Ebay burst onto the scene as a public company on September 23, 1998, at the then-lofty price of $18 per share. The stock opened at $53.50 and euphoric “investors” (Ben Graham would call them “speculators”), bid it up to the incredible price of $354.25 within six months, before a 3:1 split. Not bad for a company that would report $0.00 in earnings per share a year later.

Perhaps these investors were counting on rapid growth. Indeed, eBay was growing at a blistering pace. Between the second quarter of 1997 and the fourth quarter of 1998, revenues grew from a mere $604 thousand to $19.5 million.

In the book The Perfect Store: Inside eBay, Adam Cohen relates the beginnings of what was then still called AuctionWeb. In 1996 Pierre Omidyar, the founder, had a tough problem: so many envelopes stuffed with payments arrived by mail that he didn’t have time to open them all, so they just piled up, unopened. Ebay – still in its infancy – already seemed to be a perpetual cash machine.

Today, eBay’s stock price hovers around $12.50, so the prices above look extraordinary. But the stock split 24 times since the IPO, so it turns out that if you bought at around, say, $54 per share, you’d be sitting on a 19% gain, compounded, to today’s price, compared with a compounded loss of 2.2% for the S&P index during the same period. Indeed, even if you had bought the stock at its pre-split peak, you’d still be better off than the market. Maybe those investors weren’t so wrong after all.

How could this company have created so much value?

It turns out that eBay’s is a sticky and addictive business model, and is very cash generative. Revenues grew to $8.5 billion in 2008, and in aggregate, eBay has generated almost $13 billion in cash from operations, $9 billion of that in free cash flow even after deducting stock-based compensation.

Where has all the cash gone?

Of the nearly $13 billion, $1 billion has gone to stock-based compensation, and $3 billion to capital expenditures. The $9 billion in free cash flow have been spent in acquisitions or ended up as cash and equivalents on the balance sheet.

As with many technology companies, eBay has benefited from its expensive stock price and old GAAP accounting rules. These old rules allowed “pooling of interest” accounting in certain cases, whereby an acquirer used its bloated stock price as currency. The acquisition generated no goodwill, which didn’t have to be amortized over 40 years, and thus didn’t depress earnings. Companies would regularly “game” their acquisitions to fit the criteria allowing this accounting treatment.

In 2001, FASB eliminated the rule and instead forced all acquisitions to use purchase accounting; goodwill no longer had to be amortized, but instead tested for impairment yearly. This is what led eBay to charge $1.4bn against earnings in 2007 as a write-off of goodwill from its Skype acquisition, for which it massively overpaid.

Another interesting point – again common with tech companies that issue lots of stock for compensation – is that buybacks at eBay have been largely a mirage. In the past three years, eBay has spent $5.3 billion in buybacks. Sounds great, right? Except that since 1998, it has issued $4.2 billion in stock for compensation and acquisitions. Stock-based compensation ran $350m in 2008 alone.

So how is the market looking at eBay today? At its recent price of $12.50 per share, the company is selling for $16 billion. Net out cash and equivalents plus short-term investments of $2.3 billion, and arrive at an enterprise value – your net “out of pocket” cost to buy the entire business – of $13.7 billion.

Now, eBay is generating about $2 billion per year of free cash flow. These are the “owner earnings,” or cash you could pocket entirely since it takes into account taxes, capital expenditures, even stock-based compensation. This last one is important – as we saw, companies issue stock to employees as compensation, which then must be bought back using the company’s cash. This is a real hit to free cash flow.

The $13.7 billion you’re paying is about 7x current free cash flow. In order to understand what this means, it helps to think about how to value any asset, whether we’re talking about an apartment building, a bond, or a stock.

The value of an asset to you – we’ll call it “intrinsic value” – is the sum of all future free cash flows, discounted to present value. Discounting is important because $1 a year from now is less valuable than $1 in your hands today. Let’s say that 10% is an appropriate discount rate, one that would make us indifferent between $1 today and $1.10 a year from now.

Figuring out the intrinsic value is thus a two-step process. The first step is critical: estimating what those future free cash flows will be. This is very hard to do for most businesses, but easier to do for those whose revenues and incomes don’t fluctuate wildly. Ebay is reasonably protected by its network effects in its various businesses, so it’s unlikely that future free cash flows will suddenly fall off a cliff.

