ETSY - Etsy: Outlook As The Holiday Season Approaches

2023-11-15 06:28:53 ET

Summary

• Etsy experienced rapid growth during the pandemic, doubling its number of buyers in just a year. The combination of lockdowns and stimulus money fueled Etsy's growth. These factors are gone.
• Etsy is now operating in a tougher environment, both from a macro perspective as well as from having tougher competitors willing to outspend it to gain market share.
• Etsy's key buyer demographic is under severe financial strain and that may be causing them to seek more value purchases rather than spend more to get unique gifts on Etsy.
• The article examines whether Etsy's growth story is still intact and analyzes the status and trend of its active buyers.

Introduction

Etsy (ETSY) is an e-commerce website that differentiates itself by selling handmade, personalized products and vintage items and eschews the reselling of mass-market products. It grew very quickly during the pandemic, doubling the number of buyers in just a year. The unprecedented combination of a mandatory global lockdown and the influx of stimulus money gave fuel to Etsy's meteoric growth.

Now that both these factors are gone, and macro headwinds have replaced them, is the Etsy growth story still intact?

Is it a business that has a wide moat and a huge total addressable market that it is just starting to tap into, or has it become just another e-commerce website? Sean Dunlop, an analyst from Morningstar, believes that Etsy is a wide-moat company. In his note , he says,

We believe wide-moat Etsy offers compelling value for investors despite a brutal 2023, which has seen its share price fall by a striking 45%... Etsy is strikingly efficient for a company its size, generating $1.3 million in revenue per headcount at its core marketplace and averaging $39, $49, and $14 in average incremental GMS per dollar of research and development, general and administrative, and marketing spending, respectively, between 2018 and 2022. It continues to defend category market share in its largest online verticals despite a clear customer migration toward discounters and nondiscretionary items and has seen a clear, marked uptick in penetration with male and international buyers (up 9% and 7%, respectively) that should lay the groundwork for durable growth inflection once macroeconomic pressures ease.

Although he has reduced his calculated intrinsic valuation for Etsy down to $145 from $221 last year, he still believes that Etsy is more than 50% undervalued (more on valuation later).

In my previous research, I wrote "Etsy was profitable and remains so". Is the narrative that Etsy can continue to be relevant and profitable in a world with many e-commerce competitors selling cheap, mass-market gifts, still true? This is also a world where Amazon Handmade is a fierce competitor with its own logistics network to support the distribution of the goods, where an increasing number of Etsy sellers are blatantly selling mass-market stuff and diluting the Etsy brand, and where competition is outspending it in advertising dollars.

In this research, I will offer my take on how the holiday season may impact Etsy's Q4 2023 revenue. I will be considering the buyers' profile in light of the current macroeconomic headwinds to have a better sense of the challenges facing Etsy. In addition, I will update the trend of Etsy's buyers and sellers in light of Q2 and Q3 results. From the results of these trends I will share my thoughts on whether Etsy can still be considered a growth company, and from that perspective value it.

Holiday Season Predictions

Historically, Etsy's sales ticked up during the holiday season in Q4 which is why I am confident that Etsy's fourth-quarter sales will be much better than its third-quarter sales . The revenue boost retailers typically get from the holiday season makes this a no-brainer "forecast" with a high probability of accuracy one that I will gladly make any time.

The National Retail Federation agrees with the boost the holiday season has on retailers. On 10 November 2023, NRF forecasted that holiday spending would increase 3% to 4% from 2022 to reach a record level of between $957.3 billion and $966.6 billion. NRF President and CEO Matthew Shay explained, " It is not surprising to see holiday sales growth returning to pre-pandemic levels ."

It is not just the holiday season in the US that offers opportunities for selling their handcrafted wares but also in its major markets like Germany and the UK. In the Q4 2022 earnings call, the CEO expressed his sentiments about the holiday season results,

The Etsy marketplace ended the year on a high note with strong holiday performance and accelerating year over three-year GMS in the fourth quarter. Etsy and our sellers helped make the season bright. GMS grew year-over-year on a currency neutral basis during Cyber 5. We had particularly strong days on Small Business Saturday and Giving Tuesday, supporting our belief that buyers associate Etsy with shopping small and making a positive impact.

We pulled out all the stops to help our sellers have the best season possible, which included holiday ad campaigns in the U.S., U.K., and Germany , spotlighting well-crafted items for all budgets, types of people, and giftable moments, out-of-home campaigns in the U.K. and Germany; increased seller participation in our annual cyber sales event, educational moments, and optimized selling tools. And last, but certainly not least, our new Etsy purchase protection program, which enhances peace of mind for buyers and sellers.

