The Good, The Bad, And The Ugly About Shopify

Summary

• Shopify is a great company with excellent customer reviews.
• It has exceeded analysts expectations in all quarters as a public company.
• The company is priced to perfection as the growth in revenue and GMV slows down.

Introduction

I have followed Shopify (SHOP) closely for many years and admired its growth trajectory. I was an early investor in the company when it launched its IPO but I exited the investment in 2017 because I believed the company was a bit overvalued. That was a mistake since the stock has continued to move up. As a public company, the stock has gone up by more than 500%. There is a good reason for this. Its annual revenues have increased from $23 million in 2012 to more than $1 billion in 2018. It is estimated to generate annual revenues of almost $2 billion in 2020. It has continued to add active subscribers to over 600K. Also, it has beaten the consensus estimates in each quarter as a public company as shown below. Further, with the migration to cloud over, the company will see margin expansions this year. The company has also huge potential to grow internationally. In this article, I will look at the company and explain what I think about it.

Source: Seeking Alpha

The Good

Shopify is an excellent company that solves a major problem. It helps businesses and startups around the world create a functional store within minutes. As a result of its excellent platform, it has become the second largest e-commerce platform after Woocommerce, which is an open source Wordpress platform. With the e-commerce space growing, the company will continue to attract more users in years to come. That said, here are a number of good reasons you might consider to own the company.

First, the company operates a light asset model. By this, it only operates mobile and web platforms without the need for huge capital investments. Recently, the company completed its migration to the cloud, which was a multi-year project. This migration will help improve its efficiency and margins. The company has gross margins of 55% and I believe they will continue to rise. In comparison, Wix (WIX), which is a close competitor has gross margins of more than 78%.

Second, the company is led by its founder, Tobias Lutke. Research shows that companies that public companies that are led by their founders tend to perform better than their peers. Since Tobius is 38 years old, he will likely remain in this position for a while, which is beneficial to the stock.

Third, Shopify has more avenues for revenue growth. In the past few years, the company has launched new products such as those of financing and shipping. In fact, the merchant revenues grew by 68% in the third quarter. This was better than the subscription growth of 46%. Since some of the merchant products are not available in all core geographical regions, the company could continue to grow. In fact, in the last conference call, the company did not rule out the fact that it could one day launch its own marketplace.

Fourth, the company’s brand remains a core intangible asset. Its brand is so powerful such that Amazon (AMZN) moved its Webstore clients to the company in 2015 because it couldn’t compete. This is despite the fact that there were other peers like Big Commerce and Magento that were in the business. The company continues to have excellent ratings, which are better than those of its peers.

Fifth, for investors, Shopify has been an excellent investment. As shown below, its stock has risen by more than 500%.

Finally, the company has a great balance sheet. As of September 2018, the company had cash and short-term investments worth more than $1.578 billion. This compares to its total liabilities of just $168 million. Its shareholder equity is more than $1.67 billion. The chart below shows the growth of its assets and liabilities.

Source: YCharts

The Bad

There are a number of issues I see with Shopify. First, there is a question about its churn rate. While the numbers are not public, the fact is that most of the companies being hosted by Shopify don’t last for many years. Studies show that 90% of startups fail within the first year. Therefore, since most of Shopify’s clients are startups and small businesses, I believe that its churn rate is significantly high.

Second, the company will likely not maintain the past revenue growth. In the past few years, the company has seen its revenue growth continue to decelerate as shown below. To solve this problem, it has launched a number of additional products like Shopify Capital and Shipping. However, the revenues in some of these products continue to be weak.

The same is true with the GMV growth. In the third quarter, the GMVs grew by 55%, which was lower than the 69% of the third quarter of 2017. The chart below shows the continued weakness in GMV. There is a likelihood that the volumes will continue to weaken in the next few years.

Source: Bloomberg

Third, competition in the e-commerce platform industry is increasing. While Shopify will continue to retain most of the current customers, it will likely have problems finding new customers. In recent years, companies like Wix, Weebly, and Squarespace have started offering e-commerce capabilities. This is because these smaller companies offer pricing that is lower than that of Shopify. For example, while Shopify pricing starts at $29, that of Wix e-commerce platform starts at $16 with the most premium package going for $24. Weebly and Squarespace e-commerce packages start at $25 and $26 respectively. While Shopify will likely continue having an edge over these competitors, new cost-conscious customers will likely prefer using the less expensive option. Also, the fact that there are newer competitors, it means that it will be difficult for it to raise prices.

The Ugly

Until now, this report has shown that Shopify is a great company that has an incredible market share in its industry. It has also shown that the company continues to face headwinds related to its growth, competition, and churn.

The ugly side of Shopify is its valuation. The company is currently valued at more than $17 billion. This valuation is slightly below its all-time high of $18.2 billion. At this valuation, investors are valuing it at 121x this year’s estimated earnings. This is much higher than that of other tech companies like Etsy (NASDAQ:ETSY), Square (SQ), and Wix (WIX), which have a forward PE ratio of 36, 65, and 48. The reason for this valuation is that the company has better growth rate than these peers, which are growing at 41%, 50%, and 40% respectively.

In addition to the forward PS ratio, investors are paying 9.5x the estimated sales for this year. This is a hefty valuation compared to that of its peers like Etsy and Wix, which have a PS ratio of 6.9 and 5 respectively. The ratio is similar to that of Square, which was recently downgraded by analysts at Raymond James, who cited lack of more growth catalysts.

Further, the company has an EV to Revenue of 17.8, which is also higher than that of its peers. Etsy, Wix, and Square have an EV to Revenue ratio of 11.6, 9.0, and 9.9 respectively. All these comparable multiples show that investors are pricing the company for perfection, which exposes it to larger shocks in case growth continues to deteriorate.

Way Forward

Shopify has become one of the largest providers of e-commerce services in the world. As the growth of online shopping continues, the company is well-positioned to help small vendors reach more consumers. As described above, there is a lot to like about the company, and that is the reason why the stock has continued to show this type of growth. However, it is always important to consider the risks of investing in a loss-making company that is trading at 121x forward earnings. Its forward PS ratio is also higher than that of its peers. Therefore, In would recommend that you wait for a while before you invest in the company.

Analyst’s Disclosure: I am/we are long FB, AMZN. 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.