Etsy (ETSY 0.11%), like many other businesses that were fueled by the pandemic, is facing difficult year-over-year comparisons amid a slowdown in growth as economies reopen. Add in rising interest rates and other macroeconomic headwinds, and investors have completely soured on high-growth tech companies. Obviously, growth in excess of 100% can't go on forever, but that doesn't mean it's time to completely write off these businesses.
With Etsy's stock down an eye-popping 64% in 2022, now is a fantastic time to scoop up some shares. Let's take a closer look.
Etsy operates a differentiated marketplace
While Etsy was posting fantastic growth prior to 2020, the pandemic completely supercharged its prospects. More consumers turned to the online marketplace as physical shopping faced major restrictions with shoppers looking not only for face masks but other items like bread makers as they took advantage of increased leisure time. Etsy's flexibility was on full display, causing revenue to jump more than 125% in four straight quarters starting with the second quarter of 2020.
But in the first quarter of 2022, sales only rose 5% year over year. And this is part of the reason why the stock has sold off. However, it can't be a surprise that with pandemic restrictions easing and consumer mobility on the rise again, Etsy would face some near-term headwinds.
What investors must do is take a step back and focus on the underlying fundamentals of Etsy's business. For starters, the company continues adding more users with each passing quarter. As of March 31, there were 95.1 million active buyers and 7.7 million active sellers on the platform, up 4.9% and 62.8%, respectively, from the prior-year period. And gross merchandise sales (GMS), which is the total transaction value on the site in any given period, hit $3.3 billion during the quarter, up 3.5%.
A critical component of any investment thesis is what value a business provides to its customers. And with Etsy, the value proposition is strikingly clear. The company provides buyers with handcrafted and unique items. A company survey from 2020 indicated that 88% of buyers said Etsy sold goods that they couldn't find anywhere else.
Furthermore, from a sellers' perspective, Etsy makes it seamless and extremely easy to not only start but operate an online business. Additional services like search discovery, advertisements, payments, and shipping are invaluable, especially for those looking to take on side hustles and small entrepreneurial ventures.
Etsy's financial picture is better than most other companies out there. In 2021, the business registered a gross margin of 71.9% and an operating margin of 20.0%, both up significantly from just a few years ago. Because Etsy doesn't manufacture products itself, own any inventory, or invest in fulfillment centers, its current operating model requires minimal capital expenditures. That's why free cash flow totaled $623 million in 2021 (excluding acquisitions).
The market opportunity for Etsy is absolutely massive. Management repeatedly points out that in the company's seven core geographies, which include the U.S., U.K., Canada, Germany, Australia, France, and India, the potential GMS in relevant online retail categories is roughly $466 billion. Based on 2021 figures, Etsy's market share is just 2.6%. There is still a ton of growth potential as we look to the decade ahead, and that means greater sales, profits, and cash flow, translating to a higher stock price.
Etsy's valuation looks attractive
Despite the unsurprising slowdown in growth compared to the peaks reached during the pandemic, Etsy's fundamentals remain sound. And this is what investors should require first and foremost before making an investment decision. The next piece involves a look at the company's valuation.
Etsy's price-to-earnings (P/E) ratio is 26.5. With the stock's recent decline, this valuation is far lower than what it was a year ago, and nearly the cheapest it has been in the last five years. It's safe to say investors have written off much of this company's prospects.
But as an outstanding business that has exhibited tremendous historical growth, possesses superb financials thanks to its capital-light operating model, and still has a long expansion runway in front of it, Etsy looks like a solid addition to investors' portfolios today.