Description

Redbubble is probably the next Etsy but trades at just a fraction of the price. The stock is down over 50% since its peak in January due to short term focus on slowing profits post Covid and new CEO Michael Ilczynski’s plan to reinvest in growth to reach critical mass. The plan was communicated poorly but we believe Ilczynski is an excellent CEO who is highly incentivized and doing the right things. Redbubble trades at 4.5x EV/GP today, significantly lower than what its inferior competitor Society6 was acquired for in April. Etsy trades at 14x. We expect Redbubble’s GP to compound at 30%+ over 3-4 years and value it at 10x EV/GP. That implies A$18.5/shr vs the stock price of A$3.4 today. While the stock is likely to be volatile and there are risks around competition, the changing environment, and execution, we think at today’s price the risk of losing money over three years is limited while the chances of this being a multibagger are high.

Note: Financials are in Australian dollars unless stated otherwise.

Situation Overview

Redbubble has been written up three times on VIC before, so this writeup will focus on why we think the market is ‘wrong’ on several key issues today:

• Why the stock has declined over 50% because investors misunderstand new CEO Michael Ilczynski’s plans and are focusing on short-term results instead.
• Why ilczynski is a star who will lead Redbubble to critical mass.
• Why the threat of Amazon is overestimated.

For brief background: The company was founded by Martin Hosking, who retired as CEO in January but remains an influential board member and owns 16% of the company. Redbubble is an online marketplace with ~700k selling artists creating designs that Redbubble’s outsourced fulfillers print on-demand across over 120 products such as t-shirts, masks, stickers, and phone cases. The company has ~10mm unique customers. The economics are attractive, with no tangible capital required and printing and delivery outsourced. Sales today are split roughly 70% US, 25% Europe, and 5% others. Organic growth has averaged ~30% p.a. over five years. Despite this, average sales per customer are only ~$A65 per year, meaning that most customers are likely only ordering once or twice a year for Christmas or other special occasions. With Hosking championing Redbubble’s “flywheel”, many investors were looking forward to a steady 30% sales growth and cash generation going forwards. Or so they thought.

#1 - Why Investors Misunderstand New CEO Ilczynski’s Plan

On April 22, new CEO Michael Ilczynski presented his medium term plan for the company. At face value, this projected a halving of EBITDA margins in the short term and reduced sales growth rate of 20%-30% p.a. That left many investors disappointed. Criticisms ranged from not implementing a dividend (!), ruining the flywheel, lack of detail provided, step up in cost base, growth investments that hurt short term profits, and growth investments that did not appear to lead to higher growth. Combined with an already slowing growth outlook as results lap the beginning of the Covid surge, the stock's decline from its peak in January accelerated. It now trades at A$3.4/shr, down over 50%.

We think this was a case of poor communication rather than a poor plan. To see why, we have to first look at Redbubble’s economics pre-Covid:

Sales growth averaged 30% p.a. excluding the acquisition of Teepublic and with that came incremental gross margins of 41% and incremental EBITDA margins of 7% despite marketing as a % of sales increasing. The main source of margin expansion came from other opex (staff) as a % of sales declining ~2ppts per year as the business scaled. 

Ilczynski’s targets assume $1.25bn in sales in fiscal 2024 or 2025, gross margins flat/up to 40-42%, marketing flat/up to 12-15% of sales, other opex down to 15% of sales, and EBITDA margins up to 10-15%.

Assuming a slower 15% sales growth in FY2022 as the company laps Covid implies sales growth beyond that of 23%-37% p.a. and incremental EBITDA margins of 13%-20%. These numbers are in line or better than the historic trajectory. Gross margins are flattish rather than up because management is choosing to reinvest in better quality blanks and fulfillment, which are Redbubble's weak spots and exactly what we would want. Other opex as a % of sales continues to decline ~2ppts per year. So there is no step up in cost base.

Why then is the stock down so much?

What we didn’t show above were the financials for the 9 months so far this fiscal year (calendar Q3 2020 - Q1 2021):

Sales growth has averaged 85% so far this year, other opex dropped to 16% of sales, and EBITDA margins expanded to 11%. Now it looks like Ilczynski’s plan is to step up costs and halve margins in the short term just to get them back to where they already are in the long run .

