Summary
- Despite boasting great margins and high level of profitability, Etsy, Inc. has been showing for the past few quarters some warning signs.
- GMS growth across all of Etsy's brands has basically stalled, while even habitual buyers have been consistently declining.
- Shares are trading at a premium, which adds a lot of risk in a potential repricing to more subdued multiples due to lack of growth.
Etsy, Inc. ( ETSY ) published its final quarter report for FY2022 a few days ago and once again showed, in my opinion, some warning signs. I have been a happy ETSY shareholder for the past 4 years, however, in my opinion 2022 as a whole really showed some cracks in the bull thesis, at least at today’s valuation. I have very high regard for what management has been able to build: Etsy has carved out for itself an enviable position in the e-commerce space and enjoys a very high level of profitability. Nevertheless, as I will explain in this article, I have reached the conclusion that the risk-reward scenario at today’s price is actually quite unfavorable.
Fourth quarter 2022 overview
Etsy reported fourth quarter results on February 22 posting positive headline numbers. Revenue grew 12.6% to $807 million, which was slightly more than analysts were expecting. On the bottom line, things also looked quite rosy as the company generated about $283 million of Free Cash Flow and $109 million of GAAP Net Income. The market initially reacted positively to the report, bidding the stock up about 5%, but ultimately Etsy ended the week basically flat.
Under the hood, things did not look that positive unfortunately. Despite the growth in revenue, the company saw a muted engagement from its customers base as shown by several metrics. First and foremost, Gross Merchandise Sales in the quarter decreased -4% YoY to $4 billion also due to the impact on unfavorable currency movements. However, even by disregarding the currency headwind, the figure would have been basically flat at -0.7%. Even by considering the entire FY2022, GMS growth tells a completely different story compared to previous years: the value of everything sold on Etsy grew 29.6% in 2021, 106% in 2020 and 26.5% in 2019. Clearly the slowdown in GMS growth signals the end of the COVID-pandemic tailwinds that Etsy has enjoyed for the past 2 and a half years, however, that raises a very important question pertaining to the fundamentals of the bullish theory here: has Etsy peaked?
After years of high growth, things have stalled
COVID has turbocharged the business, assisted the company in pulling forward a lot of growth that without it would have possibly happened in a decade. Where does it leave a business like Etsy? Management has already raised prices multiple times in the past years, which is a dangerous practice as they risk potentially churning sellers. The only way to organically grow the business is to fuel the network effect, attracting new buyers, which in turn will attract new sellers as well. Ultimately, it will lead to higher GMS and higher revenue generated by Etsy when a transaction happens on the marketplace.
To highlight how Etsy grew permanently stronger during COVID, management has provided a slide showing how the company has substantially grown since 2019 in every possible metric. I agree with management that the company took full advantage of the macro conditions in 2020 and 2021 in order to become the marketplace of choice for handmade goods, despite many people doubting that the company could move away from being a temporary play on the sale of covid masks. I believe that management is right in highlighting this achievement, however, that does little for clearing the water on what is the future prospect for the business.
Etsy 4Q 2022 Presentation
Another sign that customer’s behavior is normalizing after the COVID-shock is the performance of the 6 biggest item categories sold on Etsy. Home & Living, a category that experienced an explosion of demand when people were locked at home and which represents around 30% of total GMS has experience a single-digit drop during FY2022. Craft Supplies , another category that overall saw an increased demand during COVID has actually declined double digits. More social and outdoorsy categories such as Apparel and Paper & Party Supplies actually offset these declines as more and more people have been favoring experiences over hard goods. All in all, however, GMS was pretty much flat YoY as already explained, which indicates that the weight of “indoor” categories still matters a lot more in Etsy’s case.
Etsy 4Q 2022 Presentation
Although Etsy managed to acquire 9.5 million new buyers during Q4 2022, more important metrics such as habitual buyers disappointed. That is a bit worrisome, as this buyer cohort actually contributes massively to the top line as they generated around 44% of total GMS. Habitual buyers at the end of Q4 were about 7.4 million, down around 9.4% from Q4 2021. Just to clarify, Etsy identifies habitual buyers as those customers with at least 6 purchase days and over $200 dollars spent over the course of the previous 12 months. Habitual buyers have been actually declining sequentially for the past few quarters, hinting even more to a shift in consumer habits as well as sentiment.
How to reignite growth
One avenue of growth will be international expansion and consolidation. Etsy is already present in many markets, however, a lot has been done in trying to raise awareness for the brand and grow the local business. For example, management has specifically called out how Germany GMS was up double-digits YoY during FY2022, and how Etsy in India has onboarded over 120,000 sellers which listed around 5 million products.
Etsy 4Q 2022 Presentation
Management has also provided details in relations to the collection of brands that has been built through acquisitions over the past few years. Etsy has added to its portfolio Reverb, Depop and elo7, all three dedicated to a different niche of the e-commerce market. During FY2022 all three combined contributed $1.5 billion in GMS, around 11% of Etsy's total GMS. Management has disclosed in the Annual Report that Reverb’s GMS declined 0.6%, mirroring the performance of Etsy as a whole while no clear numbers were provided for Depop and elo7.
Overall Etsy has been very keen to put cash to work and acquire some growth this way, which seems like a smart strategy considering that the market for handcrafted, unique products is generally much more fragmented than the classic retail landscape. I won’t be surprised if Etsy will be able to fuel some growth once again by completing acquisitions in the future, primarily thanks to the high amount of cash that the business generates.
Valuation and key takeaways
Despite some red flags in terms of growth, Etsy, Inc. remains today a very high quality business. The company enjoys steady high margins, an increasing network effect between buyers and sellers, and strong brand recognition among customers. FY2022 was also the third year in a row of over $600 million in Free Cash Flow generated, although that figure came in pretty much flat since the peak in 2020. The problem is, without achieving GMS growth I don’t see how Etsy can consistently grow free cash flow without simply raising the fees charged to sellers. And the last time that happened, they were not very happy .
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I personally love Etsy and I have been holding shares since 2019. I’ve seen the business grow beautifully as management capitalized on every opportunity that the crazy years we lived through since 2020 provided them. The last few reports, however, made me doubt about the future growth of the company, especially on today’s valuation. At a market cap of $15.6 billion, the company trades at a premium Price to Sales of 6, and Price to TTM FCF of about 23. I worry about stagnating GMS growth as well as declining activity from habitual buyers, all signs that point over a general lack of catalysts for the next few years.
Etsy should still be a great business, still print lots of cash, and be the de-facto marketplace for unique products. However, if the low-GMS growth will become the normality, I see the stock repricing downward to a sub-20 Price to Free Cash Flow as a real possibility. The stock has to earn its premium, and I fear that Etsy will actually be unable to do so.
For these reasons, I decided to sell my Etsy, Inc. shares and I overall do not consider today’s price as a good entry point. Nevertheless, this is a stock to monitor in order to take advantage of the market volatility and potentially scoop up some Etsy, Inc. shares at a discount in the future.
For further details see:
Etsy: Stagnating GMS Threatens The Bull Thesis