With people spending more time than usual at home during the worst of the pandemic, Etsy (ETSY 3.22%) benefited tremendously. Consumers turned to e-commerce merchants for not only things like face masks but for other products like home furnishings and apparel as well. And Etsy's unique and handcrafted offerings were in great demand with customers.
Despite year-over-year revenue growth of 5.2% in Q1, a sharp deceleration from prior quarters, Etsy has proven to be a cash machine, generating positive free cash flow (FCF) on a consistent basis. In an uncertain economic environment, like the one that the U.S. is currently in, investors should seek businesses that possess a superb financial profile.
Etsy's stock may be down 62% over the past year, but the company still has a bright and profitable future.
Etsy operates a capital-light business model
Because Etsy doesn't own any inventory and simply connects buyers and sellers on its various marketplaces (Etsy, Reverb, Depop, Elo7), its business model scales extremely well and is very profitable. After foundational investments are made in building out the technological infrastructure, for marketing to attract more users (there are 95.1 million active buyers and 7.7 million active sellers today), and corporate overhead functions, incremental revenue produces very high margins.
As a result, Etsy's operating margin has expanded significantly from 5.1% in 2016 to 21.6% in 2021. Furthermore, with low capital requirements for purchases of property and equipment and for development of internal-use software, representing 1.6% of sales in Q1, the company is sustainably FCF positive. In 2020 and 2021, it produced $1.3 billion in total FCF (excluding cash paid for acquisitions) on combined revenue of $4.1 billion. This is the mark of an exceptional business.
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Free cash flow is an unquestionably important metric that investors must keep an eye on to gauge how well a business is performing. This is because the ultimate goal of any profit-seeking enterprise is to produce cash. At this stage in its life cycle, a company has no need to raise external financing in the form of equity or debt, which is generally viewed negatively by the market, and instead can even start to return capital back to shareholders in the form of dividends and buybacks. In fact, over the past 21 quarters, Etsy has repurchased $1.2 billion worth of shares.
If investors believe that Etsy will generate more FCF five years or a decade from now than it does today, then it's a virtual certainty that the stock price will be higher in the future. As I touched on earlier, Etsy's shares are down substantially over the trailing 12 months, and they now carry a price-to-earnings ratio of just over 26 (the lowest in the company's history) and a price-to-sales ratio of 5 (near the lowest it has ever been).
Unlike many other high-growth tech stocks that have been getting crushed recently, Etsy actually makes money in the form of cold, hard cash. If the Federal Reserve's tight monetary policy causes a recession in the near term, investors will be happy to own this top online marketplace. It should be able to weather whatever the economy throws at it.
