Description

I’ve made a number of compulsive purchases since quarantine began: a new Martin guitar, an enormous trampoline, and a giant hound, to name a few.  But the purchase that started it all off was an outsized Carrara marble mortar with a hand-carved pestle made of olive wood.  It is a thing of beauty – cut, shaped, and honed in a little town in the Veneto region of Italy, and the pestle is shaped from the lathed wood of 400-year-old Tuscan olive trees.  It works beautifully.  Check out my pesto mise en place (trofie noodles made in house, of course):

Get to the pitch already!

The company is Etsy, where I found this masterpiece, along with a 3-gallon stone pickling vessel made by some artisan in Ohio that is currently fermenting a batch of Hungarian half-sours under my bar. Kerrcap wrote up Etsy 4.5 years ago and offers good background for those unfamiliar with the company. Explaining what I like about Etsy as a delighted customer, and what I like about Etsy as an investor is easy.  Etsy offers:

- Differentiated products that are not easily replicated by a competitor (i.e., they don’t have to compete on price)

- A fast-growing seller services business (shipping labels, payment processing, paid promo listings, etc.)

- A more engaging, personal retail experience which Millennials crave

- A capital-light model with the best kind of cross-border scalability unconstrained by geography

- A sticky seller platform

- A huge runway of organic growth

- Strong barriers to entry typical of two-sided marketplaces

- Really cool stuff I simply can’t find anywhere else at all sorts of different price points.

Not to mention it has already successfully defended itself against Amazon, the world’s most aggressive and competitive retailer.

This write-up is admittedly light on valuation work because the truth is that I’m really not sure what it’s worth.  Trading at ~10x revs, Etsy has predictably had a good run this year and doesn’t appear “cheap” (although it’s a long way from all the high-teens revenue multiple SaaS companies out there).  Etsy fetches a “high” multiple because it’s a very high-quality business with an enormous TAM, an impenetrable moat, and a business model with the best kind of borderless scalability.  It has already managed to fend off the single largest threat to its survival: Amazon.  I hate optically high multiples as much as the next guy, but the reality is that with businesses of such high caliber, if you hold them long enough, it is very difficult to lose money.  Time is your friend here.

Etsy sports an $18B market cap and is well-covered, so I won’t spend too much time explaining the business.  My guess is many here are already quite familiar with the business model and I am happy to address specific questions in the Q&A.

In short, Etsy operates two-sided online marketplaces that connect millions of passionate and creative buyers and sellers and has become the world’s premiere destination for unique and creative goods.  Artisans and entrepreneurs offer all manner of handmade items, vintage goods, and craft supplies.  The top six retail categories are homewares and home furnishings, jewelry and personal accessories, apparel, craft supplies, paper and party supplies, and beauty and personal care.  Etsy’s 2019 acquisition of Reverb also now offers significant exposure to the market for used musical instruments.  Etsy’s core geographies are: United States, United Kingdom, Canada, Germany, Australia, and France.

Etsy reports its revenue in two segments: Marketplace revenue (~75%) and Service Revenue (~25%).  Marketplace revenue comprises transaction revenue and payments revenue.  Etsy does not disclose the mix of transaction and payments revenue but analysts estimate transaction revenue comprises ~75% of marketplace revenue.  Etsy takes 5% of the selling price as a transaction fee and sellers also pay $0.20/listing on the site.  Payments revenue represents the amount Etsy charges on any sales made on the platform and approximates ~4% of Gross Merchandise Sales (GMS).  Service revenue is derived from optional services offered to sellers, which primarily include advertising services and shipping labels. 

Total Addressable Market –

Management estimates the company’s TAM at ~$100B and growing.  Their methodology involves estimating total retail sales (both offline and online) for all relevant categories in their six core geographies, or $1.7 trillion.  In 2018, 15% or $249B sales took place online.  However, Etsy’s brand targets consumers more interested in expressing themselves or making a statement with their purchases, rather than those who care about finding the cheapest item possible with the fastest shipping time.  Management estimates the roughly 40% of US consumers care about this purpose-driven purchasing behavior, and therefore estimate their TAM at ~40% of the $249B in online spend in their core geographies, or ~100B.  As a result, Etsy’s 2019 Gross Merchant Sales (GMS) of $5B would put them at ~5% market share.  Management’s 40% estimate is almost certainly wrong but the false precision doesn’t bother me.  What’s obvious is that Etsy’s current market share is a small fraction of their current TAM, which is itself growing at a healthy clip.  And as two-sided marketplaces with scale erect high barriers to entry, Etsy’s market share is certain to increase along with the increasing TAM.  Nonetheless, the size of the TAM is a big driver here and I think about it as follows:

- Management’s estimate is likely conservative because it ignores non-core geographies (90+% of the world’s population!)

- Management only considers retail categories they feel are “relevant.”  But with $346m in mask sales alone during Q2, Covid has exploded any traditional notion of what should be considered relevant.  CEO Josh Silverman drove this point home at a Keybanc conference last month:

“An example I would give is bread and bread-making in the month of May. I never would have guessed that bread and bread-making products would be a big category on Etsy.  Never in a million years would it have occurred to me.  But in the month of May, we started to see bread shortages in stores, and a lot of people stuck at home decided to take up bread-making as a hobby.  And so they turned to Etsy, and we started to see a surge in keywords, in demand, and literally within hours, bakers are coming on Etsy and starting to meet that demand.  And supply and demand met effortlessly and almost instantaneously because the communities are paying enough attention and bakers started to talk to bakers and word just got out.  So we actually didn’t need to do anything in that case, and we had enough supply.”

