Etsy (ETSY 0.34%) operates an online marketplace for handmade and customizable goods. Sales are down and profits have shrunk. But the company's stock is a buy right now nevertheless.
Long-term Etsy shareholders might grimace at that last statement. Those who bought shares two-and-a-half years ago at their all-time high are down about 78% on their investment -- a poor outcome.
I can't predict when an Etsy investment will pay off. But I believe it will pay off because this great business model produces lots of cash -- cash that management can return to shareholders. And the odds of this scenario playing out favorably for investors appear greater with time.
Why I love this business model
One much-followed measure of activity on Etsy's e-commerce platform is gross merchandise sales (GMS) -- the total dollar value of all things purchased. In 2021, the company hit GMS of $13.5 billion -- an impressive level that it has failed to achieve again.
In 2022, Etsy's GMS slipped to $13.3 billion. Then in 2023, it took another step back to $13.2 billion. And now, for the first quarter of 2024, management expects GMS to modestly dip again year over year.
If Etsy were a retailer selling its own merchandise, this would be a bigger problem. However, its business is facilitating third-party transactions, so in fact, investors need to monitor an entirely different set of performance indicators. One big metric to watch is Etsy's user base. In the fourth quarter, the number of active buyers on Etsy's marketplace hit an all-time high of 92 million. Moreover, its base of active sellers is growing as well, providing those customers with more and more merchandise possibilities.
In other words, Etsy is still attracting the buyers and sellers that it needs to succeed. And while GMS is receding modestly, the company can still grow revenue in other ways. Indeed, its revenue was up 7% in 2023 thanks to growth, in part, from advertising revenue.
This is one advantage of a marketplace business such as Etsy: Even when activity plateaus, a business can still grow by finding other ways to monetize its users.
Another advantage for the company is that it operates using a high-margin business model. As the chart below shows, Etsy's gross profit margin was 70% in 2023 and its net profit margin was about 11%. To be clear, the company has had higher margins in prior years. But these numbers are still quite good and demonstrate the advantages of the model.
ETSY Revenue (TTM) data by YCharts.
What to expect from Etsy now
Etsy is hoping that artificial intelligence (AI) can give its sales a boost. Its still-growing base of sellers collectively has an enormous number of listings on the site. Providing optimized search results to match buyers with the products they are seeking is difficult, but management is hopeful that AI can improve results.
One particular area of interest is Etsy's new emphasis on gifting. The idea is that consumers have frequent gifting opportunities, and associating the platform with gifting could increase traffic. Again, the hope is that AI can better guide shoppers to ideal gift ideas for friends and family.
In other words, Etsy has opportunities to grow its top line in time. In the meantime, the business still generates plenty of free cash flow -- $666 million worth of it in 2023. And management returned 87% of that to shareholders by repurchasing shares.
For perspective, Etsy's market capitalization today is only $7.9 billion. That's 12 times its free cash flow, which is cheap. And because the stock is cheap, management has been able to reduce the outstanding share count by a meaningful amount through stock repurchases.
Over the past year, Etsy has brought its outstanding share count down by about 4%, and management is authorized to spend more than $700 million more on stock buybacks, which would reduce the count by about another 9%, boosting shareholder value.
In this scenario, one of two things can happen. Either the market will notice that Etsy's valuation is getting cheaper and buyers will bid it up to a more fair level. Or the stock will stay cheap, giving management a greater opportunity to reduce the share count further.
To be clear, under different circumstances this would be an entirely different discussion. If Etsy were losing users, if its margins were getting hit hard, or if its stock were expensive, this wouldn't be a good opportunity to buy. But even facing plateauing sales, Etsy stock is a good opportunity because the company is generating plenty of cash and can repurchase shares at attractive prices.
The longer this scenario plays out, the greater the chance for upside with Etsy stock. That's why I say that the odds of Etsy being a market-beating investment should get better with time.
