Shopify: Smart Money Buying The Dips

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About: Shopify (SHOP)
by: Save Money Retire Early
Summary

Investors who do their homework are better able to control their emotions when markets start to move quickly.

Shopify's shares have had some big tumbles, which has allowed informed investors to position themselves for the long-term.

We see the path to $1 billion in free cash flow. It's still 10 years away, but the path looks reasonable.

Shopify has proven to us their ability to continue to execute while they grow rapidly. This gives us confidence they can manage the growth going forward.

Doing your homework is critical to making rational decisions, especially in real-time when the price of shares is moving up or down 10% at a time. If the stock is making new highs or gapping down lower, knowing the fundamentals of why you are invested will help you decide to buy more, sell everything, or just hold.

We believe Shopify (NYSE:SHOP) can get to $1 billion in free cash flow in 10 years. And that will be the floor going forward.

Getting there will require merchant growth of 18-27% CAGR, compared historically to their 73% CAGR in the last 4 years.

The current enterprise value to sale multiple is 12x our 2017 sales and 7.7x our 2018 sales. But in 5 years we expect that to drop to 3x while still having 30% y/y growth prospects.

Lastly, Shopify's ability to execute is clearly proven to us. Over the last 5 years, they have grown their employees from 131 to over 1900 while maintaining their innovative culture and long-term perspective. The next 5-10 years is going to require the rapid addition of employees to achieve the growth necessary to justify the current stock price. Given its history, we believe Shopify can handle the challenge ahead.

In the event of a widespread market pullback, we would be buyers of Shopify to position ourselves for the next 5-10 years.

Source: Shopify

How We View Risk

Over the weekend we were fortunate to meet a friends' friend at a wedding reception. Our Hero (as we will call him), works in Silicon Valley at a very well know tech company. But it wasn't always that way. He started out working for the government nearly 3000 miles away.

Our Hero had a secure job. A job that he could have stayed at for life, with a great pension lined up for when he retired in 35 years. In the minds of everyone he worked with, he was in the lowest risk situation possible.

But that's not how our Hero saw it.

Fast forward to now. Our Hero has a high paying Silicon Valley job at one of the biggest tech company's you can think of. But our Hero is looking again to leave a job that everyone sees as the best thing in the world.

He wants to join a start-up. He's probably not going to get a salary, but he will probably get some expenses and meals covered. The early stock options will be his upside, along with excitement and adventure.

From an uninformed point of view, our Hero is a huge risk-taker, you may even call him a risk-seeker. He is leaving a very nice six-figure salary with all the perks, a sure-thing some would say, for uncertainty with essentially no pay.

If we analogize his career to an investment. He has gone from a government bond to riding the momentum of a rapidly growing stock. And now going from a maturing tech stock to a start-up that doesn't have a name, doesn't have an office, but has some angel funding.

How can our Hero make this decision with a straight face and tell us "Not taking this opportunity is risky"?

Distilling our Hero's decision, we concluded that risk is in the eye of the beholder.

Our Hero is a smart, rational guy. He puts a lot of thought into every major decision. He knows the founder of the start-up thoroughly as a genius, and someone he has wanted to work with as soon as he met him 4 years ago. He sees this start-up solving a huge problem for enterprise level customers. He knows what he is capable of and is confident he can help bring this company to the next level. In his mind, he knows the risks but he has mitigated them.

To an uninformed outsider, we don't know the founder, we don't understand the problem they want to solve, and we just met our Hero a couple of paragraphs ago. To us, this is a huge risk. If we were responsible for choosing our Hero's next career path, we would not send him to the start-up.

But our Hero knows better than us because he has done his homework and has way more information than us.

What does this story have to do with investing?

The risk is in the eye of the beholder. We do deep dive research into the companies we invest in. We make sure we understand as well as possible how the business model works. We identify where the upside levers are for the company to succeed, whether it is scale, new products, or a rising tide. We also look for potential downside risks, like what would happen to the stock price in a recession or widespread market pullback.

The more we know about a company and the characteristics of the investors in that stock, the less risk we see in the investment. From the outside, we might seem crazy to invest, but from our perspective, we are making a rational decision.

The risk of not investing is greater to us than the risk of investing.

Shopify - Uninformed Outsider vs Informed Investor

From an uninformed outsider, Shopify is viewed as a risky stock because its enterprise value to sales ratio is well above what would normally be considered the mean. Shopify currently trades at 12x our 2017 forecast revenue and 7.7x our 2018 revenue. The stock chart looks like a 45-degree slope up and to the right. Since the IPO, the stock has gone from an opening price of $28 to a high of $100 last week, in a matter of only two years.

