2023-09-15 12:26:39 ET
Summary
- Despite being a consensus "Buy" on Wall Street, Etsy stock has declined by ~40% year-to-date amid a challenging macroeconomic environment.
- The company's top-line growth has slowed down after a surge in demand during the pandemic. And Etsy's M&A activity has failed to boost growth.
- Etsy's stock remains stuck in a downtrend; however, robust free cash flow generation, capital return program and reasonable valuations render Etsy investable at current levels.
- I rate Etsy a "Buy" in the $60s, with a strong preference for slow, staggered accumulation over the next 12-18 months.
Introduction
Etsy, Inc. ( ETSY ) is a fallen pandemic darling that can't seem to catch a bid from investors despite being a consensus "Buy" among Wall Street Analysts.
An analyst upgra de with a $100 price target from Wolfe Research and a hotter-than-expected retail sales report h ave lifted Etsy stock off of its 52-week low in the last couple of trading sessions; however, ETSY stock is still down ~40% year-to-date and ~80% from its all-time highs set in 2021.
Now, as you may know, Mr. Market often overshoots to the upside and undershoots to the downside. With Etsy trading at terminal multiples (P/FCF: ~13x), it could very well be a victim of irrational selling. In today's note, we will run Etsy through the Quantamental Analysis process to see if the ongoing capitulatory sell-off in its stock is a buying opportunity for long-term investors or a value trap.
Running ETSY Through TQI's QA Process
As you may know, Etsy is a niche e-commerce marketplace focused on handmade (or curated vintage) items and craft supplies. These items fall under a wide range of categories, including jewelry, bags, clothing, home décor and furniture, toys, art, as well as craft supplies and tools.
Despite facing massive competition over the years, Etsy has carved out a special place for itself in the hyper-competitive e-commerce industry as a platform for discovering and buying unique/differentiated gifts and products from (generally small) independent sellers.
After experiencing a massive surge in demand during the liquidity boom of 2020-21, Etsy's top-line growth has collapsed down to single digits with the abrupt end of the free money era leading to a digestion period. As of Q2 2023, Etsy's marketplace gross merchandise sales [GMS] are running at ~$3B per quarter (-0.7% y/y), and trending in the right direction in H1 2023 after a contraction in 2022.
Unlike many other fallen pandemic angels, Etsy is a free cash flow-producing machine that is still growing top-line sales (albeit via higher take rates [20.9% in Q2 2023] and not gross merchandise sales on its platform).
With Etsy's GMS inflecting back to positive y/y growth in recent months, I think there's a good chance of a revenue re-acceleration in upcoming quarters if the economy avoids a recession.
Etsy's "House of Brands" growth strategy saw the company embark on a debt-fueled M&A spree in 2021. While the Etsy marketplace has remained resilient in the post-pandemic world, recent acquisitions - Depop (second-hand fashion marketplace) and Elo7 (Etsy of Brazil) - seem to have failed miserably, with Etsy taking a $1B hit on goodwill tied to these acquisitions in late 2022 (leaving a hole on its balance sheet).
As of Q2 2023, Etsy had ~$1.1B in cash and short-term investments against ~$2.3B in financial debt, i.e., a net debt of ~$1.2B. However, with Etsy still producing tons of free cash flow (primarily from the Etsy marketplace), I think the debt load is very manageable.
In addition to higher interest rates and the macro environment in general, Etsy's failure to grow via M&A (with Depop and Elo7) has weighed heavily on ETSY stock, which is now trading at terminal multiples:
While Etsy's year-to-date stock slump seems like a reasonable punishment for a botched M&A strategy, the underlying trends and future projections for the business are still looking solid. According to consensus street estimates, Etsy is set to grow sales at a double-digit CAGR over the next five years.
Over the last twelve months, Etsy has generated $660M in free cash flow and spent $488M on share repurchases. Management unveiled a new $1B share-buyback program in June 2023, which should boost shareholder returns given Etsy's current stock pricing. In July 2023, Etsy announced the sale of Elo7, which marks a step back from management's "House of Brands" growth strategy. As of now, I expect Etsy to remain in capital return mode, with management unlikely to pursue M&A deals for the foreseeable future.
