Etsy (ETSY) is currently a massively successful marketplace, it experienced 137% YoY revenue growth in its most recent quarter – thanks in part to selling tons of facemasks. I remain cautious about the long-term trajectory of this company – since Etsy’s moat is quite weak and so the business model can easily be disrupted.

Traffic

Before elaborating why I believe Etsy’s business model might be disrupted in the coming years, I want to dive into Etsy’s traffic sources. In 2018, 15% of Etsy’s website visits were derived from its marketing efforts, this means Etsy paid for advertising on third-party websites and so it acquired traffic. I estimate this share has continued to grow over the last few years and is likely above 20% in 2020. Etsy stopped reporting these data in 2019 after reporting it for years, which in my opinion, adds to the suspicion Etsy’s growth has more and more came from paid traffic. This has been fueling revenue growth, however, also led to higher marketing costs relative to gross merchandise value, GMS for short. In 2017, marketing costs made up a 3.4% share of GMS, in 2019, this grew to 4.3%. This sounds like a really small number, but remember Etsy’s share of the GMS is only 16%. Consequently, more than one-fourth of Etsy’s revenues are spent directly on marketing, clearly, not an insignificant expenditure.

If you are wondering what’s inside Etsy’s marketing budget:

‘We continue to lean into all of our marketing investments, both higher funnel like television, as well as performance marketing in places like Google and Facebook, and we believe that they delivered very strong returns in the quarter even as we elevated the absolute dollar investments in those returns.’ ~Josh Silverman, CEO

Fortunately, a vast majority of Etsy’s traffic is from organic sources, but do not get fooled, organic sounds better than it actually is. I suspect that the organic traffic is driven by the hard work of Etsy’s sellers; Etsy sellers themselves do most of the marketing, they use platforms like Pinterest (PINS), Instagram, and Facebook (FB) to drive traffic to their store. Feel free to check this, click on a relatively popular store on Etsy I assure you that they have an Instagram and Pinterest page attaining tens of thousands of views – potentially even more – every single month. This is a huge traffic source and is accounted for as ‘organic’ by Etsy.

(Source: Etsy 2018 Annual Report)

New fee structure

Recently, Etsy has changed its fee structure – this was incredibly controversial amongst Etsy sellers. Before, Etsy sellers could pre-define a daily or monthly budget for Etsy Ads. Etsy would advertise products of sellers – who willingly paid for advertising – on its own website and also on third-party websites like Google.

I deem the new fee structure as much more lucrative for Etsy since sellers pay a mandatory 12% or 15% fee – depending on the size of the store – for every sale made to a customer who clicks on a paid ad in the last 30 days. It is understandable sellers are furious; in theory, this means sellers can share their products on Pinterest or Instagram, a customer sees the post and Googles the product, and clicks on a Google ad from Etsy of the specific product. If the consumer then goes on to buy the product, the seller has to give Etsy a 12 or 15 percent mandatory fee for doing practically nothing. And this is a mandatory service for big stores.

This 12-15% fee is added upon the other fees; I estimate that the other fees make up approximately 10% of the gross merchandise value. To conclude, this means approximately 20% of all sales on the Etsy website – as I elaborated earlier, I estimate 20% of Etsy’s traffic to be paid – account for a fee above 20%. This is a huge fee and in my opinion, gives the ability for competitors to come in and seriously underprice Etsy’s product.

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I estimate both paid and organic traffic from Instagram, Pinterest, and Facebook to account for a huge amount of traffic towards Etsy’s website. Why do I believe this is important? I believe these are the platforms ready to disrupt Etsy’s business model, actually, they have already just started to disrupt it.

Disruption

Etsy’s biggest strength is the network effect. Etsy has a huge amount of active sellers on the platform, this obviously attracts clientele and also more sellers. Apart from that Etsy has a strong brand, Etsy is seen by many consumers as a great way to buy local hand-made products, people love unique products, not the mass-produced merchandises from China. On the other hand, sellers are quite unhappy with the platform, as elaborated earlier its incredibly expensive.

Any competitor of Etsy needs a huge audience, a massive userbase interested in unique products, and needs to severely underprice Etsy. If the users are present, the sellers will come to the platform, especially if the fees are much lower.

