How am I going to endure reading about another small e-commerce vendor that doesn't make money and is going to change the world?
There's a pretty simple answer to that question and it relates to whether or not there is positive alpha to be had from a name like this. This is most certainly not a name to appeal to value or income investors. And this is not the first company that will cross into a land of "normal" valuations. If you are looking for those kinds of names, this is not for you.
On the other hand, there are just not that many companies in any field that can grow by seven times in three years. The reason to keep reading is to make a determination as to what kind of growth is going to be possible for this company over the next three years and whether or not the people that run Shopify (NYSE:SHOP) are going to take the necessary steps to balance growth and profitability. Obviously at some point, investors are going to need to see real numbers and I will explore what the business model might look like at scale. Overall, my conclusion is that growth is likely to continue at very high levels as I will explain below. I do think it is reasonable to assume that there's a path to profitability at this company but its speed is perhaps slower than is desired by many, and that is not going to satisfy all investors.
The investment world is just chock full of e-commerce platforms that are out to change the world. Not all of them are going to make it and not all of them are going to implode. Investors are looking for competitive moats where there are no moats and profitability before scale is feasible. In writing about and evaluating many of these stories - and for the most part they are of the immaturity where they are just stories - it is hard to separate the wheat from the chaff.
Shopify is a name that has more or less exploded on the scene in the last couple of years. Its revenues have quadrupled since 2013 and are forecast to grow another 70% this year which will put them at seven times the level they were in 2013 and many observers anticipate that the forecast is likely to prove conservative. In addition to the revenue growth, the number of merchants using the platform has risen to 275,000. Sub adds in the first quarter were a record of 32,000 much of that increase coming from the confluence between social media sites and some of the solutions that Shopify offers.
Needless to say, profits have been a bit more elusive. Stock-based comp at about 5% of revenues is relatively modest. On the other hand, this isn't quite a traditional enterprise software company as its revenues come from transactions are far more than subscription revenues. That has meant that deferred revenue balances are modest as well and the concept of net bookings is not useful in this analysis. The company is essentially at breakeven operating cash flow but capex is minor as well.
The company's financial outlook is not suggesting that it's going to achieve non-GAAP profitability anytime soon. If you want that in an investment recommendation, investing in Shopify shares is not for you. It's Q1 earnings release essentially consisted of a significant revenue beat of about 10% coupled with a marginal reduction in the non-GAAP loss for the quarter compared to prior consensus expectations.
Shopify's guidance during last week's earnings release was essentially more of the same. Revenue guidance for the full year is now $342 million at the mid-point up from a prior estimate of $325 million. But the company is far away from leverage at scale as the GAAP loss is forecast to be $$44 million at the mid-point compared to a prior estimate of $39 million.
Many investors are impatient with that kind of business formula and the shares dropped 13% in the wake of earnings compared to a change in the IGV-Software Index of +2%. Of course, in the current market environment, investors in the tech space are impatient about many things including beating earnings if the beat doesn't involve an increase in revenue guidance.
By any conventional value metrics, this company's shares are not cheap. The EV/S is 5.6X which is hardly the most expensive valuation in the software world but neither the P/E or the free cash flow yield can be used to support valuations.
In some ways, this company can be compared to Square (NYSE:SQ) although its business is not built around card readers and POS terminals. Its customer base is essentially "online" stores rather than physical locations although some of its customers operate both a web store and a physical store. A bit more than half of the transactions it manages come from mobile devices. But its CEO, while having nowhere near the fame of Square's Jack Dorsey has his idiosyncrasies. Company CEO and founder Tobi Lutke may not wear a hoodie, but his headgear is perhaps unorthodox for the CEO of a public company. The rest of the management team is about what one might expect from a young, upstart Canadian software company. Not a single tie to be found in the group.
I think the basic questions to be explored here are does this company have a unique offering? Does it have any kind of real product or marketing moat? And is there a path to profitability that doesn't involve an impossibly long waiting period?
