Is a PayPal Split Best For eBay?

eBay executives have found themselves in a nasty fight with billionaire activist Carl Icahn regarding a split of the business' two key segments: PayPal and Marketplace. It's no secret that eBay's Marketplace alone has performance similar to peer Overstock.com , which significantly lags Amazon.com , thus the majority of the company's valuation is tied to PayPal. However, given the multiples placed on growth, Icahn might be right in his attempt to unlock value.

An unworthy Marketplace
Breaking up eBay used to be a hot topic, but has since lost steam in recent years due to the board's unwillingness to entertain the idea. Thus, investors tend to look at eBay as a whole, which has worked out well for the company due to its lagging core Marketplace business.

The Marketplace is eBay's largest segment, which competes with companies like Amazon and Overstock.com. Last year, this segment reported revenue of $8.2 billion, growing just 12% year over year, which actually lagged peer Overstock.com's 16% growth. While Overstock.com is a significantly smaller business, it is also much cheaper at just 0.5 times sales versus a 5.0 multiple for eBay.

Compared to Amazon, eBay's Marketplace comes up short, as Amazon's revenue increased more than 20% year over year. Furthermore, Amazon is guiding for continued growth in excess of 20%, and as it grows larger, over $75 billion, it's also getting harder for eBay to find growth.

eBay is expected to experience continued weakness from Marketplace, while Amazon and Overstock.com's outlook will likely remain intact. However, eBay is able to maintain operating margins in excess of 20%, which is not commonly seen in this industry, due to PayPal. Without PayPal, eBay is just a slow-growing Marketplace with margins equivalent to its peers.

Unlocking more value
It's easy to understand why management wants to keep PayPal attached to eBay -- PayPal makes eBay look good.

In 2013, PayPal accounted for 41.3% of the company's total revenue (37% in 2012 with growth of 19% and full-year revenue of $6.62 billion). Additionally, the number of PayPal users continues to grow, as it reported 143 million at the end of 2013, versus 123 million in 2012. Overall, this is a fast-growing business in a mobile payments processing segment that is expected to triple in size by 2017 to $90 billion.

With all things considered, how much is PayPal worth? According to Reuters, it's worth $40 billion, or 60% of eBay. Yet, as Carl Icahn pointed out, there is likely far more unlocked value, as PayPal might be discounted because of its connection to eBay.

PayPal generated almost all of eBay's $2.8 billion in net income last year. So, using an extrapolated $2.5 billion as PayPal's earnings figure, a $40 billion market capitalization would result in a P/E ratio of only 16 for a company growing at an annual rate of nearly 20% in one of the fastest-growing segments of the market.

Essentially, splitting PayPal from eBay should unlock more value. We've already seen demand for Internet-based companies with large user bases in other mobile segments, and as a result, if eBay decides to move forward in the process of spinning off PayPal, its value will likely rise. Given recent history, it shouldn't be unrealistic to see the market paying 30 times earnings for PayPal, maybe more. In that event, the company could be worth up to $75 billion, the same as eBay.

History is on our side
Icahn has identified the demand for such companies and determined that both eBay and PayPal are worth far more as separate companies.

eBay's board is showing resistance now, but might eventually succumb. For one, management already made an enormous mistake with the Skype ordeal when eBay bought Skype in 2007 for $2.5 billion. eBay sold a 65% stake in 2009 for $1.9 billion, valuing Skype at only $2.75 billion. Less than two years later, Microsoft bought Skype for $8.5 billion, making it a huge mishap on behalf of eBay management, pointing out their inability to properly value the asset.

Final thoughts
In the end, a split will also work in the favor of eBay's core business. Even though eBay's Marketplace is far behind Amazon, and even lags Overstock.com in terms of growth, by splitting PayPal, eBay will have something that neither Overstock.com nor Amazon possess -- a massive cash position.

eBay would be able to sell some, part, or all of its stake in PayPal, which would give it a large cash position to buy back stock, boost its ecosystem, and make acquisitions to spark future growth. Thus, it's a win-win for all parties involved. With Carl Icahn stirring the pot, and history on his side, investors should feel confident about his chances of pushing this company into a value-creating split.