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Etsy Changes Its Tune (In a Good Way)

Chris Hill, The Motley Fool

On this episode of MarketFoolery, host Chris Hill talks with senior analyst Jason Moser about some recent market news. Equifax (NYSE: EFX) pops on reports that it'll be paying a $700 million fine for data-breach mishaps in 2017. Apparently, bad news is better than no news.

Meanwhile, Microsoft (NASDAQ: MSFT) -- the biggest company in the United States, with a trillion-dollar market cap -- managed to grow revenue by 12% this quarter. And Etsy's (NASDAQ: ETSY) taken a new company under its wing. Find out why Reverb is such a fitting tuck-in buy for Etsy, whether or not they paid too much for it, and why you might want to add Etsy to your watch list.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on July 22, 2019.

Chris Hill: It's Monday, July 22nd. Welcome to MarketFoolery! I'm Chris Hill. Joining me in studio, Jason Moser in the house. Thanks for being here!

Jason Moser: Howdy!

Hill: We have to get to a couple of fun things here. Sorry, it's the end of a long day and I'm a little undercaffeinated and brain dead. This is going to be great!

Moser: Hey, man! I'll help you through it!

Hill: First-time listeners are already thinking to themselves, "Why am I listening to this?"

Moser: "How long is this again?"

Hill: "My friend told me to listen to this? Why am I listening to this idiot?" 

Very interesting deal from Etsy that I want to get to. I think the bigger headline today is from Equifax, the credit-reporting company. Equifax, which was in the news for, let's just say some digital security issues, they're going to be paying a fine of -- help me here, is it $700 million? Is it up to $700 million? I've seen both reported. It's going to be hundreds of millions of dollars' worth of a fine that Equifax is going to be paying for this. The stock is up, which leads me to believe this is the old adage of, "the market hates uncertainty." And now that we're certain what the ceiling on the fine is going to be, we're good to proceed with Equifax.

Moser: Yeah, I think that's it. It's up to $700 million. Part of that is the fine, and part of that is actually putting together a consumer fund for monetary relief for consumers who may have been wronged by this action. To your point, you have a lot more clarity now as to the path forward for Equifax. All along the way we were thinking, "Man, someone's got to go to jail for something." Certainly, there was an executive who was caught for insider trading and is going to serve four months in prison for that. We talk a lot about these security breaches. Regardless of the industry, the way that technology works in our lives today, security breaches, unfortunately, are just part of the deal. I approach it always, at least, as a when, not if. That's not saying it's OK. It's just understanding the reality of the situation. 

I was looking back at the attitude during the time that this was going on, back in September of 2017. Of course, people were angry. They felt like they had been violated, their privacy had been broken. Fast-forward [to] today, and Facebook has obviously taken a lot of people to the cleaners, as well. This, I think, is something that is a bit more impactful, because your credit score, your credit history, is an asset that you want to try to protect as you grow up in this country. And when you see a breach like this, it's understandable that people get frustrated. But I did look at Equifax at the time and say, you know what? Given what these guys do, and given the nature of the market that they serve, it's hard to imagine that this doesn't maybe look like an opportunity to buy the stock. You may have to hold your nose doing it, but maybe there was a value play there. Fast-forward to today, and since that time, September 11th, 2017 to today, Equifax has returned 25.3% to the market's 24.1%. So there was somebody out there who was looking at this thesis and thinking maybe they could make a little money off of it. But the bottom line is, it gives them a path forward. It reminded me a lot of all of the stuff that went on with Moody's during the credit crisis, the housing crisis, the financial crisis, whatever kind of crisis you want to call it. It was a crisis of many measures. It's hard to imagine, but you look at the 10-year chart for Moody's stock, and it was a really good time to be owning that stock. If the financial crisis did not take Moody's down, that thing is pretty much bulletproof. I put Equifax in that same class after this finally being wrapped up.

