Etsy Has Growth Potential But Faces Several Challenges Ahead

| About: Etsy, Inc. (ETSY)

Summary

Etsy completed its IPO last week.

The IPO was priced at the high end of the range.

Etsy has to deliver on its potential before it can be seen as a long-term investment opportunity.

Internet stocks, normally, tend to soar during IPOs. There is so much hype and anticipation ahead of any Internet company IPO that investors often struggle to make rational assessments on the company's growth potential.

Last week, Etsy (NASDAQ:ETSY) --- an online marketplace for handmade and vintage products--- completed a very successful IPO. The IPO was priced at the high end of the range and shares shot up immediately after listing, ending the day at $30.

The excitement surrounding the IPO was not a surprise. It follows after China's leading online marketplace, Alibaba.com (NYSE:BABA) raised $25 billion through an IPO last year. Some other tech based IPOs have also been very impressive.

But let's not take away any credit from Etsy. The company is a popular marketplace in the U.S. It has a solid and loyal base of buyers and sellers. It has 19.8 million active buyers and 1.4 million active sellers. Etsy's S-1 filing shows that 21.8 million apps have been downloaded as of Dec 31st 2014.

Etsy, which lists products ranging from handcraft jewelry to custom made coffee table, has shown impressive revenue growth in last three years. Revenue in 2014 was $195.6 million, up from $125 million in 2013 and $74.6 million in 2012. Another, impressive feature of Etsy is a high-level of loyalty it enjoys among customers. In 2014, repeat customers accounted for 78% of the Gross Merchandized Sales (NYSE:GMS).

The IPO, however, did not fail to ignite a debate among investors. As is always the case with internet stocks, Etsy's IPO raised eyebrows due to very high valuation.

Etsy has never posted a net profit and yet its forward P/E ratio is well above its bigger rival eBay's (NASDAQ:EBAY) forward P/E of 16.43.

That said; let's not forget the fact that ecommerce business is growing rapidly, globally. More and more people, even in emerging markets such as India and Latin American nations place orders online. Etsy, citing Euromonitor, noted in its S-1 filing that global online retail sales are expected to touch $1.5 trillion by 2018--- which implies a 16.6% CAGR from 2013. Between 2008 and 2013, online retail sales grew from $280 billion to $695 billion, representing a CAGR of 19.9%.

Further, Etsy in its S-1 filing has highlighted a road-map for the future, which clearly mentions its ambition to grow globally.

So, yes--- there is no denying of the fact that it has potential to be a growth stock given that forecast for global online retail sales is so robust.

However, it's too early to say whether the company will be able to execute its strategy. There are so many challenges lying ahead of them that it is not easy to justify such a high valuation.

Weakness and Threats

Etsy has not been able to post net profits on GAAP basis since it started business in 2005. So at this stage, it is very difficult to predict about Etsy's future profitability, bearing in mind that it has plans to expand in international markets. Global expansion would result in increased expenses on marketing and product development, which in turn would keep sustained pressure on the bottom line. Thanks to its successful IPO, Etsy has raised lots of cash; however, it remains to be seen how wisely the company utilizes its resources as it looks to expand.

What if rivals start to eat your market-share by offering low commissions?

Although ecommerce is growing at a brisk pace globally, competition is also getting fierce. Etsy's bigger rivals--- eBay and Alibaba also list artisan products from around the world. Likewise, Etsy, as it looks to expand its presence globally, will have to contend with local marketplaces, offering similar products.

Etsy's business is of particular interest to me. I had been involved in a handicraft jewelry business for eight years in India. There is a huge handicraft industry in India, with many small manufacturers. A platform like Etsy can be of great help to these small players. Indeed, a market like India would be perfect as Etsy looks to expand overseas. However, it will not be as easy as it sounds. The company will not only have to compete with the likes of eBay and Amazon (NASDAQ:AMZN), who are already present here, but also with local players like Flipkart. What's more, the likes of eBay, Amazon and Flipkart are already well-recognized platforms, albeit they do not focus solely on artisan products. But my concern is that if these companies were to offer artisan products in India, they will have an advantage over Etsy, since the latter is not well-known in India. This means that the company will have to spend significantly on marketing to build a brand.

Another concern I have with Etsy is as the competition will increase, rival marketplaces, especially those with deeper pockets could lower commissions and listing prices. Etsy generates bulk of its revenue through commissions it gets on transactions, listings and promoted listings. Etsy charges a commission of 3.5% on a transaction and 20 cents for listing products. In case, competition intensifies and Etsy is forced to cut its commission and listing prices then it can have a significant impact on its margins.

Niche Appeal Could Erode if Etsy Diversifies

Etsy right now enjoys a special bonding with its sellers and buyers due to its niche in the online marketplace--- which is focused on handmade and vintage items.

Probably that could be the reason why it attracts a good percentage of repeat customers and has successfully retained so many sellers. But just in case, rising competition compels Etsy to diversify its offerings which are not handmade then those small entrepreneurs --- who are very loyal while listing their products on the marketplace thus far--- could start getting detached. In such a scenario, the company could fail to retain its core base of sellers and buyers.

Monetization from mobile apps

Purchases through mobile devices accounted for 36.1% of the total GMS last year for Etsy. That's a very good figure given that total online purchases through mobile devices are just a fraction of total online retail sales. According to French research firm, Criteo, purchases though mobile phones accounted for 29% of the total ecommerce sales in the U.S. in the first quarter of 2015. However, there are many markets where the share of purchases via mobile devices is very low. For example, in Brazil mobile commerce accounted for less than 15% of total ecommerce sales in the first quarter of 2015. So there is a big divergence when it comes to comes to shopping habits. This needs to be factored-in as revenue from mobile commerce from other markets may not be as high as in the U.S.

Deliver On Promise

I am not writing off Etsy but it has to answer so many questions right now. Therefore, I would remain on the sidelines and watch how the company performs at least for a year.

Remember what happened during Facebook (NASDAQ:FB) IPO in 2012. The stock vaulted on the first trading day. But soon it got hammered amid concerns over how the social networking giant will monetize. It took nearly a year for Facebook shares to reach its IPO level after the company took a series of corrective measures to boost revenue. Of course, I am not predicting a similar trajectory for Etsy shares post its IPO. But Facebook's experience shows that a wait and watch approach would be better. If Etsy delivers on its potential and shares are at reasonable levels then I would definitely look at it as a long-term opportunity, given the anticipated growth in e-commerce globally.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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