Description

Introduction

ETSY is an operator of four online marketplaces, with the primary one being ETSY.com, which focuses on handmade, personalized, and unique items. In recent years, the name ETSY has become ubiquitous when it comes to shopping for authentic, customized gifts that can be found nowhere else. In 2021, 96.3 million buyers and 7.5 million sellers transacted nearly $13.5 billion worth of goods (gross market value or GMS) mostly on ETSY.com. ETSY’s core geographic markets are the US (60% of revenue) and the UK (14% of revenue) and to a lesser extent, Canada, Germany, Australia, France and India. 42% of 2021 GMS was generated from either a buyer or seller or both being located outside of the US.

The top categories of items sold are home furnishings and housewares, jewelry and personal accessories, apparel, craft supplies, paper and party supplies, and beauty and personal care with each of these categories having over 15 million unique buyers transacting on the platform last year. These six categories comprised 87% of 2021 GMS.  ETSY.com currently has over 180 million unique monthly visitors and lists over 100 million items for sale. Approximately 23% of 2021 GMS was from custom or made-to-order items.

ETSY has opened a way for millions of individuals to start and grow their small businesses using the ETSY platform to potentially reach millions of buyers across the globe. ETSY provides the technology, payment infrastructure, marketing assistance and other seller tools which help sellers growth their businesses to a much greater extent than if they were limited to physical selling or selling on their own websites. Of the 7.5 million sellers on ETSY’s platform, nearly 80% are women and 95% of them run their shops from their homes. 56% of ETSY sellers sell over multiple channels including live events such as craft fairs and mall kiosks as well as via their own websites and other online marketplaces, and for these sellers, ETSY represents the majority of sales.

Pandemic

The Covid-19 pandemic gave a huge boost to ETSY, accelerating several years of growth into a few quarters. GMS in 2019 was nearly $5 billion, having grown by around 20% annually in the previous five years. In 2020, GMS more than doubled to $10.3 billion as the number of buyers on the platform increased 77% to 81.9 million from 46.4 million and the GMS per buyer increased by 17% to $126. Total revenue increased from $818 million to $1.7 billion. Obviously, as people were stuck at home with savings piling up, online spending on goods exploded higher and shoppers flocked to ETSY. Also, with many people being laid off or working from home, many individuals looked for opportunities to work from home and/or start their own small businesses. The number of sellers on the platform increased from 2.7 million to 4.4 million in 2020. At the outset of the pandemic, many people were drawn to the platform to either purchase or sell masks. Mask sales accounted for $743 million of GMS in 2020 from practically nothing the prior year. While mask sales have declined as the pandemic has waned, the huge ramp in sales highlights the rapidity with which ETSY can enable a new product category to be brought to market and just as quickly scaled down without ETSY having to invest in inventory or distribution infrastructure or anticipate sales trends. Encouragingly, in 2021 ETSY was able to grow further off of the incredible growth of 2020 as buyers and sellers continued to come to the platform and buyers spent more money.

Financial Overview

ETSY’s consolidated revenue of $2.3 billion, which is divided between marketplace revenue and service revenue, grew 34% in 2021. Marketplace revenue totaled $1.7 billion and includes revenue from listing fees, transaction fees, payment processing fees, and offsite ad fees, all of which are paid by sellers. Listing fees are $0.20 for each item listed on the marketplace which is good for four months. On completed transactions, sellers incur a fee of 6.5% determined based on the sales price of the item inclusive of shipping costs. The transaction fee was increased to 6.5% in April of this year from 5% previously. Payment processing fees range from 3% to 4.5% of the total sales price including shipping plus a flat fee depending on the country in which the seller is located. ETSY payments allow sellers to accept credit and debit cards, Paypal, Apple Pay, and Google Pay, as well as some bank transfers and have the funds deposited in the seller’s bank account. ETSY payments facilitate cross-border transactions including currency conversion. Over 92% of ETSY’s 2021 GMS was processed through ETSY’s payment processing. In May of 2020, ETSY began offering offsite ads where it advertises seller listings on social media, apps, search engines, etc. ETSY charges the seller either 12% or 15% (based on total seller revenue) of the total sale if a buyer clicks on the ad and purchases from that seller’s shop within 30 days. In 2021, 9% of ETSY’s GMS was subject to an offsite ads transaction fee. Collectively, these fees resulted in a take rate of 12.9% meaning ETSY collected $0.129 cents in revenue for every $1 sold on the platform. This is an increase from 9.7% since 2016.