Hill: It's a good reminder that, when there's any type of crisis -- you're right, there's absolutely an enthusiasm on the part of some to say, "That company is going down." And maybe on that day, they do. But a good question for investors to ask -- and it sounds like at the time, you were one of the investors asking this question -- is some version of, "Who are they competing with? If this company loses business, who's gaining business?" And if you have to struggle to think of who is their main competitor, maybe it's a situation where the switching costs are such that they're not in any material business. We talked recently a couple of times about Facebook, and made the point that when you look at the customers at Facebook -- not the users. You and I are the users. The customers are the people who pay Facebook -- its advertisers, and they appear to be very happy with Facebook. That seemed to play out here with Equifax.

Moser: Yeah, I think so. You also look at the market itself. The nature of what they do, it depends on other agencies essentially being out there to compile their own scores, as well. Whether it's Experian or Trans Union, you have this trifecta of companies between the three of them. It's difficult to imagine any one of them being displaced unless a crisis of epic proportions happens. I don't know that necessarily will. Of course, it could. But I think the position they hold and the market that they serve is such that it's going to be really difficult for a company like this to be fully and completely disrupted. There are investors who will look at this type of situation and say: "I know everybody's pissed at them but I'm alright with that. I'm going to try to make some money from this." And I guarantee you, somebody did.

Hill: Last week, we recorded the Motley Fool Money radio show a little early in the week, so I think it's worth touching on Microsoft's fourth-quarter results because we weren't able to do that on Motley Fool Money.

Moser: Chris, there's only one $1 trillion market cap company out there right now, and it ain't Apple

Hill: It ain't Apple, it ain't Amazon. It's Microsoft. Another monster quarter. Their fourth-quarter results were impressive on a lot of levels, particularly when you think of, this is the biggest public company we have in the United States, and revenue grew 12%. [laughs] 

Moser: I look at this company and I think to myself, "Wow!" The one thing I've taken away from these past several years, it's been very easy to give Microsoft a hard time and more or less dismiss it as being slow to change and missed the whole boat on mobile, yada yada yada. The one thing I think investors have to take away from all of this, this is not Steve Ballmer's Microsoft anymore. This is Satya Nadella's Microsoft, and he is doing a lot of great things with the team there. It's a laundry list of great results beyond that top-line growth that you're talking about. Commercial cloud had its biggest quarter ever, up 39%. LinkedIn revenue was up 28% excluding currency effects; 645 million users on LinkedIn. Good results in Office. Azure revenue up 68% excluding currency. Windows 10 is active on more than 800 million devices with accelerating adoption. That's just the beginning. We could go on, Chris, and I will if you let me.

Hill: Go for it!

Moser: OK! I talk a lot about augmented reality and mixed reality and stuff like that, and Apple's ARKit as being the largest development platform out there in augmented reality. I tell you, Microsoft is doing a lot of cool stuff here. They talked about HoloLens in the call, and this software that they have, Azure Spatial Anchors, which is essentially software to help this new generation of app builders build around mixed reality. Gaming right now is facing a little bit of a turning point, but they are making some strong investments in their gaming sector with Project xCloud. And,we were talking about Teams. There are some interesting opportunities for Teams in the coming quarters.

Hill: Microsoft Teams is certainly going to be -- for those unfamiliar, that's the Microsoft competitor to Slack. It's going to be interesting to see how they continue to roll that out. I also think -- and part of the reason I think this is because one of the people I follow on Twitter is our colleague, Aaron Bush. A great follow on Twitter, particularly if you're interested in gaming. AaronBush100 is his Twitter handle. To the extent that there was... it's probably an overstatement to say a weak spot, but to the extent that Microsoft had a part of the business that wasn't as strong as the others, it's probably the gaming section. You look at Xbox, sales down about 10% year over year. I don't think that's necessarily a weakness for Microsoft. I do, however, think it is going to be an industry increasingly in flux. Obviously, Microsoft has Xbox, but all the different gaming platforms out there, it's really going to be interesting to watch the industry.