Amazon

The first competitor that comes to mind is Amazon (AMZN). A couple of years ago, Amazon launched Amazon Handmade. This clearly was an Etsy competitor, fortunately, for Etsy, this platform has been a minor success – it has not taken off as much as some people might have thought. I suspect this is due to Amazon’s huge transaction fee of 15%, and unless they lower that fee, Amazon does not provide more value than Etsy. It showcases that for any competitor to seriously compete with Etsy, they need a lot of firepower since even Amazon was unable to replace Etsy at a similar fee.

Facebook

What if I said that a competitor with enough firepower already exists, and the Etsy sellers are already active on the platform, actually, it is one of the major ways sellers drive traffic to their Etsy stores at this very moment.

Sound familiar? The platforms Instagram, Facebook, and Pinterest obviously fit the bill. As elaborated earlier, I believe these platforms drive a lot of traffic to Etsy stores, however, I believe in the coming years this will change.

And it is happening today. Facebook has started implementing Facebook Shops and this feature can easily steal market share from Etsy’s marketplace, as Gary Alexander pointed out a couple of weeks ago. Instagram has already implemented a shop feature for quite some time, and until now, shops on Instagram have sent the user to their own website for check-out, however, this is set to change. The novel thing about Facebook Shops is that check-out occurs on the platform itself, users pay directly on Facebook or Instagram. This is obviously much more lucrative for Facebook, while it may take years for Facebook Shops to become massive, eventually, it will become massive.

Facebook Shops is much cheaper

However, that’s all great, but Amazon is also a juggernaut in e-commerce and was unable to substitute Etsy. Why should Facebook actually be successful at this? Here’s why I believe Facebook Shops is poised to grow at an incredible pace in the coming years: Facebook Shops is much cheaper for sellers than Etsy. Facebook Shops only takes a 5% fee or a flat $0.40 fee for orders under $8, and transaction fees are included. At first sight, Etsy seems just as cheap with its 5% transaction fee. However, Etsy also demands a 3-4% transaction fee, a listing fee, and an offsite-ads fee. Adding this all up makes the average fee of an order fulfilled on Etsy 12.35% – the average fee is easily calculatable by sharing Etsy’s mandatory marketplace revenues by the total GMS. If users start utilising Facebook’s new shop feature, I suspect the sellers will follow happily since the 5% fee – which includes payment fees – is significantly lower than the average fee on Etsy. Clearly, selling on Facebook can expand sellers’ margins, something they will happily do.

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I also suspect platforms like Pinterest will follow suit and try to steal a lucrative share of the market. Pinterest has started expanding its shopping features on its platform over the recent few years. Businesses are able to advertise buyable pins, currently, these pins send users directly to the website of the business for check-out; this is a huge traffic driver for Etsy. Etsy’s business account has more than 10 million monthly viewers according to Pinterest – this can be found by looking at Etsy’s business account on Pinterest. I believe it is just a matter of time until users will start buying items directly on this platform as well – bypassing websites like Etsy for their check-out.

Moat

At that point, one needs to wonder what is Etsy’s moat? What makes Etsy’s marketplace worth $15 billion? The answer is simple: the sellers. Sellers on Etsy provide customers with unique, high-quality products for a fair price, Etsy is simply connecting the sellers and customers. And when a competitor steps in who can connect buyers and sellers more efficiently and at a cheaper price, why should the sellers not move? Why should sellers pay Etsy’s huge fees if someone else can do it cheaper and better? This is not a transition that will occur in one month but also not a transition that will occur in ten years. The users are already on Facebook and Pinterest, the sellers are also already on these platforms. In my opinion, in just two years’ time, Facebook has the ability to take a massive share of Etsy’s market.

And don’t forget Amazon, the massive beast, that could lower the fees for Amazon Handmade and put even more pressure on Etsy.

Valuation

A lot of Etsy bulls point towards Etsy’s profitability as a massive reason to buy the company: here is a growth company with stable earnings, at first glance selling at a fair price. The reality is that Etsy’s marketplace is barely profitable, it is actually Etsy’s advertising revenues that have driven profits over the last few years.

Etsy’s service revenues comprise of advertising services and shipping labels, but ‘primarily’ advertising services. This revenue source grew 42% YoY in 2019, while marketplace revenue – which includes mandatory fees – grew only 33.5% YoY. In 2019, net income was $95,894,000 but without services revenue – which primarily consists of advertising services – they would have actually lost approximately $130 million, just some food for thought.

