Shopify May Have A Broken Business Model

| About: Shopify (SHOP)

Summary

Company might never turn to profitability due to challenges facing its subscription solutions.

Its drop shipping and importing system Oberlo targets Chinese companies with slow delivery time and often poor quality products.

Marketing expenses have almost doubled year-over-year to battle an increasing turnover "churn" rate as the company focuses more on finding new merchants than retaining existing ones.

Consumers can go directly to the supplier on AliExpress and purchase the item for less.

Out of more than 1,400-plus application such as Hurrify, AliReviews, Modalyst and others, add-ons tend to increase monthly subscription costs without yielding expected conversion rates for most merchants.

While the stock has been on a bullish uptrend for the last year gaining a whopping 180%, my confidence in the company primarily stemmed from its sound balance sheet with relatively low debt levels, coupled with moderate to high growth expectations.

However, for the past three months I incrementally gravitated from being bullish on Shopify (NYSE: SHOP) to strongly bearish, as some of the operational challenges which financial analysts cannot comprehend by just listening to Management Discussion & Analysis on conference calls became clear to me. Here are the primary reasons:

While the company is boasting in doubling its Gross Merchandise Value from $7.7 bln. in 2015 to $15.4 bln. at the end of 2016, as well as adding over 377,000 merchants across the world, its bread and butter still remain to be Subscription Solutions and Merchant Solutions. While both revenue streams are equally important as they compose 52% and 48%, respectively, for the sake of keeping this article as short as humanly possible, let us focus on the bread (Subscription Solutions) and leave the butter aside for now.

Shopify's subscribers are typically novice millennial entrepreneurs ages 21-35, opening similar niche type stores and selling the exact same products from AliExpress through the Oberlo importing system, hoping to strike it big with finding one or two products that may go viral like Fidget Spinners. And when the fad goes away or becomes saturated, they move to another product or open an entirely new store with the ease of Shopify's platform, upon which Shopify makes an extra $30-$50 a month until subscriber cancellation. Shopify expects this trial and phase to continue for many months as the motivated entrepreneur spends heavily on advertising, hoping one home run product will recoup all the prior losses.

Aspiring entrepreneurs or SMBs usually bombard Instagram and Facebook (NASDAQ:FB) feeds with similar advertisements by spending hundreds, if not thousands of dollars on influencers to promote their products. The name of the game is to mark up the price and offer "free shipping" incentives to lure customers, but for the transaction to make financial sense, overall markup should cover shipping costs, Shopify's payments percentage, as well as third party marketing fees for Facebook, Instagram influencer, or any other sales channel. Since each beginner needs 4-6 months to realize whether their store will start gaining ground and possibly be successful (through series of trial and errors between niche marketing or traditional store methods), this translates in ever increasing revenue for Shopify, at least for the short term.

Revenue is not sustainable if the merchant cancels their subscriptions after losing hope within several months of dwindling sales, which is usually the case.

In the 2016 Annual Report, Shopify management stated the following:

We have historically experienced merchant turnover as a result of many of our merchants being small-medium sized businesses ("SMBs") that are more susceptible than larger businesses to general economic conditions and other risks affecting their businesses. Many of these SMBs are in their entrepreneurial stage of their development and there is no guarantee that their businesses will succeed.

Those "other risks" mentioned in the first sentence of the paragraph could be open to interpretation and is more prevalent than the company admits. New merchants often see an immediate drop in return business when the consumer is not happy with the quality of the product in comparison to the advertised image, which is sometimes the case with drop-shipping from China. The average consumer is also not pleased with waiting 15-20 days for a product to arrive from overseas with the "e-Packet" feature that costs an extra $1-$3. Expedited DHL shipping costs will hardly work on select products and greatly reduce net profit margins.

While Shopify fails to comment in depth on merchant cancellations, it would be virtually impossible for the company to maintain and increase its subscription revenue levels without increasing its marketing expenditures to attract new amateur entrepreneurs. Management was indeed clear on this very issue in the annual report:

We incurred losses of $37.2 million in 2016, $18.8 million in 2015, and $22.3 million in 2014. At Dec. 31, 2016, we had an accumulated deficit of $83.2 million. These losses and accumulated deficit are a result of the substantial investments we made to grow our business and we expect to make significant expenditures to expand our business in the future. These increased expenditures will make it harder for us to achieve profitability and we cannot predict if we will achieve profitability in the near term or at all.

As a potential long-term investor, the inability of a company ever attaining profitability is quite alarming to me, especially when Shopify is currently trading at $122 a share without a positive P/E ratio.

Why would an investor pay X amount of dollars for every zero dollar of earnings now or in the future if there are no EPS growth expectations? Why wouldn't a shareholder seek growth elsewhere, when the company showed a $83.2 mln. deficit as of Dec. 31, 2016, and already $110.8 mln. as of June 30, 2017.

The stock price is way overextended as equity firms are riding the phase of online shopping craze of Amazon (NASDAQ:AMZN) and moving money from falling stock prices of traditional retailers such as Sears Holdings (NASDAQ:SHLD), Macy's (NYSE:M) and J.C. Penney (NYSE:JCP) to Shopify stock without grasping the intricacies that affects subscription solutions turnover.

As you can see in the chart below Shopify spends heavily on social media marketing to target new merchants vs. retaining existing ones.

