Etsy (ETSY) went public in April at $16 and nearly doubled to close at $30 on its first day of trading. Etsy’s first day jump proved short-lived — since then the stock has given back almost all of its opening-day gains in light of several developments that have been perceived negatively by investors.

Though the topic of counterfeit goods on Etsy isn’t a recent revelation, concerns mounted following an analyst report suggesting up to two million items (5% of all merchandise sold on Etsy) may be counterfeit or infringe on either a copyright or trademark. Investors have brought a class-action suit against the company, alleging that Etsy made “false and misleading statements” about the counterfeit issue.  Next, in its first announcement of quarterly results since going public, Etsy posted an adjusted loss of $0.84/share versus both Street expectations for a profit of $0.03/share and a loss of $0.01/share in the same quarter last year. Management attributed the quarterly loss to 1) investment in market and product development aimed at driving growth, 2) restructuring costs, and 3) the strong dollar dampening buyer activity outside of the U.S. (lowering demand for USD denominated goods)

Finally, there are reports that Amazon is actively reaching out to sellers on Etsy’s platform, surveying their interest in a new artisan-focused platform called Amazon Handmade.  This is raising questions about Etsy’s ability to defend and grow its do-it-yourself niche.

Given these early challenges, investors will be seeking reassurance that Etsy’s long-term strategy isn’t at risk. Management has indicated that it doesn’t intend to provide quarterly or annual earnings guidance as this could incentivize short-term decision-making to the detriment of long-term strategy. We recognize the benefit of this philosophy, but it’s possible that investors “shoot and ask questions later,” which may result in elevated share price volatility.

Assessing Etsy Within the Context of our DMC Taxonomy

To assess Etsy’s long-term strategy, we refer investors to our distributed marketplace company (DMC) taxonomy, which we recently introduced (see our June 9 report, “Dissecting the Sharing Economy: Business Model Opportunities and Risks”). We created this taxonomy to identify the salient characteristics and key relationships in the distributed marketplace, and to help evaluate the risk and opportunities associated with each business.

Companies can have a mix of characteristics, any of which can present a particular opportunity or risk. In all cases, the analysis comes down to who benefits and how, who might be harmed and how, and what stakeholders other than the provider and consumer may be affected.

DMC pic

We believe focusing on four categories is particularly useful in assessing Etsy:

  • Provider status
  • Regulatory framework
  • Provider’s potential geographic reach
  • Business model

Identifying how Etsy is currently positioned is useful, but it’s also necessary to think about how Etsy’s business is transitioning. Indeed, this can create issues for a company because, in attempting to build a scalable business, it may sacrifice what made it appealing in the first place.

Provider Status — Amateur vs. Professional

What’s happening?

Etsy had to enable successful sellers to continue growing while maintaining the handmade ethos of its platform. To accomplish this goal, the company updated its policies and guidelines to permit collectives and outside manufacturing. Collectives are seller accounts that involve more than one person where artisans collaborate, share a shop, and/or enlist help to manage the account. In the case of outside manufacturers, sellers can apply to partner with manufacturers as long as the design and production process meets Etsy’s standards and expectations.

While these changes accommodated successful sellers by allowing them to scale up production, critics claim that Etsy has strayed from its core values by catering to a more “professional” breed of seller. Its strategy may also have the unintended consequence of attracting larger, traditional manufacturers operating under an artisan guise.

Why should investors care?

One of Etsy’s core strengths is its reputation as an authentic, trusted marketplace. However, if its efforts to drive revenue by enabling a “professional” breed of seller are perceived as a departure from its core, artisan-centric values, then “active seller” and “active buyer” numbers could suffer[1].

This is important because Etsy views the number of active sellers and buyers as key indicators of the awareness of their brand, the reach of their platform, the potential for growth in gross merchandise sales (GMS) and revenue, and the health of their ecosystem.

We believe Etsy faces a formidable task in growing its platform while maintaining its homemade ethos. This is premised on the notion that Etsy’s growth could attract larger, professional sellers looking to leverage the platform. Admittedly, the presence of this type of seller may attract more buyers, but we’re concerned this may be negated by an erosion of Etsy’s brand.

To assess this evolving dynamic, we’ll be monitoring active seller and buyers as well as commentary around resources dedicated to insuring the authenticity of sellers.

Regulatory Framework — Clarity vs. Ambiguity

What’s happening?

As mentioned previously, investors are concerned that up to two million items (5% of all merchandise sold on Etsy) may be counterfeit or infringe on either a copyright or trademark. Investors have brought a class-action suit against the company, alleging that Etsy made “false and misleading statements” about the counterfeit issue.

CEO Chad Dickerson addressed questions about this issue on the company’s 1Q earnings call, stating:

I want to stress three points. First, we earn respect by following industry-leading best practices and established law. The second is that someone on the outside looking at our site lacks the context and the background information to determine what’s infringing and what’s not. And third, we strive for a balanced approach that takes into account the interest of our sellers and IP owners and we believe that’s working. [1]

Why should investors care?

Some DMC models operate within existing, clearly defined regulatory frameworks, or in an unregulated market. Others may operate according to different standards than incumbent competitors, creating ambiguity about compliance requirements.