But the last nine months were not representative conditions. When Martin Hosking returned as CEO in February 2020, he cut Redbubble’s staff by 15% (other opex). Then Covid happened and so far in FY21 sales are up $105mm while other opex is down $10mm. That is not sustainable nor desirable as there are areas the company should be investing in at good returns.

Investors wrongly extrapolated these results.

They were also unrealistic to expect another 30% year of growth in FY22 at similar margins as masks have been 10% of sales in FY21 so far and a greater percent of earnings. There will be particularly tough comps in calendar Q3, where masks were 21% of sales last year. FX will be another 10% headwind. Combined with some post-Covid slowdown, Redbubble’s growth rate could turn negative for the quarter despite the underlying business doing fine. We are therefore leaving room to add to our position. For the full FY22 we expect 15% sales growth in FY22 and so Ilczynski’s mid-term plan implies an average of 30% growth afterwards.

Another way to look at this is to compare Redbubble’s economics today with Etsy’s when they were a similar size in 2014:

Both companies spend a similar amount on marketing per $100 of gross profits and Redbubble spends less on other opex. At the midpoint of Ilczynski’s plan, the company will be spending less on marketing and other opex per $100 of gross profits than Etsy pre-Covid.

Another argument investors have made is that a doubling in size for Redbubble should fundamentally change the company’s economics if it has a flywheel and therefore it should not return to the previous trajectory. We interpret this to mean that not only should margins increase, but incremental margins should also.

But this is true for Redbubble. From FY16-20, incremental other opex was 47% of GP, meaning the company reinvested around half of each incremental $ from gross profits into other opex (staff). Ilczynski’s plan implies a decline to 25% from FY22-24 (excluding FY21 to ex out Covid). That is again less than Etsy.

Ilczynski’s plan does not suggest Redbubble does not have a flywheel or imply a step up in sustaining costs. In fact, if the numbers already factor in a step up in growth investments, then they actually imply a step down in sustaining costs. Ilczynski is also incentivised to be convervative in his estimates.

Most importantly, investors are missing what matters. 

What matters isn’t squeezing the last percent out of profit margins this year. It's whether Redbubble is going to be the next Etsy or CafePress.

Redbubble is a two-sided marketplace that needs to hit critical mass - that tipping point where it becomes incredibly difficult to be displaced, like Etsy. Marketplaces that have yet to reach this point are vulnerable to becoming obsolete, like CafePress. 

Etsy makes US$1.5bn in gross profit today and has an EV of US$21bn (14x), while Redbubble’s target is to be at US$400mm in 3-4 years yet has an EV of just US$600mm (1.5x). On the other hand CafePress, the former leader in the print-on-demand space, was acquired for just $27mm in 2018. 

Without accelerating their reinvestment in growth, we estimate it would take Redbubble up to 10 years to reach critical mass. The company should be reinvesting all owner earnings and Ilczynski’s plan probably accelerates this to less than 7 years. The method we used to estimate this is available in the appendix.

#2 - Why Michael Ilczynski is a Star with the Right Plan

Yes, he should have laid out his plan better. But we believe that Michael Ilczynski is an outstanding operator and will get Redbubble to critical mass.

Ilczynski is a 45 years old Australian who has a background in strategy and operations, having started at McKinsey and worked his way up at SEEK (an online employment marketplace) through product development and strategy roles. This culminated in him becoming CEO of Asia Pac and Americas. That division had $710mm in sales and $350mm in EBITDA in 2019 when he left on a sabbatical to travel with his young family. His departure was on good terms, with the company disappointed to see him leave. At SEEK, he worked with a Founder who acted more as a Chairman, leaving Ilczynski as almost the day-to-day CEO and someone who had reached a ceiling at the company. 

He took a 40% pay cut to join Redbubble.

At SEEK, Ilczynski received total compensation of $3.3-3.4mm in his last two years, with a base of $1.6-1.8mm. At Redbubble, he will receive a target compensation of $2mm and a base of $800k. He has sold the $2mm in stock of SEEK he owned and bought $2mm in Redbubble stock. We believe Ilczynski is an ambitious high-achiever who sees Redbubble as the vehicle to satisfy his personal and financial motivations.

