Etsy: The Planets Are In Alignment (NASDAQ:ETSY)

Etsy: The Planets Are In Alignment (NASDAQ:ETSY)

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Market conditions are synonymous with planets in alignment.

(Source: shutterstock)

Etsy, Inc. (ETSY) had an extraordinary second quarter with revenue climbing 147% YoY as the company was well positioned to capitalize on the consumer shift to online shopping during the pandemic. Etsy’s claim-to-fame is handmade and vintage products, and the company wasted no time aligning its sellers to make and sell masks at the start of the pandemic.

SUmmary of Etsy financial performance

(Source: Etsy)

That strategy worked out so well it resulted in $340 million in masks being sold with at least 110,000 participating sellers. This activity attracted a significant number of new buyers to the site and many have made subsequent purchases.

During the second quarter the Etsy marketplace saw an influx of 18.7 million new and reactivated buyers; the latter being those who hadn’t purchased in a year or more. Given the significant amount of new buyers on the platform…”

Revenue reporting had to be qualified

The great success of mask sales has caused Etsy management to provide financial figures sales that exclude mask sales in the Q2 2020 quarterly presentation slides. Even with the exclusion, the company’s sales performance was remarkable, with the top 6 categories up by 92% YoY.

…the breadth and depth of different purchase occasions that buyers turned to Etsy for in the second quarter was truly breathtaking, spanning all of our top categories. If you need to furnish something for your new home-office, why not get a custom-made desk made by a carpenter just for your size.

If you’re going to get something nice for the summer to wear, why not buy a beautiful linen dress direct from the cash [ph] person who made it at a really valued price. If you need a painting for your wall, why not get a personalized portrait of your pet. Even everyday goods like bread sold extremely well on Etsy.”

Statistics summary of Etsy top category growth

(Source: Etsy)

As it turns out, Etsy was actually very fortunate with the Covid-19 timing as the company had just completed a migration to the cloud in Q1 2020, a project that was commenced in 2018. Without the completion of this project, the company would not have been able to scale up its platform to meet the extraordinary demand caused by the pandemic. Etsy would have been left in the dust as other eCommerce players capitalized on the shift to online shopping.

Etsy has been a busy beaver

Etsy has been busy updating its platform and has made some significant improvements that should help to improve business going forward. Improvements include such things as “Saved Searches”, video upload, and bundles.

Saved Searches allows buyers to provide an interest in a specific area, an interest that is tracked by Etsy long term. After the buyer provides an area of interest, he or she then receives EMAILs when product sales in that area are initiated or when new products are introduced. In addition to EMAIL, every time the buyer comes back to the site, he or she can see fresh results related to the search.

Illustration of Etsy

(Source: Etsy)

In 2019, Etsy introduced free shipping for orders greater than $35. Free shipping sets the stage for a new feature called bundles, which provides buyers with an incentive to add orders from the same seller to get above the $35 threshold for free shipping.

Illustration of Etsy

(Source: Etsy)

The video upload feature allows seller to tell their stories and share videos of themselves and their products, providing the buyer with a human connection to the seller.

Illustration of Etsy

(Source: Etsy)

The problem with custom products

One issue that Etsy has to deal with, through no fault of its own, is the problem of displaying 3D images of its products. This is understandable because handmade items typically don’t come with the 3D files provided by commercial suppliers. In place, Etsy has introduced an augmented reality feature that for now is specific to wall art. The feature “helps buyers visualize wall art they’re interested in purchasing.”

Illustration of Etsy

(Source: Etsy)

Competition

Etsy competes for the shopping dollar with other online marketplaces and eCommerce sites such as Shopify Inc. (SHOP), amazon.com (AMZN), and eBay Inc. (EBAY). Most of these sites do not focus on custom made products, allowing Etsy to thrive in its market niche.

Because Etsy specializes in custom products, the company has been able to introduce the controversial Etsy ads, a feature that offers advertising on third party websites in exchange for 15% of product revenue. I personally feel that the 15% fare is quite reasonable considering that the seller only pays if the product is sold. Etsy provides the upfront funding and hence the risk. The seller benefits from having a large presence in Etsy doing the advertising. In any case, the seller is allowed to opt-out if desired. The point is that Etsy can justify the large (and profitable) fee because the seller’s products are unique and the price is not driven by low-profit competition. They are not made-in-China products that are seen all over Shopify, amazon.com, and eBay. Such online marketplaces would have difficulty promoting a high-fee service such as Etsy Ads.

Stock Chart

Etsy investors have been enjoying the benefit of not only a terrific Q2 2020 financial performance but also the recent announcement that the stock is being included in the S&P 500 index and reports from investment companies that Etsy’s gross merchandise sales growth is strong in Q3.

The stock is extremely bullish and, in fact, has even outdistanced Shopify this year. Etsy is up 215% versus Shopify’s 170% YTD.

Etsy stock chart and comparison to Shopify

(Source: Yahoo Finance/MS Paint)

Stock Valuation

There are numerous techniques for valuing stocks. Some analysts use fundamental ratios such as P/E, P/S, EV/P, or EV/S. I believe that one should not employ a simple ratio, and the reason is simple. Higher-growth stocks are valued more than lower-growth stocks, and rightly so. Growth is a significant parameter in discounted cash flow valuation.

Therefore, I employ a technique that uses a scatter plot to determine relative valuation for the stock of interest versus the remaining 170+ stocks in my digital transformation stock universe. The Y-axis represents the enterprise value/forward gross profits estimate, while the X-axis is the estimated forward Y-o-Y sales growth.

The plot below illustrates how Etsy stacks up against the other stocks on a relative basis based on forward gross profits multiple.

