- The company's revenue will grow following the price of goods offered by sellers in the marketplace.
- Goods on the marketplace have a low price elasticity of demand since handmade items are unique.
- Etsy has always been highly profitable. Moreover, the potential for growth in margins has not yet been exhausted.
- Due to the asset-light business model, the company does not need significant capital expenditures even during periods of rapid growth.
As the consumer price index rises and the rhetoric of the world's central banks tightens, the question of protecting capital becomes relevant for investors during a period of high inflation. While commodities and real estate are traditional hedging sectors, we do not know what the behavior of the "new economy" companies will be in the current environment, since similar inflation was last observed about 40 years ago. Although Warren Buffett has defined the criteria for choosing objects for investment in times of inflation very precisely, we have expanded them somewhat. We are looking for asset-light businesses that can increase revenue in line with inflation without significant capital expenditures, have relatively high profitability, and also have a short supply chain. In addition, as always, a reasonable price is important to us. Etsy (NASDAQ:ETSY) fits each of these criteria.
There is a misconception that you should keep investing in stocks during periods of high inflation, as companies increase their revenues following the rise in prices for goods and services. However, rising costs, expenses, and expenditures, and the rising cost of capital eat into a significant portion of the net present value of future cash flow. Thus, not all companies can create shareholder value during rampant inflation.
Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.
We are expanding the selection criteria somewhat. In addition to the ability to raise prices in line with inflation, the company's high profitability is important to us, since solid margins provide some margin of safety during a period of rising costs and expenses. A 5% increase in costs and expenses for a company with a 10% margin will eat up 45% of net income, while a company with a 30% margin will only see the bottom line drop by 12%.
As global logistics capabilities buckle under the pressure of unprecedented demand, we are looking for a company with the shortest possible supply chain that will keep costs down. Furthermore, the company must be able to increase revenue without large capital investments, as the cost of raising capital rises significantly during periods of high inflation.
It is easy to find good assets among the six thousand public companies trading on the NYSE and NASDAQ. Finding good assets at a reasonable price is a much more difficult task. So one of the criteria for our choice is a price that provides a sufficient margin of safety.
Etsy Is Our Choice
Such an uncommon choice may surprise some investors seeking protection in the commodities and real estate markets. Indeed, e-commerce is the last thing inflation hedges are associated with. However, the truth is that we have not seen how similar companies behave in a similar macroeconomic environment, since the last time comparable inflation was observed in 1976-1982. Etsy meets all the criteria that we outlined above.
Etsy earns 75% of all revenue from the 6.5% transaction fee. Accordingly, the company's revenue will grow following the price of goods offered by sellers in the marketplace. In turn, merchants will also raise prices due to inflation, as 71% of merchants view their stores as a business and therefore cannot sell at a loss.
In addition, goods on the marketplace have a low price elasticity of demand, since handmade items are unique. According to the company's 2021 survey, 87% of buyers say "Etsy has items I can't find anywhere else", and ~72% of buyers agree "there is no other store or website similar to Etsy". The low elasticity is also driven by relatively low GMS per active buyer per quarter, making shopping on Etsy relatively imperceptible to a household budget.
Unlike other e-commerce giants, Etsy does not have its own logistics infrastructure. The company does not control seller shipping or the associated logistics networks. The entire infrastructure of the company consists of a marketplace that connects buyers and sellers. Due to this, Etsy has always been highly profitable. By the end of 2021, the adjusted EBITDA margin reached 31%, and the net profit margin reached 21.2%.
Moreover, the potential for growth in profitability has not yet been exhausted. Marketing and R&D account for 76.6% of the company's total operating expenses. Stock-based compensation accounts for 7.5% of all costs and expenses.
Due to the asset-light business model, the company does not need significant capital expenditures even during periods of rapid growth. For example, by the end of 2020, CapEx accounted for only 2% of revenue, which is lower than a year earlier. As a result, Etsy is not only able to combine solid free cash flow with revenue growth, but also maintains a high return on assets in times of inflation.
The supply chain problems are the main challenges for the margins of most industrial companies. On average, global container shipping rates have more than quadrupled since 2019, according to McKinsey. Etsy does not and will not have problems with the supply chain, since, firstly, handmade goods are quite simple and do not consist of a large number of components; secondly, most of the consolidated 2021 GMS was generated when both a seller and a buyer were in the United States.
ETSY Stock Valuation
Our DCF model is based on several assumptions. We expect the company's top line to grow in line with the Wall Street consensus. Since 2013, the gross margin has grown by an average of 0.53% per year, we expect this trend to continue. A similar methodology is used in forecasting operating expenses and hence operating margins. Although D&A expenses and Capital Expenditures as a percentage of revenue have steadily declined, we expect them to be at the past five years' average level in the coming years. The terminal growth rate is 2% in line with the Fed's long-term inflation target, which makes our model quite conservative. The assumptions are presented below:
Based on the assumptions, the expected dynamics of key financial indicators are presented below:
With the cost of equity equal to 10%, the Weighted Average Cost of Capital [WACC] is 9.5%.
With a Terminal EV/EBITDA of 8.6x, the model projects a fair market value of $17,211 million, or $135 per share, well below the Wall Street consensus estimate of $189.2. The upside potential we see is about 39%.
You can see the model here.
Although on EV/Sales and EV/EBITDA multiples it looks like the company trades without a significant discount, Etsy is highly profitable and still growing revenue. According to the PEG ratio, the company looks quite cheap.
While e-commerce is the last thing on the mind when it comes to inflation hedges, we don't know how such companies perform in such a macroeconomic environment. What we can say for sure, however, is that Etsy has every indication that the company can maintain profitability and continue to create shareholder value under these conditions. In addition, the current price provides a sufficient margin of safety for buying. We are bullish on the company.
This article was written by
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