Etsy: The Next Facebook or the Next eBay?
Etsy was a darling of the pandemic-induced rally for online retailers during 2020. The stock rose roughly eight-fold from its March 2020 low to its March 2021 high. Etsy, along with many other 2020 high-flyers, is now more than 35% off its all-time highs.
Etsy has the potential to benefit from one of the world’s best business models; an online two-sided marketplace driven by self-reinforcing network effects. Investors are constantly on the lookout for the next big network effects beneficiary like Amazon or Facebook.
On the flip side, as promising as an online marketplace can seem, they are not all preordained to succeed forever. Just ask eBay. I wrote about eBay last year, and after being crowned king of internet retailing in the early 2000’s the company lost its way and is still in the process of returning to growth mode. The stock market has punished eBay for its mistakes and the business trades for a well below-average valuation. Here I’ll take a look at Etsy’s business model, its future prospects, and what I’d be watching for if I were a shareholder.
Overview
Etsy operates a two-sided online marketplace and connects buyers and sellers of artisan and hand crafted items. The company’s motto is “Keep Commerce Human” and they’ve successfully leveraged this into an endearing place in consumer’s hearts, which I’ll discuss more later.
I like to think of Etsy as occupying a massive niche market, which I realize is an oxymoron. Nonetheless, the company is niche in that it requires items sold on its platform to be handmade. Despite this seemingly narrow focus, the addressable market is massive. The company estimates that they compete in a $473B online market and a $2 trillion market when including offline transactions. These figures are before considering the massive pull-forward of online shopping demand caused by COVID-19 as well as the introduction of India as a new core market.
Homeware and furnishings account for more than a third of the company’s roughly $10.5B in gross merchandise sales (GMS, the value of all items purchased through the website), followed by jewelry and craft supplies.
Source: 2020 10K
Originally viewed as a one-off specialty item marketplace, Etsy has been working to increase their product offerings and drive habitual buyers. For instance, buyers may visit Etsy throughout the year for birthdays, holidays, and various one-time events like redecorating a home.
Source: 2020 10K
As of the most recent quarter, more than 4.5 million sellers market over 90 million items on Etsy to over 90 million active buyers. Like every marketplace, Etsy’s goal is to bring more buyers into its ecosystem and have buyers spend more per transaction while visiting the site more frequently.
Two-Sided Marketplace Review
As a refresher, the network effects resulting from a successful two-sided marketplace are among the strongest moats in the world. When sellers succeed in an online marketplace, they attract more sellers, and more items, which draws in more buyers. As more buyers flock to the marketplace yet more sellers are attracted, strengthening the product offering and so on. Basically sellers beget buyers which beget more sellers in a self-strengthening feedback loop.
The marketplace itself can make money by charging sellers, buyers, or both. Etsy charges sellers a 5% transaction fee any time an item is sold. Additionally, sellers pay 3-4.5% per order for any payments processed through Etsy Payments (90%+ of volume). Lastly, Etsy places ads on third-party websites (like Facebook) that direct buyers to Etsy’s platform. Etsy charges 12%-15% for sales generated from these ads. Currently, just under 10% of GMS is subject to an offsite advertising fee.
All told Etsy enjoys a ~17%, and growing, take-rate on goods sold through its website.
Competitive Position
With “just” $10.5B of marketplace volume Etsy is still very small. They are competing against giants in the battle for online eyeballs and buyers. eBay processes more than 10x the volume of Etsy and Facebook’s network is over 30x that of Etsy’s (Facebook is not currently a major direct competitor as it specializes in online advertising, rather than facilitating online transactions, though that may change quickly). So far, despite a dramatic size disadvantage, Etsy is succeeding.
Etsy’s key differentiators are its unique product offering and ability to enable buyers to feel a one-to-one connection with sellers.
In a recent survey, 90% of respondents said that they find items on Etsy that they could not find elsewhere. By offering only handmade items from over 4 million sellers across the globe, browsing Etsy is like walking into the world’s largest boutique store. It’s not surprising that this has resonated with buyers - who doesn’t like shopping local, after all? The feeling of shopping local on the internet is not easily replicable.
In addition to building a one-of-a-kind product portfolio Etsy’s insistence on artisan hand-crafted items made by small business owners fosters a sense of connection with buyers. Etsy has pioneered featuring video demonstrations of products, and encourages buyers to reach out directly to sellers with questions. Etsy has shown that the more human the sellers seem and the more personal the experience is, the higher the conversion rate for buyers. An Etsy shopper that asks a question to a seller is significantly more likely to purchase an item.
