroad. "The next decade of growth will come from the rest of the world, not the U.S.," Wind predicts. Overseas, the competition to eBay is more intense. On the international scene, the most obvious competitors are Yahoo and Google, which have the resources to take on eBay directly. Some rivals even have first mover advantage: Yahoo Japan, for example, is the leader in auctions in Japan.

eBay, however, has done its best to acquire international players such as India's Bazee.com. The strategy is to buy strong eBay-like clones to gain entry into a new market. In 2004, eBay launched two new sites in the Philippines and Malaysia, consolidated ownership of Internet Auction Company in Korea, and made two acquisitions in Europe. "The potential in expanding eBay's global marketplace is enormous," said Whitman, adding that eBay will continue to grow internationally, especially in China.

"Sites like Craigslist won't be a direct challenge, but whenever distance matters the local sites could win."

-- Wharton legal studies professor Dan Hunter

The real unknown for eBay is the competition under the radar. Wharton legal studies professor Dan Hunter says he expects U.S.-based local sites, including Craigslist, a minimalist local community site that features classified ads and local information, to become a viable threat to eBay. "Sites like Craigslist could nibble at eBay by providing a trusted local network of good products and recommendations," notes Hunter. "Sites like Craigslist won't be a direct challenge, but whenever distance matters the local sites could win." eBay may already see the threat from local merchants. It recently bought a 25 percent stake in Craigslist.

According to Hunter, social networking software and services like Friendster could also form a commerce network. The benefit of these social networking sites is that a level of trust between buyers and sellers would already exist due to peer referrals. "eBay spends a significant amount of time on disputes and keeping the reputation of sellers high," says Hunter. A commerce network of "friends of friends" could be powerful. "These social networking sites would in theory eliminate the need for that cost. You drive down costs as you start to build the network."

Fader expects peer-to-peer networks to also become a formidable eBay rival in the future. These "P2P" networks are typically used to swap music and video files but ultimately could be used for commerce, says Fader. "With P2P you could line up millions of people to buy and sell easily. It won't happen right away, though, because the technology has so many legal clouds." A P2P commerce network would be able to do what eBay does but without the centralized servers, infrastructure costs and overhead. "It could be a threat, and I wouldn't be surprised if it weren't on the back of someone's napkin somewhere."

eBay's next steps
The ultimate question is how eBay should fend off encroachment from rivals, maintain its focus and build the infrastructure and management team to continue to evolve. Chaudhuri says eBay's first mission is to maintain its focus. "eBay's big advantage is that it is focused on one area, and that's good," he says. "eBay has a first mover advantage that it can build on even if it ultimately changes its business. eBay will always be associated with commerce."

As growth slows, eBay will also have to find ways to lure consumers such as Fader, who likes eBay's business, but isn't much of a fan of the company as a shopper. "I go there as a last resort," says Fader, who doesn't care for the auction format in general. "eBay will have to reach out to get customers like me without diluting its core auction business." eBay can go more mainstream perhaps with acquisitions of consignment or "drop off" stores, which take goods and sell them on eBay. Those stores appeal to potential customers who may not be inclined to start and follow an auction on eBay.

At eBay's analyst meeting shortly after its earnings report, Whitman outlined plans to expand its PayPal unit. PayPal can be now used to buy music downloads on iTunes and Napster, and eBay is pitching PayPal as an option for merchants both off and on eBay. To support its initiatives, eBay is bolstering its management ranks. The company recently swapped executives running PayPal, and the North American and international businesses. eBay also named a new chief technology officer. According to Whitman, the moves will "effectively spread expertise throughout the company and help set the stage for our next phase of growth."

Wind says that kind of focus on management depth will serve eBay well in the future. For example, eBay executives will learn from their mistakes when it comes to managing expectations and rolling out price increases. "I think they realize that they could have done this smarter." According to Chaudhuri, eBay is up to the task. eBay, he says, "is one of the most mature companies in an immature industry."

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