Regardless of macroeconomic factors, everybody wants to feel good and spread positive vibes during the holiday season, if not for themselves then for their loved ones. Couples gifting each other, parents gifting their children, children gifting their parents/grandparents, colleagues gifting one another, and the list goes on.

Plus, Etsy helps sellers drive sales through Etsy-funded coupons; during the third quarter of 2023, Etsy's efforts helped drive well over $100 million in incremental GMS. Coupled with creative advertising, and being in the holiday season, these efforts are expected to drive more sales in the fourth quarter.

However, Etsy's CEO Josh Silverman did not sound upbeat during his opening remarks at the Q3 earnings call ,

As you all know, there's been significant pressure on consumer discretionary product spending, as high inflation, elevated interest in mortgage rates, splurges on YOLO experiences, and declining savings balances have meant that there's little leftover for many consumers after paying for food, gas, rent, and child care. These issues are magnified for lower-income buyers, and we feel the impact on the Etsy marketplace. We're also experiencing an increasingly competitive retail environment with a very heavy emphasis on deep discounting and in some cases competitors investing it potentially unsustainable levels in marketing and promotions.

If predicting growth in sales for the fourth quarter is almost a sure thing, then why was Etsy's CEO painting such a bleak picture of Etsy's outlook ahead? Was he sandbagging? Or is the situation as bad as he says? Well, Etsy's growth prospects depend on a very large part on the financial health of its customers, so let us take a look at them.

Etsy's Buyer Profile

Based on this 2023 article by Techpenny , Etsy's main buyers are the millennials. Millennials were born between 1981 and 1996, according to the Pew Research Center. The author states,

The average, and typical customer in 2020, then, based upon this evidence, would be young people between the ages of 8-35 who identify as female... it stems from a real need to try and move away from corporate greed, and support the underdog of industry - the small business owner.

As of 2023, the millennial age range is between 27 and 42. I want to focus on the financial health of this group a little because if they are doing well, they will have more disposable income to spend on sites like Etsy; naturally, the converse is true.

More Millennials Have Less Disposable Income

During the low-interest rate environment from 2020 to 2021, many American families took the chance to lock on 30-year mortgage rates at 3% or lower. However, the younger Americans, especially the millennials, were not financially ready to take advantage of the low rates then .

Now that 30-year rates are closer to 8%, it is harder for millennials to afford a home. Renting is the other option but with rents skyrocketing, a bigger chunk of every month's income has to be set aside, leaving less disposable income to spend on gifting.

More Millennials Are In Danger Of Defaulting On Credit Card Debts

As if that is not bad enough, financially struggling Americans are turning more and more to credit cards to get by, and credit card delinquency rates among the millennials are rising at the highest rate.

The author concluded with this,

Even though the increase in delinquency appears to be broad based across income groups and regions, it is disproportionately driven by Millennials, those with auto or student loans, and those with relatively higher credit card balances .

Macro factors are beyond what management can fix but with millennials forming their largest active buyer demographic, and if they are feeling the strain on their wallets, it is problematic.

Etsy's International Customers Are Feeling The Pinch Too

I have been focusing the discussion on consumers in the US because the bulk of the sales come from them. However, consumers from Etsy's other markets are also under financial strain. CFO Steve Priest of eBay ( EBAY ), one of the first online marketplaces in the world, and one of the marketplaces with many product categories such as vintage and secondhand overlapping with Etsy, said in the Q3 2023 earnings call,

... we did observe softening consumer demand in September that carried through October. This macro softness was most pronounced in Europe, particularly in the UK and Germany , our second and third largest markets, respectively... We have also seen tapering demand in the U.S. market quarter to-date . Given these trends, our base case expectation is that continued pressure on discretionary demand will lead to a relatively muted seasonal uptick in volumes during the holiday season.

Etsy's Shoppers Are Prioritizing Their Spending

Even if NRF President and CEO Matthew Shay is right in predicting holiday sales growth returning to pre-pandemic levels, I believe that the growth will not be uniformly broad-based since consumers have been more value-orientated ever since the cost of living has been rising due to inflation.

I like to share the insights from the management of two companies, Walmart and Target. These companies sell a mix of consumables like food and home essentials together with discretionary products like toys and gift items, and we can glean a lot from management analysis of their customer's spending habits.

At Walmart's ( WMT ) Q2 2022 earnings call, when discussing his observations of WMT's consumers, CFO John David Rainey cautioned,

Customers are stretching their dollars further and seeking better value across more categories more often. We see grocery staples and in-home meal options being purchased more often. Sales of general merchandise kitchen tools like hand blenders and stand mixers have inflected higher as customers are preparing more food at home. They're also buying more necessities and focusing on lower-priced items and brands, and customers still want to celebrate key moments .

