Etsy: Reasons To Be Cautious

| About: Etsy, Inc. (ETSY)
This article is now exclusive for PRO subscribers.

Summary

Etsy widened its Q4 net loss.

The growth of active sellers has stagnated.

The company signaled that it will continue to increase operating expenses in 2017.

Etsy (NASDAQ: ETSY) is a company in trouble.

On Wednesday, the company released its Q4 results, with revenues beating the consensus estimates by $2.4 million and earnings falling short by $0.21. Despite the improvement in key metrics, investors were not pleased. Shares fell by as much as 17%. The drop was attributed to three factors. First, net loss increased from $4.2 million in Q4'15 to $21 million. Second, marketing expenses increased from $22 million in Q4'15 to $31 million, with the company pledging to increase these costs in 2017. Finally, the company projected 2017 YoY earnings growth of between 20% and 22% which was below the consensus estimate of 23%. In this article, I will explain the reasons why investors needs to be cautious when investing in the company.

For starters, Etsy is an e-commerce company providing artists and entrepreneurs a platform to showcase and sell their creations. According to the company's 10-K, 91% of the customers use the company to buy products they can't find anywhere else. Etsy competes with other e-commerce companies such as Amazon (NASDAQ: AMZN), Overstock (NASDAQ: OSTK), Leaf Group (NYSE: LFGR) and eBay (NASDAQ: EBAY), among others.

This week, the company released its Q4 and full-year results which were mixed. Although the key metrics like GMS, revenue, and the number of buyers increased, they were pulled down by the increasing operating expenses. The table below presents a summary of key figures.

Screen Clipping

Source: Seeking Alpha

For 2017 and 2018, the company adjusted its guidance as shown below. While the growth is impressive, it will be weakened by the rising operating expenses. I will touch on this later in this article.

Screen Clipping

Source: Seeking Alpha

International Growth

International growth is very important for the company. For years, the management has believed that international sales could generate 50% of the company's total GMS. However, this has not come to pass. In fact, the contribution of the international market has decreased from 30.5% in Q1'15 to the current 30.3%.

In the first conference call as a public company, the CEO said this about the international growth: "Over time, we think our global-local strategy will drive international GMS to 50% of our total GMS." He repeated the same statement in the Q2 and Q3 conference calls. In the subsequent conference call, the sentence was not repeated. Instead, he continued to blame the strong dollar for the weakness of international sales.

In all the conference calls, the CEO talks about the four driving forces for the company. They are: making Etsy an everyday product by investing in mobile, building local markets globally, focusing on the seller services, and the Etsy economy which aims to add more members to the community. To date, the company has achieved three goals. 65% of the company's sales come from mobile platforms, seller services have overtaken marketplace revenue and, to some extent, active sellers and buyers have increased.

The second goal on building local markets globally has hit a wall. In the first conference call, Chad Dickerson said this about the goal:

"Turning now to building local marketplaces globally, this is about building on Etsy's global foundation and by developing local markets in key countries outside the U.S., where there are early signs of both local buyer and seller activity. Overtime we think our global-local strategy will drive international GMS to 50% of our total GMS."

He has repeated a similar statement in all the eight conference calls since. However, it is clear that the company has had serious problems in international growth despite the increase in marketing spend in these regions.

User Growth

The company announced 1.7 million active sellers and 28.6 million active buyers. In the past quarter, the number of active buyers increased by a record 1.6 million. Although this is good, the number of active sellers was stagnant despite the increase in marketing expenses. In Q1'16, the company had 1.6 million sellers. In the next three quarters, the number remained stagnant at 1.7 million.

If Etsy uses a similar model like eBay, making money from marketplace commissions, this would not be a big deal. However, Etsy's revenue model involves the buyers and the sellers. When people buy products, Etsy receives a commission from the seller. This revenue is put in the Marketplace category. On the seller side, it makes money in terms of promoted listings, direct checkout, shipping labels, and other services like the recently launched pattern platform.

The seller category has become an important revenue earner, rising from 47% in Q1'15 to 54% in the last quarter. Further, a good percentage of active sellers do not sell for a long time. In the company's 10-K, it stated that only 31% of active sellers who were active in 2013 are still active. Therefore, this slowdown will have serious implications on the future revenues.

The table below shows the number of active buyers and sellers since the IPO.

Quarter

Active Sellers (millions)

Active Buyers (millions)

Q1'15

1.4

20.8

Q2'15

1.5

21.7

Q3'15

1.5

22.6

Q4'15

1.6

24

Q1'16

1.6

25

Q2'16

1.7

26.1

Q3'16

1.7

27

Q4'16

1.7

28.6

Source: Author using information from the company

Increased expenses

Although Etsy has been impressive in terms of revenues and GMS, it is now in a difficult position. It has managed to remain relevant even with the increased competition from Amazon Handmade and eBay Craft. In 2015, months after the IPO, Amazon launched Handmade which was then touted as the Etsy killer. Today, this category in Amazon has almost 200,000 products (though clothes are excluded) while Etsy boasts of millions of products.

However, this resilience has come at a cost. The company has continued to increase its operating expenses. In the last quarter, total operating expenses increased from $55.6 million in Q3 to $69.8 million. Marketing expenses almost doubled from $18.7 million in Q3 to $31 million while product development expenses increased 15% to $11 million. As a percentage of revenue, the marketing spend was 28%, a record for the company. For instance, in Q1, marketing expenses were just 19% of the total revenue.

The increase in the expenses had mixed effects on the company. On a positive side, it led to record growth in GMS, revenue, and active buyers. In the quarter, GMS increased by a record $188 million from the previous quarter, while revenue increased by 25%. The number of active buyers increased by a record 1.8 million from the previous quarter. On the other hand, the increase in expenses led to a 405% increase in net loss and a reduction in gross profit margins.

In the guidance, while the management increased the GMS and revenue forecast, they also promised to increase the operational expenses. This increase in expenses will be as a result of the investments in marketing and the integration of the Blackbird Technologies which the company acquired in the third quarter. Brand marketing is expected to increase from $6 million in 2016 to $20 million in 2017.

As a growth company, reinvesting in the company is understandable. However, at the current growth rate, increasing these expenses will be a bit challenging for the company's net income. This is particularly because of high customer acquisition costs, decline of repeat customers, and decelerating margins as the company noted in the recent call:

"Even at the expense of lower margins in the near term, we're committed to our investment in brand marketing because we believe it will position us for sustainable future growth."

Final Thoughts

Etsy is currently valued at $1.12 billion which is significantly lower than its IPO valuation of $3.5 billion. The decline in the company’s valuation is a result of a number of factors such as the perceived competition with the likes of Amazon. However, Etsy has proven to be a market leader in the handmade category as described above. At this price and valuation, investors might be tempted to buy the company hoping it will reduce its net loss and possibly turn a profit. As I have demonstrated above, this will be tough this year as the company increases its operating expenses and the number of active sellers stagnate.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.