UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-Q

 

 

Commission file number 000-24821

eBay Inc.

(Exact name of registrant as specified in its charter)

 

 

(408) 376-7400
(Registrant’s telephone number, including area code)

 

 

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of October 24, 2007 there were 1,353,529,279 shares of the registrant’s common stock, $0.001 par value, outstanding, which is the only class of common or voting stock of the registrant issued.

 

 

PART I: FINANCIAL INFORMATION

 

 

eBay Inc.

 

CONDENSED CONSOLIDATED BALANCE SHEET

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

eBay Inc.

 

CONDENSED CONSOLIDATED STATEMENT OF INCOME (LOSS)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

eBay Inc.

 

CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

eBay Inc.

 

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

The Company

 

eBay Inc. (“eBay”) was incorporated in California in May 1996, and reincorporated in Delaware in April 1998. eBay’s purpose is to pioneer new communities around the world, built on commerce, sustained by trust and inspired by opportunity. eBay brings together millions of buyers and sellers every day on a local, national and international basis through an array of websites. eBay provides online marketplaces for the sale of goods and services, online payment services and online communication offerings to a diverse community of individuals and businesses.

 

eBay has three operating segments: Marketplaces, Payments and Communications. The Marketplaces segment enables online commerce through a variety of different platforms, including the traditional eBay auction-style site, our classifieds websites, our comparison shopping site, Shopping.com, our secondary tickets platform, StubHub, and Rent.com. The Payments segment, which consists of our PayPal, Inc. (“PayPal”) business, enables individuals and businesses to securely, easily and quickly send and receive payments online. The Communications segment, which consists of our Skype Technologies SA (“Skype”) business, enables Voice over Internet Protocol (“VoIP”) communications between Skype users, and provides low-cost connectivity to traditional fixed-line and mobile telephones.

 

When we refer to “we,” “our,” “us” or “eBay” in this document, we mean the current Delaware corporation (eBay Inc.) and its California predecessor, as well as all of our consolidated subsidiaries.

 

Use of estimates

 

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate our estimates, including those related to provisions for doubtful accounts and authorized credits, the provision for transaction losses, legal contingencies, income taxes, advertising and other net revenues, stock-based compensation expense and goodwill and intangible assets. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could differ from those estimates.

 

Principles of consolidation and basis of presentation

 

The accompanying financial statements are consolidated and include the financial statements of eBay and our majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

 

The consolidated financial statements include 100% of the assets and liabilities of majority-owned subsidiaries, and the ownership interests of minority investors are recorded as minority interests. Investments in entities where we hold more than a 20%, but less than a 50%, ownership interest and have the ability to significantly influence the operations of the investee are accounted for using the equity method of accounting and the investment balance is included in long-term investments, while our share of the investees’ results of operations is included in interest and other income, net. For the three and nine months ended September 30, 2006 and 2007, the equity method income recorded in interest and other income, net was not material to our operating results. Investments in private entities where we hold less than a 20% ownership interest and where we do not have the ability to significantly influence the operations of the investee are accounted for using the cost method of accounting and are included in long-term investments.

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

These unaudited interim financial statements reflect our condensed consolidated financial position as of December 31, 2006 and September 30, 2007. These statements also show our condensed consolidated statement of income (loss) and condensed consolidated statement of comprehensive income (loss) for the three and nine months ended September 30, 2006 and 2007 and our condensed consolidated statement of cash flows for the nine months ended September 30, 2006 and 2007. These statements include all normal recurring adjustments that we believe are necessary to fairly state our financial position, operating results and cash flows. Because all of the disclosures required by U.S. generally accepted accounting principles for annual consolidated financial statements are not included herein, these interim financial statements should be read in conjunction with the audited financial statements and the notes thereto for the year ended December 31, 2006, included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 28, 2007. The condensed consolidated balance sheet as of December 31, 2006 was derived from our audited financial statements for the year ended December 31, 2006, but does not include all disclosures required by U.S. generally accepted accounting principles. The condensed consolidated statements of income (loss) and cash flows for the periods presented are not necessarily indicative of results that we expect for any future period.

 

Certain prior period balances have been reclassified to conform to the current period presentation.