Target ( TGT ) CEO Brain Cornell concurred in the Q2 2023 earnings call ,

We know our guests want to celebrate culturally and seasonally relevant moments and we'll be leaning into those moments in a big way in the third quarter and the upcoming holiday season . And our guests have told us that affordability , availability, easy, convenient and consistently joyful shopping experience are more important than ever.

Etsy's Core Business Is Not Growing As A Growth Company Should

It would appear that CEO Josh was being straight with his assessment that the Etsy consumer is under a lot of pressure, and we must remember that Etsy sellers are also under a lot of pressure, with inflation increasing their costs of doing business.

The following table shows the trend of the activity on Etsy's platform in terms of active buyers, active sellers, habitual buyers, new buyers, and reactivated buyers. I would like to draw your attention to the "% change" rows. Numbers in red indicate a decline from the previous year or quarter, and blue indicates growth.

Although management was about to tout the growth in active buyers and active sellers, the problem lies in the magnitude of this "growth". The number of active buyers increased by just 1.2% from Q1 2023 to Q2 2023 and increased by a minuscule 0.7% from Q2 2023 to Q3 2023.

These growth figures are essentially flat, and not indicative of a growth company. Investors need to acknowledge that the pull-through effect that doubled the number of active buyers from 46.3 million in 2019 to 96.3 million in 2021 as a result of the COVID lockdown is not to be repeated.

The 12% decline in the number of habitual buyers from the peak of 8.1 million in 2021 to 7.1 million in the latest quarter is a major issue. Habitual buyers are defined by management as "loyal buyers" and arguably they matter the most because they account for 44% of Etsy's Q3 GMS. If Etsy wants to stabilize its revenue base, it has to address the huge decline in this group of habitual buyers who are responsible for almost half of Etsy's GMS. The silver lining is the decline has plateaued for the time being. This will be a number that investors should watch closely.

Etsy's Market Share Is Being Eroded

Sean Dunlop believes that Etsy is a wide-moat business. A business that can have its market share stolen with just advertising, where its customers can switch their shopping preference to lower-cost competitors with no repercussion, does not seem like a wide-moat business.

Advertising is necessary for Etsy's business to bring awareness of the brand and to bring its sellers to potential buyers. Lately, Etsy has been advertising less on Google and Meta, platforms where most of its active buyers are likely to be, and advertising more on TV where millennials are less likely to be watching. CFO Rachel Glasser shared this during the Q3 2023 earnings call,

... we are seeing a highly competitive landscape for advertising with some competitors investing without an eye to ROI. To be clear, this is not a game we will play. Etsy's performance marketing spending models dynamically adjust pulling back when we reach marginal return thresholds...

Our consolidated brand spend decreased 4% year-over-year as we pulled back a bit to run incrementality tests in select Etsy markets...

During the quarter, we were on air in our top three core markets and tested TV advertising in Austria and Switzerland.

I admired Etsy's stance on maintaining profitability and keeping a close eye on return on investments. CEO Josh explained further,

And even as they (Temu) invest a lot in certain marketing channels, we have other channels we can invest in. We are not going to drive a race to the bottom. We're not going to invest unprofitably. But we are, for example, shifting some spend to TV. So if we can't invest as much in some paid marketing channels, there's other channels we can invest and we're going to keep competing, and I believe can keep winning over time.

The fact is TV is a channel that is unlikely to yield results since the majority of its buyers are millennials and they are likely to be getting their information on non-traditional platforms. The fact is Etsy is being outspent in advertising by competitors like Temu and at least in the short term, its advertising efforts will be less effective, and that is likely to reflect in the Q4 sales figures.

If Etsy's core shoppers can be drawn away from Etsy to other e-commerce platforms that offer them products that are good enough at a lower price point, who is to say that the temporary shift does not turn into a permanent one?

Etsy's Core Brand Is Under Sieged

The number of active sellers increased from 7.4 million in 2022 to 8.8 million in the latest quarter. However, how many of these sellers truly believe in Etsy's mission to "Keep Commerce Human"?

Etsy's key differentiator has been the uniqueness of the handmade, crafted, one-of-a-kind products it sells. However, many sellers on Etsy have been caught reselling mass-produced items . There were some sellers on Etsy labeling the items they were selling as 'handmade' when the same items were also found at a high street discount store at significantly cheaper prices.

Buyers do not go to Etsy to find mass-market goods. They go to Etsy for special, individualized handcrafted goods that cannot be found elsewhere, and that is why they are willing to pay more for that special tailormade item. But if they start seeing that the same goods sold on Etsy are also sold on Wayfair, Amazon, Temu, eBay, or any other e-commerce site, and cheaper, why would they continue to shop at Etsy?

This is a real problem and Etsy has been tackling it with some success. CEO Josh said,

... we're investing about $50 million in enforcement throughout our policies this year. We've hired a lot of people, and we also have been investing a lot in machine learning and machine learning is really helping us to be able to identify among the 120 million listings on Etsy, those that may not conform with our policy.