We spoke with a number of current or former C-level executives at SEEK and their references were exceptional, even by the standard of references. They highlighted Ilczynski’s strengths on strategy, product innovation, financial control, people skills, and high performance culture. When pushed on his lack of consumer goods experience or focus on the customer, virtually all sources denied that would be an issue.

Ex-colleague #1: “He did a great job with every role he had and I would rate him as one of the very best I have worked with. He evolved from more strategic roles through to heading product and tech and then heading our employment classifieds business across Australia and Asia.  He did this in a very autonomous fashion [Redacted] and very well through a fair bit of challenge and change…the fact he joined was enough for me to make a small investment.”

Ex-colleague #2: “On a strategy front Michael is one of the best I've ever seen. Very insightful. Not just the research but understanding it and drawing conclusions. Over time he took responsibility of the core business from a technology and product point of view and did a terrific job on that. That moved him into all the operating businesses in employment apart from China. I have to say one of his strengths there was building a really good team around him…Terrific leadership. Good understanding of what it takes to run a high performing team…If you're looking for negatives he can be pretty hard on his people because he drives pretty hard. I personally don't see a problem with that but sometimes he needed to bring people along with him. He got better and better at that. Really good on self-reflection…I did have aspirations to get him for something, so that's how highly I rate him…His financial acumen is also very strong…[On culture]: Very high performing. Quite open…We used to have board meetings and Michael would cycle his direct reports in on a pretty regular basis. I always look for does he want to control the base and discussion. He was supportive and challenging but absolutely gave his people plenty of scope. To me that's the secret of having high performing teams.”

Ex-colleague #3: “Ace cards are operations and meeting metrics and people management. Teams love him. SEEK business is across the world. Very good with people, culturally, diversity…Think the world of him. Didn't want to lose him…I imagine he wants something small that he can grow aggressively. Want to grow something to $10bn. He's not lacking in ambition. [On why Redbubble picked him]: From what I heard they want someone hands on…SEEK is relevant because product innovation has been key to success...[When asked on Michael’s lack of consumer goods experience]: That's very fair…The candidate side of SEEK is still a consumer business . Still have to build awareness and get attention but really playing with product. Not a discretionary item. Redbubble is a discretionary item. No doubt Mike will put good people around him.”

Ex-colleague #4: “I have significant respect for his skills. His appointment at Redbubble could potentially be seen as a double plus, as (i) Mike is a strong executor, and (iii) he is a strong strategic thinker with many options, therefore I see his choosing of Redbubble as a meaningful endorsement of company potential.”

Ex-colleague #5: “Mike is one of the best executives I've worked with. Combination of his intellect - very bright person. Obviously gets the strategic components. His background is from consulting. Operations came after. Very focused. Very hard working. Driven by results. Very focused on what the right inputs are and the results are the output. Thinking strategically and translating to operations components. Gets the people part. At SEEK we had greater founders. Understood the culture part and surrounds himself with the right people…A good human being. Good values. Good person. Youngish family. Couldn't speak more highly of him…Worked with founders which is important given Martin is stepping down. [On customer focus]: There is a big customer focus at SEEK. Huge focus on the jobseeker is king. We have to nurture and engage with the jobseeker because without the jobseeker we don't have a marketplace…Did a lot of work on an outstanding customer experience on the product side. Don't see any issue. Mike is a super smart guy….He will treat shareholders with upmost respect. He spends money like its his own. I think they're fortunate to have him. He's a very good balance of IQ and EQ.”

Redbubble needs these qualities.

While the company’s Founder Martin Hosking clearly had an exceptional track record and understands the business well, we think a stronger customer focus and cultivation of a high-performance culture will drive better results.

Redbubble also needs investment.

The biggest factors customers are critical of are Redbubble’s product quality (particularly print quality) and delivery (late or not delivered). This is both on an absolute basis and relative to some competitors such as Etsy and Teespring. Redbubble’s products are also inconsistent, with phone cases and stickers having relatively high quality and masks and clothing outside t-shirts having low quality. T-shirts are about average.

We view these as positives as it shows how many easy wins there are. Ilczynski is aware of this.

We believe Ilczynski’s planned investments will first improve quality and delivery to increase customer retention, then go for customer acquisition to accelerate growth. 

