Shopify-The ABC's of the powerhouse of E-Commerce platforms
Why write an article on Shopify (NYSE:SHOP) in the wake of another strong quarter? Possibly because it is instructive to see how real growth companies look. Possibly because the shares were actually downgraded by one analyst yesterday and another analyst downgraded the shares in the wake of earnings to sell. And possibly because the company presents an object lesson in what to expect from growth enterprises that you will not see in analyst reports.
There is one issue that analysts and investors have to ponder in considering this name-how much are the shares worth. By now, Shopify is acknowledged to be the leader in its space. The downgrade from Merrill Lynch alluded to above was based on "the need to retain valuation discipline."
I have two problems with the thesis presented by the analyst. One of those is the supposition that price targets are like soldiers and that to get things correct it is merely necessary to use a formula (usually Discount to Present Value or some variant) although in this case the analyst has cited some measure of premium to average EV/S.
Interestingly, in the case of this particular research note, Merrill raised its price target from $62 to $84. Since the stock is $82, the potential upside is less than 5%. What happened to the appreciation between $62 when the analyst made the shares a hold and now is left unsaid. If the price target methodology produces such shockingly awful results, the case for using it going forward is pretty fraught. (In fact the shares are up by 90% YTD and up by 187% over the past year, and most assuredly that appreciation was far greater than the price targets of almost all analysts who follow the name.)
And that gets me to the second cavil. Simply put, most analysts, with a natural bias regarding reversion to the mean, will not "get" the opportunity for a business like Shopify which is tearing up the playbook on how potential entrepreneurs become merchants. No one knows how large that market is because no one before has ever been able to open a business using these kinds of tools. And the recent addition of a POS device, as well as shipping, payments and capital to the mix of tools available from Shopify simply makes it harder still to define the TAM for this space.
Shopify has 2 basic buckets in which its collects revenue. These are Subscription Solutions which is basically the monthly fees that merchants pay the company for the use of its platform and Merchant Solutions, the charges the company collects for specific services, most importantly including the charge that the company receives for payments through the site. Merchant solutions is slightly larger these days compared to Subscription Solutions and is growing noticeably more rapidly. It is one reason why I think the company's growth rate is likely to maintain high levels far longer than the consensus. The company's gross merchandise volume grew by 81% year on year The 11 points of difference between GMV and revenue growth related to other merchant solutions such as capital and shipping that are starting to contribute noticeably to revenue. One of the key differentiators that will likely enable SHOP to maintain its growth rate at higher levels than forecast by analysts is that it has become a one stop shop for aspiring web merchants with more services that can simplify the life of an aspiring retail entrepreneur. And the services to which users can subscribe include both those developed by SHOP and its network of who are using its platform and API's to offer SHOP customers lots of custom solutions.
At this point, as the analysis linked here shows, Shopify is said to have a 7% market share. There are significant problems with the study. The market leader in terms of # of sites, Woo Commerce gives away its product and does not have a fully functional E-Commerce platform. Magneto, with an 8% share, is losing customers and SHOP has been successful in its marketing campaigns to attract Magneto users. Woo and Magneto together have a 47% share. How much of that 47% is available to SHOP? What might the cadence be in terms of SHOP take-aways.
Of course, the company has just reported its results for fiscal Q1 which affords contributors the opportunity to use the newly published results as a backdrop with which to display the company's virtues…and whatever issues perceived by some observers. The results were apparently stronger than expected by analysts and investors as the shares appreciated by 7% in the wake of earnings.
Most observers have long since come to the belief that SHOP will beat expectations and raise guidance consistently. In terms of providing readers with trading advice, I find it well-nigh impossible to know what constitutes an adequate beat or a large enough raise. To be sure, this quarter was a more significant beat than many in the company's history.
The company increased its revenue forecast by 5% for the year, after beating revenue expectations for the just announced quarter by about 5% in Q1. At the mid-point of guidance, that would bring full year top-line growth to 60%. That compares to 75% growth in Q1 and probably leaves the company with some additional potential to exceed published expectations for the balance of the year. It is also likely that analysts will raise 2018 top-lines estimates noticeably above the current expectation for 37% growth in 2018.
In the case of the Merrill report previously cited, the analyst increased his 2017 estimate to be congruent with management guidance and increased his 2018 forecast to maintain the same percentage growth rate embodied in his old analysis. Why might revenue growth decrease from 60% to 35% next year and then decelerate further to 30% in 2019. And if revenue growth did decelerate in that fashion, how fast would earnings growth really be. The company just went through a quarter in which its opex growth was about 75%. Presumably that kind of growth was to support rapid growth in the future. My own guess is that the growth will not slow down at anywhere near the rate assumed by some. I assume that the company expects to beat the guidance it has provided consistently. And it will, indeed, need to beat guidance to support a stock price that has been one of the better performers in the universe that I follow.
