Why Etsy can hold onto its lockdown gains

Cast your mind back to March 2020, and recall the hysteria that gripped shoppers worldwide. Toilet paper disappeared from supermarket shelves. Hand sanitiser was near-impossible to find. Facemasks were even rarer, as people rushed to kit up against the initial outbreak of Covid-19 in the west. 

One place resourceful shoppers turned to was Etsy (US:ETSY) to source home-made alternatives. Independent sellers on the retail platform had plenty of stock. Some of them would lose their other jobs in the months to come and devote themselves full-time to their Etsy shops. Mask sales alone, which the company grouped into beauty and personal care, added $743m (£534m) in gross merchandise sales in 2020, 7 per cent of the total. 

This attention super-charged Etsy’s stock, even beating Zoom’s (US:ZM) gains last year. It was one of the best performers in the S&P 500, second only to Tesla (US:TSLA), finishing 2020 up 302 per cent. This year the share price has fallen back, as the company warns of lower revenue growth in the upcoming quarter. But a cool-off was inevitable. We think Etsy’s fundamentals and long-term growth drivers still look strong.

A winning formula

A group of friends founded the company in 2005 in a flat in Brooklyn, including Etsy’s first chief executive, Robert Kalin, an amateur furniture-maker who was searching for a better way to sell his product online. 

Etsy was completely dedicated to its mission to “reimagine commerce in ways that build a more fulfilling and lasting world”, and helped sellers – who were overwhelmingly women – to make a living. But Kalin, and later his successor Chad Dickerson’s, human-first approach often left the numbers behind in the dust. By late 2016, a year after the company had listed on the public market, the board had ousted Dickerson and installed current chief executive Josh Silverman. 

The group’s history and culture may not be simple, but its business model is happily straightforward. The company operates an online marketplace, primarily through Etsy.com, where creative entrepreneurs set up shops for typically hand-made products. The company also presides over Reverb, a smaller online marketplace for first- and second-hand musical instruments. 

Etsy makes most of its money from its fee system, through which it charges sellers a flat fee of $0.20 for each listing, as well as a 5 per cent transaction fee. That is supplemented by ad products (categorised as ‘services’ revenue), which are designed to help sellers generate more revenue and scale their shops. 

Together these businesses benefit from what is referred to as a "network effect". The more products listed on Etsy’s websites, the more shoppers they attract. This in turn creates greater value for sellers and a more comprehensive variety of listings, which again attracts more buyers. In this way, Etsy’s platform becomes more valuable the more it is used. 

This asset-light model boasts a chunky gross margin that has averaged 68 per cent over the past five years, and a free cash generation rate of 190 per cent in 2020. Meanwhile, helped by the Covid-induced surge in profits, return on average capital employed (ROCE) – which measures how effectively money invested in a business is turned into profit – sat at an eye-popping 50 per cent last year. 

A formidable moat 

As ecommerce booms, Etsy may start to see the emergence of new competitors. But we think the company is protected by a formidable moat that will make it difficult to dethrone. This is chiefly based on three things: its first-mover advantage; dominance in a niche market; and an ongoing commitment to its underlying technology. 

There are plenty of websites that allow third-party sellers to peddle their products online. Amazon (US:AMZN) is the most obvious player, although its products are so varied and its pricing strategy so aggressive that it is difficult to single out a specific market where it has an especially glaring dominance, apart from books. Meanwhile, Etsy (US:ETSY) is by far the leader in its niche for hand-made, artisan and vintage products. Its closest competitor is Ebay (US:EBAY) and privately-owned apps like Vinted, which also operate online marketplaces. But their speciality lies in second-hand products, which is a market that Etsy has only recently set its sights on. More on that later. 

That has not stopped Amazon from trying its hand at Etsy’s game. The ecommerce giant launched ‘Amazon Handmade’ in 2015, a section of its consumer website dedicated to hand-crafted products. But it is hard to rival Etsy’s decade-long head start of relationship-building with sellers as well as customers. Most seller forums are plagued with complaints about Amazon’s difficult user interface, complex fee structures and alleged search biases. 

Meanwhile, Etsy’s continued investment in its underlying technology has protected the market share that it has built.  Management invested early in machine learning technology through the acquisition of Blackbird Technologies in 2016 for $32.5m, vastly improving the platform’s search quality and creating a more tailored shopping experience. 

The standard of Etsy’s platform therefore has remained competitive, and its sellers are very sticky. According to a company survey, 55 per cent of its 4.1m active sellers are multi-channel and on average Etsy is their primary source of sales. In 2019, Etsy’s closest competitors were craft fairs and live selling events. 

Growth beyond the pandemic

The group has grown massively during the pandemic, with active buyers up by more than three-quarters last year to 82m, compared with 46m at the end of 2019. In the first quarter of 2021, Etsy said that habitual buyers (those with six or more purchase days and $200 or more in spend in the trailing 12 months) more than tripled year on year. In fairness, that was compared with a period that was not affected much by the breakout of the coronavirus in the west. But the company is prioritising marketing spend in order to hold onto these new customers, with its budget nearly doubling in 2020. 

In the short term, such outlays might not look sustainable, but for a company that does not require any meaningful tangible investment, this spending should be seen as fuel for growth. Indeed, the company's profits need to be seen in the context of accounting standards that force companies to treat intangible investments (such as brand-building and customer recruitment) as upfront expenses rather than treating them in the same way as tangible investments (such as machines and property) which have their costs spread out to match up with the spending's longer-term benefits.

A further avenue for growth comes from Etsy's $1.6bn acquisition of Depop, the UK-based second-hand fashion app. The app offers access to the younger ‘generation Z’ demographic, since 90 per cent of its active users are below the age of 26. It will also boost Etsy’s market share in apparel, as well as the second-hand market, which it forecasts will grow at a 39 per cent compound annual growth rate from 2019 to 2024 in the US. This may sound rosy, but potential investors should note that while Depop has been decorated with several exciting growth forecasts, it has yet to turn a profit in its near-10-year history. 

The ‘right to win’ 

Etsy’s rather long-winded “right to win” strategy involves a number of components, including – but not limited to – ‘unique sellers’ items’ and ‘human connections’. Stripping back the company’s lingo, we think that the fundamental investment case is supported by three key growth drivers: a formidable brand, a robust network effect and smart investment in the technology behind its platform. We think that its long-term competitive advantage is unlikely to wane, even in the face of tougher competition. A forecast free cash flow yield of 3.1 per cent looks reasonable for a market leader with significant growth potential.