Etsy, Inc. (ETSY​) shares are down over 11% year to date as of March 2017 following a February earnings announcement that worried investors. The results exceeded analyst expectations on both top-line growth and adjusted earnings, and its gross margin improved 170 basis points over the prior year. However, a lukewarm outlook added to panic that Etsy was more exposed to competitive pressures than previously hoped. This can spell disaster for speculative growth stocks, and holders of such stocks tend to be more willing to part ways when trouble rears its head.

ETSY ytd Performance

Etsy was founded in 2005 and went public in 2015, notching rapid user and revenue growth throughout these early stages. The marketplace had 1.748 million active sellers and 28.566 million active buyers in 2016, with $2.84 billion in merchandise sales during the year. For comparison, eBay Inc. (EBAY) has roughly 25 million active sellers globally across its broad product categories. Etsy's growth was exceptional for a young niche player, and the company established itself as the go-to online marketplace for handmade or vintage apparel, decor and crafts. Users also cite the quality of search results, contrasting Etsy's marketplace with the often disorganized and unreliable nature of competitors' listings. (See also: Etsy Stock Tumbles Despite Earnings Beat, Strong Revenue Growth.)

Strong brand identity is one of the keys to creating an economic moat in a highly competitive environment, and Etsy would struggle to succeed in the crowded e-commerce landscape without such an advantage. Amazon.com, Inc. (AMZN​) and eBay both announced dedicated markets to compete directly with Etsy in recent years, a fact that caused some alarm among shareholders. The full impact of these pressures remains to be seen, but Etsy's ability to differentiate itself carries enormous consequences for long-term profitability, and this will be under intense scrutiny moving forward. (See also: Should Etsy Investors Fear Amazon's 'Handmade'?)

This context is essential for understanding the 18% drop following a superficially positive earnings announcement and the subsequent 8% rebound. Active users, merchandise sales, revenue and GAAP net loss all improved in 2016 over the prior year, and this performance also exceeded analyst expectations. Seller services grew 47 percent from 2015, indicating Etsy's value to the vendor community. However, sales growth continued to decelerate. This is a natural progression for maturing companies, but it can worry growth investors in a speculative stock.

Management's outlook was even more troublesome. The company announced heavy spending for 2017, largely due to increased marketing expenses. Etsy's brand marketing budget is expected to rise from $6 million in 2016 to $20 million in 2017. The negative signal here is that customer acquisition is becoming more expensive, which can be ominous for internet companies. If this trend continues, it indicates economic moat erosion, and margins will be depressed permanently. Etsy is also launching a market dedicated to craft supplies in April 2017, which could be a worrisome departure from its niche into a much more competitive market segment. (See also: Etsy to Launch New Craft Supply Marketplace.)

The e-commerce, television and catalog marketplace industry is dominated by a few major players and otherwise highly fragmented, making it difficult to construct a clean peer group for Etsy. Nonetheless, the market has shown willingness to attach aggressive valuation ratios to stocks such as Wayfair Inc. (W), Overstock.com, Inc. (OSTK), LightInTheBox Holding Co., Ltd. (LITB) and QVC Group (QVCA). Internet and other technology companies have historically maintained expensive valuations throughout their growth stages as well, so there is little reason to expect Etsy to falter simply because it looks expensive.

Despite its recent declines, there's little evidence to suggest that Etsy is now cheap, and it remains a speculative growth story. The company will continue to focus on growth over profitability, and its competitive advantage as a strong niche brand relative to the large players remains the central question to its success. (See also: The Art of Speculation.)

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