 

Recent accounting pronouncements

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. The changes to current practice resulting from the application of this statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. We will be required to adopt the provisions on FAS 157 on January 1, 2008. We are currently evaluating the impact of adopting the provisions of FAS 157, but we do not currently believe that the adoption of FAS 157 will materially impact our financial position, cash flows, or results of operations.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115,” which is effective for fiscal years beginning after November 15, 2007. This statement permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. We are currently evaluating the potential impact of this statement.

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Basic net income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income for the period by the weighted average number of shares of common stock and potentially dilutive common stock outstanding during the period. The dilutive effect of outstanding options and restricted stock is reflected in diluted earnings per share by application of the treasury stock method. The following table sets forth the computation of basic and diluted net income (loss) per share for the periods indicated (in thousands, except per share amounts):

 

 

The calculation of diluted net income (loss) per share excludes all anti-dilutive shares. For the three and nine months ended September 30, 2006, approximately 90.4 million and 69.1 million common stock equivalents, respectively, were not included in the computation of diluted net income per share because the effect would have been anti-dilutive. For the three and nine months ended September 30, 2007, approximately 139.6 million and 142.4 million common stock equivalents, respectively, were not included in the computation of diluted net income (loss) per share because the effect would have been anti-dilutive.

 

 

Acquisition of StubHub, Inc.

 

On February 13, 2007, we acquired all of the outstanding shares of StubHub, Inc. (“StubHub”) for a total purchase price of $292.4 million. The purchase price was comprised of cash totaling $283.2 million, $1.1 million in estimated acquisition-related expenses and the assumption of StubHub’s outstanding common stock options, valued at approximately $8.1 million. The fair value of StubHub stock options assumed was determined using a Black-Scholes model. StubHub is an online marketplace that facilitates the resale of event tickets and is included within our Marketplaces segment.

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

We accounted for the acquisition as a taxable purchase transaction and, accordingly, the purchase price has been allocated to the tangible assets, liabilities assumed, and identifiable intangible assets acquired based on their estimated fair values on the acquisition date. The excess of the purchase price over the aggregate fair values was recorded as goodwill. The fair value assigned to identifiable intangible assets acquired is determined using the income approach, which discounts expected future cash flows to present value using estimates and assumptions determined by management. Purchased intangible assets are amortized on a straight-line basis over the respective useful lives. Our preliminary allocation of the purchase price is summarized below (in thousands):

 

 

The estimated useful economic lives of the identifiable intangible assets acquired are three years for the trade name and developed technology and five years for the user base. The final purchase price allocation will depend upon the completion of our integration plan by the end of the first quarter of 2008, although we do not expect it to differ materially from the above amounts.

 

The results of operations for the acquired business have been included in our condensed consolidated statement of income (loss) for the period subsequent to our acquisition of StubHub. StubHub’s results of operations for periods prior to this acquisition were not material to our condensed consolidated statement of income (loss) and, accordingly, pro forma financial information has not been presented.

 

Goodwill

 

The following table presents goodwill balances and the movements for each of our reportable segments during the nine months ended September 30, 2007 (in thousands):

 

 

Investments accounted for under the equity method of accounting are classified on our balance sheet as long-term investments. Such investments include identifiable intangible assets, deferred tax liabilities and goodwill. As of December 31, 2006 and September 30, 2007, the goodwill related to our equity investments, included above, was approximately $27.4 million.

 

The changes in goodwill during the nine months ended September 30, 2007 were substantially due to the recording of goodwill for completed acquisitions, the settlement of the earn out with Skype, impairment charges related to Skype and foreign currency translation adjustments.

 

We conducted our annual impairment test of goodwill as of August 31, 2007 in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” As a result of this test, we concluded that the carrying amount of our Communications reporting unit exceeded its fair value and recorded an impairment loss of approximately $1.4 billion during the quarter ended September 30, 2007. The impairment charge includes the impact of the

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

earn out settlement payment described below and was determined by comparing the carrying value of goodwill in our Communications reporting unit with the implied fair value of the goodwill. We determined the fair value of the Communications reporting unit using the income approach, which requires estimates of future operating results and cash flows discounted using an estimated discount rate. Our estimates resulted from an updated long-term financial outlook developed as part of our strategic planning cycle conducted annually during our third quarter. Our estimates of future operating results for our Communications reporting unit are for an early stage business with limited financial history, as well as developing revenue models. These factors increase the risk of differences between projected and actual performance that could impact future estimates of fair value of the Communications reporting unit.