Investment 1 - Other opex. This goes beyond more staff to keep up with Redbubble’s growth since Covid. The company lacks the tech to track and understand customers, product quality, and fulfillers. It didn’t even track customers by name until four years ago. Other neglected areas such as the licensing and fan art program have shown promise but only have a few people working on them.

Investment 2 - Gross margins. These include investments in shipping, product quality, and consistency, which are the areas where customers have the biggest complaints. We think listening to customers will lead to fewer blind spots - Redbubble previously talked repeatedly about improving the “unboxing experience” when many customers weren’t even getting the box on time or at all. There are other simple investments to be made - spending an extra $1 on a blank t-shirt would significantly improve its quality.

These investments should lead to improved customer retention, average order values, and orders per year.

They should also result in higher conversion rates from Investment 3 - increased spending on new customer acquisition. That will likely start in FY23. As a sense check, we estimate that marketing today is being spent at an ‘all-in’ LTV/CAC of 2.5x. Management told us that investments in general are being made with a 12 month payback in mind.

Redbubble does not disclose most of these numbers, but we estimated it costs $18 post tax to acquire a customer and that customer has a LTV of $44. We estimated cohort retention using numbers from Etsy’s 2015 prospectus (those numbers have improved for Etsy since but Redbubble’s retention is not as good so we kept it at that level), GTV growth from Etsy’s 2013-17 cohorts, marketing spend from Redbubble’s FY18-20 results, and incremental EBIT margins of 15.8% from the mid-point of the Ilczynski’s mid-term guidance.

Our guess is that the LTV of A$44 - which represents just a handful of t-shirts - will grow substantially from Ilczynski’s investments. That makes this LTV/CAC calculation conservative.

The same analysis for Etsy implies a CAC of US$23 - 60% higher - but LTV of US$173 - 400% higher. The higher LTV is driven by customers purchasing twice as frequently. Ilczynski’s investments will look to close that gap.

As an aside, the high end of Redbubble’s mid-term plan implies a CAC of exactly $18 in FY23-24, in line with history, whereas the low end implies a near doubling to $31. This again suggests that the high end is the realistic scenario.

#3 - The Threat of Amazon is Overestimated

The threat of Amazon is not what has caused Redbubble’s stock to decline recently, but is the most common pushback that we see from investors who are skeptical. We think the threat is overstated.

Perhaps the best proof of this is that Etsy has arguably beaten Amazon Handmade. Just six months after Etsy IPOed in 2015, its stock halved after Amazon launched a replica called Amazon Handmade. Yet today, items on Amazon Handmade get a fraction of the reviews of those on Etsy.

Amazon's website and search algorithms are designed to optimize for the mass of customers who want an item that is affordable and delivered quickly. These tend to be fairly generic items that can be easily mass produced and afford sponsored listings or highlighted as “Amazon’s choice”.

As a result, a customer searching for handmade products would really have to select the department "Handmade", which is number 20 on the list of departments. 

As a former member of Redbubble senior management told us, "All [of Amazon's] recommendation engines and AI are around volume. It's a similar engine. The search problem for Redbubble is the opposite. It's about a dissimilar engine. It's about how you and I differ. It's profoundly different search problems. They're culturally different. All of Amazon's architecture is designed around volume."

A search for "funny t-shirt" on Amazon brings up official shirts from Friends, then sponsored shirts, then shirts from major retailers and brands such as Disney and Star Wars. Most of these are sponsored listings. None of them are from the Merch by Amazon platform for independent artists - artists cannot afford sponsored listings and it is not optimal for Amazon to promote a niche shirt designed by an independent artist over shirts by Disney or Friends that are likely to sell in much greater volume.

There is one other important disadvantage which Amazon has and that is the greater risk of being sued for copyright infringement.

Since it is impractical to go after all items infringing upon copyright across marketplaces, lawyers are much more likely to focus on Amazon simply because it is a far bigger target. As the CEO of an online marketplace told us, "Amazon cannot play in the area inspired by artists because every lawyer will go after Amazon. They are doing business with brands that don't like artistically inspired work".

