Artisan marketplace Etsy Inc. (ETSY, Financial) has shown tremendous growth in the past two years and has expanded its e-commerce capabilities, yet remains a small fish in a large pond that is dominated by Amazon (AMZN, Financial), eBay (EBAY, Financial) and Alibaba (BABA, Financial).
The stock, which experienced significant gains during the pandemic, has fallen significantly so far in 2023 despite the Nasdaq Composite's rise to new highs. The fact its sales volumes have not changed over the past few quarters is one explanation for the underperformance.
In this discussion, I will review Etsy's key risks and explain why investors should be cautious toward the stock.
Increasing debt and declining GMS
The high intensity of the competition within the e-commerce space threatens Etsy's market position. Further, its rising level of debt might ring alarm bells for risk-averse investors. The company reported long-term debt of $2.28 billion as of the second quarter. However, even though it makes financial sense due to its superior return on invested capital of 25.19% versus its weighted average cost of capital of 11.82%, indicating the company generates high value for investors, the piling debt is very concerning.
For the second quarter, Etsy's gross merchandise sales, which counts all items sold in a given period, dropped to $3 billion, but was above estimates of $2.98 billion. The company's top and bottom lines also exceeded expectations. A significant sales trigger during the quarter was the services revenue, which includes items like advertising, increased by about 21% year over year.
Moreover, GMS per active buyer on the Etsy marketplace fell 6% year over year to $128, but the trend stabilized sequentially. The number of active vendors increased by 12.3% to 8.31 million, while active buyers increased by 2.5% to 96.3 million.
Investors will look for indicators of progress toward these objectives via data like the buyer pool, average expenditure per user and profit margin. Etsy's near-term outlook predicts modest growth for the upcoming quarter, with third-quarter transaction volumes expected to be between $2.95 billion and $3.1 billion and revenue between $610 million and $645 million. According to that estimate, sales growth will resume, primarily due to rising seller fees.
By increasing seller fees and relying more on advertising to drive sales, Etsy has been able to hide its GMS weakness. However, it cannot keep increasing costs as its seller base is already very outspoken about charge hikes, which would slow down the purchasing process. However, the stock may continue to be under pressure until Etsy can provide higher numbers in areas like average spending and overall profitability.
Nevertheless, even though revenue reached $629 million in the second quarter, signaling a 7.5% year-over-year increase, the underlying GMS trend, which is vital for an e-commerce business, has yet to give me hope that the company will return to fundamental growth soon.
Source: Etsy's second-quarter earnings results
Risks outweigh the benefits
Etsy recorded a sluggish expansion in its buyer pool for the most recent quarter, which follows a decline in each previous quarter since late 2021. Without a more vigorous recovery on this front, it will not be easy to see a route toward robust growth.
The potential for Etsy is there, and engagement is considerably higher now than before the pandemic. But due to its protracted history of poor sales trends and deteriorating profitability, there is a strong chance that operating trends will continue to decline.
There is little doubt the stock's current valuation is far more fair. Etsy currently trades for about 4 times annual sales, down from a previous high of over 15 times. However, the company is currently priced higher than eBay and, if management's aspirations for a recovery continue to be delayed, the valuation may fall much further. The stock is trading significantly lower than its peak, which reached an earnings multiple of over 166 times during 2020 as the market re-rated the company's growth potential.
However, in the event Etsy can restore future growth expectations for revenue or earnings, this presents an upside scenario for the shares. Currently, the risks exceed the stock's attractive valuation, leading to an unfaborable risk-reward profile.
Takeaway
In conclusion, Etsy's journey has been marked by impressive growth, yet the current challenges raise concerns for investors.
Despite its initial pandemic-driven gains, the stock has experienced a significant decline this year, which is partly linked to stagnant sales volumes. A review of Etsy's risks highlights the weight of increasing debt and a decline in GMS, indicating it will struggle to maintain its market position.
While the company's financials show signs of promise, such as a superior ROIC and an optimistic near-term outlook, the shadow of mounting debt and declining sales trends cast doubts on the path to sustained growth. Investors are urged to exercise caution and await clearer signs of recovery before making a decision.