Moser: Yeah, I think that's a fair statement. I would say, if there was a weak part to the quarter, that would have been it. But that's not to say it was really weak. Again, it's a segment of the business that's in transition. We're in this late cycle in regard to the consoles. And if you remember, recently, with Alphabet and the Stadia offering, I think there are more opportunities for these big tech companies essentially to become streaming platforms for gaming. It seems like Microsoft is working its way toward that, as well. 

Again, you look at the popularity and the success they had with Minecraft. They're bringing an entirely new perspective to Minecraft for gamers with a mixed reality component to it. Again, I don't think gaming was weak as much as just a period of transition for the company. I feel pretty confident that they see that opportunity of 2 billion gamers out there in the world, and they're going to be able to get their fair share of their attention.

Hill: Nobody here at The Fool tweets about gaming like Aaron. Definitely worth a follow if you're interested. 

Shares of Etsy are up 4% today. Etsy is buying Reverb for $275 million. Reverb, which I'd never heard of until today, is a marketplace for new and used music gear and equipment. What is the thinking here for bullish investors? Is it, "We like this price?" Etsy is not a trillion-dollar company like Microsoft, but this doesn't seem like all the money in the world. 

Moser: No, I don't think it is. It's a $275 million deal. It'll be all cash. Etsy will get a lot out of bringing Reverb under its wing. It gives them a brand-new vertical in that music equipment, whether it be vintage or new. It's admittedly niche, but a very strong community. Plenty of opportunity, I think, to juice the revenue as a percentage of gross merchandise sales through the network, with Etsy's expertise in running an online marketplace at scale. 

We talk a lot about organic revenue growth vs. inorganic. This is an example of that inorganic. It's growing through acquisition. You always want to put acquisitions under the microscope and try to figure out what exactly is the thinking here. The nice part about this is that, we've talked a lot about how the economics of the music business can be really brutal. That's on the streaming side of the music business. This is really more musical equipment -- guitars, synthesizers, amplifiers, pedals, stuff like that. Those economics can be pretty solid. You're not talking about rights that you're paying to an artist, you're talking about just selling goods across a network, which is something that Etsy already does really well. So, you're basically plugging a smaller network in Reverb into a larger network in Etsy. I think that it gives Etsy a lot of opportunity to bring plenty of results to the bottom line. 

If you look at a couple of numbers here, the way these businesses work, when you look at the gross merchandise sales that flow through the network over a given period, we'll just go ahead and use a year, 2018, the gross merchandise sales that flowed through the network, and then you have the revenue that Etsy would bring in. Etsy saw about $3.9 billion in gross merchandise sales flow through their network in 2018. They brought in around $604 million. Reverb pushed through about $600 million in gross merchandise sales and brought in about $42 million. So essentially, Etsy is bringing in about 15% revenue to gross merchandise sales, vs. Reverb's 7%. Now, part of that is the nature of what they're selling -- but also, part of that is that Etsy is going to be able to take some of the efficiencies in their model and apply them to Reverb. They're really good at what they do. Reverb is a very resilient and growing community. I think there are a lot of reasons why this will work. Again, it's a matter of a network. It's not like they're bringing in a bunch of inventory that they then have to fire sale later. It's just another community -- just a far different one than what they've been catering [to] up to this point.

Hill: Etsy shares are up nearly 60% in the past year. Does this look frothy to you? Spicy? Pick your adjective. I'm a fan of the business, I'm not a shareholder. I just look at this and widen the chart and ask myself, "Wait a minute, how expensive is this stock right now?" Maybe the answer is not that expensive.

Moser: I'm not going to come here and say it's on fire sale. It is on the more expensive side. But you have to also keep in mind that this is a profitable business. It's a cash flow positive business. You have to look at the track record of what has been going on with this company for the past couple of years. Josh Silverman, when he took over the CEO position at this company, really got down to business. He cut a lot of the fat. He got them focused on building out this network and doing what they do really well. You fast forward to today, the stock is where it is. I'm a shareholder personally and I feel good about that. A lot of that is because it is beyond just an e-commerce platform. There's a community there that I think a lot of people are very happy to be a part of. And they do something a little bit different. Most of all, they have, in an age of Amazon, demonstrated that they can compete and win against Amazon. Most of the businesses that we look at now, we're trying to figure out, how does Amazon displace this company? How does this company withstand being marginalized by Amazon? And there are only a few companies that are doing that with flying colors. You got Wayfair doing a pretty good job of it, Home Depot doing a pretty good job of it, and I would put Etsy in that same class. They're doing a pretty good job with it, too.

