PE multiple compression? ETSY as an example

I should start off by saying that although I think ETSY is an intriguing stock, I don’t know it well and I don’t own it directly (there’s the odd chance that a mutual fund or etf I own holds it, but if so I’m not aware of that).

Why choose ETSY? It’s an e-commerce platform that allows craftspeople and small businesses to sell their wares online. At one time pretty badly managed, it seems to me to be much better run today. Perhaps most important, the other main vehicles for craftspeople to sell their wares–fairs, trade shows, physical stores specializing in craft goods–were all shut down by the pandemic. The BIG question for ETSY: as the world reopens, how much of the phenomenal sales growth the company has had over the past year will ETSY be able to retain? …how much will revert to other outlets as they reopen?

There’s no consensus on this, as analyst estimates for ETSY’s earnings for 2021 and 2022 illustrate:

2020 eps = $2.69

estimates

2021 2022

high $3.55 $5.22

average $3.11 $3.80, based on 13 analysts

low $2.44 $1.25.

1Q21 results are already in. ETSY reported eps of $1.00 vs. $0.10 in 1Q20. In other words, even the high estimate suggests that analysts believe ETSY would do well to have flat comparisons for the rest of the year.

Next year is the interesting one, because of the extremes. The most pessimistic analyst thinks earnings will be cut in half. The most optimistic thinks growth might approach (or even exceed) a 50% gain. The average posits flat for the rest of 2021 and a resumption of earnings expansion at a 20%+ clip next year. If we remove the most pessimistic from the mix, eps growth is closer to +30%. Remove the most optimistic and estimated eps growth is more like +18%.

If we think the pessimist is more likely to be wrong than the optimist (whether this will turn out to be right or not, I have no idea), expected earnings performance will almost certainly put upward pressure on the stock price.

Here’s where interest rates come in.

ETSY is trading at $185 as I’m writing this. That’s about 50x trailing earnings, or about a 20% premium to the market. If we assume the 10-year Treasury rises to 3% by the end of next year, the academic stock/bond equivalence theory says the market multiple will shrink to 33X. A 20% premium to that would be 40x. 40 x $3.80 = $152, a loss of 18% from the current stock price of ETSY.

For ETSY to go up by 10%+ over the coming 18 months would seem to require the most optimistic analyst outlook to be correct.

If we say rates will rise to 2.5%, this translates into a 40 market multiple and a 50x multiple for ETSY, assuming it retains its premium rating. In this scenario, the stock stays flattish, save in the case that the most optimistic analyst proves most accurate.

the grain of salt

I’m using precise numbers in the illustration above. Reality is almost always a lot messier. The general point, however, is important–as/when interest rates begin to rise, that alone will be enough to put downward pressure on stock prices through PE contraction based on the greater attraction of fixed income. If rates rise enough, higher rates will begin to have a negative effect on economic activity (people will save instead of spending), and therefore on corporate earnings growth. A 3% 10-year Treasury probably isn’t high enough for that to happen on a large scale–but it probably is enough to make some investors worry about the possibility.

If I were still working, or if I owned ETSY, I’d want to have a talk with the very pessimistic analyst. Assuming that 2022 estimate isn’t a typo, my guess is that the analyst thinks the company’s recent success is purely pandemic-related, and that customers will go back to patronizing traditional brick-and-mortar outlets for art/craft items. I’d like to hear the reasoning.

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