Time Is On The Side Of Shopify Investors

Summary

• While growth is slowing down, it's slowing down less than we feared, and the company is still in hyper-growth phase.
• To boot, it enjoys an entrenched market position, powerful platform economics, and the kicking in of operational leverage.
• The valuation is steep, though the losses and dilution are still substantial and the share based-compensation rich.
• We never feared any blowback from the Facebook/Cambridge Analytica saga, though.

In February last year, we advised buying the shares (in the low $50s) of Shopify (NYSE:SHOP), and the shares continued to rise inexorably for much of last year. This year, the sailing is a little tougher.

We predicted that growth would slow down, but that was hardly controversial, given that a hyper-growth triple-digit rise is simply difficult to maintain as the company becomes bigger - the law of large numbers.

We have a habit of looking at business SaaS service provider platforms through a specific lens of the business model, which consists of the following generic steps:

SaaS business service model

1. Get a foot into the door with a killer app, something at which the company is good at that fulfills a real business need.
2. Convert license clients into recurring revenues via SaaS in the cloud.
3. Expand users (seats) at existing customers.
4. Expand geographically.
5. Have a nice side business called services, where you help customers understand the product, show what it can do for them, and train them and help in installation, configuration, etc.
6. Open a partner channel, i.e., build a community or ecosystem.
7. Use the recurring (subscription) revenues to build out sales and R&D.
8. Use R&D to build additional functionality and/or verticals, modules that can be used to up-sell ("land and expand").
9. M&A might be used for the same purpose as R&D - to acquire new capabilities to up-sell.
10. Open up the platform for third-party/customer apps and take a share of the cut or use it to solidify the platform position and value.
11. Grow revenues in order to achieve operational leverage.
12. Ultimately, earn enough free cash flow to deleverage (where applicable) or allow the company to buy back the shares that are issued as stock-based compensation and/or pay dividends.

Not all of these steps are equally important, or even relevant, for each SaaS business service provider (so we'll skip a few here), but it's nevertheless a useful framework, we feel.

1) The killer app was simply taking much of the hassle at starting e-commerce, especially for smaller players. What the company got right from the start is opening a one-stop shop where the software was not unlike an operating system, a unified system that connects otherwise disjointed services and a basis on which to build additional stuff.

2) It has always functioned on a SaaS model, so this point is irrelevant. However, the company does generate two revenue streams:

• Subscription (the monthly fee for online presence) generating high gross margins.
• Merchant solutions (additional services like payments, shipping, capital, etc.) generating lower gross margins.

4) International expansion is quite a growth area and focus point for management lately, now that the company is well-established in its home market (Canada, US).

The company is still in the early phase of international build-out, and there are lots of opportunities here. It does involve localizing the services, like additional languages and adding a host of local payment methods.

5) We're not aware of Shopify having a service business (beyond a helpdesk), and that would beat much of the point, which is that it should be easy to set up an e-commerce business. Shopify Plus (for corporate customers) might have some handholding business for customers, but we don't think this is a substantial revenue generator.

7) The company has good recurring revenues. MRR make up $32.5 million, or 15.1%, of revenues. Of the MRR, an increasing part is from corporate customers using Shopify Plus (increasing from 17% to 22% of MRR y/y).

8) The company has built out several new modules, products or services, like:

• Payments, which is continuously adding solutions (like Google Pay in Q1).
• Shipping
• Shopify Plus
• Capital (cash advances)
• B2B (business-to-business commerce)

This is just a fraction of the service that the company offers for demonstration purposes. What matters is that a platform allows the company to continuously build more. This adds additional revenue streams, increases revenue per client, improves the value proposition of the platform and hence makes it more sticky.

And it adds up. While Pay (growing at a blistering 64% itself) is still the largest single element, revenue of Capital and Shipping both more than doubled for the year.

9) Acquisitions are also part and parcel of Shopify's strategy to increase the functionality and value of the platform. For instance, last year the company acquired Kit CRM, and the year before it acquired Boltmore - both were privately held companies.

Recently, the company has raised cash, and we suspect that it's not done on the acquisition field.

10) Shopify has a thriving ecosystem. From the Q1CC:

A part of ecosystem is healthy and thriving, with 2,400 apps available to merchant in the platform today and nearly 16,000 partners having referred merchants to Shopify over the past 12 months... The ecosystem at Shopify has created between merchants and developers, designers and agencies, is very powerful. We believe this ecosystem can and will inspire with the future of technology and the future of commerce looks like.

This is yet another route for increasing the value proposition of the platform and its stickiness. For instance, it uses third-party apps like:

• Oberlo (drop shipping)
• ePacket (global courier)
• Core (fulfillment)

11) and 12) will be discussed below.

Growth

That business model described above leads to lots of growth:

SHOP Revenue (TTM) data by YCharts

This doesn't yet include the Q1 figures, but the trend is pretty clear, at least in terms of revenue growth. Growth is, of course, slowing down, but it's still very substantial for Q1:

• Revenue in Q1 grew 68% y/y
• GMV (gross merchandise volume) grew 64% y/y
• MRR (monthly recurring revenue) grew 57% y/y
• Subscriptions grew 61% y/y
• Merchant solutions grew 75% y/y

Below you see that deceleration (not including the Q1 figure of 68%):

SHOP Revenue (Quarterly YoY Growth) data by YCharts

But we have to say, this is still hyper-growth and the slowdown has occurred somewhat slower than we expected.