As it pertains to trademark infringement and counterfeit goods, a 2010 U.S. Supreme Court ruling on the Tiffany & Co v. eBay lawsuit provides a degree of regulatory clarity. The jewelry maker sued eBay for trademark infringement in an effort to force eBay to proactively remove Tiffany branded items — many of which were counterfeit — from its site. The court sided with eBay, suggesting that it was ultimately the responsibility of brand manufacturers to find counterfeit items and request their removal.

Despite the precedent set by this case, we expect Etsy’s trademark and counterfeit policies to be scrutinized further for a few reasons:

  • First, Etsy is expanding internationally, where it may be less protected under local laws. For instance, the European Court of Justice (ECOJ) ruled against eBay when L’Oréal, the French cosmetics company, accused it of being involved in trademark infringement. In the end, the companies decided to address the issue through cooperation instead of litigation, but this ruling underlines the risks Etsy faces as it expands into new markets.
  • Next, one of Etsy’s core strengths is its reputation as an authentic, trusted marketplace. As such, an increasing number of counterfeit items could damage its brand and, ultimately, impact its ability to attract buyers and sellers to the platform.
  • Finally, a push by brand manufacturers to remove their goods from Etsy’s platform could impact Etsy’s listing and commission fees, directly impacting revenues and earnings.

Etsy faces a similar set of challenges as Amazon, eBay, and Alibaba when it comes to trademark infringement and counterfeit goods. However, the risks to Etsy’s brand may be greater given the importance of its authentic, artisan value proposition.  That said, we’re encouraged by management’s comments addressing the situation, particularly that Etsy is partnering with major brands to address the problem and develop technology intended to proactively locate bad actors and prevent them from returning.

Provider’s Potential Geographic Reach — Global vs. Local

What’s happening?

International GMS constituted 30.9% of overall GMS in 2014, up from 28.4% in 2013. Etsy is focused on growing its international footprint and plans to invest in local marketing and content and local payment and shipping solutions.

Why should investors care?

By expanding into international markets, Etsy is building a broader market for buyers and sellers. It’s also offering people in remote or economically marginal communities the opportunity to generate income.

As in all globalized industries, however, there may be the perception that Etsy is enabling a “race to the bottom.” This relates to our discussion about amateurs versus professionals, as a global platform increases the likelihood of attracting cost-competitive, traditional manufacturers (i.e., professionals) operating under the guise of an artisan.

As discussed in our assessment of Etsy’s “Provider Status,” we believe the company faces a formidable task in growing its platform while maintaining its homemade ethos. Expanding into new markets will likely attract more “professional” sellers, and Etsy will be expected  —  by buyers and sellers — to have the systems and technology in place to verify the identity of sellers. If the company fails to deliver on these expectations, Etsy’s marketplace may be seen as just another e-commerce website.

Business Model – Pioneers vs. Disruptors

What’s happening?

There are reports that Amazon.com is actively reaching out to sellers on Etsy’s platform, surveying their interest in a new artisan-focused platform called Amazon Handmade.  This is raising questions about Etsy’s ability to defend and grow its do-it-yourself niche.

Etsy’s active buyer universe rose to 20.8 million from 15.3 million a year earlier in Q1. By comparison, Amazon has 278 million active accounts. Etsy currently charges $0.20 to list an item on its site for four months and then takes 3.5% of the subsequent sale. Amazon doesn’t charge listing fees (for those selling fewer than 40 items per month) but takes a commission fee that varies from 6-15% depending on the product sold.

Why should investors care?

Sharing economy entrepreneurs can create brand new models where there’s been limited or non-existent supply by traditional corporations; or, they can challenge directly established monopolies and incumbent corporations. Pioneers develop markets that previously took place only through personal relationship. Disruptors bring greater efficiency or quality of service to existing markets.

Etsy was the first to establish a robust online artisan marketplace, squarely aligning it in the pioneer category. However, as incumbents like Amazon roll out competitive platforms, we question whether barriers to entry exist such that Etsy can defend its pioneer status. We believe Etsy’s brand and artisan ethos is paramount in differentiating itself from incumbents that compete primarily on price.

[1] Bloomberg Q1 2015 Earnings Call transcript

[1] “Active” is defined by Etsy as engaging in at least one transaction in the past 12 months.

Michael Shavel is a Global Thematic Analyst at Cornerstone Capital Group. Prior to joining the firm, Michael was a Research Analyst on the Global Growth and Thematic team at Alliance Bernstein. He holds a B.S. in Finance from Rutgers University and is a CFA Charterholder.

Andy Zheng is a Research Associate at Cornerstone Capital Group. Andy graduated from Bowdoin College with an interdisciplinary major in Mathematics and Economics and a minor in Visual Arts.  He spent his junior year studying abroad at Oxford University and the summer prior to that at the Sorbonne in Paris. Andy passed Level I of the CFA Program in January 2014.

For more information about this report please contact Tanya.Khotin@cornerstonecapinc.com or Alice.Petrofsky@cornerstonecapinc.com.

See the attached report for important disclosures.