Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Today we're going to look at a stock that quite honestly frightens me -- Etsy (NASDAQ: ETSY) -- and it frightens me because I've seen this story unfold before. (Hint: The Spanish-language version of this story is called "MercadoLibre.")
The story goes like this: Unprofitable "tech stock" bursts onto the market in a hot IPO, craters on miserable earnings but then...gets better. The business turns around, profits begin pouring in, the shares skyrocket, and eventually, the company ends up looking wildly overpriced -- but is still growing like gangbusters.
It's at this point that a value investor like myself has to decide whether the growth justifies the price (and most often it does not appear to). Other investors, however, beg to differ.
This time, the other investor recommending a highflier is Needham & Company.
Image source: Getty Images.
Yesterday, Needham announced that after sitting out Etsy's 200% gain in share price since early 2018, it's finally prepared to dive into the stock -- and is initiating coverage at buy, with a price target of $75 implying more than 21% additional upside.
Why does Needham think this?
StreetInsider.com has the details. "Etsy is an e-commerce marketplace that allows entrepreneurs (sellers) to transact with consumers (buyers)," says Needham by way of introduction. "We believe Etsy has the right drivers to continue growing sales by >mid-teens%. We see it capturing new buyers, generating higher sales with existing buyers, and improving its take rate from sellers."
And the numbers bear this out. For example, last quarter Etsy reported a 13% increase in the number of active sellers on its marketplace, and a 28% increase in the number of active buyers. But sales and profits grew all out of proportion to this increase in the number of users populating Etsy's marketplace.
Sales: Up 40% year over year.
Earnings: Up 140%!
Etsy turns it around
Nor were Etsy's fiscal Q1 2019 results any kind of a fluke. Indeed, data from S&P Global Market Intelligence show that over the last five years, Etsy's sales have grown at a compound annual rate of 37%. Gross profit margin on those sales has climbed more or less steadily, from 61.8% in 2013 to 68.4% in 2018 (and 69% over the last 12 months). Operating profit margin is up from less than 1% to more than 15%. And net profit margin, negative from 2013 all the way through 2016, is now approaching 15% as well.
And Etsy may not be done yet. According to Needham, not only are the company's numbers "strong" already, but the analyst also expects them to "expand further on leverage from sales growth and benefits of high-margin service revenue." In other words, not only should sales continue to grow, but the profitability of each additional sale will grow as well.
As a result, Needham has every reason to believe that "Etsy's positive momentum and narrative are poised to continue."
The upshot for investors
Of course, this is the part of the story where things get tricky for value investors.
On average, analysts polled by S&P Global forecast that Etsy will keep on growing its earnings at better than 21% annually over the next five years -- a prediction that could prove to be conservative if the company continues going the way it's been going over the last five years.
The question is whether Etsy will grow fast enough, however, to justify its very rich valuation of nearly 37 times free cash flow -- and more than 77 times trailing earnings. Personally, having seen how a company like MercadoLibre with similar dynamics has outperformed expectations, I strongly suspect that Needham is right, and Etsy will continue to defy expectations and grow faster than predicted.
But that still doesn't mean I'm brave enough to buy Etsy at these prices -- not even on Needham's say-so.
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