Services revenue, which totaled $583 million in 2021 includes onsite advertising and shipping labels. ETSY allows sellers to pay for prominent placement in search results. Placement prices vary based on demand for ads and the ad budgets of sellers. ETSY also provides discounted shipping labels claiming it can save sellers up to 30% on shipping costs due to volume discounts. ETSY records shipping label revenue net of purchase costs. The total service take rate in 2021 was 4.3%, up from 3.1% over the previous five years. The overall take rate increased to 17.3% last year, up 440 basis points over five years.

As revenues have grown, ETSY has experienced positive operating leverage as the adjusted EBITDA margin has increased from 22.8% in 2019 to 30.8% in 2021. Gross margins have increased and product development and general and administrative expenses have declined as a percentage of revenue. However, the company has continued to invest in marketing, increasing it to 27.6% of revenue in 2021 compared to 25.9% in 2019. A significant amount of this increase is due to the off-site ad program. It is difficult to pinpoint with any accuracy what percentage of ETSY’s operating expenses are to fund growth versus more fixed in nature; however, I think it is very likely that there is still room for additional margin expansion in the future should the company decide to reign in growth spending. The company is already highly cash generative, producing over $600 million in free cash flow in both 2020 and 2021. The company has negative working capital and very low capital expenses (both PP&E and capitalized software costs). In 2021, $0.27 of every dollar of revenue was converted to free cash flow. Returns on invested capital are strong, even including the acquisitions of Depop, Elo7 and Reverb. For example, over the past five years, incremental growth in adjusted EBITDA is over 25% of the incremental invested capital. If you exclude the acquisition of Depop, which was bought for approximately $1.5 billion in 2021 and contributed negligible if any EBITDA, the incremental ROIC is over 60% which highlights the high quality and favorable economics of ETSY.com.

Valuation

I think given the growth that occurred in 2021 off the explosive growth during the pandemic year, and the growth that has continued into 2022, albeit moderated, ETSY will build off the growth it has experienced thus far. In other words, unlike other pandemic beneficiaries, I think it is unlikely that ETSY will give up the gains it experienced during the pandemic. As the economy slows and inflation dampens consumer purchasing power, near-term growth will possibly stall for a while, but I think with a growing number of habitual buyers and ETSY only taking a low single digit percentage of share in the markets in which it operates (online by product category), the longer-term growth potential remains intact. At a stock price of $103, the company trades at a 2021 free cash flow yield of almost 5% which is too high for a capital-light, cash generating platform asset operating in a strong competitive position. Assuming growth in buyers and GMS per buying at low single digit rates, the take rate moving up 19% within five years, slight margin leverage, free cash flow used to repurchase stock, and an exit multiple of 20x free cash flow, I can get the equity to compound at low double-digit rates. I think this is attractive given the competitive position of the business, the relatively low debt (net debt of around 1.8x), and potential for future growth and additional margin leverage. The stock has fallen along with other pandemic beneficiaries from a 52-week high of over $300 as the air has come out of the bubble. A valuation of $300/share was egregious on the upside, but a price of $100 or less has gone to the other extreme.