 

In conjunction with our acquisition of Skype in 2005, we agreed to certain performance-based earn out payments. During the three months ended September 30, 2007, we entered into an earn out settlement agreement with each of the former shareholders of Skype who had elected the earn out alternative at the time of the acquisition, under which we were relieved of all obligations under the original earn out agreement in exchange for an aggregate cash payment of €375.1 million, or approximately $530.3 million. Payments under the earn out settlement agreements will be paid during the fourth quarter of 2007 and as such are included as a component of accrued expenses and other current liabilities as of September 30, 2007. Goodwill was recorded because the earn out settlement amount was considered additional purchase price. Based on our impairment analysis, the goodwill recorded as part of the earn out settlement was included as a component of the goodwill impairment charge.

 

Intangible Assets

 

The components of acquired identifiable intangible assets are as follows (dollars in thousands):

 

 

As of December 31, 2006 and September 30, 2007, the net carrying amount of intangible assets related to our equity investments included above was approximately $2.5 million and $1.7 million, respectively. All of our acquired identifiable intangible assets are subject to amortization. Aggregate amortization expense for intangible assets was $52.6 million and $56.7 million for the three months ended September 30, 2006 and 2007, respectively. Aggregate amortization expense for intangible assets was $169.3 million and $167.6 million for the nine months ended September 30, 2006 and 2007, respectively.

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

As of September 30, 2007, expected future intangible asset amortization was as follows (in thousands):

 

 

 

Operating segments are based upon our internal organization structure, the manner in which our operations are managed, the criteria used by our Chief Operating Decision Maker (“CODM”) to evaluate segment performance and the availability of separate financial information. We have three operating segments: Marketplaces, Payments and Communications.

 

The following tables summarize the financial performance of our operating segments (in thousands):

 

 

 

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

Direct costs of operating segments include specific costs of net revenues, sales and marketing expenses, and general and administrative expenses over which segment managers have direct discretionary control, such as advertising and marketing programs, customer support expenses, bank charges, site operations expenses, product development expenses, billing operations, certain technology and facilities expenses, transaction expenses, provisions for doubtful accounts, authorized credits and transaction losses. Segment managers do not have discretionary control over expenses such as our corporate center costs (consisting of costs related to corporate management, human resources, finance and legal), amortization of intangible assets, stock-based compensation expenses and impairment of goodwill as they are not evaluated in the measurement of segment performance.

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

Customer accounts for certain PayPal foreign subsidiaries include liquid assets set aside for certain customer liabilities as required by regulations in those jurisdictions. These assets may only be held in specified types of highly liquid investments. The customer liabilities represent claims on those foreign subsidiaries and generally against these assets. These assets are included on our balance sheet as current assets with an offsetting current liability in funds payable and amounts due to customers. Customer funds held by PayPal as an agent or custodian for the benefit of its customers are not reflected in our condensed consolidated balance sheet.

 

 

Long-term investments

 

Effective during the three months ended September 30, 2007, we began to account for our investment in MercadoLibre as an available-for-sale marketable security due to MercadoLibre’s initial public offering of its common stock in August of 2007. Our investment is reported at fair value of $294.7 million as of September 30, 2007, as a long-term investment with unrealized gains, net of tax, excluded from earnings and reported as a component of accumulated other comprehensive income.

 

 

Litigation and Other Legal Matters

 

In April 2001, two of our European subsidiaries, eBay GmbH and eBay International AG, were sued by Montres Rolex S.A. and certain of its affiliates in the regional court of Cologne, Germany. The suit subsequently was transferred to the regional court in Düsseldorf, Germany. Rolex alleged that our subsidiaries were infringing Rolex’s trademarks as a result of users selling counterfeit Rolex watches through our German website. The suit also alleged unfair competition. Rolex sought an order enjoining the sale of Rolex-branded watches on the website as well as damages. In December 2002, a trial was held in the matter, and the court ruled in favor of eBay on all causes of action. Rolex appealed the ruling to the Higher Regional Court of Düsseldorf, and the appeal was heard in October 2003. In February 2004, the court rejected Rolex’s appeal and ruled in our favor. Rolex appealed the ruling to the German Federal Supreme Court, a hearing took place before that court in December 2006, and a written decision was issued in June 2007. The court’s decision found that eBay must take reasonable measures to prevent

