The Hidden Problems Lurking in Etsy’s ‘Feel Good’ IPO
Business + Economy

The Hidden Problems Lurking in Etsy’s ‘Feel Good’ IPO

Matiz Architecture & Design

In this age of mass-produced goods and impersonal commerce, it's refreshing to find a place like Etsy, where you can buy unique, hand-crafted stuff at reasonable prices.

If you've never visited Etsy, think of it as a blend of Amazon (AMZN), eBay (EBAY) and Alibaba (BABA) for the Santa Fe crowd. It's a great place to buy handmade items like jewelry, clothing and household goods, especially for anyone who gets psychic value out of supporting artisans. In Etsy's own words, the company is all about "reimagining commerce" and "connecting people."

Judging by sales trends, a lot of consumers like these values. It's no doubt a pushback against the plethora of cheap-looking goods made by overseas workers toiling long hours for low wages — the kind of stuff you get at Walmart (WMT).

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After all, Walmart's sales growth is barely positive. In contrast, the amount of stuff sold on Etsy grew by 43 percent last year to $1.93 billion. Etsy's take, its revenue, grew 56 percent to $195.6 million.

Etsy has 54 million members, including 1.4 million sellers and 19.8 million buyers who have been active at least once in the past year. Etsy's revenue comes from a 3.5 percent commission on sales and a 20 cent per item listing fee. It also gets lower-margin revenue by offering advertising, card processing services and shipping labels to sellers.

Now, Etsy is coming public. And, surprisingly, at a reasonable valuation. At $16 a share, where Etsy priced its offering late Wednesday, Etsy goes for an enterprise value (or market cap plus net debt) to sales ratio of about 8. That's much lower than the double-digit multiples for other online sellers like Alibaba, points out Kathleen Smith, an IPO expert at Renaissance Capital, a manager of IPO-focused exchange traded funds (ETFs) like the Renaissance IPO ETF (IPO). Yet Etsy could have room for much more growth, because it is smaller.

True to form the IPO has many hand-crafted and “feel good” overtones. A portion of the offering, up to 5 percent, was reserved for Etsy fans and individual investors who lack the large brokerage accounts normally needed to participate in an IPO. Etsy is a so-called "Certified B" company, which means an entity called B Lab confirms that Etsy abides by social and environmental standards.

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These positive vibes are no doubt meant to appeal to the company's user base, and they serve as an expression of corporate values. Unfortunately, though, investors may be left with less than a warm and fuzzy feeling when all is said and done with Etsy.

Here are three reasons why you may want to keep position size limited if you buy Etsy, wait for moves below the original offering price or just avoid it altogether.

Reason No. 1: The growth potential here could be seriously limited
Sure, Etsy revenue grew 161 percent to $195.6 million from 2012 to 2014. That's amazing. But there's a little problem beneath the surface. Operating expenses went up just about as much, or 149 percent, to $128.2 million. This expense growth, plus share dilution and declining margins, all explain why losses compounded to 19 cents a share, from four cents a share, over the same time.

More importantly, the ballooning marketing expenses may confirm that Etsy could have a growth problem. After all, how big is the market for artisan products?

"They have very loyal customers and there are a lot of people who like to buy artisanal goods, and a lot of people who want to make money selling them," says Tom Taulli, author of High-Profit IPO Strategies and the IPO Playbook blog. "My question is, 'How big is this market, really?' This is a company that could run out of opportunities to grow because it may be a little too narrow. It just looks like a niche."

The fact that marketing costs and operating expenses went up pretty much in line with revenue over the past three years suggests the company has to stretch to grow. Is the IPO a signal that Etsy has already peaked? It's at least possible. Wall Street bankers are not dumb. They often bring companies public just when enthusiasm in their end markets is at a high.

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Here's another problem: More of the recent revenue growth came from lower-margin services to sellers, like card processing services, labels and ad fees, as opposed to those higher-margin commissions and listing fees. The former grew by 93 percent, or $39.6 million, from 2013 to 2014. The latter grew by just 38 percent, or $30 million. This explains why gross margins came in at 62.4 percent last year, compared to 67.2 percent in 2013.

Companies don't talk to the media in the run up to IPOs. But in Etsy's defense, it claims in filings that 53 percent of consumers prefer to buy stuff from individual producers. If true, this suggests room for more growth ahead.

Reason #2: Etsy is losing its religion, as the sense of community erodes
There's no question that part of the secret sauce here is the marketing value in providing a sense of community, authenticity and "connectedness" that comes from buying hand-crafted goods.

Etsy's mission statement is full of idealistic expressions and new era buzzwords like authentic, community centric, create a better world, mindful, and my favorite: "We keep it real, always." Etsy likes to say, "Our community is the heart and soul of Etsy."

Yet message boards are full of complaints about how Etsy is degrading this sense of community for artisans by letting in more manufacturers, or mass-produced stuff. This threatens to dampen the good vibes, because it goes against the artisanal appeal.

Of course, you always have to take anonymous message board comments with a grain of salt. But the website Consumer Affairs is full of these kinds of complaints. "Tricia" of Chippewa Falls, Wisc. recently complained that "Etsy no longer gives small crafters a means to spring board their home based business. Unless your home based business entails buying manufactured products overseas, employing 15 people to slap a tag or ribbon on it and market it as handmade."

Another poster claims some sellers sold thousands of printed t-shirts during winter holidays, and questions whether they could have been handmade at that volume. “Etsy won’t care. Cause all they care is to get more profit," said this poster.

The problem here is that the more Etsy loses its community feel and becomes like Amazon, the tougher it is going to be to compete against Amazon. Things will not end well for Etsy if it has to compete with Amazon on its home turf. "I think it is going to be constant battle trying to balance that artisanal feel and figuring out a way to grow the business," says Taulli.

In defense of Etsy, it points out in filings that repeat purchasers made up 78 percent of buyers last year, up from 76 percent in 2011.

Acknowledging the growing relevance of 3D printing, Etsy also states some manufacturing is not only fine, but that it fits in with the company's mission. "We believe the decrease in the size and the cost of these tools will make it easier for creative entrepreneurs to start new businesses," says the company.

Reason # 3: Empire-building could be a troubling signal
Though it is not as glaring a contrarian signal as paying for stadium naming rights, using lots of shareholder money to build a snazzy new corporate headquarters smacks a little of hubristic empire-building at a company this size. But that's what's going on here.

Etsy, which was founded in Brooklyn in 2005, will use $50 million worth of the funds raised in the IPO to build a new corporate headquarters there. Etsy CEO Chad Dickerson might claim this huge construction project is merely an effort that "supports our own local economy and ecosystem" — something along the lines of employees using bikes to cart Etsy compost to a farm in Red Hook, Brooklyn, "where it is turned back into the soil that produces the food we enjoy together," as Etsy states in filings.

But not all investors are going to see the big project this way. Says Taulli: “That's definitely in the category of risk factors for me.”

At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.

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