To say that Etsy (ETSY +3.45%) shareholders have been on a roller-coaster ride would be an understatement. The stock was up almost 10-fold from its initial public offering in April 2015 to an all-time high in November 2021. But since that peak, shares have cratered 75%.
That wild swing doesn't do the company justice. Etsy operates a unique business model that gives it an advantage in the retail sector more broadly, and the e-commerce space more specifically. Let's take a closer look.
An online marketplace
Etsy operates various online marketplaces where shoppers can find unique and handcrafted merchandise. However, investors unfamiliar with the company likely don't know that the business doesn't own any inventory itself. This means no warehouses, trucks, or delivery drivers. Instead, Etsy just collects revenue when its 8.3 million sellers conduct transactions with its 96.3 million buyers. There are add-on services too, like payments and advertising.
For sellers, the platform is a game changer because it makes being a small business entrepreneur easy, allowing them to reach a global customer base. Buyers can shop for products from worldwide merchants that they might not be able to find elsewhere. The value proposition for both user groups is clear.
NYSE: ETSY
Key Data Points
In this way, Etsy isn't unlike businesses such as Uber or Airbnb that simply connect customers who want a service with a supplier of that service, collecting fees when transactions happen. This means Etsy also benefits from powerful network effects. If more buyers join, it immediately makes Etsy more valuable to sellers by increasing the number of potential customers. And if more merchants join, buyers are presented with even more product choices.
As the business scales, network effects typically result in rapidly improving financials. Etsy's operating margin expanded from 5% in 2016 to 22% in 2021. This is possible because the company is capital-light; the technological infrastructure to facilitate transactions among buyers and sellers is already built out. To be fair, Etsy continues to invest in product development and marketing initiatives to make the service even better. Nonetheless, every additional transaction should carry very high margins.
Low capital expenditures translate into lots of free cash flow, to the tune of $660 million total in the last four quarters. This is what shareholders should get excited about, especially when many growth tech stocks are still far from being profitable.
Is the stock worth buying?
Investors would be better off looking only at businesses that have some sort of economic moat. In particular, network effects are one of the strongest moat sources. It's almost impossible for a start-up to compete with Etsy. Not only would a new rival have to attract buyers without first having any sellers, but it would also have to convince these sellers to want to use its platform when there probably aren't any customers on board. That's the classic chicken-and-egg problem, something Etsy has clearly solved already.
With this framework in mind, it looks like Etsy is an attractive company to own in your portfolio. This is primarily because it should be protected from a competitive standpoint. Moreover, it has become a household name for people looking for those special handcrafted items.
But investors should also think about Etsy's growth prospects. Based on gross merchandise sales, the management team believes the business has only penetrated less than 3% of its total market opportunity. It's probably best to take this estimate with a grain of salt, but it still demonstrates huge expansion potential.
With the stock trading at just 16 times projected earnings per share, investors might want to add Etsy to their shopping carts.
