Etsy: Distinctive Niche Focus Could Pay Off

Summary

• Etsy sees continued solid growth and more importantly sees operating margins stabilize in 2020.
• This is comforting for investors after two quarters of quite severe margin pressure.
• The long term still looks promising amidst a somewhat distinctive e-commerce business model, yet real margin work and continued growth are to be done to deliver on appeal.
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In a week in which global equity markets have seen significant turmoil, and that is quite an understatement, there was a rare winner in the form of Etsy (NASDAQ:ETSY) which managed to gain in a week in which many competitors would be happy to see share price losses limited to single digits.

The reason for that outperformance should be seen in light of the fourth quarter results and the outlook provided for 2020, as investors like the risk-reward here for the company and its shares.

The Company, The Thesis

Etsy might be a compelling business as it claims to be a global marketplace, yet unlike most of its peers, it focuses on unique and creative goods. Despite trying to be unique the company is very large in its scale with more than 2 million sellers and 40 million buyers being active on the platform. Nonetheless, the treasure hunt and unique products make that user scores and satisfaction remains high. The mission of the company is telling a lot with regards to the goal of the company and that is to "keep commerce human".

In past takes on the business, I noted that this business is what might distinguish the company from other platforms and might really be a key distinctive feature with regards to protests arising against large internet giants, anti-trust issues and activism from consumer groups being on the increase.

I looked at the shares in this article dating back from July of last year when the company acquired Reverb in a $275 million cash deal. In that article I noted that the company enjoyed great operating momentum in recent years. The company generated $441 million in sales in 2017 on which it reported operating earnings of $12 million. Revenues rose 37% to $604 million in 2018, but note that fourth quarter sales growth accelerated to 47% confirming that growth was only accelerating throughout the year. More importantly, accelerating growth came hand in hand with leverage in terms of operating margins, with operating earnings increasing a factor of 6 times towards $75 million, with normalized earnings power seen around $0.40 per share.

With shares trading at $70 last summer I noted that the company was valued at $9 billion, while it generated about $4 billion in gross merchandise value and $600 million in actual revenues on that amount. The company was already taking a bit cut of 15%, defined as revenues divided by gross merchandise value, yet the company has ambitions to increase this percentage.

In that article I made some projections out to 2025. I noted that if GMV could increase from about $4 billion in 2018 to $10 billion in 2025, and the "take rate" could increase to 20%, there was potential for $2 billion in sales. Assuming EBIT margins anywhere between 20 and 40%, EBIT might come in at $400-$800 million as tax rates and the share count would translate into earnings between $2.50 and $5.00 per share in such a scenario.

That might result in a $50-$100 valuation by 2025, or perhaps a bit higher. Yet with shares already trading at $70, some 7 years ahead of the outcome of such a rosy scenario, shares were arguably more than fully valued already.

What Happened?

My cautious take in July at $70 has proven to be quite right as shares fell to levels in the fifties in August following softer than expected second quarter results, and in fact shares hit the $40 mark in November upon release of the third quarter results.

Third quarter results showed a 30% increase in gross merchandise value, an acceleration from the 23% growth reported in the first nine months of the year thanks to the Reverb deal which closed pretty much halfway during the quarter. The issue was that revenues were up just 32% for the quarter which means hardly any growth in excess of GMV growth, while revenue growth of 36% in the first nine months of the year, far stronger than GMV growth reported for that period.

All of this and the Reverb deal have some real implications on the margin front. The company generated third quarter operating profits of $14 million, equal to about 7% of sales. Note that operating earnings totaled about $18 million in the third quarter of 2018, equal to more than 12% of sales. This pullback is worrisome as operating earnings for the first nine months of the year were up from $45 million to nearly $68 million.

Following strong fourth quarter results shares recovered to $58 per share. GMV growth accelerated to 33% with revenues up 35%, as Reverb contributed to the results for the entire quarter of course. Again, operating earnings fell from $29 million and change in the final quarter of 2018 to $25 million in the fourth quarter of 2019.

Amidst a shrinking share base, with 123 million diluted shares outstanding, shares are valued at $7.1 billion at $58 as the company operates with a roughly flattish net cash position. This values shares at 8.7 times sales and a sky high earnings multiple of around 100 times. While the company reported net earnings of $0.76 per share, this is only the result of a tax refund, adding to net profits.

Outlook For 2020

For the current year the company sees resilient growth although it is hard to judge how much of that is guidance adjusted for the impact of the Coronavirus. GMV growth is seen at 25-28%, with revenues seen up 27-30% to a midpoint of $1.05 billion. Adjusted EBITDA is seen at $220-$235 million, for margins around 21-22%.

For you reference, sales totaled $818 million in 2019 on which $186 million in adjusted EBITDA was generated, for margins equal to 22.7%. This suggests that EBIT margins which came in at 10.7% could be stable at around 10% and no longer see continued pressure, as was the case in the third and fourth quarters. This suggests EBIT of around $105 million for the year 2020. Assuming a 20% tax rate, earnings power comes in around $0.70 per share, still resulting in sky high valuation multiples.

With GMV seen around $6.3 billion this year, the $10 billion number is still very much attainable by 2025, as the take rate comes in close to 17%, which makes a $2 billion revenue number perhaps still attainable in 2025. The question is what margins could do as they have been coming down in recent quarters and currently come in around 10%, far lower than the 20-40% range required to deliver on earnings of around $2.50-$5.00 per share by 2025. That would still justify a $60-$120 valuation by 2025 and makes the $58 current valuation look reasonable, although real margin expansion is required to justify further upside.

So while the valuation at $58 looks more healthy than the $70 valuation last summer, note that shares have seen a big rebound from the $40 low in November already. Hence, I see appeal improving, but I am not necessarily buying just yet, notably as I have concerns about the long-term operating margin potential, after a few difficult quarters on that front.

Nonetheless, this remains an interesting stock to watch given that it really tries to distinguish itself from other major platform companies and peers.

Analyst’s 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.