Just why is this e-commerce platform different or better than all of the other e-commerce platforms out there?
It is probably a good idea to start with a description of what this company actually does. In that regard, the name is actually a bit helpful. Essentially, the company helps aspiring web merchants build and manage their web sites. There can be a fair level of customization in the process. The company facilitates the use of mobile devices for shipping. It does offer a POS solution for those web merchants who have need to take payments directly. The company charges as little as $9/month although its standard offering costs $29/month and the Pro version costs $79/month. Shopify can setup a logistics solution for their customer base and nowadays can guarantee next day delivery. The basic service allows the aspiring merchants to sell on Facebook (NASDAQ:FB), accept credit card payments and to have a buy button on their website. There is a retail package add-on for $40/month which enables Shopify customers to have the ability to operate a physical store that has the standard POS technology required these days and the ability to accept payments.
The company also charges its merchants a fee for accepting credit cards and gets them paid in a timely fashion. At the moment, revenues from the two different revenue streams are about equal, but inevitably, if the company is successful, the stream that it calls merchant solutions will grow more rapidly as its base of installed customers continues to rise. Again, not terribly surprisingly, gross margins on subscriptions are 79% and gross margins on merchant solutions are far lower at 26%. It is, and will continue to be, lots easier to collect revenues from subscriptions than to process payments.
Shopify offers many different services such as chat to help its merchants better sell what they have to offer and it actually offers some primitive analytics and has recently acquired a minuscule CRM vendor. It is a lengthy list and it would be tedious to go through all of it. But if you are a small retail business setting up for the first time, Shopify has a host of things from hardware to pretty themes for your site that you can buy - and it probably has more, if not necessarily better, features than anyone else in the space.
The market for web commerce solutions has plenty of competition. Almost anyone wanting to open a retail business these days is going to need both a web site and a way to take payments. The days of renting a store and acquiring a POS terminal are long since passed. The number of start-ups with the expertise to "build their own" is low and it would be hard for anyone to justify not outsourcing the task to specialist companies who have been there and done. Significant competitors include BigCommerce, Magneto, WooCommerce with WordPress, WixeCommerce and Weebly eCommerce. And as many competitors as there are in the space, there are almost as many services that offer advice as to which platform to buy. I don't propose to do a feature/function comparison. I am not trying to write a guide to buy e-commerce platforms. In a nutshell, the BigCommerce is probably the closest to what Shopify offers, the Magneto and WooCommerce solutions are Open Source and probably will require developers and are far less robust overall, and the last two solutions are more basic drag and drop tools for building e-commerce web sites. There are other platforms as well including Volusion, Demandware (NYSE:DWRE), IBM (NYSE:IBM) and Nexternal.
One major factor in Shopify's success is its partnership with Amazon (NASDAQ:AMZN). Amazon surprisingly decided to get out of the web site business and is trying to move its Webstore users to Shopify. It is a pretty far-ranging partnership in which Amazon is trying to migrate its customers to the Shopify platform. This company has been aggressive in recruiting an eco-system. It has partnerships with FB, Twitter (NYSE:TWTR), Paypal (NASDAQ:PYPL) and many others. None of the partnerships is exclusive but in all of the cases Shopify was first to embrace these other companies and it is reaping a disproportionate share of the reward.
The other major advantage that Shopify enjoys is scale. This company is far better known than its competitors. It is able to spend far more on advertising and promotion. This story is a familiar litany of the first mover advantages in tech, where it is difficult to compete with the 600-pound gorilla because he is 600 pounds and you are puny. Having never used any of the competitive solutions, or the Shopify solution either, I have no objective way of telling readers whose product will build a better web site in the shortest time period without the involvement of IT professionals.
