This Controversial IPO Could Still Yield Massive Upside

David Sterman's picture

Friday, May 29, 2015 - 12:00pm

by David Sterman

The recipe for a top-performing IPO is quite simple: Bring in a broad cross section of investment banks to underwrite the deal, ensuring an ample number of bullish research reports; deliver knockout results in your first quarter as a public company; and steer clear of any sort of controversy.

The executives at Etsy, Inc. (Nasdaq: ETSY) heeded none of those lessons. And quite predictably, the company's shares have already been tossed in the dust bin. Yet as the company finds its footing in coming quarters, this operator of an online crafts-oriented marketplace, could still turn out to be one of the hottest IPOs of 2015.

A 50% Downdraft
To understand this stock's rebound potential, we should first review the litany of bad news that has beset this stock.

On April 16, shares of Etsy opened for trading at $31 a share, and within a few hours, moved above $35. In many respects, the Wall Street hype machine was not engaged in the offering. Etsy's management decided to mostly place shares among retail investors (many of whom are Etsy's clients) and as a result, major institutions such as mutual fund firms like Fidelity Investments weren't in a position to get a big part of the deal.

The lack of institutional support was a clear error on management's part, as these investors are crucial in building a stable, long-term base. The deal structure also meant that Etsy got much less post-IPO Wall Street research coverage than similarly-sized tech companies typically garner.

Soon after the IPO, a research report from Wedbush suggested that a small portion (around 5%) of Etsy's sales were dedicated to counterfeit goods. Notably, Alibaba.com (NYSE: BABA) was dogged last year by similar allegations, which eventually proved to be unfounded. 

A trademark infringement lawsuit involving goods sold on eBay established that it is the responsibility of the branded good company (in this instance, Tiffany's) to pursue the copyright violators and not the marketplace operator. To be sure, Etsy prides itself on the integrity of its marketplace and will need to squarely address this concern.

Shares also took a hit on Q1 results, when management announced plans to boost headcount to stave off any potential competitive threats from firms such as Amazon.com, Inc. (Nasdaq: AMZN). That signals a plan to generate minimal operating profits in the near-term, which always spooks investors.

Despite the recent stumbles, this is still a very impressive business model. Sales rose 56% last year (to $196 million), and thanks to a nascent international expansion, are likely to exceed $400 million by 2017. For now, Etsy is focused on English language countries such as the United States, United Kingdom and Canada, but foreign language sites are slated for launch in coming years.

Thanks to the recent IPO, Etsy finished the first quarter with $293 million in the bank and will have the marketing resources to fully establish a broad moat around its business.  Amazon.com, with its decision to target this market, will surely take some market share, but Etsy has built a strong reputation with its buyers and sellers over the past decade.

Etsy currently has 1.4 million registered sellers, 21 million active buyers and has 40 million goods on its site each year. The company collects a 3.5% sales commission on each transaction and also generates nearly $100 million in annual advertising revenue.

In this kind of marketplace, success begets further success due to the viral nature (i.e. network effects) of buyers and sellers seeking the largest audience.  According to management, almost 50% of sellers that used the site four years ago still do.

That stickiness is a clear testament to the company's extensive efforts to build a community. Indeed Etsy scores far higher than eBay.com by a range of customer loyalty measures. Amazon also scores quite high in terms of loyalty, but fears that Amazon will simply decimate Etsy with some pricing perks appears quite misplaced.

If Etsy can continue to hit all the right notes in terms of customer loyalty and marketplace execution, the company may be looking at a potentially massive future revenue base. "Given Etsy's focus, we estimate a total addressable market of $70 billion, though with products across 30 categories, we believe Etsy could address as much as $1.4 trillion in retail spending globally," note analysts at Goldman Sachs. Etsy will surely not capture all of that, but even a less substantial figure, multiplied by the company's 3.5% sales commission, highlights the profit potential of this business model.

Here's the stark reality of newly-public cash-rich tech firms: They tend to spend a lot of money to capture their market opportunity as quickly as possible. That means that Etsy won't likely show decent profits for at least several years.

That should be a serious concern for any companies that operate in high-touch, high-overhead businesses. But this is a fairly frictionless business model, meaning most customers and transactions will be handled in a fully automated fashion. In other words, there should be a great deal of operating leverage in the long run as sales rise faster than overhead.

Risks To Consider: Etsy needs to stay ahead of the concerns regarding counterfeit goods. Its client base prides itself on the quality and integrity of buyer/seller relations.

Action To Take --> Etsy provides a clear example of how not to operate as a newly-public company. From limited Wall Street support to a quick move to boost spending, investors feel rightly burned. But few companies face a target market opportunity as large as this. Investors will eventually pivot form short-term stumbles to longer-term potential, and this stock will eventually reflect a half-full rather than half-empty bias.

My colleague Andy Obermueller devotes his time to identifying game-changing trends and the companies that should benefit from this. This has led readers to investments that went on to gain triple-digits.

More recently, Andy has been talking about the threat that cyber criminals pose on individuals, multinational corporations and even governments. This is a serious problem, in its infancy and one that will take decades to fight. But don't let this scare you. Andy has identified four companies that specialize in protecting sensitive information from criminals. These are young firms, which provide robust upside potential for early investors. If you haven't heard about this opportunity yet, then I urge you to check out his comprehensive report on how to profit from the world's greatest threat, by clicking here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.