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

recurrence once it is informed of clearly identified infringement, and that eBay may in certain circumstances be liable upon first notice of infringement. The court referred the case back to the Higher Regional Court to determine (i) whether, in some circumstances, a low starting listing price was sufficient to indicate that a listing was infringing and (ii) under what circumstances online sellers are “commercial dealers” within the meaning of the German intellectual property laws. In July 2007, the German Federal Supreme Court extended the reach of the Rolex decision in IVD v. eBay. The court held that (i) in certain circumstances, a duty of care could be found to exist to competitors requiring eBay to take reasonable measures to prevent illegal items from being listed (even where the competitors were not directly harmed) and (ii) such duty would extend to listings by the same seller in the same category (not just identical listings). Prior to these decisions, we had implemented proactive measures to find and remove illegal listings from our sites; these decisions may require us to undertake further efforts and will subject us to liability if our efforts are deemed to be insufficient. We expect that this ruling will likely result in increased costs and litigation against us in Germany although we do not currently believe that it will require a major change in our business practices.

 

In August 2006, Louis Vuitton Malletier and Christian Dior Couture filed two lawsuits in the Paris Court of Commerce against eBay Inc. and eBay International AG. The complaint alleges that we violated French tort law by negligently broadcasting listings posted by third parties offering counterfeit items bearing plaintiffs’ trademarks, and by purchasing certain advertising keywords. The plaintiffs seek approximately €35 million in damages. Around September 2006, Parfums Christian Dior, Kenzo Parfums, Parfums Givenchy, and Guerlain Société also filed a lawsuit in the Paris Court of Commerce against eBay Inc. and eBay International AG. The complaint alleges that we have interfered with the selective distribution network the plaintiffs established in France and the European Union by allowing third parties to post listings offering genuine perfumes and cosmetics for sale on our sites. The plaintiffs in this suit seek approximately €9 million in damages and injunctive relief. We filed our initial briefs responding to the first complaint in February 2007, and initial briefs in response to the second complaint were filed in April 2007. We believe that we have meritorious defenses to these suits and intend to defend ourselves vigorously. Other luxury brand owners have also filed suit against us or have threatened to do so, seeking to hold us liable for counterfeit items listed on our sites by third parties, for “tester” and other not for resale consumer products listed on our sites by third parties, for the misuse of trademarks in listings, for alleged violations of selective distribution channel laws, for non-compliance of consumer protection laws or in connection with paid search advertisements.

 

In September 2001, MercExchange LLC filed a complaint against us, our Half.com subsidiary and ReturnBuy, Inc. in the U.S. District Court for the Eastern District of Virginia (No. 2:01-CV-736) alleging infringement of three patents (relating to online consignment auction technology, multiple database searching and electronic consignment systems) and seeking a permanent injunction and damages (including treble damages for willful infringement). Following a trial in 2003, the jury returned a verdict finding that we had willfully infringed the patents relating to multiple database searching and electronic consignment systems, and the court entered judgment for MercExchange in the amount of approximately $30 million, plus pre-judgment interest and post-judgment interest. The U.S. Court of Appeals for the Federal Circuit later reduced the award to $25.5 million. In May 2006, following appeals to the U.S. Court of Appeals for the Federal Circuit and the U.S. Supreme Court, the Supreme Court remanded the case back to the district court for further action. In parallel with the federal court proceedings, at our request, the U.S. Patent and Trademark Office agreed to reexamine each of the patents in suit, finding that substantial questions existed regarding the validity of the claims contained in them. In separate actions in 2005, the Patent and Trademark Office initially rejected all of the claims contained in the three patents in suit. The Patent and Trademark Office has given notice of approval of same claims (and rejection of others) under the patent relating to online consignment auction technology and in September 2007, it tentatively approved some of the claims and rejected others contained in the patent that underlies the jury verdict, which relates to electronic consignment systems. We requested that the district court stay all proceedings in the case pending the final outcome of the reexamination proceedings, and MercExchange has renewed its request that the district court grant an injunction. In July 2007, the court denied MercExchange’s request for an injunction and ruled that the proceedings related to one of the patents will be stayed and another of the patents will not be stayed pending action by the Patent and

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Trademark Office. MercExchange is appealing the court’s order denying the injunction, and we have filed a motion seeking that the court find the non-stayed patent invalid. Even if successful, our litigation of these matters will continue to be costly. As a precautionary measure, we have modified certain functionality of our websites and business practices in a manner which we believe avoids any infringement of the consignment patent. For this reason, we believe that any injunction that might ultimately be issued will not have any impact on our business. We also believe we have appropriate reserves for this litigation. Nonetheless, if the modifications to the functionality of our websites and business practices are not sufficient to make them non-infringing, we would likely be forced to pay significant additional damages and licensing fees and/or modify our business practices in an adverse manner.