What I think is self-evident to most is that the Shopify solution is at least equal in most comparison analysis and perhaps does have some advantages in its ability to design attractive web sites. Their pricing is comparable to those of the other major products on offer. Products that are at least as good if not better than the competition, partnerships with Amazon and other web commerce companies significant first mover and scale advantages. It is a pretty reasonable moat. Technology moats can look splendid on the outside but can be ephemeral. Advantages in marketing, positioning and overall reputation can last a long time. Shopify is at least "good enough" so that it continues to gain in mindshare compared to its competitors and mindshare is probably the best moat that anyone can build.
Another major advantage of scale is the size of the partner ecosystem that Shopify has been able to build. I am not sure that there is one partner or the other that I might highlight, but because Shopify has so many customers, 275,000 at last count, it is going to attract more partners to its ecosystem when compared to its far smaller competitors. Partnering with Shopify affords far more opportunity than - partnerships with most of the other vendors in the space.
The combination of partner features and the core Shopify technology has enabled the company to start to build its cohort of the company's premium service, Shopify Plus. Shopify Plus costs users more than twice the monthly fee when compared to the core Shopify offering and it is a major margin opportunity for the company. Brands such as Nescafe, Jones Soda (OTCQB:JSDA), the Golf Channel and Ellen DeGeneres are now using the platform and while they are not typical users, the capabilities that the combination of solutions built by partners + the Shopify platform has allowed some larger users to take advantage of capabilities unavailable from smaller competitors.
Finally, I think it is relevant to talk about the Shopify Merchant Cash Advantage offering. Of course, there are a huge number of potential lenders to SMBs. The problem is simply that the old style lending paradigm for these kinds of customers is totally broken. Banks still aren't lending without interminable waits and massive documentation. And the so-called "VC" lenders are able to charge exorbitant interest rates. Given the position that Shopify has in the market, it is far better situated to make loans to its customer base and to minimize credit losses. It can do that and most of its smaller competitors cannot. That is a very significant competitive advantage and one that is likely to grow significantly.
What is the path to profitability and how long is the wait? And what are the risks of a black swan that just changes this category completely and eviscerates Shopify's advantages?
The company's goal is to reach non-GAAP profitability in Q4 of 2017 and they reiterated that plan on the call last week. Shopify CFO Russ Jones said several times during the call that 2016 was a year for investments and in CFO speak that essentially means not to expect material operating leverage this year. Lutke talked about the company rarely putting together specific projections for specific investments and said that when it came to initiatives, the company starts off small and if the initiative works, it gets more resources until it starts to slow down. Maybe not a traditional way of doing things but typical of an entrepreneurial culture.
I don't think there is any particular secret regarding the path to profitability for Shopify. Sales and marketing grew by 115% year on year last quarter and total revenue grew by 95%. Sales and Marketing is currently 39% of revenues. R&D is 19 % of revenues. The only expense category that isn't dramatically elevated is G&A at 10% of revenues.
I don't think that it will be very difficult for this company to constrain the growth in sales and marketing almost at any pace it determines. This is not a typical enterprise software vendor that has hundreds of sales reps and an involved field sales hierarchy. This company has paid for leads and it spends a lot in fostering partner relationships. It spent $2 million last quarter on just a single partner event called Unite.
While R&D is people-centric in terms of its expense, cutting the ratio back for a company growing 95%/year is not a huge amount of constraint. Indeed, as the absolute size of the company increases, it becomes more difficult to hire the number of R&D personnel necessary to support outsize growth in R&D spend. And this is a Canadian company, with headquarters in Ottawa. Many developers are simply not used to long, cold winters. The average January temperature in Ottawa is 13F and the weather web site describes the January weather as being frigid 55% of the time.
The path to profitability is not incredibly long. Last quarter, the GAAP margin was -12%. The non-GAAP margin was -8%. The expense ratio cuts necessary to reach non-GAAP profitability are certainly in the manageable range. The only issue that this company is likely to have in terms of reaching non-GAAP profitability is the inevitable decline in gross margins as the company's Merchant Solutions business grows more rapidly than Subscription Solutions. Like many smaller tech startups companies that have recently gone public, Shopify has a business model goal of 20% non-GAAP operating margins. While I am sure that such a goal is reachable, the question is going to be the growth rate under the circumstances of constrained marketing and development spending.
