Investment Summary

We are long shares of Etsy, an emerging e-Commerce platform specializing in handmade goods. Etsy IPO’d earlier last year and is among a basket of internet stocks that have underperformed due to the recent market turbulence. While $16 was certainly an optimistic valuation at IPO, we think Etsy has probably sold off too hard as it’s been dragged along with other high-growth tech stocks like Fitbit, GoPro and Twitter. However, a closer look indicates that Etsy benefits from a powerful and scalable brand. For the first two months of Q4, a key period entering the holiday season, Etsy was the 10th most visited retail site, an incredible achievement for a 10-year old platform.

We acknowledge the diffuse set of outcomes as e-Commerce companies regularly morph in unpredictable ways; however, Etsy has established an e-Bay like platform at what seems to be a cheap valuation given the growth, market opportunity, resilience against Amazon and brand awareness. We spoke to over 20 Etsy sellers and there was one clear conclusion: there is no alternative platform for current store owners. While the addressable market may not be as sky high as some sell-side analysts believe, we think Etsy’s current global merchandise sales (GMS) of ~$2.3 billion is probably too small given the large general size of some of Etsy’s end markets (like jewelry, clothing and accessories). Under a conservative DCF analysis, we estimate shares are worth at least $11, implying about 55% upside from current levels. Etsy also probably makes an attractive acquisition target with a valuation of 2.3x LTM revenue, but we think shares look cheap even on a standalone basis.

Attractive valuation

Due to the recent selloff of the tech sector (namely TWTR, YELP, ETSY), we think Etsy is among the cheapest internet stocks available in the market. In the last twelve months, revenue grew 45% y-o-y; however, Etsy trades at only 2.3x LTM revenue. With nearly $2/net cash and breakeven cash flow generation even at this small scale, we believe the equity could be worth significantly more in time as the business continues to grow.

The valuation looks particularly compelling on a relative basis when comparing projected revenue growth to current EV / Revenue. In the chart below, we found Etsy to be the cheapest on this basis relative to Yelp, Twitter, Amazon and eBay. While EV / Revenue may not be the best valuation metric, we consider it a good proxy for relative valuation for certain industries, particularly for fast growing companies generating less than $1 billion (a la Etsy and Yelp).

Even on an absolute basis, Etsy appears to be cheap even under a modest growth scenario. We modeled 12% revenue CAGR over a 10-year DCF and arrived at an intrinsic value of ~$11/share, implying at least ~55% upside. Some of our assumptions include:

• Growth begins to decelerate with GMS reaching ~$4 billion in 2018

• Revenue yields stay constant at 11.5%

• We think reasonable given similar take rates at Amazon and eBay

• Gross margins gradually to decline to low-to-mid 50s per management guidance

• EBITDA margins gradually expand to high teens per management guidance

“And what we said is that our gross margin we thought over time might go to the low 50s from the low 60s today, and our EBITDA margin would go from roughly low double digits from the time of IPO to high teens over time” – Kristina Salen, ETSY CFO at UBS conference (12/08/2015)

Brand creates barrier to entry

We believe Etsy’s greatest and most valuable asset is its brand. Developing an eBay-like eCommerce platform and scaling it to a nationally known brand is extremely difficult. As the first mover in the crafted product category, Etsy benefits from a scaled platform that helps to aggregate a very fragmented seller base. Based on our conversations with multiple sellers, there really is no alternative platform to sell crafted goods. While eBay and recently launched Amazon Handmade serve as alternatives, every seller we spoke to rely on Etsy to generate at least 50% or more of their revenue. Below are some quotes of sellers we spoke with:

“There was no other site like Etsy that would give artists and online marketers a platform to promote themselves. We know what is hard is not creating a great product, but to get known and get people to click your website. And of course there are sites like eBay and Amazon and Amazon is trying to get into this category with Handmade but these are giants. And Amazon is good for what it is, if you want to buy electronics, gifts, or whatever that’s where you go. If you want to buy second hand stuff and bid on stuff and pay less than the store, then you go to eBay. Etsy was one of a kind, the first guy out there to do what they’re doing and we jumped on the wagon when it was the right time and it’s been a success story since then. Etsy was the first one out there. That I think is their strength. eBay reached out to us because they’re thinking of starting a handmade category.”