Competitive Advantages

As an online marketplace, ETSY has earned high returns on historical capital investments and incremental returns on capital have been very strong in recent years. As an online marketplace, the company’s capital investments are very modest. It produces no product, holds no inventory, and has no distribution network. ETSY’s sellers use their capital to produce the product and hold inventory and third parties provide shipping. From a capital investment standpoint, ETSY’s spent 1.2% of its revenue on PPE and capitalized software costs in 2021. The company has typically generated cash inflows from working capital. As a two-sided marketplace, ETSY simply takes its cut of GMS and passes the rest to its sellers. The potential for high incremental ROIC was on full display during 2020 as adjusted EBITDA increased by over $320 million on incremental capital investment of approximately $278 million, including the acquisition of Reverb in 2019 which added very little EBITDA. Even prior to the pandemic, incremental return on invested capital were very high as the company invested very modest amounts and growth resulted in tremendous incremental EBITDA and cash flow.

Like other two-sided marketplaces, ETSY benefits from network effects as the platform becomes more valuable as more people use it. As more buyers look to shop on the platform, more sellers open ETSY shops to meet the demand from those buyers which increases the breath of products for sale which in turn attracts new buyers, etc. I think the network effect can be seen given the growth that occurred during the pandemic in 2020, but even more so the growth that occurred again in 2021. For example, the number of active sellers grew to 4.36 million in 2020 from 2.7 million the prior year, but sellers grew even more in 2021, increasing to 7.52 million. Buyers increased from 46.3 million in 2019 to 81.9 million in 2020 to 96.3 million in 2021. I think it is a very positive sign that ETSY was able to increase the number of buyers and sellers on its platform in 2021 off the huge pandemic growth, and those gains have held relatively steady into 2022. Given the critical mass achieved by ETSY and the important role it plays for both buyers and sellers in the market in which it serves, it is well positioned from a competitive standpoint to keep potential competitors at bay. While there are alternative online marketplaces for unique and handcrafted goods, none are close to ETSY’s size and global scale. And the pandemic no doubt boosted ETSY’s network effect, making it even stronger and likely more durable.

As ETSY is the largest marketplace, either physical or digital, for unique, handmade goods, it has more data than its competitors which it can use to improve its product offerings for both buyers and sellers. ETSY is investing in improving its search function to make it even more relevant to buyers. It invests in seller tools, including offsite ads, to improve the seller experience, including growth through improvements in marketing effectiveness. As the company’s vast collection of data continues to grow, it can invest more in improving the platform while spending less per user as compared to its competitors.

Risks

The biggest risk for equity shareholders is capital destructive acquisitions. ETSY has completed three acquisitions in the past few years, Reverb in 2019 and Depop and Elo7 in 2021. The company has discussed pursing a “house of brands” strategy where it acquires and operates other two-sided marketplaces using shared expertise in “product, marketing, technology, and customer support” to enhance the value of acquired platforms. Reverb (musical instruments) and Elo7 (like ETSY but in Brazil) were acquired for $275 million and $212 million, respectively. Depop, which is an online seller of pre-owned and vintage clothing, was a much larger acquisition purchased for approximately $1.5 billion. Depop’s revenue is likely in the range of $60 to $65 million and its net loss was $37 million for the 5.5 months that ETSY owned it in 2021. I have no explanation for how ETSY thought it was a good idea to pay between 23 and 25x revenue for a money-losing platform which sells used clothing other than to assume it got caught up in the bubble hype with many others during late 2020/early 2021. This was obviously a very poor deal which will be likely be written down in the future. Hopefully the company has learned from this mistake and will be more circumspect when it comes to future deals. The ETSY platform is a very valuable asset, and additional acquisitions will mostly likely only be dilutive.

Conclusion

The ETSY.com marketplace is a high-quality business with high margins, strong cash flow, and potential for future margin expansion as the business grows. The platform benefits from network effects which makes the platform more valuable to buyers and sellers as it gets bigger. As commerce continues to move online, especially globally, ETSY has a long runway for future growth, yet the stock is currently trading for around 20x free cash flow. With only low to mid-single digit growth, a slight increase in the take rate, and some incremental margin leverage the stock could compound at double digit rates moving forward.

Catalyst

Continued revenue growth and margin leverage