The biggest risk that this company faces is that it gets all of its revenue from the retail sector. It is hardly a black swan, but it is, nonetheless, a swan of some color. Less retail spending, lower transaction volumes and lower percentage increases in the rate of subscription revenue growth are all concomitants that Shopify would face were retail sales to decline. The company will not escape a significant cyclical downturn because its customers are highly exposed to discretionary retail spending.
I think the second largest risk this company has relates to the position it already has in the mobile market. One of the reasons this company has grown quite as fast as it has, was that it took a large bet on retailers building sites on mobile devices earlier than many of its competitors. The growth in mobile as a percentage of total transactions has leveled off in the US although it continues to rise overseas. Going forward, the company will not have the tailwind it has enjoyed from rising volumes of mobile transactions.
The final issue to talk about is how does this company keep its growth elevated as it continues to scale. Obviously even with 275,000 customers, it has a trivial percentage of the overall SMB space in retail. And its initiatives with its plus service might be a far greater source of revenue going forward than has been the case heretofore. And the impact of its partnerships with many much larger companies that sell on the web is just starting to have an impact. But like most tech vendors, it wants another leg under its stool.
For this company that leg is likely to be its SMB finance business, Merchant Cash Advance. One can envisage simply awesome projections for a business in which the cost of acquiring clients is close to zero. There are, no doubt, some infrastructure expenses that the company has already started to incur for making cash advance loans to its clients. This company has enormous advantages compared to most other lenders in that it has a far better view into its prospective borrowers than anyone else is likely to have. These days, data scientists are in a position to use customer data to forecast loan losses far more effectively than heretofore has been the case. And the company is in the best position of any lender to achieve repayment by simply deducting repayments from the sales that its borrowers transact through its payment network.
Obviously, there is a risk that investors who will be needed to fund this program at scale, may have different risk assessments than Shopify. Look no further than Square to see how that happens. But overall, the opportunity to achieve substantial net interest spreads for Shopify is quite tempting. How it will play out, and how investors will choose to value net interest income is something that is not easy to forecast before there is any material track record.
Shopify is another e-commerce web site. It is the leading vendor in its space of building web sites for SMB retailers who are either starting up or who are graduating to a higher plane of success. The company gets revenues by selling subscriptions to its clients and by taking a fee on their sales, either as part of their payments platform or directly. Growth has been spectacular and this company quadrupled its revenues between 2013-2015 and continues to grow rapidly. It has built a formidable partner network including FB, Amazon, Twitter and Pinterest. The company has proven to be a very conservative forecaster since it has gone public, and it has significantly increased its growth forecast for this year.
The company has lots of competitors and it has some significant moats against those competitors including its scale which has brought it advantages in terms of its visibility within the community of potential users. It has enjoyed significant first mover advantages, particularly in building mobile web sites for its customers. The competitive moat seems destined to survive for years into the futures.
The company has declared that 2016 is to be a year of investment which means that despite huge sales growth operating margins will remain negative. The company expects to reach non-GAAP profitability in the last quarter of 2017 and there is little reason to doubt that the company will reach such a target.
The company is just starting to build out the infrastructure required to build a cash advance business within its current user base. The opportunities for that business are very considerable and the company has many advantages over some potential customers in the SMB loan space.
This company's valuation and lack of visible profits until the end of 2017 may not be to the liking of some investors. On the other hand, the company's growth at some level of scale is one of the most rapid I have seen in some time. The business model calling for 20% operating margins certainly appears achievable at this point. Shopify shares reached a low valuation earlier this year of just below $20 during the tech panic. The shares have declined again since the earnings release when some investors were disappointed by the 2-year path to profitability. I think this is a favorable time for investors to consider making a commitment to SHOP shares at these levels.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.