Time to Buy the Dip on Etsy?
The latest stock I’ve been reading about is Etsy. One, because we just recorded a podcast about it, and two, because of the post-earnings dip. They released the third-quarter report on October 30th and saw their stock drop viciously, likely because of gross-margin compression.
Here are some highlights from the report:
$198 million in revenue, up 31.6% YoY (28% discluding acquisition of Reverb)
2.59 million active sellers, up 27% YoY
44.8 million active buyers, up 20.7% YoY
Gross margin of 65.2%, down 360 bps
Net income of $14.8 million, down 25.6% YoY
The real wart of the report was the gross margin number. Here is what management had to say about it: “The contraction in gross margin was primarily driven by fees related to Etsy Payments, amortization related to our recent acquisition of Reverb, and our consolidated ad platform, Etsy Ads….” If we believe what management is saying, it looks like they made some long-term investments (acquisition, in-house ad platform) that will hurt margins in the short-run but help the business in the long-run.
Here is what they guided for the full fiscal year:
$179 – $187 million in Adjusted EBITDA
34 – 35% revenue growth (including Reverb acquisition)
Based on the current market cap, if Etsy hits the midpoint of their guidance they will have a price-to-EBITDA ratio of 29 by year-end. Their LTM P/E ratio is 55.7 and their LTM P/OCF is 23.2. But is that a fair valuation for the stock?
Is Etsy Near Market Saturation?
Since Etsy is an e-commerce platform, investors tend to worry about competition from Amazon. I don’t subscribe to that notion. Amazon is the Wal-Mart of online shopping (huge catalog, low prices), while Etsy is, for lack of a better term, the internet’s antique/thrift store. Nobody goes to Wal-Mart looking for antique items. I believe they won’t do the same with Amazon.
The one thing that does concern me is Etsy’s addressable market. I mean, that’s got to be the first thing that pops into your head, right? How long is their run-rate going to be? Well, according to one analyst, they haven’t even hit double-digit market penetration. Nomura Instinet thinks Ety’s addressable market is $140 – $170 billion and growing. They are expecting GMS (gross market sales) to barely hit $5 billion this year, so they are nowhere near market saturation.
What Etsy’s Financials Could Like in Five Years
In 2018, Etsy had an operating cash flow margin of about 33%. I think it’s reasonable to assume they will stay at these levels as Etsy continues to scale. Next, let’s assume they can keep up their 30% organic sales growth over the next five years.
Doing some quick math, 30% revenue growth starting at an $812 million base is about $3 billion in annual revenue in five years. Using the 33% OCF margin, that is about $1 billion in cash flow annually. Based on Etsy’s current P/OCF, that would give them a market cap of $23.2 billion, which is quite the premium to current levels.
Obviously, cash flow doesn’t directly correlate to net income, which is what truly matters in the long-term. Etsy also has $775 million in debt that they will have to pay off eventually. However, even if future numbers don’t reach these estimates, we still could (emphasis on could) see a sizable increase in Etsy’s share price. It’s for these reasons and more that I am liking the company more and more as a potential investment.
Disclosure: The author is not a financial advisor, and may have an interest in the companies talked about.