So, the reason to write an article about SHOP is that the company continues to find ways to extend its hyper growth streak and over-attain expectations. It is highly unlikely to be able to continue to see its share price grow at the rates of the recent past. The shares are valued at more than 11X EV/S, although the "S" is a very questionable number that will almost inevitably be altered in the course of the coming quarterly earnings announcements. But it still has the opportunity to appreciate as investors re-think what a reasonable growth rate expectation is for the company. It is totally likely, I believe, to see the current 37% consensus forecast for 2017 to become 50% and that would go a long way to providing positive alpha for this name.
The formula for hyper-growth
The formula includes dominance of one of the more rapidly growing spaces in the software world, a charismatic leader who has built a highly effective team that has pushed the organization to focus on growth-and not least of all a willingness to spend at rates that simply are beyond the comfort zone for some observers/analysts.
More electrons have been spilled on the subject of the end of brick and mortar retailing. I don't want to add any unnecessary electrons to that debate. But Shopify, as well as Amazon (NASDAQ:AMZN), is the other side of that equation. That Amazon is and will remain the gorilla of e-Commerce is very likely. But Shopify has made it possible for merchants to set up a store that functions well and can provide a service to consumers. It is still a new frontier in retailing.
Shopify spending continued growing at an unabated cadence this quarter and GAAP losses grew while GAAP opex grew at the same overall rate as revenue. Gross margins were able to grow about 100 bps because the company's Merchant Solutions, which have higher gross margins than what the company calls Subscription Services, is growing a bit more rapidly and has become a slightly greater percentage of total revenues and has continued to grow gross margins in the process.
I think at this point, the story of Shopify is known by many growth stock investors but remains a bit less known by investors as a while. The company simply has a better solution for most users who want to build an E-commerce on the web and haven't a clue as to how to go about the task.
Many times in preparing articles I comment about competitive positioning using available material from industry consultants. I have no real direct way of determining whether or not the virtualization offered by Citrix (NASDAQ:CTXS) on a desktop is better than that offered by VMWare (VMW
While I don't want to pose as an expert on web site construction tools, I think I have a little bit more foundation which I use beyond the rather bloodless commentary seen in analyst reports. I have used Shopify and it works well and is as advertised-reliable and user-friendly. Most of the competition is far less capable and has far older technology with less effective user interfaces. The fact is that Q1 saw a record increase in the number of merchants added by the company. Obviously records like that are going to have to be set more often than not for percentage growth to continue at the rates that it has, but the ability the company is having in continuing to attract customers is probably a testimony the functionality of its offering as much as anything else.
While setting up a web store using Shopify is not quite as self-service as advertised, it can be done quite rapidly and a prospective merchant can be enabled with all that is required to open a business from an operational point of view. That is a capability that has never before existed and is certainly a far cry than what is required to set up a bricks and mortar store.
The size of the E-Commerce space as a whole is probably unknowable at this point. A business with no historical parameters is hard business to forecast as there are no signposts of comparables or historical precedents to use. In the case of a company like Shopify that is consistently adding new services for its merchants, it is even harder to accurately project a long term growth rate.
Some of the newer services such as Capital and Shipping that round the offering are providing a small but noticeable improvement in gross margins. It is very likely going forward that these new services will contribute meaningfully to growth in ways dimly understood at the moment.
Is the company Pivoting Up-Market?
One of the principal growth opportunities for Shopify is a pivot upmarket. Shopify's future, in whole or part is going to be played out in the next few years within its offering of ShopifyPlus. The company is beginning to achieve revenue traction from its Plus offering. The company doesn't specifically report the results of the Plus offering but it is said to be about 10% of revenues. Last quarter the company started to offer what it calls Wholesale Channel for Plus. This is an offering that allows merchants to create a separate storefront from which the merchant can offer wholesale prices.
But Plus is mainly designed for merchants who have surpassed volume levels that are traditional for basic Shopify. Within Plus are stores for brands such as GE, Red Bull, Nestle and even Tesla. I have linked a 3rd party review of ShopifyPlus that was prepared in February that probably answers many questions about why the platform is likely to add to SHOP's growth.
At one point, Plus service was designed as an offering for the SHOP installed base who could migrate seamlessly as their operations expanded and their GMV became substantial. Pricing today is such that the platform has been attracting net new merchants. The company has a promotion these days in which it offers Shopify Plus free to Magneto customers for a 6 months' span.