With $803.2 million in long-term debt, $677.5 million in cash and cash equivalents, $365.7 million in short-term investments, and a market cap of $14.97 billion, the company’s enterprise value adds up to $14,730 million. Over the trailing twelve months, Etsy generated $247.24 million in EBITDA – according to YCharts. Consequently, the trailing EV/EBITDA ratio is 59.6. Clearly, the market is continuing to expect Etsy to grow its earnings in a major way. According to YCharts, the current 2020 EBITDA estimate is $442.05 million. This puts Etsy at a forward EV/EBITDA ratio of 33.32, still expensive but clearly more reasonable.

I believe the market is rational with its cheap valuation of Etsy in comparison to other tech companies. For example, Apple is selling at an EV/EBITDA ratio of 26, however, Etsy is clearly growing its revenues much faster. At first glance, Etsy seems undervalued due to its high growth rate, but I believe otherwise.

2020: The year everything went right for Etsy

First, we need to wonder how sustainable Etsy’s 2020 earnings are. The entire world locked down for a couple of months and tons of people started wearing face masks. Face masks you say? Oh, right they made up 13% of Etsy’s Gross Merchandise Value. So, clearly, that part is not sustainable since I suspect people won’t be buying millions of face masks in 2022. Additionally, Etsy includes Reverb into its 2020 reports, this is a company they bought in 2019 and, again, makes the growth rate seem higher than it actually is.

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While total sales on Etsy YoY in Q2 2020 are up 146.7%; when excluding masks that YoY growth becomes 93% when excluding Reverb that number would become even lower. After all, Etsy’s growth remains formidable but not as huge as before. And we should not forget, in 2020, everything went right for them, but that may change going forward. One needs to wonder how sustainable is the growth?

Over the last decade, Etsy has struggled to grow its revenues more than its revenues. In March 2020, its operating trailing twelve months operating margin was a meagre 9.4%, this exploded to 16.35% a couple of months later. That’s all great but there a lot of reasons to believe the margin expansion will not continue. The first one being that the 2020 surge in sales will eventually stop, in 2022, people will not be buying masks anymore. Additionally, we discussed Facebook and their ability to compete with Etsy, this might contract Etsy’s margins.

The third reason is Etsy’s marketing costs. There is a lot of data available implying that Etsy has grown its marketing expenses quite significantly in relation to both its revenues and gross merchandise value, this has fueled growth.

This is a trend that has been ongoing for years. Amazon spends 5.5% of its revenue on marketing. For Etsy, in Q2 2020, 27% of its revenues were spent on marketing costs, an increase from the 25% seen a quarter earlier. The marketing costs as a percentage of GMS show a similar trend, Etsy continues to expand its marketing efforts. While marketing costs as a percentage of GMS have declined significantly from 2019 into 2020, this is not due to Etsy’s management but lower ad prices. As we know, companies like Google and Twitter experienced severe YoY revenue declines, while user activity actually grew. As a consequence, ad prices plummeted. Fortunately, or unfortunately, for Etsy – it seems like ad prices have recovered quite meaningfully over the last few months, for example, Pinterest experienced a 50% YoY revenue growth in July.

(Source: Etsy IR)

Again, this has helped Etsy’s bottom line in the short term, I suspect that marketing costs in relation to GMS will grow quite meaningfully going forward. This can put pressure on margins.

A struggling company

The growing marketing expenses are showcasing that Etsy is struggling to remain competitive. Facebook doesn’t need to pay more than a quarter of its revenues on marketing costs to get people on their platforms, they already have the users. This is why Facebook – and Amazon in theory as well – is able to underprice Etsy’s product significantly.

Ironically, for Etsy to continue to grow revenues, they need to spend more and more on marketing, while sellers want lower fees like Facebook offers them. That is contradictive and is a problem going forward.

Takeaway

Clearly, the valuation of Etsy is relatively cheap for a growth company, but I suspect Etsy may no longer be a growth company from 2021 and onwards, which makes its valuation quite expensive. Etsy’s management is currently milking the platform for shareholders – to the frustration of sellers – and one needs to wonder how long management can do that successfully. The valuation prices in stable earnings growth for years on end, one should wonder whether that is realistic considering the changing e-commerce environment.

Disclosure: I am/we are long FB, PINS. 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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