This 4-Star Stock Has Significant Growth Potential

Note from Daily Trade Alert: The following article first appeared in The Growth Stock Advisor, a premium newsletter offered by Investors Alley.

At the start of the pandemic, I could not find a mask anywhere. Masks were sold out everywhere I searched.

So I (and many other Americans) turned to Etsy (ETSY), the online marketplace focused on handmade items and craft supplies. It had lots of handmade masks and I bought one.

I was not alone. Mask sales ended up adding $743 million to the platform’s gross merchandise sales in 2020, accounting for 7% of the company’s total sales.

Masks were just a small part of Etsy’s success. It became a go-to-website in 2020, turning its stock into one of 2020’s hottest investments. Etsy’s stock ended 2020 trailing only Tesla (TSLA) in S&P 500 stocks, finishing the year up 302%!

Etsy’s share price has fallen back this year, and the company warns of lower revenue growth in the upcoming quarter. But a slowdown from its torrid 2020 pace was inevitable. It does not mean the company has suddenly become a bad investment. Etsy’s fundamentals and long-term growth drivers still look strong.

Let’s look at why…

Etsy’s Business Model

The company’s business model is straightforward:. it’s an online marketplace where creative entrepreneurs set up shops for hand-made or vintage products. Etsy also owns Reverb, a smaller online marketplace for first- and second-hand musical instruments.

Etsy makes most of its money from its fee system. It charges sellers a flat fee of $0.20 for each listing, as well as a 5% transaction fee. That is supplemented by ad products (which it calls “services” revenue), which are designed to help sellers generate more revenue and grow their businesses.

Businesses with listings on Etsy website benefit from what economists call a network effect. This is what happens when increased numbers of participants improve the value of a good or service.

A great example of the network effect was the internet. Initially, there were very few users, because it was of little value to anyone outside the military or science. But as more people began getting online, they produced more content, information, and services. And we know what happened next.

In Etsy’s specific case, the more products listed on the website, the more shoppers the platform attracts. This in turn creates greater value for the sellers and a growing variety of product listings, which then attracts more buyers. And so on. It’s a positive feedback loop.

This asset-light model gave Etsy a stout gross margin that averaged 68% over the past five years. It also had a free cash generation rate of 190% in 2020. Return on average capital employed (ROCE) came in at a very impressive 50% last year.

Etsy Is Unique

While some may be worried about competition for Etsy coming from Amazon or Ebay, I am not.

Etsy is unique with its core focus on its niche: hand-made, artisan, and vintage products.

It has already beaten off Amazon, which launched “Amazon Handmade” in 2015. There were numerous complaints about Amazon’s difficult user interface, complex fee structures and search biases.

Meanwhile, Etsy management wisely invested in machine learning technology. The company acquired Blackbird Technologies in 2016 for a mere $32.5 million. This technology improved Etsy’s platform search quality, creating a better shopping experience for both shoppers and sellers—a main reason why its sellers are so “sticky.” According to a company survey, 55% of Etsy’s 4.1 million active sellers do try to sell their goods elsewhere—but on average, Etsy is their primary source of sales.

What Etsy’s Future Holds

There is no doubt 2020 was a banner year for Etsy.

Active buyers were up by more than three-quarters last year to 82 million, compared to 46 million 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!

The company is prioritizing marketing spending to hold onto these new customers, with its budget nearly doubling in 2020. It can afford to do this because its business model is so asset-light.

I will be interested to see how well Etsy’s new foray into second-hand clothing goes. Etsy spent $1.6 billion to acquire Depop, the UK-based second-hand fashion app. The app offers Etsy access to the Gen Z audience, as 90% of Depop’s active users are below the age of 26.

This deal will boost Etsy’s market share in apparel, as well as the second-hand market. Etsy forecasts this market will grow at a 39% compound annual growth rate (CAGR) from 2019 to 2024 in the U.S.

Depop has been growing rapidly but has yet to turn a profit in its near-10-year history. Still, this may be a fertile area. The recent IPO in the same sector—ThredUp (TDUP)—has done well.

I believe Etsy’s long-term competitive advantage is unlikely to wane, even in the face of competition. And with its stock down more than 20% from its high, I like buying a market leader in a niche market with significant growth potential.

I will make Etsy a 4-Star stock, instead of a 5-star stock, until I see how well its purchase of Depop goes. It can be bought at any price up to $235 a share.

— Tony Daltorio

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Source: Growth Stock Advisor