Now, let us evaluate Etsy's intrinsic value and expected CAGR returns using our proprietary valuation model.
Etsy's Fair Value And Expected Return
According to our Valuation Model, Etsy is worth ~$93 per share despite using conservative assumptions for growth and margins.
Now, assuming a base case exit multiple of 15x P/FCF, we get a 5-year price target of $205 for ETSY stock. This target implies a CAGR return of 25%.
Since Etsy's expected CAGR return is well above my investment hurdle rate of 15%, I like ETSY stock at current levels from a valuation standpoint.
Etsy's Technicals And Quant Factor Grades
After a spectacular run-up in 2020-21, Etsy re-traced all the way back down to pre-pandemic levels by early 2022 as you can see on the chart below. Before 2020, the $60-$70 range proved to be a strong resistance zone for ETSY stock, but this range turned into a support zone last year, serving as a launching pad for a rally back up to ~$150.
However, Etsy has failed to hold this rebound, and we are back down to that $60-$70 zone. While I do expect to see buyers emerging in this zone, Etsy is clearly in a downtrend and the stock can decline further in upcoming months.
On the daily, weekly, and monthly charts, Etsy is very close to "Oversold" territory; however, stocks can stay in oversold territory for long periods. Hence, I would avoid any near-to-medium-term investments in this counter.
According to SA's Quant Rating system, Etsy is rated a "Sell", with an overall score of 1.70/5. Etsy's single-digit growth and weak price action justify low grades for "Growth" and "Momentum". However, I think the "Valuation" [D-] and "Profitability" [F] grades are unjustified.
On a relative EV/S basis, Etsy may look expensive compared to other e-commerce companies; however, Etsy is a pure marketplace business with high margins (like Shopify), which deserves a higher relative multiple. On an earnings or free cash flow basis, Etsy looks attractively valued at ~13-14x.
Furthermore, Etsy is a highly profitable business adjusted for the one-time goodwill impairment loss of $1B. Over the next few quarters, I see Etsy's profitability grade improving considerably (as long as the macro environment doesn't deteriorate significantly).
As a long-term investor, I like to buy solid businesses with broken stocks! Considering Etsy's niche platform (brand and scale moat), robust free cash flow generation, strong capital return program, and reasonable valuation, I am willing to nibble on Etsy here, with the goal of building up a long position over a period of time despite unsupportive technicals and quant factor grades.
Concluding Thoughts
In the post-pandemic world, Etsy's core marketplace business has remained resilient, but the company has found growth hard to come by amid a challenging macroeconomic environment. Etsy's "House of Brands" growth strategy has failed to garner the desired impact, and management seems to have lost a good bit of credibility due to poor M&A deals. That said, a renewed focus on capital return to shareholders, and Etsy's attractive valuation, render the stock a buy at current levels. At this point (~13.5x P/FCF), Etsy is looking like a value play with solid growth potential.
Technically, Etsy is a broken stock, and it could be headed even lower in the coming months. As I see it, ETSY stock still finds itself in a demand vacuum with sales growth deceleration forcing an arduous shift in shareholder base from growth to value-oriented investors. Timing the bottom is virtually impossible; hence, I prefer buying via slow, staggered accumulation.
Just to be clear, Etsy is very likely to underperform as a business during recessionary environments (we are not in one yet, but could be headed there). Hence, anyone buying ETSY here must have a 3-5+ year investment horizon. At my investing group, we have initiated a position in ETSY recently, and we plan to build this position slowly over the next 12-18 months.
Key Takeaway: I rate Etsy a "Buy" in the $60s, with a strong preference for slow, staggered accumulation.
Thank you for reading, and happy investing! Please share any questions, thoughts, and/or concerns in the comments section below or DM me.
For further details see:
Etsy Is A Falling Knife Worth Catching