 

In June 2006, Net2Phone, Inc. filed a lawsuit in the U.S. District Court for the District of New Jersey (No. 06-2469) alleging that eBay Inc., Skype Technologies S.A., and Skype Inc. infringed five patents owned by Net2Phone relating to point-to-point Internet protocol. The suit seeks an injunction against continuing infringement, unspecified damages, including treble damages for willful infringement, and interest, costs, and fees. We have filed an answer and counterclaims asserting that the patents are invalid, unenforceable, and were not infringed. The parties are in the process of conducting discovery and claim construction briefing, and we expect a trial date to be scheduled for the second half of 2008. We believe that we have meritorious defenses and intend to defend ourselves vigorously.

 

In August 2006, Peer Communications Corporation filed a lawsuit in the U.S. District Court for the Eastern District of Texas (No. 6-06CV-370) alleging that eBay Inc., Skype Technologies S.A., and Skype Inc. infringed two patents owned by Peer Communications relating to uniform network access. The suit seeks an injunction against continuing infringement, unspecified damages, and interest, costs, and fees. The parties are in the process of conducting discovery, and a trial date has been scheduled for October 2008. We believe that we have meritorious defenses and intend to defend ourselves vigorously.

 

In September 2006, Mangosoft Intellectual Property, Inc. filed a lawsuit in the U.S. District Court for the Eastern District of Texas (No. 2-06CV-390) alleging that eBay Inc., Skype Technologies S.A., and Skype Software S.a.r.l. infringed a patent owned by Mangosoft relating to dynamic directory services. The suit seeks an injunction against continuing infringement, unspecified damages, and interest, costs, and fees. We have filed an answer and counterclaims asserting that the patents are invalid, unenforceable, and not infringed. We received an initial scheduling order from the court that sets some discovery deadlines, but not a trial date. We believe that we have meritorious defenses and intend to defend ourselves vigorously.

 

In February 2007, our StubHub subsidiary was sued in the U.S. District Court for the Central District of California (No. CV-07-1328) in a purported class action lawsuit alleging that StubHub violated the Fair and Accurate Credit Transaction Act by allegedly printing receipts containing more than the last five digits of a credit card number or the expiration date. The complaint seeks compensatory and punitive damages and attorneys fees. We believe that we have meritorious defenses and intend to defend ourselves vigorously.

 

In March 2007, a plaintiff filed a purported antitrust class action lawsuit against eBay in the Western District of Texas alleging that eBay, through its wholly owned subsidiary PayPal, used illegal tie-in and steering practices to improperly “monopolize” the forms of payment that sellers can use on eBay. The plaintiff alleges claims under sections 1 and 2 of the Sherman Act, as well as related state law claims. The complaint seeks treble damages and an injunction. In April 2007, the plaintiff re-filed the complaint in the U.S. District Court for the Northern District of California (No. 07-CV-01882-RS), and dismissed the Texas action. In June 2007, we filed a motion to dismiss the class action complaint. We believe that we have meritorious defenses and intend to defend ourselves vigorously.

 

In May 2007, Netcraft Corporation filed a lawsuit in the Western District of Wisconsin (No. 07-C-0254C) alleging that eBay and PayPal infringed two of its patents entitled “Internet billing methods.” The suit seeks an injunction against continuing infringement, unspecified damages, and interest, costs, and fees. The parties are in the process of conducting discovery. We have filed a motion for summary judgment of noninfringement on both patents. The claim construction hearing is currently scheduled for November 2007. The trial is expected to be

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

scheduled for June or July 2008. We believe that we have meritorious defenses and intend to defend ourselves vigorously.

