Seeking Alpha

Etsy Is A Buy

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About: Etsy, Inc. (ETSY)
by: The Prospector
The Prospector
Long only, Growth
Summary

Etsy shares have sold off sharply since the Q3-19 report, largely due to reduced profitability guidance. Shares were pricey going into Q3.

Shares are 40% off their 52-week highs. This looks like a good entry point if you believe in the Etsy story long term.

The company has developed a strong niche in selling creative goods made by artisans, despite the beliefs of many that Amazon or eBay or another platform would crush Etsy's prospects.

The recent free shipping option has placed some pressure on sellers, but I suspect this situation will resolve itself as the company and sellers make adjustments.

Etsy has a long growth runway ahead of it, is consistently profitable, and is generating strong free cash flow growth. I have initiated a position.

Thesis

Etsy (ETSY) has gotten pummeled since the Q3-19 earnings report. The shares were arguably overvalued heading into the Q3 release. The Q3 revenue and earnings numbers were fine, as revenue slightly exceeded expectations and EPS was in line.

Etsy disappointed some with profitability guidance, with a minor revision to expected full-year 2019 adjusted EBITDA of 22-23% due to its recent acquisition of Reverb, a marketplace for musical instruments and gear that is not profitable. This is the second quarter in a row that profitability guidance was lowered. The company lowered guidance last quarter due to increased marketing spend.

The subdued profitability guidance has made Etsy an attractive proposition. Though profitability may take a hit in the short term due to investments in the business, the company continues to operate a strong niche marketplace for handmade goods, craft supplies, and vintage items. Shares are still priced for growth, but look reasonable given the company's growth runway, its niche position in online retail, and its massive addressable market.

(Source)

Hiccups, But Strong Growth Continues

Etsy reported another quarter of strong revenue growth. Absent the recent Reverb acquisition, revenue was up 28% yoy. For the first nine months of 2019, revenue is up 34%, excluding the Reverb acquisition. This is an acceleration over the first nine months of 2018 when revenue was up 32%.

Gross margins contracted in the quarter, and the company guided for lower adjusted EBITDA for the year. The reductions were a result of the acquisition of Reverb, an unprofitable marketplace for musical instruments and accessories. The company expects Reverb to be EBITDA breakeven by the end of 2020.

(Source)

In addition to absorbing Reverb, Etsy has struggled with the creation of a new service called Etsy Ads. The company makes revenue in two primary ways. The first is through Marketplace revenue, which consists of listing and transaction fees for items being sold on the Etsy site. The second is Services revenue for optional services Etsy sells to its sellers, including Etsy Ads, discounted shipping labels, and other services like storefront customization. The Etsy Ads services was launched in Q3 and is a combination of its promoted listings service and Google Ads. The promoted listings service helps a seller improve the visibility of their products on the Etsy website. Google Ads helps sellers promote the visibility of their products on websites external to Etsy.

The Etsy Ads launch has sparked backlash from some Etsy sellers, who believe having to pay Google for external marketing is not as cost-effective as simply paying for promoted listings on the Etsy site itself. Previously, Etsy sellers could pay for promotions and Google Ads with two separate ad budgets, but now the promotional services are combined into one ad budget. It remains to be seen how this topic will evolve or if it could drive some sellers away from the platform.

(Source)

There have also been operational issues with the new Free Shipping option. The company began promoting Free Shipping in July. It wanted Free Shipping for orders $35 or greater to become a core offering by its sellers. That said, while most sellers now offer free shipping, many are not pricing their products appropriately and are losing money because of it. Etsy has launched an educational effort for sellers to help them better price their products in a Free Shipping environment. Overall, the Free Shipping emphasis has benefited Etsy sales. Purchases per visit are up.

Habitual buyers - those who make six or more purchases per year - is the segment thus far that has reacted most positively to free shipping and has shown increased conversion rates. The company says data shows that free shipping is boosting the number of items per transaction for merchants.

(Source)

Valuation

In addition to maintaining strong revenue growth, Etsy continues to improve on profitability and free cash flow generation. Net income in the first nine months of 2019 is up 78% yoy, and free cash flow, which more than tripled in 2018 to nearly $200 million, is up 27% in the first nine months of 2019. If the company continue improving profitability, Etsy will grow into its current valuation of a forward P/E of 67. Etsy has a tiny piece of a massive market, which it estimates is at least $250 billion vs. the company's anticipated 2019 revenue of <$1 billion.

That said, uncertainties remain. Marketing costs are rising. Sellers are angry at the new Etsy Ads program, and revenue is being lost due to sellers not appropriately pricing for Free Shipping.

Conclusion

If you don't manage other people's money for a living and you're playing the long game, the recent Etsy selloff is an opportunity. I have initiated a position and may add if the stock price continues to get punished in upcoming quarters.

Disclosure: I am/we are long ETSY. 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.