Etsy (ETSY 0.34%) sells a lot of stuff. The e-commerce company, which specializes in unique and handmade goods, processed over $13 billion of transactions in each of the last two fiscal years.
You might be surprised to learn that Etsy's profits don't come from its customers, though, as they do for a retailer like Walmart or Home Depot. That's because Etsy operates as a marketplace platform that works to connect buyers with sellers. Thus, its merchants are the ones funding the business. And the profits Etsy extracts from these sellers are much higher than Walmart could earn.
Buyer, meet seller
Marketplace businesses have some major advantages over traditional retailers. For example, they don't hold inventory, which is a huge cost burden and financial risk that saddles its vertically integrated peers. Etsy also doesn't need to maintain its own expensive shipping and logistics network like Amazon.
The financial benefits of this middleman approach aren't lost on management. Etsy tells investors their approach is a major reason to own the stock. "Our capital light business model allows for investments that we believe can enable long-term growth while also delivering strong profitability and cash flow," executives say in their investing thesis.
The fees are high
That's clear if we look at some high-level numbers. Consider that Walmart and Amazon each generate profits of about 3% on their retailing businesses. Yet, Etsy's profit margin is 10 percentage points higher, and eBay (EBAY 1.32%), a more established marketplace, earns over 20% on its sales.
ETSY Operating Margin (TTM) data by YCharts. TTM = trailing 12 months.
Etsy gets these profits mostly from the fees it charges to sellers who make transactions through its platform. These merchants come to Etsy to find a pool of engaged shoppers looking for their types of products. It's also convenient to let Etsy handle things like payment processing and marketing.
In exchange, Etsy collects roughly 20% of the transaction price in fees charged to merchants. This cash includes standard listing and transaction fees but also variable fees such as payment processing.
The company is building out a more feature-rich platform, just as Shopify has done in recent years. Success here should allow it to boost profit margins further as its merchants depend on Etsy for more parts of the online selling process. It should also mean more recurring revenue from subscription products.
What it means for investors
You might think this selling approach would make Etsy too focused on satisfying the merchants who account for most of its profits. And it's true that this stakeholder group is a priority. Executives said as much when they launched a new restructuring program. Delivering more sales to sellers is "the single most important thing we can do for them," executives told investors in mid-December.
But sellers are happiest when buyers are satisfied and engaged. That's why the marketplace approach can be a win-win for everyone involved. More buyers means more sales, and more sales means higher transaction fees and additional resources to devote to improving the platform. Rinse and repeat.
Lately, Etsy's growth cycle has been interrupted by stalling sales volumes. The company knows that engineering a rebound here is critical to its wider profit ambitions. That's the surest path toward keeping those lucrative merchant fees climbing over time.