However, I do not see these errant Etsy sellers stopping voluntarily, and therefore rooting out these sellers will be an uphill task for Etsy's management.

Valuation

Buffett said,

Price is what you pay; value is what you get.

Depending on what you believe to be Etsy's growth prospects, you will arrive at a different conclusion.

Factset analysts believe that Etsy will grow sales at an average rate of 9.26% annually for the next two years. The TTM P/S is 2.89 and the forward P/S is 2.78. Assuming that this average sales growth rate is sustainable, and gives Etsy some P/S expansion to 3 (I doubt there are grounds to support a return the Etsy's past 5-year average P/S of 9.3), Etsy could be fairly priced now and may offer a total annualized rate of return of 7.82%.

That is not value to me. An entry at this price does not provide me with an insufficient margin of safety. The 10-year treasury yield is 4.444% at the time of writing; it was even higher at 5% barely a month ago. Between a safe 4.444% return that I can count on versus investing in a company that is struggling to grow amidst a tough macroeconomic environment and facing tough competitors, I will need more than twice the return on the risk-free rate.

While I believe Etsy's Q4 sales will be up, I also think its earnings will come down, due to a combination of management needing to spend more to attract buyers and to reactivate previous buyers, and sellers needing to discount more which will result in a lower share of the earnings for Etsy.

Etsy also has a lot more debt than cash, and when I take these factors into account, plus considering analysts' growth estimates, and putting those in my discounted cash flow analysis, I arrive at a fair value of $51.33.

In my best-case scenario where Etsy hits all the growth estimates, the fair value would come to $63.53, which is still lower than the current stock price. And if the macro conditions drag out, buyers continue to feel the pinch in their wallets, and more are drawn to other retailers in their search for better value, forcing Etsy to do more advertising, spend more on coupons, and Etsy sellers feel the need to discount more, this vicious cycle will lead to falling earnings.

Conclusion

I am quite certain that Etsy's sales will be up in Q4 of 2023, taking into account that the job market is strong with low unemployment numbers, and bolstered by resilient consumers who do want to return to the previous spending patterns pre-COVID.

However, I also think that the sales growth may not be as significant as desired. Etsy's core buyers, the millennials, as a group, are not as financially healthy as they could be and are more indebted than other demographics. Although the Consumer Price Index indicated zero inflation month over month in October 2023, prices that did rise in October included rent, owners' equivalent rent, motor vehicle insurance, medical care, recreation, and personal care - non-negotiables that every household has to budget for.

The lifting of COVID-19 restriction measures in the last two years has also spurred spending in many areas, including expenditure on experiences like traveling. There is a limit to the number of disposable income dollars that get to go around during the holiday season, no matter how generous folks may feel. There is only so much disposable income one has after deducting for rent, mortgage, gas, food, utilities, phone bills, insurance, and child care. Consumers need to prioritize their spending and are turning more value-oriented. Retailers know this and the whole environment is getting more promotional in order to pull in consumers.

That kind of dynamic is likely going to shift some Etsy buyers to consider buying their gifts from sites that sell mass-market products that may not be unique but are almost certainly cheaper. And when these e-commerce competitors throw in free shipping and coupons to encourage high ticket spending, Etsy will find it harder to retain existing buyers and to attract new buyers.

Looking Beyond Q4 2023

Although I do believe that the sales figure in Q4 will increase, I am similarly sure that the sales in Q1 of 2024 will fall off the cliff. The following table shows the degree of sales decline following every 4th quarter of every year stretching back to 2013.

In the pre-COVID years, the average decline in sales from Q4 of a year to Q1 of the next year was -10.5% , likely a result of shopper fatigue after each intensely expensive holiday season. In the post -COVID era from Q4 2020 till Q1 2023, the average decline in sales worsened to -16.9% . That can be attributed to the ending of the global lockdown and people returning to work and school and thus having less time to shop online exacerbating the usual downseason brought on by shopper fatigue.

What about from Q4 2023 to Q1 2024? Will the decline in sales from Q4 2023 to Q1 2024 be closer to the pre-COVID average of 10% of the post-COVID average of 16%?

My take is the decline will be worse than before, and the weakness will be sustained until the macro-economic situation improves.

Finally, I do not think that buying Etsy now provides any margin of safety, considering its debt level and constrained growth prospects. I do think that Etsy will continue to be profitable, and it still has levers to press to increase sales. I just do not think that the days of adding double-digit growth in buyers or making double-digit growth in sales are returning anytime soon.

Of course, I could be way off the mark and Sean Dunlop could be right to say that Etsy is more than 50% undervalued. For, I just do not see a scenario where Etsy's fair value is $145.

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