# Updated: Skype, Margins Still Weigh on eBay

Like Yahoo (YHOO) yesterday, eBay’s (EBAY) stock is up following its third-quarter earnings report, rising some 3 percent. But while eBay is making progress at getting its business growing again, there are still a couple of issues to consider, namely falling operating margins and the nagging question of what to do with Skype.

eBay’s revenue grew a healthy 30 percent in the quarter, down just slightly from the 31 percent growth rate in the third quarter of 2006. The organic growth rate tells an even more impressive story. Organic revenue grew 23 percent in the latest three-month period, up from the 20 percent rise a year ago. In other words, eBay is making more from its core business without having to import revenue growth through acquisitions.

So far, so good. But it’s a little troubling to see the operating margin fall to 31.4 percent, its smallest margin in several quarters. Last quarter, non-GAAP operating margin was 32.4 percent and a year ago, it was 32.1 percent. In short, revenue is growing, but the cost of running eBay has been growing faster.

eBay CFO Bob Swan said in an interview that the third quarter seasonally delivers lower margins, as relatively slower revenue is coupled with higher spending ahead of the holiday season. He pointed out that eBay’s fourth-quarter guidance implies a recovery in operating margins, which could leave the company close to the 33 percent margin it has said it expects
for the full-year 2007 period.

Revenue rose 26 percent in eBay’s marketplace business, flat with last quarter, while PayPal revenue increased 35 percent, above the 34 percent growth last quarter. Skype was a little less impressive. Revenue did rise to $96 million from$90 million, but that growth feels a little slow for a business that was hoped to be lucratively disruptive, and it’s still only 5 percent of eBay’s total revenue.

But eBay has vowed to put the overvalued price it paid for Skype behind it, and some of the metrics included show why. Although 246 million users are signed up for Skype, the number of Skype-to-Skype minutes has fallen 8 percent year-over-year, to 6.1 billion.

And while Skype Out minutes (which bring in revenue) are up 25 percent year-over-year, to 1.4 billion minutes, they are still less than a quarter of the free Skype-to-Skype calls. Skype is doing OK, but it’s not the growth driver and synergistically magical force eBay had hoped for.

Skype’s book value was $2 billion after the revaluation, or six times the trailing 12 month revenue. The value that the market is according eBay’s stock – its$55 billion market cap – is 7 and a half times its recent revenue. Put another way, Skype may be 5% of eBay’s revenue, but it’s value is equal to 3.6% of eBay’s market value. Either way, Skype seems valued at a slight discount to the rest of eBay.

Meg Whitman got a little confessional on the conference call about Skype, saying that the criteria for the \$1.4 million earnout promised to Skype’s founders — including revenue growth and gross margin — siphoned money away from things like customer support and user interface that could have “delighted the user.”

“We over-monitized Skype a little bit and we dropped a bit too much of the profitability to the bottom line,” Whitman said. “The team wasn’t focused on how we could move excess profitability to drive user engagement.”

Now eBay wants to make the Skype experience more delightful, which would translate into less profits, or maybe a loss, at Skype in the near term. Skype has been profitable for three straight quarters — eBay didn’t say how profitable it was this last quarter — but it may have to break that streak if it means finally turning Skype into a service with broad mainstream appeal.