Hill: This is a different business, a recent IPO, Pinterest. I was surprised to see that on a market-cap basis, Pinterest is nearly double the size of Etsy. 

Moser: Yeah. [laughs] 

Hill: But you look at Pinterest's business model, they are not profitable, but it seems like they have an opportunity to get there. I don't know. It still surprised me. Not that I thought Etsy was this behemoth, but I thought, Etsy's got their niche, they're doing it well, they're profitable, they're cash flow positive. I was like, wow, really? Pinterest is nearly double the size of this?

Moser: That doesn't necessarily make it right. We have a lot of companies out there that are worth a lot more than they probably should be trading for right now. We have to remember, we are in the face of a market that is just in love with these tech names, whether it's SaaS [software-as-a-service] or anything that is based on an advertising model. I think the enthusiasm with Pinterest right now is that there is a connection to advertising on Pinterest and actual consumer behavior. The chances of a consumer actually taking action and buying something based on what they've seen on Pinterest is far greater than Twitter or Facebook or Snap or Instagram. So that's probably a lot of the enthusiasm there with Pinterest. 

Etsy, I think, it's a bit easier to let fly under the radar because it is a bit more of a unique type of community. But when you dig in a little bit further, you understand actually how the business works. It's kind of like Wayfair, it's the power of the network. When you have this network that you continue to cater to, it continues to grow over time. The numbers tell us everything we need to know. More people are getting on that platform to sell more things every year. The chances are pretty good that they'll exploit that same talent with Reverb, too. I live in a house with a lot of musical instruments. We have a piano, we have several guitars. I told you, I got a banjo for my birthday or Christmas last year. Reverb, I've loved checking it out, because I feel like any given day, I might go there and buy a guitar just for the hell of it. Well, now I'll be supporting Etsy, and that's OK with me because I own shares of Etsy, it makes me feel pretty good.

Hill: To go back to the numbers you mentioned, it is going to be very interesting to see how Etsy integrates Reverb, and if they are -- the next quarter or the quarter after that, to the extent that they feel like they want to break out numbers -- if they can take Reverb from 7% and move it in the direction of the 15% that you talked about. Then not only does that mean good things for this acquisition, but it also probably signals at least a willingness on the part of Wall Street to say, "Hey, if you guys want to go out and make some more tuck-in acquisitions, it looks like you have a way to make those work, so go for it."

Moser: That's a really good point. You've given us exactly the metric we'll keep our eyes on -- watching the revenue vs. the merchandise that's going through that network. I think we'll probably get that clarity. It sounds like Reverb is going to be given the freedom to basically keep doing what they're doing as their own entity. Reverb is not going to change, it's just now an Etsy company. Typically, we get a little bit more clarity. We'll be able to follow the actual shopping behavior and the numbers on Reverb. That'll be what we'll pay attention to. You're right -- if they do prove success there, then the market will, for certain, give Etsy a little bit more credit to go do something else like this. 

Hill: Jason Moser, thanks for being here!

Moser: Always a pleasure!

Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery! The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Chris Hill owns shares of Amazon. Jason Moser owns shares of Alphabet (C shares), Amazon, Apple, Etsy, and Twitter. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Etsy, Facebook, Microsoft, Moody's, Twitter, and Wayfair. The Motley Fool owns shares of Pinterest and Slack Technologies. The Motley Fool is short shares of Equifax and has the following options: short August 2019 $195 calls on Home Depot, long January 2021 $120 calls on Home Depot, long January 2021 $85 calls on Microsoft, short January 2020 $155 calls on Apple, long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and long January 2020 $150 calls on Apple. The Motley Fool recommends Home Depot. The Motley Fool has a disclosure policy.