Etsy (ETSY 4.76%), an online marketplace for unique items, reported earnings for its second quarter of 2022 just a few days ago. The market seemed to be overjoyed with the results as the shares jumped nearly 10% the day after the report.

Short-term price movements -- down or up -- often fail to tell the full story, and while Etsy's results were quite encouraging, taking the sharp rise in share price at face value may blindside business-focused investors. Let's dig deeper to see why. 

Resilient growth in the face of macro headwinds

Etsy's online marketplace has become a popular shopping destination for over 90 million buyers. The appeal of the exclusive and hand-crafted goods keeps those buyers coming back to Etsy's platform, and as buyers grow, they attract more sellers, creating a network effect and a key source of competitive advantage for Etsy. 

The second quarter wasn't an exception to that trend. For the period ended June 30, Etsy reported that the number of buyers increased from 90.5 million a year ago to almost 94 million. The number of sellers went up from 5,233 to 7,403 for the same period.

Equally impressively, Etsy's gross merchandise sales (GMS) -- the total value of all transactions on its platforms -- stayed relatively flat at just over $3 billion for the quarter. That means Etsy is able to hold onto the massive, pandemic-fueled gains it made in 2020 and 2021 when GMS spiked 107% and 31% respectively. That's not an easy feat.

And to top it off, despite the flat year-over-year GMS, the company grew its revenue by 10.6%, thanks mainly to the increase in its seller transaction fees -- a big portion of its take rate -- from 5% to 6.5% that the company instituted on April 11, 2022. The continued growth in the number of sellers despite that increase in the seller fee also underscores the value of Etsy's platform.

A person making a hand-crafted gift item.

Image source: Getty Images.

Whether the current economy is in a "recession" or not, what is evident is that the consumers have been hurting for some time because of the historically high inflation and rising interest rates. Consumer confidence is close to its lowest level in the past 25 years. It is quite remarkable that Etsy is still able to attain this growth in buyers, sellers, and revenue in such challenging conditions.

Not as clean as it initially looks

While Etsy attained that steady year-over-year growth, it is coming at a higher cost relative to past years. The company's operating expense for the quarter increased to over $341 million, or 58.3% of the revenue. That's much higher than 55% a year ago and 56% for FY 2019 and 2018, pre-pandemic. One driver of the increasing operating expense is the growth in Etsy's headcount arising from its 2021 acquisitions of Depop, a fashion resale marketplace, and Elo7, the "Etsy of Brazil."

Etsy's stock-based compensation awards -- where employees are awarded shares of the business with the intent of aligning the organization's success with the individuals -- grew dramatically to over $64 million for the quarter, or over 11% of the revenue. For reference, Etsy's stock-based compensation on an annualized basis has never exceeded 6.3% of its revenue over the past five years. And Etsy's stock-based compensation of over $113 million for the first six months of 2022 is more than double the $48 million for the same period in 2021.

Stock-based compensation is a valuable and popular tool of incentivizing and retaining top talent. However, it has two potentially negative effects. First, it is dilutive to existing investors, and second, if Etsy doesn't grow its revenue at a higher rate than its expenses, the stock-based compensation is a major contributor to the decline in profit margins. And the net income margin of 12.5% for the latest quarter -- much lower than 18.6% a year ago and 15% a quarter ago -- points to that possible concern. 

Etsy's strategy of becoming a "House of Brands" is certainly powerful as it allows the company to create multiple sources of revenue, but the company has to back that strategy with successful and synergistic integrations of Depop and Elo7. Rising acquisition-led expenses, without commensurate revenue gains, can derail the company's growth trajectory and affect investor returns.

While Etsy is doing a good job of navigating the macro headwinds, and the market was relieved that second-quarter results were "not as bad" as expected, savvy investors should keep a close eye on Etsy's rate of revenue and expense growth over the coming quarters.