Many uninformed investors end up buying the stock based on hype, the recommendation of others, momentum, and comparisons to Amazon. But making a proper investment decision needs more than knowing the ticker, the price, the chart and reading one or two paragraphs on a company. It is these uninformed investors that create a short-term risk for any stock and which create short-term price inefficiencies in Shopify's stock, both up and down.

Emotional Decisions

Uninformed investors who buy on a "stock tip" do not have enough information to steady their emotions and make a rational decision during high-stress times.

When the stock rises 10-20% in a short period of time, they sell too early. When the stock falls 10-20% in a short period of time, they sell instead of buy. It's where we believe the "sell first, ask questions later" mentality comes from.

Let's take an example of Shopify's recent sell-offs and bounce backs.

On May 11, 2017, Shopify saw an early day sell off. It opened near$93 but dropped to $89.50 about 30 minutes after the open. It closed the day at $92 and several days later at over $95.

On May 18, 2017, Shopify opened below $84, after closing the previous day at $90. But 2 hours later was trading around $90 once again.

On June 12, 2017, Shopify opened at $90, but quickly reached a low of $82.50 about 20 minutes after the open. 2 hours after the open the stock was back to $90, closing the day at $89.

These are examples of uninformed investors selling short-term positions and informed investors taking advantage, to position for the long term.

We do not assume that every sell off will find support like these last three significant occasions. Informed investors may have a full allocation to the stock already which will restrict their ability to buy more. They may also run out of new money to invest as they continue to buy on the dips.

Long-Term Informed Investors Want The Price to Drop Today

While short-term price doesn't matter as much to long-term informed investors, we still want to get our shares as cheap as possible.

Either way, we are invested in seeing Shopify become a multi-billion-dollar revenue company. And follow that by becoming a billion-dollar-plus free cash flow company. Cash flow is how we expect to be paid for our investment. We don't necessarily expect the company to pay a dividend when it gets to that point, but if that recurring cash flow is valued fairly by the market, we believe our shares will be worth much more than they are worth today.

To simplify. We believe Shopify needs at most 2 to 4 million merchants on its platform to generate $1 billion in free cash per year. That is a huge range. But here are the scenarios.

The Road to $1 Billion Free Cash Flow

We take what we know today to forecast the eventual breakeven point on cash flow. We see free cash flow break even in 2019, and free cash flow minus share-based compensation breaking even in 2021. $1 billion free cash flow comes at the end of our forecast period in 10 years. But given Shopify's recurring revenue model, that $1 billion becomes a floor.

Scenario 1: Shopify's subscription revenue per merchant stays flat for the next 10 years at $615/merchant per year (calculated based on the average merchants active on the platform in 1Q17). At this rate, Shopify will need 4 million merchants to generate $1 billion in free cash per year. From today, that is about 10x the merchants or 27% CAGR growth for the next 10 years. In the last 4 years, the merchant base has grown from nearly 42k in 2012 to 377k in 2016, that's 73% CAGR growth. We think this is a very achievable outcome given this history.

Scenario 2: Shopify's subscription revenue per merchant increases at 5% CAGR for the next 10 years, revenue per merchant could grow to $1000/merchant. In this scenario, only about 2 million merchants would be required, or an 18% CAGR over the next 10 years.

This is a trade-off of quality merchants versus quantity of merchants. The third scenario would be to get both the 4 million merchants and the $1000/merchant, but that would be quite ambitious.

A basic subscription merchant generates $29/month or $348/year.

A regular subscription generates $79/month or $948/year.

An advanced subscription generates $299/month or $3,588/year.

Shopify Plus generates $2000/month or $24,000/year.

As merchants become more successful on the platform over the next 10 years, they will upgrade to higher price plans. Additionally, the ratio of new merchants starting on lower priced plans compared to existing merchants on higher priced plans will be lower. Instead of 50% new merchants coming on the platform, that ratio will drop to 15-25% in the latter part of the next decade, in our model. This means the average subscription revenue per merchant should increase.

This is before any potential price increases over the next 10 years. But there is also a potential that base subscription prices will drop in the next 10 years as competition, innovation and business models change the landscape.

