ETSY (NASDAQ: ETSY) is an American e-commerce company focused on handmade, vintage, and craft-related items. They sell a wide range of products including, jewelry, bags, clothing, home décor, and art. Etsy's shares were up 10% during market hours and up another 1.7% in after-hours trading, as results came in better than expected. Other e-commerce companies such as Shopify (NYSE: SHOP) also witnessed gains, as results came in better than expected, with negative sentiment already baked into the valuation. Etsy's shares are down over  65% from their 52-week high.

Highlights

-Gross merchandise sales declined by 0.4% y-o-y.

-Revenue grew by 10.6% compared to the same period last year, coming in at $585 million.

-Net income declined by 25%, meanwhile adjusted (non-GAAP) EBITDA increased by 16.7%.

“Second quarter revenue grew over 10%, despite strong macroeconomic headwinds and challenging year over year comparables,” said Rachel Glaser, Etsy, Inc. Chief Financial Officer. “This growth is attributable to the Etsy marketplace transaction fee increase, the addition of Depop and Elo7 to our House of Brands portfolio, and the strength of our Etsy Ads product, which continues to be a great solution for sellers looking to grow their businesses. We are pleased that Etsy’s highly variable cost structure helped drive a strong second quarter adjusted EBITDA margin of 28% and an operating cash flow of $125.8 million.

Etsy's gross merchandise sales continued to struggle as the base effect from 2021 and economic weakness continued to weigh on results. The company continues to make improvements to its business model as it looks to become relevant once again. For years management had indicated that the potential addressable market for their business was over $100 billion dollar, and growth will continue to be strong for many years, but results have not matched expectations.

Etsy has been focusing on improving the overall experience of its product as it looks to improve customer retention and repeat sales. Some of those improvements have started to pay off, as the current quarter witnessed a 30% decline in dead-end searches, as the search was improved through numerous advancements. The company also continued to improve its ad ranking capabilities, a result of which was noticed in Etsy’s profitability.  A new buyer protection program was also introduced and should go online after the 1^st of August, which will help sellers and customers who sell or purchase items for less than $250 dollars to receive a refund in case the order does not match expectations.

The company has struggled to expand beyond the North American market, but management has been working to improve its go-to-market strategy for the international market as it looks to get back on track towards growth.

The biggest reason for Etsy’s slowdown can be attributed to their overall strategy, where they have tried to compensate for a slowdown in growth, by increasing their fees from 5% to 6.5%, and more than double the 3% that Etsy used to charge a few years ago. Many sellers as a result were turned off and moved away from the platform, which has resulted in a slowdown in merchant growth. Etsy did not report its merchant growth for the quarter, but the numbers were likely poor.  Furthermore, the number of active buyers fell slightly by 2% to 88 million. Repeat buyers are classified as those who spend more than $200 within a 12-month period.

Etsy’s management in order to compensate for the struggle to sell merchandise, has increasingly turned to ad sales to drive revenue. This strategy remains circumspect, despite the fact that ad budgets increased by 80% during the quarter, as ads are highly dependent on demographics. The company also continues to focus on product development with the product and development budget increasing to 12% up from 10% of revenue. But considering the purchasing power and demographic of Etsy’s customers a premium product may not suit the sensibilities of the market.

Etsy’s Valuation             

Etsy continues to have a relatively aggressive valuation of price-to-sales of 6x and forward price-earnings (P/E) of 36. Investors continue to invest in the company due to the belief that the company will be able to turn around its business eventually.  One of the reasons for the high valuation is the gross margin which is currently at 71%, and profit margin ex-adjustments hovers around 12-14%. Investors believe that the asset-light nature of the business could ensure that profit margins could increase to 20-30% in the long-term, which could result in profits soaring, thereby justifying current valuations. Also, metrics such as return on investment and return on equity also remain strong, at 16% and 71% respectively, which helps as long as the company is growing

Etsy’s shares soared as results weren’t as negative as the market expected. But the current business model is clearly struggling and the company may have to cut fees in order to get back to growth in its core business.