 

Other third parties have from time to time claimed, and others may claim in the future, that we have infringed their intellectual property rights. We are subject to additional patent disputes, and expect that we will increasingly be subject to patent infringement claims as our services expand in scope and complexity. In particular, we expect that we may face additional patent infringement claims involving various aspects of our Marketplaces, Payments and Communications businesses. We have in the past been forced to litigate such claims. We may also become more vulnerable to third-party claims as laws such as the Digital Millennium Copyright Act, the Lanham Act and the Communications Decency Act are interpreted by the courts, and as we become subject to laws in jurisdictions where the underlying laws with respect to the potential liability of online intermediaries like ourselves are either unclear or less favorable. We believe that additional lawsuits alleging that we have violated copyright or trademark laws will be filed against us, especially in Europe. Intellectual property claims, whether meritorious or not, are time consuming and costly to resolve, could require expensive changes in our methods of doing business, or could require us to enter into costly royalty or licensing agreements.

 

From time to time, we are involved in other disputes or regulatory inquiries that arise in the ordinary course of business. The number and significance of these disputes and inquiries are increasing as our business expands and our company grows larger. Any claims or regulatory actions against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time, and result in the diversion of significant operational resources.

 

As part of the earn out settlement agreement with the former shareholders of Skype who had elected the earn out alternative at the time of the acquisition (See Note 3 “Business Combinations, Goodwill and Intangible Assets” in these condensed consolidated financial statements for further details), we agreed that if, on or prior to March 31, 2008, eBay sells or transfers to an unaffiliated third party securities representing greater than 50% of the outstanding voting power of, or economic interest in, Skype or all or substantially all of the assets of Skype and its subsidiaries, taken as a whole, we would pay up to an additional €138.4 million, or approximately $195.2 million, in the aggregate, to these former shareholders of Skype.

 

Credit Agreement

 

In August 2007, we entered into an amendment to our 2006 Credit Agreement. The amendment increased the lender commitments and borrowing capacity under the Credit Agreement from its prior level of $1.0 billion to $2.0 billion, maintained an option to increase borrowing capacity by an additional $1.0 billion (after giving effect to the $1.0 billion increase described above) and extended the maturity date by an additional year to November 7, 2012.

 

Indemnification Provisions

 

In the ordinary course of business, we have included limited indemnification provisions in certain of our agreements with parties with whom we have commercial relations, including our standard marketing, promotions and application-programming-interface license agreements. Under these contracts, we generally indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party in connection with claims by a third party with respect to domain names, trademarks, logos and other branding elements to the extent that such marks are applicable to our performance under the subject agreement. In a limited number of agreements, we have provided an indemnity for other types of third-party claims, which are indemnities mainly related to copyrights, trademarks, and patents. In our PayPal business, we have provided an indemnity to our payment processors in the event of certain third-party claims or card association fines against the processor arising out of conduct by PayPal or PayPal’s customers. It is not possible to determine the maximum potential loss under these indemnification provisions due to our limited history of prior indemnification claims and the unique facts and

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

circumstances involved in each particular provision. To date, no significant costs have been incurred, either individually or collectively, in connection with our indemnification provisions.

 

 

In 2006, our Board of Directors (“Board”) authorized a stock repurchase program for $2.0 billion of our common stock, excluding broker commissions. In January 2007, our Board authorized the expansion of the stock repurchase program to provide for the repurchase of up to an additional $2.0 billion of our common stock by January 2009. The stock repurchase activity under the program during the first nine months of 2007 is summarized as follows (in thousands, except per-share amounts):

 

 

These repurchased shares are recorded as treasury stock and are accounted for under the cost method. No repurchased shares have been retired.

 

During the nine months ended September 30, 2007, we entered into structured equity hedging transactions as described below. According to the terms of the transactions, on the maturity date, if the market price of our common stock exceeded a pre-determined price, we had the option to settle the transaction in cash or shares of our common stock. If the market price of our common stock was below that pre-determined price, we were required to settle the transactions in shares of our common stock.

 

During the three months ended March 31, 2007, we paid $99.6 million to enter into a structured equity hedging transaction that matured on March 30, 2007. On the maturity date, based on the market price of our stock, we chose to settle for the receipt of $102.3 million in cash. Our premium of approximately $2.7 million was recorded as additional paid-in capital. During the three month ended June 30, 2007, we paid $93.7 million to enter into a structured equity hedging transaction that matured on June 29, 2007. On the maturity date, based on the market price of our stock, we settled for the receipt of approximately 3.0 million shares of our common stock at an effective per share price of $31.40. During the three months ended September 30, 2007, we paid $98.2 million to enter into a structured equity hedging transaction that matured on September 28, 2007. On the maturity date, based on the market price of our stock, we chose to settle for the receipt of $103.1 million in cash. Our premium of approximately $5.0 million was recorded as additional paid-in capital.