Valuation Multiples

Shopify currently trades at 12x our 2017 forecast revenue and 7.7x our 2018 revenue. Some investors may think looking even 2 years forward is too far for a disruptor company. We are long term investors though, we don't know exactly what will become of our investments in 10 years, but trying to make an educated guess about it today is part of becoming an informed investor. Putting that extra effort into understanding what assumptions make today's valuation fair is what makes us informed. Then when the company shows us earnings results that underperform, meet, or outperform those assumptions, we can make a rational decision to buy more, sell all or some, or hold on for more data points.

Informed investors will base their valuation on more than just the enterprise value to sales ratio for this year or next year. From our model, we see that in 5 years, the valuation will be only 3x sales but still be expected to grow 30% a year.

Proven Ability to Execute

Shopify's execution in the last 5 years is clear proof to us of their ability to execute, as they doubled revenues in 2013 and 2014, and nearly doubled them in 2015 and 2016.

Imagine how difficult it is to go from 131 employees at the end of 2012 to 632 employees by March 31, 2015. Shopify added 501 employees to a base of only 131 in only 2 years and 3 months. Meanwhile, they were able to maintain their culture of long-term thinking and innovation.

Two years later and the employee count has tripled to over 1900 today. The cogs kept spinning smoothly throughout the last 4-5 years despite this rapid internal change. Many companies would have failed to succeed as the business grew out of the start-up stage, but not Shopify. They have found guidance from directors on their board to grow while maintaining their independence. This gives us confidence in their ability to execute and maintain their culture even as they continue to grow rapidly in both employees and revenue.

Macro Tail Winds - A Rising Tide Lifts All The Boats

The tailwinds from online retail adoption versus physical retail should lift all e-commerce related companies. This is one of those data points that is driving widespread uninformed investors to invest in Shopify. They are jumping on the bandwagon. Many are using Shopify to add e-commerce exposure to their portfolio without understanding the underlying business giving them that exposure. This creates a flow of money tied to e-commerce data points. If the macro data is stronger than expected, Shopify shares may rise. And if it's weaker, then Shopify shares may fall.

Source: Shopify

In 2016, US e-commerce sales were $395 billion according to the US Census Bureau, +15% y/y and accounting for only 8.1% of total retail sales. As the shift to online sales continues to rise, Shopify should see more gross merchandise volume (GMV) being transacted over its platform. Total retail sales in the US was $4.8 trillion in 2016, so there is plenty of room for growth as e-commerce as a whole penetrates further into the overall retail sales.

Our forecast model does not imply a further acceleration of this trend. E-commerce has moved passed the Innovators phase of the technology adoption life cycle into the Early Adopters phase. When e-commerce approaches Early Majority and Late Majority phases, merchant additions and GMV could see accelerated growth even faster than we have already experienced.

Summing It All Up

We believe there are two main types of investors of Shopify.

The uninformed investor is buying and selling on short-term valuation metrics, "stock tips", and macro data related to retail and e-commerce.

The informed investor is buying with a proper rationale of how much potential revenue Shopify could generate in the next 5 to 10 years.

The risk is in the eye of the beholder. If you have done your homework and know the company you are investing in inside and out, then the investment risk is much lower. The more you know, the less risky it will be to you.

Those on the "outside" who have not done their homework, but insist on "investing" create a risky situation for themselves. When prices start to move up or down, how does an uninformed investor make a decision to buy, sell or hold?

Uninformed investors cannot eliminate emotion from that decision because they never had the right logic when they bought the stock in the first place. This creates opportunities for informed investors to buy stock for low prices.

Conclusion

We believe Shopify can get to $1 billion in free cash flow in 10 years. And that will be the floor going forward.

Getting there will require merchant growth of 18-27% CAGR, compared historically to their 73% CAGR in the last 4 years.

The current enterprise value to sale multiple is 12x our 2017 sales and 7.7x our 2018 sales. But in 5 years we expect that to drop to 3x while still having 30% y/y growth prospects.

Lastly, Shopify's ability to execute is clearly proven to us. Over the last 5 years, they have grown their employees from 131 to over 1900 while maintaining their innovative culture and long-term perspective. The next 5-10 years is going to require the rapid addition of employees to achieve the growth necessary to justify the current stock price. Given its history, we believe Shopify can handle the challenge ahead.

We are long-term shareholders with a fair value of $90/share. See Shopify: Cash is Cash, M&A is Upside for more details on our fair value.

In the event of a widespread market pullback, we would be buyers of Shopify to position ourselves for the next 5-10 years.

Check out our article Shopify in a Recession, to see why we think Shopify could drop 40-60% in the event of a widespread market pullback.

If you like our insight you can follow us in real-time.

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.