Plus is sold based on several major value propositions. It has developed a very extensive eco-system that allows even the largest retailers to develop a custom store that incorporates highly specific features that are important to some particular users.
The company's eco-system-this is real the target for the eco-system-will turn out to be a principle advantage for plus customers For the most part SHOP has made ease of migration and launch key component of its offering. And it really has been a pioneer in the multi-channel capabilities of the service. In addition, Plus offers the ability to deal with surges of up to 10,000 checkouts/hour and a high level of security. I have provided a link to a rather thorough review here. As can be seen, the reviewer likes the fact that the service essentially outsources the requirements for a company to have its own e-commerce capabilities.
The thing about ShopifyPlus from the point of view of investors is that it produces revenues per user that average something more than 20X the price of Shopify. (Shopify offers all kinds of plans for all kinds of use cases. Plus itself offers loads of different service options but the most basic capability starts at $2000/month.) I think that if one is projecting a growth trajectory, it is key for this company to break beyond the SMB space-it simply a matter of market size. It has some large customers with whom this writer has never heard-but that is more a function of the conservatism of the writer.
Shopify Plus is really aimed at successful retail entrepreneurs who already have a successful store and are seeking to establish a web presence. In some instances, the potential customer has jury-built his/her own web show front but it isn't working well and takes substantial management resources. In other cases, Plus is the initial platform to which the merchants go in establishing a web presence.
In any event, the potential size of this market-and it really does appear to have different parameters when compared to the company's SMB homeland-may be larger than the potential size of the company's original focus on SMB start-ups. Those analysts who choose to forecast rapidly declining percentage growth rates do so without considering the potential opportunity that SHOP has outside of the SMB space with substantial enterprises who are looking for a service that is reliable, scalable, customizable and can eliminate the pains of supporting a home grown platform.
The question of valuation
Valuation is most certainly no science despite the best efforts of some to portray price targets as being much more than a whim and a prayer. I will not try to make the case that SHOP shares are cheap. The company has 90.2 million shares outstanding which reflects the capital raise the company did last summer. At the current market price of about $82. That yields a market capitalization of about $7.4 billion. The company has $395 million of cash and no debt. So the enterprise value is around $7 billion. Current year sales have been projected by the company to be a bit over $620 million at the current guidance range. They will most likely be higher. But an EV/S of greater than 11X is an outlier, even in this market.
The company is now forecasting a non-GAAP EPS loss of $.07 for this current quarter. This would appear to be quite conservative. Because of seasonality, Q1 can be expected to be the nadir of revenues from merchant solutions. Part of the forecast is built on revenue assumptions that do not seem to be realistic. It would, I think, be surprising if quarterly revenues rose by only 12% sequentially, both because of the record new subscribers who chose SHOP in the just past quarter as well as the seasonality that has been historically in evidence with regards to Merchant solutions revenues. I would be surprised as well, if the company weren't able to improve marginally on its Q1 non-GAAP EPS. But no one buying these shares today is doing so based on its' projected P/E for the next couple of years. Potential investors want to see hyper-growth and to achieve hyper-growth it is more or less inevitable that the company will build up sales and marketing and research and development. The expansion of Shopify Capital, particularly as well as shipping and of course pay will probably yield a higher level of gross margins in the future. But Capital is likely to require some more substantial levels of general and administrative expense.
The climb to respectable operating margins is going to be a long one. It should be noted that stock based comp expense, while small at 7% of revenues increased by 2.5X year on year. Part of this relates to the very strong share price appreciation and part of it relates to the rapid increase in staff, almost all of whom get stock awards when they join the company.
Shopify generated $4 million of operating cash (CFFO) last quarter. The company doesn't forecast that metric and regardless, it hasn't reached a level of significance that would determine an investment decision. Cash flow last quarter was created because of stock-based comp., some contribution from balance sheet items and a larger contribution from deferred revenues. But at the end of the day, this has not been and will not be a cash flow story. The company will have to achieve material improvements in operating profits and that is not going to be a quick climb.
Yes, the shares are expensive when looked and compared to what are called comparable companies. But the company is growing 2x or more the rate of those comparable companies. Of course the shares are not likely to double every 4 months or I will be forced to sell mine, much though I do not wish to do so. But for those investors looking at perhaps the absolute best set of expectations to be seen in what I consider the enterprise software space, look no further. The quarter was strong, the outlook provided by management is eminently beatable and the company is just at the start of its life in terms of disrupting the retail space. I am willing to sacrifice quite a bit to invest in a company with that kind of opportunity.
Disclosure: I am/we are long SHOP.
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.