“One of the reasons I don’t have my own website at this time is because Etsy is a great platform with a built in level of traffic. It’s well known and for me to go out and recreate that..I would love to escape the Etsy fees because my fees right now are between $1,500-$2,000 a month and they’ve been as high as $2,000-$3,000 when I had really good sales but it’s worth it at this point for me to not have to worry about anything. I don’t have to manage my own site, I don’t have to drive traffic”

“ETSY has been our main source of income. No matter what Etsy manages to bring in shoppers. And they do an excellent job of bringing in shoppers. eBay we do. eBay they come in clusters. Their site’s not really geared towards art but we do have sustained art sales on eBay. About 65% of our sales come from Etsy, maybe 15% eBay, maybe 5% Amazon Handmade is new, so this is insignificant and our own website would be another 20% or so.”

Etsy’s first mover advantage has resulted in a large scale platform with a base of sellers and buyers that continue to grow. As of Q3’15, there were nearly 23 million active buyers and 1.5 million sellers. The market for individual handcraft sellers is extremely fragmented and Etsy is the only current platform that has successfully brought this community together. We think this is one of Etsy’s most unique aspects and allows customers to find items not widely available elsewhere.

The success is more evident when looking at Etsy’s web traffic relative to other online retailers. For the months of October and November, a key time period heading into the holidays, Etsy was the 10th most visited retail site (in terms of unique visitors) according to comScore. We think this is an incredible achievement for a platform that is only 10 years old.

Highly attractive business model

Similar to eBay, Etsy has a very attractive business model as the intermediary connecting a large fragmented group of sellers and buyers. For every transaction on Etsy’s platform, Etsy earns an all-in yield of ~11.5%. The fees are categorized by two primary categories: marketplace (50% of revenue) and seller services (48% of revenue). A brief overview of how they earn their fees from their two categories is as follows:

Marketplace revenue

• 3.5% fee charged to seller for every transaction

• $0.20 listing fee for every item. The listing is good for four months but sellers will often list multiple times (instead of waiting for the four months to pass) as re-listing the same item brings it up on search results

Seller service: Direct checkout (~1/3 sellers currently use this)

• Direct checkout allows buyers to pay with credit and debit cards (vs. the default option of just using Paypal) and is the largest seller service (however mgmt. does not disclose % by sub-segment)

• Sellers are charged 3-4% for every transaction and fees are based on total transaction value including shipping

Seller service: Promoted listings (~15% sellers currently use this)

• Cost-per-click advertising for listings showing up at the top of the first page of search results

• These listings have the words “Ad” next to them (example below)

Due to the growing popularity of Etsy’s platform and brand, Etsy has benefitted immensely by acquiring most of its site traffic for free and on an organic basis. In fact, 90% of Etsy’s traffic to the site is organic despite the recent increases in marketing spend.

“Even so, even with our increase in marketing spend in 2014, 90% of our traffic is organic. So what that means is the roughly 1.4 million active sellers and 20.8 million active buyers have come to us organically”

-Kristina Salen, ETSY CFO at June 2015 Goldman Sachs Conference

We think Etsy’s high proportion of organic traffic differentiates it from other growing internet businesses that rely on a model to buy revenue.

The other positive trend at Etsy has been the high percentage of repeat buyers. Between FY 2011-FY2014, 75-78% of purchases have been from repeat customers.

We believe that as Etsy continues to scale, these trends in organic traffic growth and high repeat purchases will continue. Sellers on the Etsy platform are naturally incentivized to promote their listings and advertise their Etsy stores, creating an attractive network effect of increasing Etsy’s brand awareness as more and more sellers promote the platform.

Amazon Handmade concerns overblown

“Yeah we called it the infinite drumroll because they (Amazon) started announcing it in February of 2015 and we had great expectations of course. Oh this is going to be the Etsy killer and everyone was talking forever about it. By the time it was actually released in September we realized it was almost a glitchy site. Simple things like uploading multiple photos with one click were missing. Kind of reminds me of a bonanza or one of those 2nd or 3rd tier e-commerce sites rather than a professionally polished site. Um it didn’t meet my expectation of what I was thinking a company of that level should be producing. Sales there are very erratic. I don’t even know how to promote it. I have maybe a 100 items there.”