Another important dynamic at Etsy is its seller base adaptability. CEO Josh Silverman elaborated on this during the Q1 earnings call:
“So unlike so many others, we're not sitting around guessing what's going to happen in June and buying inventory against that and putting marketing spend against that only to maybe be proven right and maybe be proven wrong. We have a marketplace that naturally adapts.”
Unlike a traditional retailer who has to purchase inventory ahead of season and anticipate what may or may not sell, Etsy has millions of small businesses ready to respond to trends in real time. The explosion of masks available on Etsy to meet the sudden demand surge is a great example. This subtle difference can be very impactful over time in capturing demand at the fringes that less nimble competitors may miss.
Etsy’s emphasis on creating an intimate “local” shopping experience has successfully tapped into a human instinct much in the same way that discount retailers tap into the “treasure hunt” instinct. Naked Wines is executing a similar strategy with individual winemakers. This stands in contrast to the traditionally more transaction-focused feel of eBay and Amazon. Both models can be successful, it’s just important that Etsy holds onto what has allowed it to win thus far. Competitive advantages like this are often subtle, but that doesn’t make them any less important.
While offering a broad range of unique items and creating a sense of connection between buyers and sellers is not irreplicable by other marketplaces, Etsy’s laser focus in these two areas has given it a leg up on others. Because of its early success, new entrepreneurs creating handmade items are increasingly likely to turn to Etsy first thanks to its relationships with sellers and growing network of buyers. Etsy is in prime position to ride the wave of increased interest in entrepreneurialism for years to come. With the world moving entirely online in early 2020, the COVID-19 pandemic greatly hastened Etsy’s position.
COVID Acceleration
While Etsy was growing at a solid 25%+ clip heading into COVID, the pandemic initiated a step change for the business. The surge in new users seemed to start when Etsy sellers stepped in to supply homemade facemasks during the early part of the pandemic when masks were limited. As in-person retail shut down buyers shifted virtually all of their spending online, and Etsy’s business flourished. From 2019 to 2020, GMS more than doubled from $5B to $10.3B, revenue grew 110%, and net income rose 264%. Active sellers increased 62% to 4.4 million and active buyers rose 77% to 82 million. Basically, the pandemic pulled forward several years of demand inside of 12 months.
The influx of new buyers and sellers was not the biggest benefit Etsy enjoyed from last years’ boom. The huge increase in transactions that took place on Etsy’s platform strengthened the company’s competitive position by enhancing the search and suggestion algorithms along with targeted offline advertising capabilities. Facebook’s ad targeting is so successful, and valuable to advertisers, because of the vast swaths of data generated by billions of users. Etsy benefited from the same dynamic (on a much smaller scale) in 2020. As more and more users browsed the website, Etsy accumulated more data and fine-tuned algorithms used to suggest new items to returning users and more successfully place ads on third party websites.
So, not only were financial results accelerated by several years, but equally strengthened was the quality of Etsy’s website and value proposition offered to buyers and sellers. This will only serve to draw more buyers and sellers onto the site going forward, feeding the positive feedback loop mentioned above.
How to Avoid Becoming the Next eBay
Munger loves to invert questions he’s trying to solve, and I think Etsy investors should do the same. The question isn’t: “How can Etsy become the next massive online marketplace?” but rather “How can Etsy avoid becoming the next eBay?”
As I wrote about last year, eBay’s growth stalled, and the stock got punished, when the company a) forgot what they were really trying to do and b) neglected to invest in their infrastructure and the buying and selling process became clunky and outdated.
eBay rose to prominence by dominating the non-new and vintage in-season categories. They also had a stronghold with enthusiasts who had a passion for things like luxury items, accessories, motors, fashion, electronics, and collectibles. eBay lost its way when they tried to become everything to everyone and spread their focus thinly across too many categories.
Worse, as eBay lost focus on its core market, the buying and selling process deteriorated and sellers lost confidence in the platform. Until recently, eBay’s homepage and search functions were outdated, its payments process a mess, and registration and shipping were a headache. Sellers began to feel neglected. This is the quickest way to fade into obsolescence and reverse hard-earned network effects. eBay is finally refocusing on the aforementioned areas where they have a loyal customer base and the expertise to offer products other marketplaces can’t. They’ve improved the sites interface and removed friction for sellers, but they’ve lost years of lucrative growth in the process. This has cost shareholders billions of dollars. Etsy can learn vicariously from these mistakes.
If I were an Etsy shareholder, I’d hope to see Etsy stay laser focused on only offering hand crafted artisan items. The “shop local” feel that Etsy has managed to create over the internet is a huge advantage but not one that’s guaranteed to last forever. If management starts to discuss priorities in areas that stray from this core offering, I’d consider it a red flag for investors.
