Is This the Biggest Reason to Be Bearish on Etsy Stock?

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    Gone are the days of monster growth for Etsy (ETSY 4.76%). The online marketplace for handcrafted, unique, and vintage goods did report a year-over-year revenue gain of 4.3% in Q4 2023, but gross merchandise sales (GMS) dropped 0.7%. Weaker spending activity on the platform is discouraging, particularly when you consider GMS also fell 4% in Q4 2022.

    This e-commerce company‘s ongoing struggles reveal what I think might be the core of its bear case. Here’s what investors need to know.

    Driving repeat purchases

    There’s no denying Etsy’s business was a major beneficiary of the coronavirus pandemic. People had extra cash from stimulus payments and less options to spend it on with social-distancing restrictions in place. These were favorable ingredients that led to strong user, revenue, and GMS gains for the company during the early months of the health crisis.

    More recently, consumers have grappled with an uncertain macroeconomic environment and high inflation. As a result, Etsy’s growth has stalled, revealing the cyclical nature of its business. Early shareholders wanted a tech enterprise that could rapidly expand long term. What they have now is a company that appears to have plateaued after pulling forward growth during the pandemic, and consumers cut back on discretionary spending. This is the most convincing bear argument for the stock.

    Even though Etsy is a top platform that has differentiated itself in the competitive e-commerce industry, it’s hard driving repeat purchase behavior. Of the 96.5 million active buyers across Etsy’s platforms, 7.1 million are considered habitual buyers. This means they made purchases on at least six different days worth a total of $200 or more during the previous 12-month period. The number of these loyal customers, while up significantly from pre-pandemic Q4 2019, has been trending lower in the past few quarters.

    Etsy’s largest product category, by far, is home and living, representing 35% of GMS in 2023. Think of things like furniture, bedding, and storage supplies. The next largest, jewelry and accessories, made up 20% of GMS last year. When times get tough and people are looking to cut back on spending, these discretionary purchases can easily be delayed, especially when compared to essentials like food and rent.

    This helps explain why Etsy has been losing market share in the e-commerce sector in the last two years.

    After understanding this reality, management is trying to encourage more frequent purchases. Marketing spending remains a meaningful expense category at about 28% of revenue. This makes sense as it’s a priority to get customers to think of Etsy as a top shopping destination, particularly for gifts.

    Time will tell whether the company can return to healthy GMS growth, but these challenges point to the cyclical nature of Etsy’s business.

    Reasons to be optimistic

    Before investors rush to sell the stock, however, it’s a good idea to revisit Etsy’s favorable attributes too. There are a few that stand out.

    First, the business benefits from network effects thanks to its two-sided platform of global buyers and sellers. This economic moat protects Etsy from the threat of disruption.

    Unlike many growth tech enterprises, Etsy’s business model has proven it can generate sustainable earnings too. In fact, free cash flow totaled $666 million last year, translating to a superb margin of 24%. This reduces financial risk, and it allows the company to weather market turbulence.

    Perhaps the most obvious reason to stay bullish on Etsy is its current valuation. The stock trades at a dirt cheap forward price-to-earnings ratio of 14.9, a significant discount to the broad market.

    It’s best to closely monitor Etsy going forward to make sure management can drive greater growth and customer engagement. If those things start to improve, there is potential for sizable returns.

    Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Etsy. The Motley Fool has a disclosure policy.

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