Etsy Q2 2021: The Most Important Thing is TAM Saturation

A mixed quarter, at best. Last week, Etsy reported 31% non-mask GMS growth. Mask sales were ~$40M this quarter on the way to $0. Putting up 31% growth was encouraging to see compared to what was implied by their guidance last quarter. If the earnings call stopped there, the stock would have popped. Sadly, management guided to just mid-teens non-mask GMS growth in Q3, which signals clear post-COVID slow down. During the quarter, Etsy core GMS decelerated significantly from $1B to $840M a month. The new guidance implies that GMS has stabilized at >$800M per month. Now it's possible that Etsy guided conservatively and could beat this number as they did last quarter when they guided to 10% GMS growth, with one month of data to gauge the trend, and ended up growing 13%. Still 15% non-mask growth may not be good enough for its growth-oriented investors.

Source: Etsy

Source: Etsy, me

That's a good segue into TAM saturation. Active buyers and habitual buyers were flat sequentially. Remember that this is the first quarter in which the low quality buyers (mask buyers, let's say) that came to Etsy during the depth of the pandemic are no longer counted as active buyers if they choose not to return. $349M of masks were sold on Etsy in 2Q20 compared to just $40M in the latest quarter. Etsy added nearly 19M new and reactivated buyers in 2Q20 compared to 12M in 2Q21. That Etsy added a healthy number of new and reactivated buyers this quarter was encouraging. However, the headwind of removing the one-time COVID driven buyers that no longer shop on Etsy will likely continue for another quarter or two with diminishing effects.

Source: Etsy

TAM also expands as buyers see Etsy as a regular purchasing destination with increasing mindshare. New buyers spending grew 24% YoY against the trough set in the depth of COVID outbreak. GMS per active buyer also grew 23% YoY. More importantly, GMS per new buyer and per active buyer grew nearly 11% and 29%, respectively, over two years since 2Q19. Given buying frequency remains low, there's room to grow.

Etsy announced XWalk, which is just another iteration of improvements in its search and discovery journey. When I first invested in Etsy after earnings crapped the bed in 2019, what was difficult to quantify, but important to the thesis, was this journey to improve conversion rate. An engineer at eBay confirmed to me at the time that the search algorithm at eBay is greatly different from that at Amazon. Consumers searching on Amazon have more purchase intent and generally got what they expect when they searched. Products on Amazon are more standardized and, thus, more easily categorized/mapped. EBay on the other hand will have many vintage items that don't have clear mapping, which makes the search problem more difficult. Etsy falls even further on this spectrum. Many items are unique and sold in small quantities and buyers are not well trained to know the right keywords to find relevant products. It is up to Etsy to bridge the gap of search relevance. To me, this is core to the Etsy flywheel: reiterated product improvements that drive better conversion and marketing efficiency. Moreover, it is a key capability we can point to that Etsy is uniquely better at than Amazon, which was often cited as a competitive risk at the time. In turn, it gives me some comfort in the recent directional strategy of acquiring similar platforms to apply its search expertise (among other things).

Etsy also announced Star Seller program, which aims to promote better buyer experience and drive sales to high quality sellers by displaying a visible Star Seller badges. Trust is a significant issue in ecommerce and every successful platform has had to solve for it; Etsy is no different. Like Amazon's Choice or eBay's seller ratings, the Star Seller badges give buyers more confidence when clicking the "buy" button, driving conversion rate.

Marketing expense as a percent of revenue (31.7%) was up YoY and QoQ, and gross profit / marketing expense ($2.27) was down. What's interesting is that paid channel traffic mix (19%) was down as well. Etsy spent more on TV ads relative to a flat growth on digital ads. Since traffic driven by TV ads are, unfortunately, tracked as organic, it explains the mix shift to organic. TV ads have a longer payback period, driving lower marketing efficiency in the quarter.

That digital ads spend is flat is worth pausing at because since Etsy doesn't use an explicit budget for performance marketing and drives that line item based on ROI. Remember that Offsite Ads helped drive gross margin expansion last year. That gross margin was down this quarter also points to digital ads being quite competitive during the quarter. This is indicated by what I've heard from internet analysts who tracked accelerated cost per click and cost per impression metrics. For example, Google's Search & Other revenue was up 68% YoY and Facebook's Advertising revenue was, similarly, up 56% YoY. If true, it would clearly be a negative development for Etsy as reopening brings more competition both in consumer mindshare and in digital marketing, which had been a very successful channel for Etsy.

Remember that linear TV took a huge hit during the pandemic, which accelerated spending on digital platforms. Even as the physical world reopens, eyeballs are not returning to linear TV, which means that there will be more marketing budget competing for digital impressions - great for Google, not for Etsy. While it gives me some comfort that lower marketing efficiency and disappointing GMS guidance can't just be chucked up as its TAM being more saturated than we think, Etsy will face cyclical pressure as more businesses compete for a slice of consumer mindshare and digital advertising pie.

Source: Etsy

In summary, there are clear signs of a pull-forward and a withdrawal from COVID-induced growth, but also signs that management remained disciplined in allocation of performance marketing and Offsite Ads dollars in a competitive advertising environment. What's more important for long-term investors is that management appears to be focusing on the right things and that the guidance should not be read as a TAM saturation narrative.