2023-05-11 05:29:26 ET
Summary
- Etsy has outperformed the market over the last five years.
- This is due to the firm’s underlying profitability and exceptional growth.
- Nevertheless, the firm experiences significant churn suggesting that the model can be improved and that Etsy is vulnerable to competition.
- Nevertheless, the firm remains attractive, at least in the near term.
Global platform, Etsy ( ETSY ), is a phenomenally successful marketplace, with a history of profitability, solid returns and strong free cash flow generation. The firm creates far more value than it takes, providing significant room for growth. However, the firm has a clear weakness: it does not seem to be as attractive for its buyers as it first seems. While the business is attractive, it is not suitable for an invest-and-forget approach.
In the last five years, Etsy's has generated a total shareholder return (TSR) of nearly 210%, compared to a relatively disappointing 56% or so from the S&P 500 ( SPX ).
Network Economies
Etsy is a two-sided platform, matching active sellers with active buyers. The number of active buyers has grown from 39.45 million in 2018 to 95.08 million in 2022, at a 5-year CAGR of 19.24%. In Q1 2023, the number of active buyers was 95.3 million, compared to 95.1 million in Q1 2022. The number of active sellers has grown from 2.12 million in 2018 to 7.47 million in 2022, at a 5-year CAGR of 28.65%. In Q1 2023, the number of active sellers was 7.94 million, compared to 7.65 million in Q1 2022. The pattern of growth in both these numbers makes the platform increasingly attractive to the marginal seller or buyer, creating network effects that drive value creation.
Bill Gates is reputed to have said that , "A platform is when the economic value of everybody that uses it, exceeds the value of the company that creates it. Then it's a platform." We can see very clearly that Etsy is a platform. In the last five years, the company has grown gross merchandise sales ((GMS)), which represents how much sellers made on the platform, from $3.93 billion in 2018 to $13.3 billion in 2022, at a 5-year CAGR of 27.6%. In Q1 2023, GMS was $3.1 billion, compared to $4 billion in Q4 2022 and $3.25 billion in Q1 2022. Meanwhile, revenue has grown $604 million in 2018 to $2.57 billion in 2022, at a 5-year CAGR of 33.55%. In Q1 2023, revenue was $641 million, compared to $807 million in Q4 2022 and $579 million in Q1 2022.
What this shows is that Etsy is capturing just a fraction of the value that it is creating. This provides the company with ample room to continue to grow revenues in future, because the platform's active sellers keep the bulk of value created. This value creation occurs as the number of both active sellers and active buyers grows, which provides buyers with more choices at declining prices, and provides sellers with more buyers to sell to. So long as Etsy continues to create more value than it takes, its long-term potential will continue to be high.
Profitability and FCF Generation
Since 2018, Etsy has grown gross profits from $412.93 million in 2018 to $1.82 billion in 2022, compounding at 34.54% a year. Gross profitability, which scales gross profits by total assets, has grown from 0.46 in 2018 to 0.69 in 2022. This is way higher than the 0.33 threshold for attractiveness observed by Robert Novy-Marx , and reflects the asset-light nature of the business.
The firm's operating margins have deteriorated from 12.39% in 2018 to -25.66% in 2022, on the back of the steep losses the company faced in 2022. The firm's net income has declined from $77.49 million in 2018 to -$694.29% in 2022. If we take out 2022, the four years prior saw earnings compounded by 44.8%. This gives an indication of the strength of the business model, when we take out the much-publicized exceptional losses of 2022 .
Etsy has generated enormous free cash flows ((FCF)) over the last five years, growing them from $178 million in 2018 to $653 million in 2022, compounding at 29.69% a year. That represents $2.32 billion in FCF over a 5-year period, or 20.3% of the firm's market cap. In Q1 2023, the firm generated $47 million in FCF. The firm has shown good but unsteady returns on invested capital ((ROIC)), which have declined from 12% in 2018 to -22% in 2022, declining to -23% in the TTM period.
These results show tremendous strength in the business, with enormous possibilities, but they also indicate a weakness in the business model.
A Not So Loved Platform
Etsy calculates active buyers, who bought within the trailing twelve months, new buyers, and reactivated buyers, who bought in the last year and had not bought in the year prior. Following MBI Deep Dives , we can calculate Etsy's "consistent buyers", who are buyers who have bought on Etsy over two consecutive years. When we calculate this metric, we discover that the number of consistent buyers is a fraction of active buyers, amounting to around 30% to 45% of active buyers. Implied churn as a percentage is incredibly high, at over 50% in the full years since 2018.
Active Buyers (in millions) | New Buyers (in millions) | Reactivated Buyers (in millions) | Consistent Buyers | Implied Churn | Implied Churn as a Percentage | |
2018 | 39.45 | 17.5 | 10.4 | 11.55 | ||
2019 | 46.35 | 19 | 12.6 | 14.75 | 24.70 | 62.61% |
2020 | 81.90 | 38.4 | 22.3 | 21.20 | 25.15 | 54.26% |
2021 | 96.34 | 34.8 | 21.4 | 40.14 | 41.76 | 50.99% |
2022 | 95.08 | 29 | 24 | 42.08 | 54.26 | 56.33% |
Q1 2023 | 95.53 | 6.7 | 6 | 82.83 | 12.25 | 12.88% |
Source: Etsy Filings and Author Calculations
These horrific numbers are the tale of a business which, despite being strong, has clear weaknesses. Buyers are simply not finding that their experience of using Etsy, or the utility derived from the platform, is high enough for them to return. This weakens Etsy's ability to grow revenue and profits in future, and opens the platform up to a peer with a superior value proposition.
Valuation
Etsy has a price/earnings (P/E) multiple of -19.66 compared to the S&P 500's P/E multiple of -23.84 . This is a perverse undervaluation, and the firm's FCF yield tells a truer story of the economics and attractiveness of the business. With $600 million in FCF in the TTM period, Etsy has an FCF yield of 4.69%, compared to the market's FCF yield, which New Constructs estimates to be 2.7% . Finally, the firm has a very attractive gross profitability, at 0.69.
Conclusion
Etsy operates a two-sided marketplace that generates enormous value for its active sellers and active buyers. Value creation continues to grow as buyers and sellers are added to the platform. The strength of the business can be seen from its profitability, and FCF generation. However, the business does have significant weaknesses in its ability to retain buyers. This opens the platform up to threats from platforms that can generate a superior experience or value proposition than Etsy. This weakness makes the company unsuitable for long-term investment. Rather, investors should invest in the business with a watchful eye to threats and any signs that churn is starting to affect the firm's profitability.
For further details see:
Etsy Is Attractive Despite Its Struggles To Retain Buyers