 

During the three months ended September 30, 2007, we entered into a $200 million volume weighted average price share repurchase agreement. As a result of this agreement, we repurchased approximately 5.8 million shares of our common stock at an effective price per share of $34.24 during the third quarter of 2007.

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Stock-Based Compensation Expense

 

The impact on our results of operations of recording stock-based compensation for the three and nine months ended September 30, 2006 and 2007 was as follows (in thousands):

 

 

Total stock-based compensation included in capitalized development costs was $2.3 million and $2.2 million for the three months ended September 30, 2006 and 2007, respectively. Total stock-based compensation included in capitalized development costs was $6.8 million and $6.4 million for the nine months ended September 30, 2006 and 2007, respectively.

 

Valuation Assumptions

 

We calculated the fair value of each option award on the date of grant using the Black-Scholes option pricing model. The following weighted average assumptions were used for each respective period:

 

 

Our computation of expected volatility is based on a combination of historical and market-based implied volatility from traded options on our common stock. Our computation of expected life was determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior. The interest rate for periods within the contractual life of the award is based on the U.S. Treasury yield curve in effect at the time of grant.

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Stock Options

 

The following table summarizes stock option activity for the nine months ended September 30, 2007 (in thousands):

 

 

Stock options granted under our equity incentive plans generally vest 25% one year from the date of grant (or 12.5% six months from the date of grant for existing employees) and the remainder generally vest at a rate of 2.08% per month thereafter, and generally expire seven to ten years from the date of grant. The weighted average exercise price of stock options granted and assumed during the period was $32.27 per share and the related weighted average grant date fair value was $10.51 per share.

 

Restricted Stock Units and Nonvested Shares

 

The following table summarizes restricted stock unit activity for the nine months ended September 30, 2007 (in thousands):

 

 

In general, restricted stock units vest over three to five years and are subject to an employee’s continuing service to eBay. The cost of restricted stock units is determined using the fair value of our common stock on the date of the grant. The weighted average grant date fair value for restricted stock units awarded during the period was $32.59 per share. During the first quarter of 2007, restricted stock units were awarded as part of our annual incentive compensation review for the first time.

 

During the nine months ended September 30, 2007, there was no significant activity in nonvested shares.

 

 

On January 1, 2007, we adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” As of January 1, 2007, we had $385.7 million of liabilities for unrecognized tax benefits. If recognized, the portion of liabilities for unrecognized tax benefits that would decrease our provision for income taxes and increase our net income is $279.6 million. The impact on net income reflects the liabilities for unrecognized tax benefits net of certain deferred tax assets and the federal tax benefit of state income tax items. The adoption resulted in a reclassification of certain tax liabilities from current to non-current and had no significant cumulative impact to retained earnings.

 

As of September 30, 2007, our liabilities for unrecognized tax benefits were $489.5 million and are included in deferred and other tax liabilities, net. The total liabilities for unrecognized tax benefits and the increase for the current period of these liabilities relate primarily to the allocations of revenue and costs among our global

 

eBay Inc.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

operations. Over the next twelve months, our existing tax positions will continue to generate an increase in liabilities for unrecognized tax benefits. We recognize interest and/or penalties related to uncertain tax positions in income tax expense. The amount of interest and penalties accrued at September 30, 2007 was approximately $9.4 million.

 

We are subject to taxation in the U.S. and various states and foreign jurisdictions. We are under examination by certain tax authorities for the 2003 tax year. The material jurisdictions that are subject to examination by tax authorities for tax years after 2002 primarily include the U.S., California, Switzerland and Singapore.

 

During the three months ended September 30, 2007, our effective tax rate was impacted by the non-deductible goodwill impairment charge and a tax benefit, including amounts related to prior periods, from a favorable ruling issued by a tax authority.

