Shares of Etsy (ETSY 0.34%) are trading slightly higher over the past year but still more than 70% off their all-time high. It's been an unusual three-year pattern for e-commerce. During 2020, consumers had no choice but to shop online, which drove incredible growth for Etsy. The company was seeing gross merchandise sales more than double during the pandemic, but the last two years saw a reversal of those trends as the return of brick-and-mortar shopping and inflationary headwinds pressured sales.
While Etsy could see a return to the high-growth days before the pandemic, there are some weaknesses the company needs to work on to realize its full potential.
What is wrong with Etsy
On the surface, Etsy's focus on providing small businesses and artisans a platform to reach consumers separates itself from other retailers. Its unique merchandise is a key differentiator from other online retailers like Amazon or eBay.
Moreover, Etsy's reliance on third-parties means it doesn't have to invest in its own inventory or capital-intensive warehouses, which is why the company has been consistently profitable in recent years, while other e-commerce companies have not.
But there are trade-offs with this strategy. The perception of Etsy as a gift-giving destination has made it difficult for the company to maintain strong growth in its active buyer base. In the first quarter, active buyer growth was just 0.4% year over year.
The slow active buyer growth coincided with a 4.6% decline in gross merchandise sales. That is relatively weak against the broader U.S. e-commerce market that saw sales grow 8% in the quarter.
Also, since many items on Etsy are handmade, there can be long lead times before the customer receives their order. Many buyers don't want to wait, especially when buying from a random seller on a marketplace where there is always the risk that something will go wrong with the transaction.
Why Etsy can still succeed
Improving buyer frequency and building a trustworthy marketplace are top priorities for management. Although management has been working to change the perception of Etsy as a gift-giving destination to an everyday shopping platform for a long time, I don't think this is the company's biggest problem. After all, Etsy has held this image for years, but that didn't prevent the company from growing at high rates over the last decade.
Building buyer trust and making it easier to find the right item are the most important things the company can do to improve growth. To that end, Etsy is investing heavily in search technology. Management sees enormous potential to improve the shopping experience through large language models and generative artificial intelligence technology.
In the future, buyers will be able to describe to Etsy's search engine what they are looking for. Etsy will ask questions and curate items based on the buyer's input. This will also create a very personalized shopping experience.
Another way Etsy is trying to boost buyer trust is through editors' picks. With this feature, Etsy curates items that are made to high standards of quality and by sellers that adhere to company policies and quality customer service. Management has found that items labeled with the "editors' picks" badge have higher conversion, which speaks to the problem some buyers have in trusting sellers.
Why the stock is worth buying
The most important factor is that Etsy is profitable. It generated $650 million of free cash flow on $2.6 billion of revenue over the last four quarters. It has the resources to invest where it needs to in order to drive more growth.
Data by YCharts.
I believe the market offers investors an attractive risk-to-reward scenario here. The stock trades at a more attractive valuation than it did a year ago, with the forward price-to-earnings ratio at 19.9, which is a discount to the S&P 500's 25 multiple. On a price-to-sales basis, Etsy stock trades at 4.4 times trailing revenue, compared to 3.9 for the average e-commerce stock.
Overall, Etsy is a good investment at these share prices. The e-commerce market is expected to reach over $7 trillion by 2025, according to eMarketer. The growth runway here could make the stock a monster winner for long-term shareholders.