Leadership at Etsy has done a great job of continuously improving the experience of both buying and selling on Etsy. For instance, when discussing improvements in search algorithms the CEO noted on last month’s earnings call:
“for example, cocktail attire for men, a good search result for that might be a blue blazer. And yet the word cocktail nor attire might appear in the title of blue blazer. So there's a lot of work we've been doing to improve our models on that.”
The company has also rolled out seller scorecards and analytical tools to help them better understand what is driving success in their small businesses.
With the search and suggestion algorithms improving, Etsy payments widely adopted, and a growing targeted advertising presence, the company has put the success of sellers at the forefront. Here again, if focus strays from enabling sellers it would be cause for concern. If the company starts obsessing over constantly improving take-rates, tacking on fees for buyers, or sees diminishing service levels, the seller community could revolt.
To be clear, I think Etsy has done an excellent job thus far in these areas and I have no reason to believe they’ll go down the same path as eBay. Instead, it should be helpful for investors to know what to watch out for in the event things don’t always look so rosy. With the benefit of hindsight it seems investors in eBay could have spotted some of these areas of trouble before it was too late.
Etsy has a formula that is winning, and if it avoids some of the pitfalls of eBay, and simply continues doing what it’s doing, the growth is likely to take care of itself.
Growth and Valuation
With ~$10B in GMS against a TAM of at least $500B, Etsy is just scratching the surface of its potential. Before COVID, the company was growing GMS at 20-25% per year. With the niche they’ve carved out in hand crafted items and the success they’ve had in connecting with buyers, I’d expect this growth to persist for some time. The company is drawing in more “habitual” buyers, defined as those who spend more than $200 annually on Etsy. They now have 8 million habitual buyers, up 200% year-over-year. This cohort makes up just 9% of buyers but 40% of GMS. Investors should pay attention to this metric over time as this group has an outsized impact on growth and retention.
Etsy has some low hanging fruit in terms of improving existing visitor penetration. Etsy and Wayfair have similar visits per unique visitor per month. However, Wayfair only sells home furnishings, and one would expect much less frequent visits for those looking for furniture compared to the assortment of items on Etsy that could be purchased for any holiday, special occasion, or everyday use. Visits per unique visitor per month at eBay are 3x that of Etsy and Wayfair, and I’d expect Etsy to gravitate closer to eBay than Wayfair over time given the nature of what they sell.
It’s reasonable to expect 25% annual growth in GMS for the next five years, putting out-year GMS at $30B+. Take-rates have been expanding recently thanks to Etsy’s success in high-margin advertising revenue. To be conservative I’ll assume take-rates five years from now won’t expand from the ~17.5% observed in the most recent quarter. This gets us to about $5.3B in revenue five years from now. With consistent free cash flow margins I can see $2B of free cash flow compared to $680M in 2020.
If Etsy can deliver these results a 25x multiple of free cash flow would not be inappropriate, putting the market cap somewhere in the neighborhood of $50B or higher. This compares to a current market cap of around $20B. This valuation would be in-line with how other successful and somewhat mature network effects platforms have been valued in the past (eBay, Facebook, etc.) and imply achievable mid-single-digit terminal growth. Even if interest rates rise between now and then, this valuation doesn’t seem unrealistic. With shares outstanding increasing modestly due to share-based comp equity investors would still be looking at attractive mid/high-teens annual returns in this scenario.
With that said, Etsy’s stock is hardly cheap on trailing metrics, so the growth expectations need to be largely met to justify the current valuation. Presently, Etsy is priced at more than 45x free cash flow and over 50x earnings. This is down substantially from a March all-time high valuation, but still a price that offers little in the way of wiggle room for investors like us. Luckily, for those of us that missed this eight-bagger last year, all is not lost.
If I’ve learned anything watching exceptional businesses in the market it’s that you don’t need to buy them immediately to do well. For years Facebook traded above our comfort range – it was valued between 50x and 70x earnings in the early and mid-2010’s – before dropping to ~17x earnings in the 2018 meltdown. It was only then that we initiated a position. Buffett waited to purchase Apple until 2016 when it traded for 13x earnings! Apple has grown handsomely since then and is now valued at more than 30x earnings and Buffett has roughly quadrupled his money. For those of us less willing to pay-up dramatically for growth, patient investors are periodically afforded no-brainer prices even for great businesses like Facebook, Apple, and Etsy.
While Etsy looks poised to grow for years and has carved out an excellent competitive position that should benefit from one of the world’s strongest moats (network effects), the current price doesn’t discount potential competitive pressures from eBay, Facebook, and others, or any hiccups in execution. Etsy may do quite well over the long-term from today’s prices, but patient investors might just get a chance at a fat pitch in the coming years.
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