Amazon is also disadvantaged because it owns its own manufacturing. Through a legal quirk, pure marketplaces that don't have their own manufacturing like Etsy and Redbubble are considered to be facilitating rather than selling the items on their website. That has largely exempted them from copyright infringement (so far). 

These reasons are why Merch by Amazon limits the number of artists on its platform and vets each design before it is uploaded. It will always have a fraction of the artists that Redbubble has and designs that are uploaded slower - significant disadvantages in the personalization space.

In our research, we found that sources expected Amazon to own a large share of the POD market, but leave significant niches open to others. Former and current executives at Redbubble are increasingly relaxed about the Amazon risk.

Valuation

Redbubble trades at 4.5x EV/GP today, the same multiple that Leaf Group was acquired for in April. But Leaf’s marketplace (Society6) makes up only half of sales and is the significantly higher value part of the business, implying it fetched a higher multiple. That is despite Society6 being in an inferior competitive position to Redbubble. Downside at today’s stock price therefore appears limited.

Etsy trades at 14x and just acquired Depop for 31x.

We think something like 10x EV/GP is an appropriate multiple for Redbubble. Assuming 40% gross margins and 15% EBIT margins at scale implies an EV/EBIT multiple of 27x at scale, which seems reasonable for a business growing 30%.

At today’s GP of ~$185mm that implies an EV of $1.85bn or $6.8/shr. At a GP of $500mm in 3-4 years that implies $5bn or $18.5/shr. The stock trades at $3.4/shr today and both these valuations exclude ~$1.5/shr from net cash today + cash generation over 3-4 years.

The stock is likely to be volatile, particularly around calendar Q3 results. But over 2-3 years downside appears limited if we’re wrong and this is a multibagger if we’re right.

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Appendix - Redbubble Remains 5 - 10 Years Away From Critical Mass

Etsy is a marketplace that appears to have reached critical mass. Its market share really started expanding rapidly from 2012 onwards, when it had 9.3mm active buyers. Since Google searches for these marketplaces are 4 times higher today than 2012, it would take ~37mm customers today to achieve the same level of market share that Etsy had in 2012.

CafePress is a former leader that appears to have never reached critical mass. Its market share peaked around 2004-5. From company filings the earliest numbers available are from 2008, when the company disclosed it had 2.1mm customers. That is the equivalent of ~32mm customers today when adjusted for the fact that Google searches for these marketplaces are 15 times higher. 

This analysis suggests that an online marketplace needs to have somewhere between 30mm-40mm customers today to have reached the tipping point for critical mass.  Assuming the market continues to grow at 15% p.a, the range for critical mass will have increased to 60mm - 80mm in five years’ time. 

If Redbubble grows at 30% it will take a decade to reach critical mass. At 40% this is cut to seven years. 

There is some anecdotal evidence that the tipping point is reached sooner. When we asked sources whether Redbubble had reached critical mass, many said the company was at or past this point, at least in its niche for independent artists. This included senior management from both the major direct competitors we spoke with, all former members of Redbubble senior management we asked this question to, and the company itself. 

The CEO of a major competitor notably told us that "It's probably going to come down to Amazon, Redbubble, [and us] as general open marketplaces. And maybe a couple niche ones like TeePublic...5 years from now there will be 3 groups. Amazon doing POD for lots of stuff and two other major groups. If you're not in those two groups you're out...I have a feeling that Redbubble has kind of won on the artistic front...Honestly I am not certain we can catch up to get the artistic mindset that Redbubble has. That's why we concentrated on quality and actually on the range of products we are ahead of Redbubble". 

It also appears that CafePress' decline was largely due to its own mistakes and so perhaps it did reach critical mass but shot itself down. After Bob Marino took over as CEO in 2011, the company tried to broaden beyond POD by making acquisitions of tangential online businesses that were ultimately distracting, unprofitable, required inefficient marketing and tech spend, and integrated poorly. CafePress also had staff manually curated items recommended for customers rather than rely on a search algorithm, which left them vulnerable when consumer tastes changed. Marino was ultimately replaced in 2014 and Founders Fred Durham and Maheesh Jain returned. 

Catalyst

No hard catalyst. Sentiment on the stock is poor and some normalization as growth accelerates, particularly from calendar Q4 onwards, should lead to a re-rating.