Guidance

This is from the earnings PR:

For the full year 2018, Shopify currently expects:

• Revenues in the range of $1-1.01 billion
• GAAP operating loss in the range of $105-110 million
• Adjusted operating profit⁴ in the range of $0-5 million, which excludes stock-based compensation expenses and related payroll taxes of $110 million

For the second quarter of 2018, the company currently expects:

• Revenues in the range of $230-235 million
• GAAP operating loss in the range of $32-34 million
• Adjusted operating loss⁴ in the range of $5-7 million, which excludes stock-based compensation expenses and related payroll taxes of $27 million

The full-year improved guidance implies a 50% revenue growth versus 2017, which is a considerable slowdown from the near-70% levels we're at. We think this is the level management is comfortable of making, and the real outcome is likely to be higher. It has always been that way.

Margins

SHOP Gross Profit Margin (Quarterly) data by YCharts

There is some gross margin creep as merchant solutions outgrow subscriptions while the former enjoy roughly half the gross margin of the latter. What is encouraging, of course, is the rising trend in operating margins, suggesting considerable leverage.

And margins were negatively affected by the transition to the public cloud, which is complete by the fourth quarter.

Cash and balance sheet

There was a net use of cash from operations of $1.87 million in Q1, down from a positive $4 million a year ago. What is a little high is stock-based compensation:

Stock-based compensation in 2018 is now expected to be approximately $110 million for the full-year with about $27 million of this in the second quarter.

This was $17.9 million in Q1, so it is increasing rather rapidly, at $110 million this year - this is 11% of guided 2018 revenue, which is really quite substantial. Even so, the company doesn't have positive free cash flow:

Shopify sold 4.8 million shares in February, hence it's no surprise that its cash and cash equivalents and marketable securities balance increased to $1.6 billion (from $938 million at the end of 2017). This is $10 per share.

As we've seen above, there is considerable operational leverage, so the problem of negative cash flow should gradually lessen (unless the company increases CapEx a lot), but we're not there yet.

On the other hand, the cash bleed isn't such that one should get worried about debt or dilution anytime soon, apart from the fact that we had significant dilution just a couple of months ago.

SHOP Shares Outstanding data by YCharts

But as you can see, there has been a roughly 50% dilution over the past 3 years already, and with the jump in stock-based compensation there will be more of that to come.

Valuation

SHOP EV to Revenues (TTM) data by YCharts

Of course, on an EV/S basis, the shares are still very expensive, although the 18 multiple is on the basis of 2017 revenues. It's a less dramatic 11.5 on this year's expected revenue, and given that the company has a habit of beating these, it's more likely to be 11. That's still expensive, needless to say.

Risks

Citron has touted a Facebook (FB) risk, as a clampdown on Facebook data use could affect marketing for merchants, for which Facebook is the most important channel.

Quite frankly, we never saw anything in this, even if we've written quite a few critical articles about Facebook data policies. The Cambridge Analytica scandal centered on clients owning data, and how easy that was for third-party app developers and how sloppy Facebook was in allowing that and handling the problem.

However, advertisers do not own Facebook data, they merely using it. It allows them to target ads precisely, of course, and this is mostly a benefit (the more relevant the ads, the less intrusive they are).

So, unless there is something we're not seeing, we don't see much change in that. And if there is any change, it would be around the board for data policies (like the GDPR rules the EU adopted at the end of last month), which would leave Facebook's competitive position unaltered versus other online marketing channels.

Conclusion

Shopify is a beast, as simple as that. Even if company guidance materializes and growth slows down considerably, that's still 50% revenue growth. It has a dominant position and enjoys some powerful platform economics - it's actual difficult to see what can go wrong from a business perspective.

However, the share valuation reflects this - by how much is up for discussion - although we're inclined to say fully, or even more than fully. That doesn't mean the shares can't go higher. In fact, that's what we expect.

Advising people to buy Shopify shares is more art than science. We are generally inclined to argue that if results fall short of expectations (which are generally a couple of points higher than company guidance at the minimum), the share price is in trouble. If results are considerably better than that, the shares could take another leap.

But this is all against a backdrop of impressive company performance, even if growth disappoints, so unless something dramatic happens, time would tend to be on the side of the investor here.

We tend to prefer Baozun (BZUN), while concentrating on big brands (it's a sort of Shopify-plus, one could argue). It's already profitable, enjoys much better margins and the shares are much cheaper (less than 4x 2017 sales) but growing at similar speed (once the change in business model is factored in).

So we summarize. There are negatives, like the steep valuation, the stock-based compensation, the losses, the increasing dilution and the slowdown in growth. The positives are its still-hefty growth, the entrenched market position, the powerful platform economics and good operational leverage. If you add that up, we still think there is good risk/reward here.

Analyst’s 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.