Let’s assume, for now, they don’t grow or decline. In this case, our second step would be to add up those future free cash flows:

It turns out that this series of sums converges to a simple formula, current free cash flow times 1 / r, where r is the discount rate. So in this case, we’d be willing to pay $19.6 billion for eBay’s future free cash flows.

This should give you the idea that, perhaps, eBay is cheap today, since you’re paying less than you’d get. But we left out a critical piece: growth. What would happen to our estimate of eBay’s intrinsic value if its free cash flows grew at, say, 2% per year?

Growth may be a distant memory in a recessionary environment, but remember that growth will one day return. Populations will expand, incomes will rise, and eBay will penetrate new markets. Last – and perhaps most important – an inflationary environment would benefit eBay, since it collects a percentage of transactions it processes both on its marketplaces and PayPal.

Amending our formula to 1 / (r - g) takes growth into account. At 2%, we’d be willing to pay 1 / (10% - 2%) or 12.5x free cash flow for eBay. But let’s instead invert our thinking: what would happen if eBay shrank?

Plugging in a negative growth rate of 4.3%, for example, would get us to 1 / (10% + 4.3%) or 7.0x free cash flow. This brings us back to eBay’s current stock price. It turns out that the market seems to think eBay will shrink 4.3% per year, forever.

This is a pretty Draconian assumption. Embedded in eBay are some fast-growing businesses, like PayPal and Skype. The new CEO, John Donahoe, has plans to cut $2 billion in costs by 2011, which should further juice free cash flow. But PayPal is only 16% of operating income, and Skype a mere 4%. The slow-growing marketplaces segment is 80% of the total. Time will tell whether management’s recent improvements to eBay’s core business will bear fruit.

But because forecasting is a fool’s game, paying a modest amount for future free cash flows should afford the investor a decent margin of safety. In fact, at 7x free cash flow, quite a few things could happen and you still wouldn’t lose money. For example, free cash flow could decline 20% in 2009, and another 15% in 2010 and 2011, before resuming a conservative 2% growth, and you’d still break even.

In the past, eBay hasn’t been very cheap. In fact, only recently has the stock fallen below 10x free cash flow. The chart below shows the de-rating in eBay’s stock from high flyer with a sexy multiple into an also-ran with a stock price that makes it look like road kill:

The red lines show the yearly high and low stock prices divided by per-share free cash flow (actually, they show the enterprise value, which is stock price less net cash). Over the years, eBay’s valuation has compressed, and reached the all-time low of 5.4x free cash flow in early 2009. Over those same years, free cash flow grew from $192m in 2001 to nearly $2 billion in 2008. The drop between 2005 and 2006 is accounted for by an increase in capital expenditures and a 10-fold step-up in stock-based compensation.

One of the biggest risks with eBay is that management will repeat mistakes of the past, namely, overpaying for acquisitions. The company doesn’t pay a dividend, and stock repurchases – which now should be in overdrive mode – have completely dried up in Q408. Why should we expect management to be any different than the average panicked investor? In any case, at the right price, it’s hard to pass on this deal.

Marcelo P. Lima is a securities analyst. He may be reached at MPL4@cornell.edu

The number of net/nets (companies trading below their net current asset value) continues to grow as the markets continue heading south. This is nothing new; the last time I saw this many net/nets (400+) was post tech bubble, post 9/11. At that time, the list was chock full of broken tech companies. Sure, there were some good names that prospered in the ensuing years, and handsomely rewarded those brave enough to deploy some capital into the land of the forgotten.

This time around, the quality of net/nets seems better, although it’s not all that surprising given the beating that the market has been taking. But I’m seeing many more profitable names, some with relatively large amounts of cash compared to the 2000-2003 period.

There are some that Ben Graham might have even taken a look at if he were alive today. Well, maybe that’s a stretch, because old Ben was pretty particular in that area. While I’ve often written about net/nets trading as those companies trading below one times net current asset value, Ben was much more stringent. He’d typically only consider those names trading at less than 2/3 of NCAV. Certainly, those have been few and far between until recently.

