The specialty e-commerce marketplace Etsy (ETSY -2.35%) was a major winner throughout the coronavirus pandemic. Handcrafted masks, DIY home improvement kits, and personalized gifts kept millions of buyers safe and connected in 2020.

While no company can maintain triple-digit growth in the long term, Etsy stock took a hit when company leadership admitted that it expects growth to slow from its pandemic heights. However, Etsy's trajectory still makes it a compelling growth stock.

Making sense of the sell-off

Etsy shares dropped almost 15% over the last week, following the company's earnings report for the first quarter of fiscal year 2021. The company's results exceeded expectations, with a 142% increase in revenue and a 1,048% increase in net income over the prior-year quarter. Gross merchandise sales (or GMS -- the total value of goods sold through the platform) increased 132% to $3.1 billion, and GMS per active buyer was up 20% over the prior-year period.  

All of these numbers are impressive, but growth in GMS per active buyer is especially important for long-term growth. Habitual buyers (i.e., a buyer who makes six or more purchases and spends at least $200 over the trailing 12 months) represent 40% of Etsy buyers and its fastest-growing buyer segment, with habitual buyer GMS up 205% over the prior-year period.

Woman on laptop at desk with parcels

Image source: Getty Images.

Strong network effects are at play here for Etsy's benefit -- the more buyers shop on Etsy, the more sellers open up shop there in hopes of earning their business, and those sellers in turn attract more new buyers.  

However, investors weren't very concerned with the details of this quarter, instead turning their attention to the next quarter. Etsy CFO Rachel Glaser shared the company's second-quarter estimates for slowed year-over-year growth in revenue and GMS, while reminding analysts on the earnings call that the prior-year period was not just any period for comparison purposes. The second quarter of 2020 ushered in the initial facemask-buying frenzy, with masks accounting for 14% of Etsy's GMS. Masks now account for less than 3% of total GMS. 

Still, the market was disappointed by the second-quarter guidance. On the day after the earnings report, investors sold off Etsy stock in the largest single-day selling volume in the past year. 

Digging into success drivers

Well-executed internal strategies drove Etsy's strong results in Q1. Its significant growth in habitual buyers was owed partly to enhanced user experiences like engaging product videos, personalized recommendations on buyers' home pages, "buy now pay later" options, and updates from buyers' favorite shops.

These factors contribute to Etsy's unique value proposition -- the site is not just an e-commerce platform, but also an engaging community in which sellers can connect to small businesses and buy products that are customized and completely unique.  

Between a growing base of habitual buyers and growing average GMS among those buyers, it's clear how Etsy is achieving continued top-line growth. The quadruple-digit bottom-line growth is a different story, primarily resulting from Etsy's ultra-high-margin seller services segment, even despite the fact that seller services revenue accounts for only 25% of total revenue.

Though Etsy doesn't disclose its exact margin for this segment, revenue from seller services like Etsy Ads (which allows sellers to promote their products on-platform) and Etsy Payments (which enables sellers to facilitate payments for their products) grew by 90% and 156%, respectively. Clearly, it is the increase in active sellers, not (directly) the increase in active buyers, that played the biggest role in Etsy's 74% gross margin and huge bottom-line growth.  

Why this business model is built to last

Etsy is a platform built for the growing shopping (and selling) trends of our time. In a study of 1,600 Americans during the pandemic, Red Egg Marketing found that over 80% of people would rather spend more money to support a local small business than spend less money to buy from a large corporation.  

Combine this sentiment with millennials' and Gen Z's growing attention to ethical sourcing, socially responsible business practices, eco-friendly packaging, and desire to support women-owned and minority-owned businesses -- and Etsy's highly connected platform is poised to benefit. Etsy buyers connect seamlessly to the small businesses they buy from, allowing them a relatively transparent look into the shop owner's life and business practices.

According to the company, 83% of Etsy sellers are women. 2020 census data revealed that the number of women-owned businesses had increased 21% over the past five years, while all businesses increased only 9%. The implication of these combined data is a continued increase in seller activity on Etsy as more women-owned businesses launch and list their products on Etsy, leading to higher revenue through network effects and higher margins through seller services.

The bigger picture

With $1.7 billion in cash and positive free cash flow, Etsy has a healthy balance sheet with well-covered debt. After rallying more than 300% during the pandemic, then dropping 25% in the last three months, Etsy is not so much a value stock as it is a growth stock, with comparable companies like (JD -2.98%) generally trading at cheaper multiples.  

Going forward, look for continued double-digit growth in active buyers, especially ultra-valuable habitual buyers (currently 8 million), and active sellers (currently 4.7 million), as more women-owned businesses are expected to open up shop.  

From both the buyer and seller perspective, no competitor matches Etsy on both the unique product personalization factor and the built-in community factor. Therefore, the platform's network effects and improving user experience should be more than enough to retain and profitably grow its community. Investors who believe in the growth vision and hold for the long term are poised to benefit.