 

 

FORWARD-LOOKING STATEMENTS

 

This report contains statements that involve expectations, plans or intentions (such as those relating to future business or financial results, new features or services, or management strategies). These statements are forward-looking and are subject to risks and uncertainties, so actual results may vary materially. You can identify these forward-looking statements by words such as “may,” “should,” “expect,” “anticipate,” “believe,” “estimate,” “intend,” “plan” and other similar expressions. You should consider our forward looking statements in light of the risks discussed under the heading “Risk Factors That May Affect Results of Operations and Financial Condition” below, as well as our consolidated financial statements, related notes, and the other financial information appearing elsewhere in this report and our other filings with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements.

 

You should read the following Management’s Discussion and Analysis of Financial Condition and Results of Operations in conjunction with the unaudited condensed consolidated financial statements and the related notes that appear elsewhere in this report.

 

Overview

 

About eBay

 

We operate three primary business segments: Marketplaces, Payments and Communications. The Marketplaces segment enables online commerce through a variety of different platforms, including the traditional eBay auction-style site, our classifieds websites, our comparison shopping site, Shopping.com, our secondary tickets platform, StubHub, and Rent.com. Our Payments segment, which consists of PayPal, enables individuals and businesses to securely, easily and quickly send and receive payments online. Our Communications segment, which consists of Skype, enables VoIP communications between Skype users and also provides Skype users low-cost connectivity to traditional fixed-line and mobile telephones.

 

Executive Operating and Financial Summary

 

Our focus is on understanding our key operating and financial metrics

 

Members of our senior management team regularly review key operating metrics such as registered users, active users, listings, gross merchandise volume (“GMV”), total accounts, active accounts, total number of payments, total payment volume, and transaction rates. Members of our senior management also regularly review key financial information including net revenues, operating income margins, earnings per share, cash flows from operations and free cash flows, which we define as operating cash flows less purchases of property and equipment, net. These operating and financial measures allow us to monitor the health and vibrancy of our Marketplaces, Payments, and Communications segments and the profitability of our business and to evaluate the effectiveness of investments that we have made and continue to make in the areas of marketing, product development, international expansion, customer support and site operations. We believe that an understanding of these key operating and financial measures and how they change over time is important to investors, analysts and other parties analyzing our business results and future market opportunities.

 

Financial summary

 

Net revenues for the three months ended September 30, 2007 were $1.9 billion, representing a growth rate of 30% year over year. Operating loss for the three months ended September 30, 2007 was $937.7 million. Net loss for the three months ended September 30, 2007 was $935.6 million, or $0.69 loss per diluted share. Both the operating loss and net loss for the quarter were driven by a goodwill impairment charge in our Communications segment of $1.4 billion resulting from our annual goodwill impairment test that is performed during the third quarter. The impairment resulted from an updated long-term financial outlook for the Skype business generated through our annual long-term strategic planning cycle and our settlement payment with respect to the Skype earn out agreement.

During the third quarter of 2007, we repurchased 14.8 million shares of our common stock under our repurchase program for an aggregate purchase price of $500.1 million.

 

Our expectations for growth

 

For the remainder of 2007, we expect that our net transaction revenues will increase as we continue to grow GMV, our non-GMV based businesses (Shopping.com, Rent.com and our classified websites), total payment volume and Skype user activity. Additionally, we expect our advertising revenue to continue to grow. We expect to continue our investments in the areas of product development, customer support, marketing and international expansion across all segments. We believe these investments are necessary to support the long-term demands of our growing business. In addition, to the extent that the U.S. dollar fluctuates against foreign currencies, and, in particular, the Euro, British pound, Australian dollar and Korean won, the remeasurement of these foreign currency denominated transactions into U.S. dollars will impact our consolidated net revenues and, to the extent that they are not hedged, our net income (loss).

 

The discussion of our consolidated financial results in this report is intended to assist those reading this report to better understand the key operating and financial measures summarized above, as well as the changes in our consolidated results of operations from year to year, and the primary factors that accounted for those changes.

 

Seasonality

 

The following table sets forth, for the periods presented, our total net revenues and the sequential quarterly growth of these net revenues:

 

 

We expect transaction activity patterns on our websites to increasingly mirror general consumer buying patterns, both online and offline, as our business expands, with the strongest sequential growth occurring in the fourth quarter.

Results of Operations

 

The following table sets forth, for the periods presented, the breakdown of net revenues by type, segment and geography. In addition, we have provided a table of key operating metrics that we believe are significant factors affecting our net revenues.