At last look, there were more than 200 companies trading at less than 2/3 NCAV. That’s a raw list, mind you; I ‘ve not yet verified the data, and it includes companies with a minimum market cap of $5 million, so there’s bound to be a lot junk. Moving the market cap limit to $100 million, I’ve identified a handful,

Six Companies Trading at Less than 2/3 Net Current Asset Value

Signet Jewelers (SIG)
Market Cap: $638
Net Current Asset Value: $977
Mkt Cap/NCAV: .65
Cash/Share: $.4
P/E: 4
Price: $7.48

Olympic Steel (ZEUS)
Market Cap: $123
Net Current Asset Value: $203
Mkt Cap/NCAV: .61
Cash/Share: $.22
P/E: 2
Price: $11.31

Opnext Inc (OPXT)
Market Cap: $146
Net Current Asset Value: $256
Mkt Cap/NCAV: .61
Cash/Share: $3.19
P/E: NA
Price: $1.6

Electro Scientific Industries (ESIO)
Market Cap: $146
Net Current Asset Value: $266
Mkt Cap/NCAV: .55
Cash/Share: $5.87
P/E: NA
Price: $5.4

Rackable Systems
Market Cap: $108
Net Current Asset Value: $212
Mkt Cap/NCAV: .51
Cash/Share: $5.77
P/E: NA
Price: $3.62

Movado
Market Cap: $133
Net Current Asset Value: $300
Mkt Cap/NCAV: .44
Cash/Share: $3.49
P/E: 3
Price: $5.54

If Ben Graham were alive today, would he have any interest in any of these companies? Hard to say, but I’m thinking that he’d laugh at me for even suggesting them. But that would be a small price to pay for a conversation with the master.

Jonathan Heller, CFA

Contango Oil & Gas (MCF)

Contango Oil & Gas is a truly unique situation. MCF has no debt, $38 million in cash, is
free cash flow positive at current natural gas prices of $4 per mcf (one thousand cubic
feet), and has one of the lowest cost structures of any E&P company. Even better is that
at current prices you can buy natural gas reserves at around $1.70 per mcf with no geopolitical
risk (reserves are in the Gulf of Mexico).

Why does the stock sell at such a level with these great statistics? One reason is that no
analysts cover the company. The other major reason is that the stock has suffered from
liquidations especially from one hedge fund manager who put his entire fund in the stock
last summer, then levered up and recently had to sell.

Investors now have the chance to buy a completely un-levered company, whose balance
sheet is like Fort Knox, with one of the cheapest costs of producing natural gas at the low
valuation of $1.70 per mcf. And you would be buying it right before another massive
surge in natural gas prices. Maybe that is why the company itself put off drilling two new
wells and instead is buying back stock.

Contango Assets Are Two Very Large Fields

Contango has an interest in 66 offshore leases. The primary assets are Contango’s
interests in its Dutch and Mary Rose reserves in the Gulf of Mexico. The Company’s
independent third party engineer recently estimated that the Dutch and Mary Rose fields
have total proved reserves of 961 billion cubic feet equivalent (“Bcfe”) (364 Bcfe net to
Contango).

Contango’s Low Cost Hyper Efficient Strategy and Philosophy Are Key

Contango has two core beliefs:
1) “The only competitive advantage in the natural gas and oil business is to be
among the lowest cost producers.”
2) “Virtually all the exploration and production industry’s value creation occurs
through the drilling of successful exploratory wells.”

Contango has lived up to both maxims. They are one of the lowest cost producers of
natural gas. Their operating costs were an astonishing $0.82 per mcfe in 2008 and their
finding, developing and acquisition costs were $1.36 per mcf, leading their costs to be a
little over $2 per mcf. The company’s largest cost is actually taxes! They pay 38% in taxes and this has
historically been their highest cost. This is indeed a rare company.

How Does Contango Achieve Such a Low Cost

To start, Contango only has 7 employees. Contango’s job is quite similar to a hedge fund manager’s:
capital allocation. Contango outsources everything else. Contango formed a partnership with Juneau Exploration L.P., a private company that finds domestic natural gas and oil prospects. Under their agreement, JEX generates natural gas and oil prospects and evaluates exploration prospects generated by others. Contango and JEX share in the upfront costs. Then if a prospect is successful, Contango
will fund the development and JEX will share in the revenue. This has been an
enormously successful partnership as evidenced by the Dutch and Mary Rose fields.
For development and operation, Contango hires contractors and independent third party
operators to do the job.