Six Months Ended June 30, 2017 Six Months Ended June 30, 2016
Cost of Revenues
Subscription Solutions $25,942,000 $17,330,000
Merchant Solutions $94,011,000 $54,431,000
Operating Expenses
Sales and Marketing $100,206,000 $57,421,000
R&D $59,308,000 $30,402,000

This is a situation where I would prefer the company to increase its debt levels and operate more efficiently rather than live with a parallel correlation between revenue and marketing expenditures.

On the contrary, Shopify completed another public offering in Aug. 2016 of 8,625,000 Class A voting shares with aggregate net proceeds of $224 million to strengthen its balance sheet and provide flexibility to fund its growth strategies.

Advertised Price vs. Real Price

Basic Shopify Shopify Advanced Shopify
Monthly Price $29 $79 $299
Credit Card Rates
Online 2.9% + 30 cents 2.6% + 30 cents 2.4% + 30 cents
In Person 2.7% + 0 cents 2.5% + 0 cents 2.4% + 0 cents

While a Basic Shopify plan should not break the bank as it costs less than a tank of gas, the app add-ons such as Hurrify, AliReviews and others quickly push the basic monthly plan to $50, if not more. Add-ons such as Modalyst will increase the plan to $75 a month excluding any other apps that a new merchant will need to make a sale. And if you choose to put your store in a sleep mode, it will still cost you $14 a month.

Application Add-Ons Have Room for Improvement

Hurrify ($6.99 a month) is a countdown timer app with a fake "left in stock" number used to manipulate a sale and create a sense of urgency. A merchant enters any number of products left in stock, which absolutely has no connection to the supplier's stock number. One problem is that upon refreshing the app or reopening the page, the "left in stock" number restarts again. I am not sure if this is even legal.

AliReviews ($9.00 a month) is an app that is supposed to increase conversion rates by importing reviews from AliExpress into a merchant's store on a specific product, but while they pride themselves with many authentic reviews, some are 2-3 words maximum creating doubt rather than being trustworthy.

Kit CRM Inc. (Free) is another $7 million acquisition of Shopify which integrates with Facebook Messenger and automates its ads by marketing merchant products. While the app has few shortcomings, it does a great job at shortening the process of posting ads on Facebook's news feed. This translates to millions of dollars a month for Facebook's ad revenue stream, but does very little for Shopify's bottom line.

Modalyst ($45 a month) is an app that allows one to reach other drop-shippers across the globe if a merchant is not satisfied with quality of suppliers at AliExpress. It does a great job at staying up to date with automated real-time product feeds, including inventory levels and descriptions, but is the most priciest of all the apps, making it difficult for a beginner to thrive.

Although these are just few of many, some of the third-party apps that Shopify depends on and pays revenues to have plenty of room for improvement.

Mobile Audiences Are Mostly Sharp Millennials

Commerce transactions done over mobile devices still continue to grow faster than desktop transactions. Mobile purchases have surpassed desktop purchases for the first time consisting of 54% vs. desktop's 46% in the year 2016. Mobile purchasers are typically millennial or generation Z consumers who are sharp: they think fast, act fast, and adapt fast. Within a few searches, they can locate the advertised product on Alibaba and buy it way cheaper directly from the supplier vs. the marked up price advertised by the merchant. They are quick to copy each others retail stores and try their own Shopify store by watching a few Youtube training videos.

The result? Increased revenue for Shopify in the short term and oversaturated array of products, which eventually results in declining sales and cancelation of subscription renewals.

There are dozens of Shopify-made millionaire entrepreneurs on YouTube who are now charging thousand dollar courses to reveal their advertising "secrets." Gurus teach novices how to properly target audience ads on Facebook to create the best impression possible on a mobil/desktop ad to gain a consumer's trust and make a sale. This may be the secondary red flag that what used to work no longer isn't. One may want to ask why these millionaires are not trying to repeat the process to turn into multi-millionaires but rather focus on selling their own programs at discounts on Youtube.

Conclusion

The online consumer is becoming pickier than ever. To generate sales an online merchant needs to stay competitive, which often means having plenty of cash on sidelines for advertising and great quality products with on-time deliveries. Automation and drop-shipping tends to be the area that suppliers and merchants are gravitating toward to, but there are many internal problems. Asia suppliers run out of inventory, the quality of the product is sub-par and is drastically different than the image on AliExpress upon arrival, a shipment may take 20-30 days to arrive or not arrive at all. A consumer is being tricked with fabricated "left in stock" numbers that have absolutely no connection to the suppliers inventory, and the list goes on. All of this weighs in negatively on a merchant's store and its ability to retain a loyal following of repeat customers. Switching to a local drop-shipper often means higher monthly subscriptions costs, higher sales price and less sales, albeit shorter delivery times. It's a trade off.

At what point does an entrepreneur decide after several unsuccessful attempts, to switch to eBay (EBAY) or Amazon, where heavy traffic is guaranteed and the advertising burden is lifted off a merchant's shoulders. They also have the option of creating a website on Wix.com (WIX) and pay a fraction of the cost of $100-$120 for an entire year by easily creating a shopping cart website and uploading the products manually without drop-shipping features.

To an average analyst who is busy dissecting companies in numerous industries, reading an annual report or listening to management's discussion and analysis, this could be perceived as a typical company working out its challenges and risks associated with growing a business. However, actually beginning an online store and trying to overcome the hurdles, makes one realize that Shopify may have a broken business model that it's trying to fix.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SHOP over 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.

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