-Etsy Seller

“It’s so massive the network it’s so massive the Amazon website that artists don’t have that kind of shining spot and don’t get found on Amazon. It doesn’t yield the same sales. On Etsy I will make roughly 10-15k a month on images and artprints and art and there’s no other website right now that I can tell you where I can make that type of money. Yeah I make a little here and there and we tried different stuff like Boomboom prints. But if you ask me if there’s a place where you can make the same amount of money as Etsy? I can not find one yet. I think that’s what Amazon is trying to do right now. It’s still early on with their Handmade section. We’ll see what’s going to happen but right now I don’t see Amazon as a real competitor in this category. We (my friends) get approached on Amazon. I can say that there are 80k products on Amazon Handmade and 5k sellers. We make roughly $100-$200 a month on Amazon. There’s 1.4 million sellers on Etsy and 21 million customers that buy on Etsy a year. There’s a lot of more people even selling but we still manage to make $10k-$15k a month on Etsy. The two platforms cannot even be compared right now. One side I’m making pocket change and the other I’m making a real family income.”

We think the concerns around Amazon’s recently launched Handmade category are overblown. While Amazon has infinitely more resources than Etsy, we’ve found the platform to be less than successful. After numerous discussions with Etsy sellers, it’s evident that Amazon just hasn’t invested the resources to seriously play in this category. On the front page of its jewelry section (Etsy’s largest category), the top listed products had between 5 – 23 reviews.

This is a stark contrast to many popular items on Etsy’s jewelry page where some listings have more than 10,000 reviews. Based on sellers feedback, we discovered that not a single seller generated significant revenue from Amazon. It’s more evident as we estimate there are ~100-200k items listed on Amazon Handmade vs. 30-40 million listings on Etsy. Overall, we think this category is too small for an e-Commerce platform generating more than $100 billion of annual revenue. Any incremental success from this small category (relative to what they currently sell) has no impact on Amazon’s bottom line.

Should the Amazon Handmade marketplace fail to gain momentum, Bezos & Co. could quietly exit the business, as they’ve done in adjacent verticals. In 2011, Amazon latched onto Groupon and LivingSocial’s success by launching Amazon Local, a daily deals site. It was quietly shuttered by 2015. Recent IPO Square was thought to absorb a body blow with Amazon Register, which launched on August 2014 with plans to compete on transactional costs for small business payments. Register was gone by October 2015. Planning to book a weekend rental in Montauk? Amazon Destinations would like to book your hotel – actually, sorry, it was shut down after just six months.

While Amazon Handmade officially launched in October, it began recruiting a network of sellers in early 2015. Yet even after this prolonged push, we see evidence that the network lacks ETSY’s scale: it has fewer customer reviews, less inventory, and potentially waning interest from customers. As such, we wouldn’t be surprised to see Amazon quietly exit its craft project sometime in 2016.

Large addressable market

Etsy’s growth opportunity looks compelling when considering the end markets. While sell-side estimates are probably overly optimistic (MS estimates $34 billion; GS at $70 billion), we think at Etsy’s current GMS of ~$2.3 billion, the opportunity seems interesting when looking at some of the individual categories. Jewelry, Etsy’s largest category, accounts for ~20% of GMS (per ITG research). The other large categories are Home & Living, Craft Supplies, Art & Collectibles, Accessories and Clothing.

Instead of looking at the global market sizes by each category, which would obviously show extremely large numbers (i.e. jewelry is estimated to reach 250 billion euros globally by 2020), we’ll look at what eBay currently does in some of Etsy’s largest categories. In 2013, eBay’s GMS were $83 billion and many of its categories overlap with Etsy’s.

The eBay categories highlighted above total about ~$21 billion, or about 9x Etsy’s current GMS. Also note that eBay’s GMS has since grown since the data above shows 2013 (eBay GMS increased 8% in 2014 and 5% in 2015). We also think Etsy could expand to other categories like coins/stamps, which eBay did ~$1.4 billion, which is about half of Etsy’s total GMS.

While we recognize that eBay has a much longer operating history and stronger brand, we don’t see why Etsy couldn’t scale to at least 20% of eBay’s size in the highlighted categories over the next few years (which would mean Etsy GMS would double). Etsy has already gained recognition as a large e-commerce platform based on its web traffic, but even a simple Google search for “gold necklace” shows Etsy among the top 5 search results along with jewelry giants Tiffany and Jared.

While it’s difficult to quantify the precise TAM, we think at $2.3 billion, Etsy represents a very small portion of the overall opportunity considering the scale that a competitor like eBay was able to achieve in similar categories.

comScore data indicates potentially strong Q4

In terms of recent trends, traffic data from comScore lead us to believe that ETSY probably had a fairly strong fourth quarter. For the months of October and November (we don’t have December data yet), the number of unique visitors on Etsy.com increased 43% y-o-y.

Conclusion