This leaves Contango with the sole job of making sure that it invests in the best possible
fields. And as part of their strategy, Contango management believes just as I do;
concentrate your bets on your best risk/reward situations. Contango has done a marvelous job growing reserves from 11.4 Bcfe in 2001 to the current 364 Bcfe with only 5% share dilution and the taking on of zero debt. It’s one thing to talk the talk; it’s another to walk the walk.

The Company was almost sold last summer. In June, Contango considered selling off its two main assets, the Mary Rose and Dutch fields, and spinning-off the future prospects to do it all over again. The company opened up its data to prospective buyers, hired an investment bank and started fielding offers. The
stock hit a high of $95.16 per share in June. But the economy and the energy markets had a different idea. The sale process was terminated in September when it became clear that due to the credit crisis and
deteriorating financial conditions, the company would get nowhere near to fair value for
its crown jewels.

Financial Hurricane, Then Real Hurricane, Then Hedge Fund Hurricane

After the financial hurricane came Hurricane Ike, which caused damage and
shut or slowed production of the company’s wells. Then news started drifting out of a hedge fund in trouble. Sellers Capital  had so believed in the Contango story, that they put almost their entire fund in the stock and then used some leverage as well. When the stock started to fall, other investors started to
worry about what Sellers Capital would do. This culminated in Sellers Capital locking the fund up and preventing a forced sale of its over 15% position in Contango.

The failed sale of the company, the collapsing energy markets, the hurricane damage and
finally the flight from the stock due to fears of massive selling and essentially, the stock
has never recovered.

Sellers Capital overhang is over

Sellers Capital told its investors that if they wanted out of the fund, they could
withdraw as of April 1st. In the meantime, the firm has sold over 800,000 shares, reducing
their position to 13.2%, or 2.24 million shares. The firm announced in a filing dated March 10th, that the firm was done selling to meet redemptions. This removes a short-term pressure from the stock that has seen relentless selling pressure. And you can see the reaction from the stock the last two days.

With A Balance Sheet like Fort Knox MCF is Buying Back Lots of Stock

Outside of short term trading fluctuations, shareholders have little to fear. The company
has $38 million in cash and no debt. They also have a $50 million untapped credit line.
And the company’s all-in costs as mentioned above are a little over $2 per mcf, meaning
that they are still cash flowing nicely even in a horrific natural gas environment. After the sale fell through last September, the company initiated a $100 million buyback. And on March 3rd, they announced that they had purchased almost 1 million shares at an average price of $44.60 per share and that meant they were essentially buying their own reserves at $2.12 per mcf, or around their very low cost of finding, developing and producing natural gas.

At today’s prices, investors and the company can buy back the stock at $1.70 per mcf!
And that is precisely what the company is doing. In one filing, Sellers Capital announced
they sold 100,000 shares back to the company. Natural gas production is about to plummet
There has been a sharp decline in drilling rigs of natural gas in response to the price drop
of natural gas. U.S. drilling rigs are down 37% year to date and poised to keep falling and
Canadian natural gas rigs are down 52%. This is very important because natural gas
fields deplete much faster than oil fields. More importantly, much of the growth in natural gas has come from gas found in shale and at current prices it is not economic to drill there. Compounding this is that
production at a shale gas well will fall over 75% from Day 1 to Day 90, so you need to
constantly be drilling wells to keep production up. In the Barnett Shale formation in
North Texas, the number of operating rigs in the past four months has plummeted to 97
from 214, according to RigData. While demand is low now due to a pullback in industrial and electricity demand, investors may not realize how much natural gas production is going to fall by year end.
Consider a major natural gas producer such as Canadian Natural Resources (NYSE:
CNQ). On March 6th CNQ announced that natural gas prices would have to recover to
$6.50 to $7.50 per mcf before they ramp up production, after cutting back production
substantially in response to falling prices. Expect natural gas to surge back after the summer doldrums.

Valuation Summary

The PV-10 (standard net present valuation used for oil and gas production companies) of
this company with natural gas prices at around $6 per mcf is over $72 per share. At $9
per mcf of natural gas it is $106 per share. This shows the upside the
company has when natural gas prices recover. And prices will recover; because we need
more natural gas production, not less. In the meantime, the company has a terrific balance sheet and will be profitable and cash flow positive in even more difficult times. Any time you can buy natural gas
assets at below $2 per mcf with no geopolitical risk, you should jump at the opportunity

Aaron Edelheit is the portfolio manager of Sabre Value Fund in Santa Barbara, California.