Scatter plot of fundamentals for 170+ digital transformation stocks

(Source: Portfolio123/private software)

A best-fit line is drawn in red and represents an average valuation based on next year’s sales growth. The higher the anticipated revenue growth, the higher the accepted valuation. In this instance, Etsy is positioned near the best-fit line, suggesting that the company is fairly valued relative to its peers. I have also highlighted Shopify for comparison purposes. As can be seen from the scatter plot, the stock is attempting to escape Earth’s atmosphere, and investors should be careful with long positions on the stock. Expectations are much higher for Shopify than they are for Etsy.

The Rule Of 40

One industry metric that is often used for software companies is the Rule of 40. The rule provides a single metric for evaluating both high-growth companies that aren’t profitable and mature companies that have lower growth but are profitable. Revenue growth and profitability (expressed as a margin) must add up to at least 40% in order to fulfill the rule. Analysts use various figures for profitability. I use the free cash flow margin.

The rationale for the Rule of 40 is as follows. If a company grows by more than 40% annually, then you can tolerate some level of negative free cash flow. But if a company grows by less than 40%, then it should have a positive free cash flow to make up for the less-than-ideal growth. This rule accommodates both young, high-growth companies as well as mature, moderate-growth companies. The 40% threshold is somewhat arbitrary but typically divides the digital transformation stock universe in half, separating the best stocks from the so-so ones.

For a further description of the rule and calculation, please refer to a previous article I have written.

The two factors required for calculating the Rule of 40 are revenue growth and free cash flow margin. Etsy’s annual revenue growth for the latest year is 60%. The company’s TTM free cash flow margin is a strong 33%.

Etsy annual growth rate and free cash flow margin

(Source: Portfolio123/MS Paint)

Therefore, the Rule of 40 calculation for Etsy is as follows:

Revenue Growth + FCF margin = 60% + 33% = 93%

Its score is significantly higher than the necessary 40% needed to fulfill the rule of thumb, suggesting that this company has a healthy balance between growth and profitability.

The planets are aligned

In general, I like Etsy as an investment, but what really gets me excited is the current market conditions. The market for digital transformation stocks is starting to come alive after a couple of volatile months. I expect that this area of investment is going to get very bullish in the near term. There are several reasons for this, as explained below.

First is the talk of new government stimulus. While politics are still involved, particularly with regards to the size of the stimulus package, everyone including the president agrees on the need for stimulus to keep the economy alive. The only real question is whether it will come before or after the election, and how large the package will be. My bet is that it will happen prior to the election. Politicians like to keep their high salaries and positions of power.

The second point concerns the election and the resolution of uncertainty. I am not advocating for one party over the other, just that Mr. Market doesn’t like uncertainty. Once the uncertainty disappears, then the markets will likely respond in bullish fashion.

The third point is that Thanksgiving is just around the corner. With Thanksgiving comes Black Friday and Cyber Monday. As far as eCommerce is concerned, this year will be huge. Online sales records will undoubtedly be set.

The fourth point is that Christmas follows Thanksgiving by about a month and this will be a time of optimism, not only for the festive occasion, but as some believe, a lightening of the shutdown rules. And indeed, it will be a time when announcements of Covid-19 vaccine and therapy approvals start to happen. There are several vaccines and treatments in the pipeline and I expect that some will be successful through Phase 3 trials.

Even with an approved vaccine, I don’t expect that the economy will open up for at least another year as the vaccine supply ramps up. But keep in mind that the stock market is a leading indicator. I expect that news of an approved vaccine and successful treatments will send the markets flying.

Investment Risks

There are several risks that investors should consider before investing in Etsy. First of all, I view the current stock market action to be reminiscent of the dot.com era, immediately prior to the crash starting in 2000. Technology stocks were performing well beyond what many analysts considered acceptable valuations. It wasn’t long before the market turned into a disaster, and the same could happen here, although I believe that there is much more substance behind the internet companies than existed 20 years ago.

When you remove the effects of the pandemic and stay-at-home mandates, Etsy’s performance is very much tied to the economy. We are currently in a recession and no one really knows how long it will persist or how deep it will get. Ultimately, economic recovery will drive Etsy’s success.

We also don’t know how successful Etsy will be in retaining customers once the pandemic is over. There will undoubtedly be some retracement of sales but it really depends on how well Etsy executes. As it stands right now, Etsy is doing a great job in boosting the number of return customers.

Summary and Conclusions

Etsy operates as an online marketplace specializing in handmade and vintage products. It has been very successful during the pandemic, growing revenue by 147% YoY in Q2 2020, with overwhelming success in its six main categories of product. The sale of homemade masks brought in $340 million alone in Q2. Without the mark revenue, the company’s revenue was still up by 93% YoY.

Etsy completed its conversion to a cloud-based business in Q1 2020, very timely as the cloud has allowed Etsy to scale its marketplace exponentially as the pandemic set in. Scaling should be uninhibited from this point forward. The company has introduced several new features, including Saved Searches, video upload, and bundles. These features demonstrate the company’s drive for continuous improvement, providing sellers with new and better tools, and the roadmap to future success.

There are some risks with investing in Etsy. eCommerce is huge and although the company is selling into a market niche, the company could lose market share to another company. The fact that Etsy is now being included in the S&P 500 is a huge vote of confidence for investors.

I believe that the planets are in alignment, not only for Etsy, but for the stock market in general. Government subsidies will come, the election results will subdue unrest, and Black Friday will happen and it will be unbelievable for online shopping. Then comes Christmas and the likelihood of FDA approvals for vaccines and Covid-19 therapies. I expect that we are in the early stages of a fairly significant bull market and now is the time to jump onboard. I am giving Etsy a bullish rating. Two thumbs up.

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.



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