Summary
- Etsy is the target of a recently released short-seller report regarding counterfeit goods.
- Revenue growth has slowed, and estimates don't anticipate any uptick in the near future.
- Etsy's stock-based compensation is vastly outpacing revenue.
Arts & Crafts
We here are Ironside Research are fans of online service businesses that have tangible, real-world impacts, particularly ones that act as market makers by connecting buyers and sellers in some physical way (for example, see our recent write-up on Airbnb ). Etsy, Inc. ( ETSY ) is just one of those businesses, connecting independent store owners who provide myriad services to buyers while collecting fees along the way.
However, we think that at this time the Etsy, Inc. business is both overvalued and currently has other issues under the hood that need to be addressed. We will outline those issues here.
The Business
Etsy operates its business in two main segments: Marketplace and Services.
Marketplace consists of the actual transactions between buyers and sellers. It covers the listing, transaction, payments, and offsite ad-listing fees. With almost $2 billion in annual revenue, Marketplace makes up with lion's share of Etsy's revenue.
With 25% of overall revenue, Services makes up the rest. Services includes on-site optional advertising and services that facilitate buyers completing their transactions with ease, such as providing shipping labels.
The ecosystem that Etsy has created is quite large. Gross merchandise sales ((GMS)), which is the total dollar value of all transactions across the platform, were $13.3 billion in 2022 between 7.5 million sellers and 95.1 million buyers.
Growth?
In 2022, Etsy, Inc. posted a 10% year-over-year gain in revenue, from $2.3 billion to $2.5 billion. The company posted a net loss for the year as well, losing $5.48 per share in 2022 versus a gain of $3.88 in 2021 (both figures basic, not diluted). The main reason for the loss was not operational mismanagement, but a one-time goodwill impairment charge of over $1 billion.
Despite the one-time nature of this charge, we suspect that Etsy's fastest growth days may be behind it. Given its rich valuation, this is a cause for concern.
Historic growth rates for Etsy have been in the double digits - as high as 70% per year in the early days. Despite an uptick in revenue in 2021, however, growth has consistently slowed.
Analyst estimates for earnings per share have similarly fallen off.
From their peak in 2021, analyst 2- and 3-year forward earnings per share estimates have declined. While estimates still remain elevated above pre-pandemic levels, the outlook for hyper-growth seems to have faded to the rearview mirror.
Rich Valuation
Given that growth is slowing, it would be reasonable to expect that valuations would fall as well. This would be correct.
However, despite falling, valuation levels remain high in our opinion (which we'll qualify in a moment). Forward price to earnings currently sits at 33x, and EV/EBITDA at 21x.
First, if we are going to buy a company posting growth rates in the low teens or even high single-digits, we would expect a much lower EV/EBITDA multiple than 21x.
Second, the valuation seems especially pricey once investors consider that Etsy, despite being profitable, has a significant amount of debt and is currently equity-negative. The company ended 2022 with $2.3 billion in assets and $3.1 billion in liabilities, resulting in a negative shareholder's equity of $547 million.
Some may point out that the turn to negative equity was driven by the aforementioned goodwill impairment of $1 billion. However, we would point out that this amount of goodwill was the main reason that the company posted positive shareholder equity in 2021, and, as a general rule, we tend to be fairly skeptical of management goodwill estimates (especially in tech).
Stock-Based Compensation
Like many other tech companies, however, we find Etsy's level of stock-based compensation ((SBC)) to be concerning. From 2020 to 2021, SBC expenses grew 115% year over year to $139 million. In 2022, they grew another 65% to $230 million (almost 10% of revenue).
Those who disagree with our negative view may point out that while, yes, Etsy does partake in generous SBC, it hasn't impacted the overall share count (and thereby diluted investors) too dramatically.
The above chart clearly shows that, despite a jump in 2021, the overall share count has remained steady since then. In fact, it has even declined a bit.
We want to point out that simply viewing the share count can be a bit misleading. Etsy has, after all, been a buyer of its own stock for several years.
Since 2018, the company has had a positive buyback yield, meaning that the company has been actively repurchasing shares. Since the stock doesn't have a dividend, stock buybacks would typically be welcome news for investors - however, we suspect that this buyback activity actually masks the dilutive effect of Etsy's SBC expenses. This, in essence, creates a feedback loop where the company allocated capital to cover the expense of SBC.
As negative as we are about high levels of SBC, we are even more negative about companies utilizing precious capital to buy back shares that are concurrently being diluted by it.
Counterfeit Risk?
On February 16th, famed short seller Andrew Left of Citron Research released a report about Etsy , alleging that the company is carrying a massive amount of litigation risk by allowing counterfeit goods to be listed on its site.
We strongly recommend that investors at least peruse the report because the allegations are serious. The report references search results for Disney ( DIS ), Nike ( NKE ), and Rolex products that appear to be very obviously counterfeit. Left notes that such questionable search results do not appear on competitor sites like eBay ( EBAY ).
Whether or not investors agree fully with Left's analysis, it is important to point out that without stringent anti-counterfeit measures, Etsy does have a significant risk of running afoul of the government.
To give a sense of the significance, the U.S. Chamber of Commerce estimates that counterfeit goods cost the economy almost $500 billion per year , and research from North Carolina State University estimates that the counterfeit economy topped $3 trillion in 2022 .
Given that these dollars largely escape the purview of tax collectors and debase the value of goods sold by corporate taxpayers, the government has a strong incentive to take action.
While nothing has yet taken place, we think this is a risk that all online marketplace providers (and their investors) must be aware of.
The Bottom Line
We believe that Etsy, Inc. runs a good business - we just happen to think that it is currently overvalued, and has potential hidden risks. Our main reasons for this thinking are:
- Growth rates seem to be slowing. Analyst forward estimates echo this.
- Debt levels are high relative to assets, as evidenced by the company's current negative equity position.
- Stock-based compensation is growing rapidly, and its effect is - in our opinion - largely masked by the company spending capital to buy back stock.
- Etsy may need to re-assess its anti-counterfeit enforcement policies in the near future. Doing so could raise the cost of maintaining the marketplace and potentially affect revenue.
For these reasons, we will be staying away from Etsy, Inc. stock for the time being.
For further details see:
Etsy: Attractive Business, Rich Valuation, Counterfeit Risk