Examples like the above illustrate the folly of trying to nail down the TAM. Etsy owns the marketplace, and therefore does not have to identify trends or make assumptions about how many people will buy which products and for how long. The millions of buyers and sellers, coupled with the magic of the price system in a free market, do that for them. In other words, Etsy's TAM is constrained only by the unwillingness of consumers to engage on their platform, which comes down to two things: awareness and execution. If Etsy invests in improving awareness and continues to execute, the sky is the limit. As far as awareness is concerned, Covid seems to have done for Etsy in sevent short months what might otherwise have taken years and required hundreds of millions of marketing dollars. As far as execution is concerned, Etsy CEO Josh Silverman has done an excellent job thus far, and with Fred Wilson (tech VC superstar and founder of Union Square Ventures) as Chairman of the Board, shareholders can look to the future with confidence.

- Secular e-commerce tailwinds only accelerated by Covid.  Even in the event of a reliable vaccine, I believe e-commerce penetration rates will continue to accelerate faster than the market had anticipated pre-Covid.  Etsy has been around a long time but I somehow only just discovered it during Covid (apparently so did actor Steve Martin).  I now routinely check Etsy before Amazon to see if there are more interesting versions of various products I’m looking to buy.  I mean…check out this 1960s vintage butcher block.  It’s no wonder that 88% of Etsy buyers believe Etsy carries items unavailable anywhere else – a rarity in today’s interconnected global supply chain.

Competitive Moat –

Sameer Singh has written an interesting article about defensibility vs scalability that is applicable to Etsy, though he doesn’t single Etsy out in his analysis.  Consider the geographic scalability of the hyperlocal network effects at a company like Uber.

The more riders / drivers there are on the platform, the more value any given rider/driver ought to be able to extract from the experience.  But if Uber increases the number of drivers in a particular geography, the marginal utility to a rider of the incremental driver being added to the platform eventually begins to erode.  If there are 1,000 riders in your neighborhood being serviced by 2,000 drivers, the presence of an additional driver does nothing to reduce wait time for riders and thus provides no value.  The scalability of Uber’s model is constrained by geography.

Etsy’s model has no such constraint, as its network effects are not bound by geography.  Every incremental seller on Etsy creates incremental differentiation of supply and improves the buyer’s experience.  Much like Airbnb, differentiated supply coupled with cross-border network effects produce a highly defensible and scalable model.

Amazon Threat –

Just six months after Etsy’s 2015 IPO, Amazon launched Amazon Homemade.  At the time, investors failed to understand the fundamental differences between the two models and abandoned Etsy in droves.  This ended up providing a spectacular buying opportunity for those who understood Etsy’s unique selling proposition.  Nothing about Amazon is “vintage” or “handmade.”  Etsy management never harbored ambitions to be as efficient as Amazon’s logistics department.  Etsy’s mantra is about “keeping commerce human.”  ~30% of the items on Etsy can be customized.  Sellers can upload videos to show buyers how their products are being made, underscoring the company’s core message of keeping commerce human.  It’s about as far away as possible from Amazon’s approach and taps into an entirely different consumer desire.  My mortar and pestle took a little longer to ship to me than my Amazon paper towels, but I didn’t mind one bit, and the experience of engaging with the artisan and watching the artistic process was infinitely more fulfilling.  Don’t get me wrong – our household is an Amazon Prime power user.  Etsy is just an entirely different experience.  What’s more, with GMS of ~$1T vs ETSY’s of ~$10T, Amazon Homemade simply doesn’t move the needle for AMZN.

Finally, Etsy’s brand is much more relevant to young consumers today.  eBay, Etsy’s most direct two-sided marketplace competitor, has more active buyers but has been around for 25 years.  Despite Etsy’s “youth,” the brand appears to have much more momentum, with >8x the presence on Instagram.

Take rates going up –

Etsy takes 5% of an item’s selling price as a transaction fee (this figure was only 3.5% until 2018).  However, since ETSY defines “take rate” as total revenues as a percentage of total GMS, the reported take rate was closer to 16% in 2019.  With no standard definition of take rates and marketplaces with very different characteristics, comparing take rates across different platforms is difficult.  What seems obvious, however, is that as the value of the platform to sellers increases, so too will take rates.  Take rates at Amazon’s 3P retail platform are ~25% and up to 30% once you include advertising fees 3P sellers pay on Amazon Marketplace.  Other marketplaces, while not exactly comparable, also suggest Etsy has ample room to increase take rates over the next several years.

To be sure, increased take rates inevitably lead to increased tension between Etsy and its sellers, but I don’t lose too much sleep over this as there is simply no other comparable alternative for sellers.  Finally, conversations with IR have indicated that management appreciates how to balance the risks associated with increasing take rates too quickly and maintaining good relations with sellers. 

Valuation –

As mentioned before, I really don’t know what Etsy is worth.  What I mean by that is that as I stare at my model with all its assumptions about active buyer/seller growth, GMS per buyer/seller, the growth of underpenetrated international markets (China?  India?), increases in transaction fees, listing fees, how aggressively mgmt. invests in SG&A, how LTV/CAC evolves over time, etc., I fear any number I offer here is false precision, at best.  It’s quite possible Etsy is fairly (or even slightly over-) valued today.  What I have more conviction about is the fact that intrinsic value will increase over time because of the nature of the business model.  A tier 1 marketplace with a highly defensible and scalable model, a growing TAM, low-single-digit market share despite being the leader in its niche, and a high ROIC model requiring little incremental capital to grow all make for a good recipe, even if one is paying a fair (rather than wonderful) price today.

Catalyst

- more effective marketing spend on consumer awareness

- time