Published: October 22, 2024

By: Philip MacKellar

“Is Etsy in your portfolio or on your watch list?” Over the past few months, I have had this question pop up a few times, as the shares of the e-commerce platform are down more than 80 per cent from a 2021 high of more than US$300. A drawdown of this magnitude is huge and has landed the name on our contrarian radar.

Back in 2020 and 2021, e-tailers such as Etsy ETSY-Q +0.67%increase , which connects artisans and related small businesses with shoppers, saw significant gains as consumers shifted to online shopping during pandemic lockdowns and sellers moved to digital platforms to meet the demand. Not only did Etsy benefit from a trend that lifted most e-commerce boats, its handcrafted and vintage merchandise proved particularly popular during the dark, isolating COVID years.

As retail normalized, Etsy’s sales growth and user numbers slowed, and inflation cut into discretionary spending. The platform saw fee increases, higher rates of seller dissatisfaction and a less enthusiastic consumer base, as Etsy’s roots in specialized, quality products were tainted by a proliferation of low-quality, mass-produced merchandise.

Today, the stock exhibits duelling bullish and bearish characteristics. On the bullish front, its business model is unique and carries value. People enjoy shopping online from the comfort of their home and supporting small businesses or people who produce handcrafted objects. Moreover, Etsy does well in organic online searches, which help drive traffic, and once shoppers have landed, the website is user-friendly and invites exploration and discovery.

The company’s income statement has performed well over time. The share count has jumped from 40.2 million to 136.3 million over the past decade, but sales per share have appreciated much more rapidly, earnings per share have expanded, and free cash flow has boomed from US$19.7-million to US$561-million. The buyer base has more than doubled since prepandemic times, and in the past year, the numbers of active buyers and sellers have increased. These trends point to a company in growth mode and, better yet, one that – excluding 2022 – is doing so while maintaining profitability.

The valuations have also fallen to multiyear lows on a variety of metrics. As value investors, we like this, and the low multiples are perhaps the most compelling argument for buying the stock.

On the bearish side of the ledger, the business model has faults. The e-commerce landscape is competitive, and the focus on handmade and artisanal crafts is more suited to one-off and special purchases, not repeatable and scalable mass orders, which are common on platforms such as Amazon and Walmart. Fortunately, the success of companies such as eBay demonstrates that the market is diverse enough for other business models.

It is hard to police Etsy’s platform and ensure it is true to its authentic small business roots. It has a handmade policy, but enforcement is costly, time-consuming and a bit like playing Whac-A-Mole. It is also unclear if enforcement is accidentally taking down legitimate artisans. To make a long story short, it appears the company is alienating some shoppers who feel it is pumping out mass-produced merchandise and some sellers who feel they have had their accounts suspended illegitimately.

In addition to some business-model woes, bears can point to a significant increase in debt over the past few years as a source of risk. Not only is Etsy’s debt high, it is a negative equity enterprise, meaning its total liabilities exceed its total assets. This is an unusual characteristic. While it can be seen as bad (often very bad), there are instances where negative equity companies make excellent investments. Sometimes these entities are fundamentally sound corporations and generate huge cash flows, so their assets (especially brand assets) are undervalued. Negative equity standouts that fit this mould include McDonald’s since 2016, Philip Morris since 2012 and Domino’s Pizza since its IPO in 2004. It is possible Etsy fits this mould as well, but it is too soon to say.

Short sellers are betting against the enterprise, analyst price targets have been drifting lower, and insiders have sold to the tune of US$4.8-million over the past year. The company also has a bad habit of using – some would argue overusing – stock-based compensation. In 2019, for example, stock-based compensation was US$44-million; for the past three years, it has averaged US$218.5-million. This practice artificially increases reported net income. All these issues add weight to the bearish arguments against it.

No summary of its woes would be complete without at least a passing mention of its recent demotion from the S&P 500 large-cap index to the S&P 400 midcap index. When corporations are cut from the S&P 500, it is generally because business is bad and other companies deserve the spot among the 500 blue chips.

So there you have it – a quick assessment of an aspiring e-commerce giant through the lens of a contrarian investor. Etsy is on our watch list and is a possible investment candidate. It has a unique business model, it has been growing and the valuations have fallen to multiyear lows. However, before getting more interested in the name, we would like to see insider selling abate, debt drop, analyst forecasts stabilize or improve and stock-based compensation fall. Though it could well rally without these features, such an outcome would be a little too speculative to get involved with for my liking.