Summary
- We were not impressed with Etsy's Q4 and 2022 results.
- For several quarters, the company has only managed to retain most of its Covid period GMS gains, and failed to grow the marketplace in a significant way.
- To justify the current valuation, the company has to prove that it can convert product development and marketing investments into GMS growth.
In the past, we have been very optimistic about Etsy ( ETSY ), writing for instance that shares offered significant value when they were around $110. Unfortunately, what we have seen from the company, for several quarters now, is that management keeps boasting how they've been able to retain most of the pandemic gains, while making little additional progress. This is in spite of the very significant investments the company has been making to improve the user experience, as well as marketing investments. We believe it was reasonable to give the company a few quarters to consolidate the pandemic gains, but now it is time for the company to start showing some real growth again, otherwise the current share price is difficult to justify.
We are looking in particular at gross merchandise sales ((GMS)) growth, that is to say the size of the economic activity taking place on Etsy's platform. The company managed to deliver ~10.2% revenue growth in FY2022, but most of it came from increasing sellers' fees. We believe growing revenue in that way is not sustainable long-term, and it risks alienating some of the Sellers on its platform. Sellers are critical for the company to remain an attractive and vibrant marketplace. The most important metric, in our opinion, is therefore GMS, which for Etsy in 2022 was ~$11.8 billion. When consolidating the rest of the platforms, including Reverb, elo7, and depop, it reached ~$13.3 billion. For comparison, the enterprise value of Etsy is currently about $16.7 billion, and its market cap is about $15.4 billion.
Investments
The thing that concerns us the most is that the company is clearly ramping up investments to the detriment of profitability, all to stay roughly in the same place. As can be seen below, from FY2019 to FY2022 the company more than tripled its annual marketing spend. In spite of this, growth was very disappointing in 2022. If all you get from ramping up marketing investments is retaining previous growth, that is not a great result for what is supposed to be a growth company. During the earnings conference call CFO Rachel Glaser made a comment that highlights our concern, she said:
For the Etsy marketplace specifically, performance marketing spend drove approximately $2.5 billion in annualized GMS in 2022, up from $2.3 billion in 2021. Moving to Etsy marketplace performance on a stand-alone basis. During the fourth quarter, Etsy marketplace GMS declined 3.5% year-over-year and was largely flat on a currency-neutral basis.
In other words, GMS was flat on a currency-neutral basis, yet the amount of GMS that came from paid channels was ~$200 million higher. This is the opposite of what we want to hear, we would prefer to hear that more revenue is coming from direct customer visits.
Etsy Investor Presentation
Similarly, product development investments started increasing in 2021 and significantly ramped up during 2022. The company says that these investments usually have a pay back of ~18 months. It will therefore be very difficult for the company to justify another year of lackluster growth in 2023, when we should have already started seeing some benefits in 2022. While the increase from 2020 to 2021 appears to be a modest 2%, in reality the dollar amount would appear much higher given the increased revenue in 2021, than it is showing the investment as a percentage of revenue.
Etsy Investor Presentation
Financials
These investments are clearly impacting the bottom line, with the adjusted EBITDA margin declining ~300 bps from Q4 2021 to Q4 2022. We therefore have the bad combination of GMS declining ~4% y/y, and profit margins decreasing ~300bps. That is not what is supposed to happen when you ramp up marketing and development investments. Revenue has been increasing, but that is mostly the company increasing the take rate from Sellers, which we view as risky as it can alienate one of its most important stakeholders.
To be clear, we continue to believe Etsy is an attractive business with solid profit margins and a strong competitive moat. We are just pointing out that the company is so far showing relatively few benefits from its increased investments, and that the valuation is more difficult to justify if the company fails to re-ignite growth.
Balance Sheet
Etsy ended the year with ~$1.2 billion in cash and financial investments, and a $200 million revolver that is currently undrawn. It also has ~$2.2 billion in long-term debt. During Q4 the company repurchased $150 million in stock, but much of this repurchases serve only to help offset the effects of stock-based compensation, which has significantly increased in recent years.
Growth
One of the most sustainable ways to grow revenue is to grow the number of customers, and here we are very disappointed with Etsy. The number of active buyers is actually a bit lower in Q4 2022 compared to Q4 2021. Looking at the last few quarters, the trend is as flat as a pancake, and it is not reflecting the increased marketing spend.
Etsy Investor Presentation
Valuation
In terms of valuation, we believe shares are currently neither too cheap nor too expensive, assuming the company's growth is not permanently impaired. The EV/Revenues multiple is currently very close to the ten year average.
Given that the company has not yet proven that its increased investments will do more than just retain Covid period gains, we are double downgrading our rating to 'Hold' from 'Strong Buy' previously. We'll continue to follow the company, and see if it is able to re-ignite growth in the next few quarters.
The price/earnings ratio also looks reasonable when compared to the ten year average, however it is quite high for a low-growth company. Bringing us back to the point that the company needs to start growing its marketplace at a decent rate if it is to deserve its current valuation.
Analyst appear optimistic that Etsy can grow earnings and revenue the next couple of years at a decent rate. This is a double edge sword, however, as it means shares have significant room to fall should these analyst estimates prove too optimistic.
Seeking Alpha
Risks
Internet retailing is proving to be a very competitive business, just as regular retailing has been for decades. This means the company will have to compete with very tough Internet retailers and marketplaces, including the likes of Amazon ( AMZN ) and eBay ( EBAY ).
The biggest risk we see for investors, however, is a valuation that reflects growth expectations that the company is currently failing to deliver. Should investors become convinced that Etsy is no longer a "growth company", shares could significantly decline from current prices.
Conclusion
We were not impressed with Etsy's Q4 and 2022 results, despite liking the company and its business model. It has been many quarters where the company has just managed to retain most of its Covid period GMS gains, but failed to grow the marketplace in a significant way.
While it was to be expected that the company would face tough comparisons for a few quarters, we believe it is now time for the company to show that it can grow from this higher base. Especially when it is increasing investments in marketing and product development to the detriment of profitability. Given this reality, we are double downgrading the shares to 'Hold' from 'Strong Buy' previously, until the company proves it can grow its marketplace GMS in a meaningful way once again.
For further details see:
Etsy: Retaining Previous Gains Is No Longer Enough (Rating Downgrade)