2023-06-12 21:12:17 ET
Summary
- Etsy's stock price has significantly declined, but the selloff is an overreaction to slowing revenue growth and shrinking margins, which I consider temporary.
- The company's investment in R&D and strong management track record suggest future growth potential, with valuation analysis indicating substantial upside.
- Despite risks such as competition and foreign exchange fluctuations, the upside potential outweighs the risks, making Etsy a "Strong Buy" recommendation.
Investment thesis
Etsy ( ETSY ) has been one of the main beneficiaries during the pandemic. The stock demonstrated a massive rally in 2020-2021. But, currently, the stock price is much lower than all-time highs. ETSY experienced a selloff even year-to-date, while many other e-growth stocks rallied substantially.
My analysis suggests the selloff was an overreaction to the company's slowing revenue growth and shrinking margins. The management has a strong track record of success and innovation. During the last quarter, ETSY increased its investment in R&D, which added pressure to the operating margin. But I believe it is temporary and not secular. Moreover, my valuation analysis suggests the upside potential for ETSY stock is massive.
Company information
Etsy is a global marketplace for creative goods, founded in 2005. The company went public in 2015 and became a member of the S&P500 index in 2020 . Etsy operates two-sided online marketplaces connecting millions of creative buyers and sellers worldwide. According to the latest 10-K report , the company's Etsy, Reverb, Depop, and Elo7 marketplaces collectively joined 7.5 million active sellers to 95.1 million active buyers as of December 31, 2022.
The company's fiscal year ends on December 31. ETSY has determined it has four operating segments, Etsy, Reverb, Depop, and Elo7, which qualify for aggregation as one reportable segment. The company disaggregates its revenue by country; the U.S. represented over half of total FY 2022 sales.
Financials
Etsy delivered a staggering 35% revenue CAGR over the past decade. As a potential investor, it is also crucial that profitability significantly improves as the business grows. The company has a solid free cash flow [FCF] margin with stock-based compensation [SBC] deducted. Though, the FCF softened significantly from pandemic highs. This indicates that the company's execution was excellent during the pandemic.
The company demonstrated a steady decline in the SG&A to revenue ratio, which means we can expect a further positive effect from economies of scale. At the same time, the company's revenue reinvested into R&D has been very stable at about 17%. It is good for investors, meaning the company is investing in improving users' experience and introducing new features to the marketplace. An e-commerce company must innovate to remain competitive in the business. Therefore, I am optimistic about the management's allocation of revenues because it will enable the company to continue differentiating itself, which was the key to the past decade's growth.
Narrowing down to quarterly financial performance, we can see that revenue growth momentum is still solid, with consistent double-digit YoY growth over several quarters, except for Q1 FY 2022.
On the other hand, we see that cost of revenue and operating expenses grew faster than the topline during the last quarter. The gross profit growth was slightly lower than the revenue growth, which is ok for me. But the operating profit has been declining for a few quarters in a row, so I need to dig deeper here.
As we can see, the operating margin shrunk substantially from about 15% last year and became much closer to 10% in Q1 of FY 2023. It is a significant margin contraction, but I would like to highlight that it was not because of the increasing portion of SG&A to revenue. It is because of the significantly increased R&D to revenue ratio, from 15.5% in Q1 of 2022 to 18.1% in Q1 of 2023. It means the company keeps an eye on its SG&A expenses and increased investment in R&D. The story of stellar revenue growth over the past decades gives me high confidence that these R&D expenses will likely fuel future growth. Therefore, I consider the narrowed operating margin temporary and not secular.
The company's balance sheet looks healthy, with over $1 billion in cash and cash equivalents. Liquidity ratios also look robust. The company is in a net debt position, but it is not a problem, given solid free cash flow margins. The interest-covering ratio looks solid, even with a recent weakness in operating margin.
Valuation
The Etsy stock declined almost 20% year-to-date and significantly underperformed the broad market. Seeking Alpha Quant assigned ETSY the lowest possible "F" valuation grade. The company's valuation ratios are far higher because of the significant discrepancy between ETSY's multiples and sector median. But, I want to underline that current multiples of ETSY are much lower than the company's 5-year averages across the board. For a growth company, it indicates undervaluation.
I use discounted cash flow [DCF] approach to evaluate ETSY stock. Valueinvesting.io suggests that the company's WACC at about 8%. I consider this too loose, and I prefer to be more conservative. Therefore, I use an aggressive 10% discount rate. I have earnings consensus estimates suggesting revenue will compound over the next decade at about 10.5% per year. As seen in the "Financials" section, the FCF margin has been volatile over the past decade, so it might be tricky to project it. I use the FCF margin, which I derived from calculations derived from TTM data. Therefore, the FCF margin I use for FY 2023 is 11.9%, and I expect it to expand by 75 basis points yearly. The peak FCF margin projected for FY 2032 is still lower than the company's all-time high achieved in FY 2020. Therefore, I consider my FCF assumptions very conservative.
Under these assumptions, my DCF template returns the business's fair value at about $18 billion, significantly higher than the current market cap. According to calculations, the upside is substantial at approximately 62%.
This might look too good to be true for bears. Therefore, let me also simulate the second scenario with much softer assumptions regarding revenue growth and FCF margin. For a pessimistic scenario, I use an 8% revenue CAGR and expect the FCF margin to expand by 50 basis points yearly instead of the 75 I used for the base case scenario. Even under these very pessimistic assumptions, you can see that the stock is still undervalued with a 9% upside potential.
To conclude this part, the ETSY stock is significantly undervalued. The margin of safety is attractive, especially given the undervaluation, even with very pessimistic underlying assumptions.
Risks to consider
Investors in growth stocks face a significant risk that the company may fail to deliver the expected growth rate or improve profitability as the business scales up. The valuation model assumes cash flows that will be generated over the next decade and beyond, and many unfavorable factors can happen over such a long period.
Etsy's offerings are differentiated from other e-commerce players, but the landscape is rapidly evolving. The possibility that a giant like Amazon ( AMZN ) might become Etsy's direct competitor is not equal to zero. If so, it will be very challenging for Etsy to keep up with this behemoth with unmatched financial and human resources.
The company generates about half of its revenue outside of the U.S., meaning that financial performance is vulnerable to fluctuations in foreign exchange rates. Broad geography also means elevated regulatory and taxation risks as the company operates in various countries with different legislation. This means a high risk of fines and penalties if the company fails to comply with foreign legislation.
Bottom line
Overall, the upside potential massively outweighs the risks. The year-to-date selloff we have seen provides an attractive buying opportunity. Yes, the company experiences downward pressure on profitability metrics, but it is temporary. The current stock price offers an appealing investment opportunity with massive upside potential. Therefore, I assign ETSY a "Strong Buy" rating.
For further details see:
Etsy Is An Apparent Strong Buy For Me