Thanks to a massive boost from the coronavirus pandemic Etsy (ETSY -0.72%) experienced a real growth spurt a few years ago. Online shopping has been in high demand among consumers. And as a popular marketplace for unique and handmade goods, Etsy benefited tremendously.
However, financial gains have slowed due to macroeconomic headwinds. This could still be great Growth stock. However, there is one major warning sign that investors cannot ignore.
Reasons to be optimistic
My view of Etsy as a solid investment opportunity has not changed. One of the most compelling reasons is the differentiated product offering. A survey found that 87% of Etsy shoppers found items on the site that they couldn’t find anywhere else. This is a remarkable competitive advantage. And it protects Etsy from something similar Amazonthat focuses more on speed and comfort.
Etsy also benefits from network effects that support its economic advantage. It is a two-sided marketplace with 97.3 million buyers and 8.8 million sellers, and its value to everyone increases as it grows. If I wanted to create a competing platform from scratch, it would be impossible.
From a financial perspective, it is generally a very successful company. Etsy is a capital-light company because it has no inventory or warehouses. And that leads to consistency Free Cash Flowsomething you don’t typically see in growth companies.
The stock is also cheap. As it is currently 72% below its November 2021 peak, shares are trading at a forward price-to-earnings ratio of 17.4. This represents a discount for both S&P 500 and that Nasdaq-100.
The red flag: capital allocation
Perhaps the most important task of a leadership team is successful capital allocation. As owners of a company, shareholders should demand that management do what is in their best interest. From this perspective, investors will encounter a glaring red flag in Etsy.
In 2021, the company acquired Elo7 (for $217 million) and Depop (for $1.6 billion), two smaller e-commerce marketplaces that could create what CEO Josh Silverman calls a “house of brands.” “ referred to. Elo7 is known as the Etsy of Brazil and Depop is a reseller of second-hand fashion. The strategic reason for these purchases was that they could complement Etsy’s main marketplace by offering shoppers an even greater selection of goods.
But about a year later, in the third quarter of 2022, the management team reported one Impairment expense of just over $1 billion to write off the goodwill value associated with these two acquisitions. In other words, the value of these assets was not as high as originally thought.
This impairment is a clear admission that the CEO and his team significantly overpaid for these two acquisitions. In fact, Elo7 was already sold, so in the end it didn’t even work from a strategic perspective.
“We bought these companies when valuations of technology and consumer companies were much higher,” CFO Rachel Glaser said during the third-quarter 2022 earnings call. The market was certainly in turmoil at the time, with stocks and cryptocurrencies in the experienced a bull market in 2021.
A $1 billion writedown is nothing to sneeze at. As of this writing, Etsy’s market cap is $10 billion. If only that $1 billion had been used instead Buy back sharesthe number of shares outstanding in the company would currently be a whopping 10% lower.
The hope is that executives have learned from this costly mistake and are smarter about allocating capital. This is their financial obligation to their investors.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Neil Patel and his clients have no positions in the stocks mentioned. The Motley Fool has positions on and recommends Amazon and Etsy. The Motley Fool has a disclosure policy.