Shopify: Buy On Dips

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About: Shopify Inc. (SHOP)
by: Damon Verial
Summary

Shopify's growth story is one without a bleeding balance sheet, yet investors are asking when this growth story will become an earnings story.

Despite astounding merchant acquisition success, Morgan Stanley downgraded SHOP, causing the stock to dip.

My statistical analysis on the stock's price action and my sentiment analysis on management's forward-looking statements show that the stock should continue upward over the next quarter, at least.

Shopify (SHOP) has undergone a great rally over the past four months, to the tune of 76%, and many are asking when the top will be in. From a business cycle perspective, as we near the end of the expansion phase, tech stocks such as SHOP should begin to slightly underperform. From this perspective, and with SHOP’s rally seemingly overdone, we should be eyeing that top:

But SHOP’s revenue growth is showing no sign of slowing. With the company’s strong customer acquisition results, SHOP has now a total of 800,000 vendors, an increase of 25% over the past year. That increase in vendor numbers correlates exactly with the company’s yearly revenue increase: 25%, beating the IT market by 15%.

Safe Growth

Growth stocks like these typically grow via debt. Yet, the company has under $300M in long-term and short-term liabilities. Its assets are 21x its debt:

(Source: Simply Wall St)

The company’s growth in terms of client acquisition and revenue is indisputably astounding. Yet, this room has an elephant. Investors are concerned with SHOP’s ability to convert this into profitability.

This is where the SHOP bulls and bears hit a real division. One outlook is that SHOP is digging itself a hole: The company might be growing its base, but that base contains considerable churn, which does not result in profit but does come at a cost, namely marketing and commissions. The other outlook is that SHOP is acting like a venture capitalist: Many of its acquired shops will fail, but those that do find success will be producing revenue according to a power law (or Pareto distribution – think fat tails), thus justifying the large expense to acquire these clients.

I am not about to tell you which way of thinking is correct; only future earnings will answer that. For now, your choice is to hang on and wait or to get out while SHOP is at or near its top. I prefer the statistical method, which is to convert the data I have available into a prediction.

Price Action Analysis

With SHOP’s volatility spiking, especially after yesterday’s downgrade from Morgan Stanley, I think we should start with an analysis of SHOP’s price action. I ran a Markov chain model over the stock’s price movement to find that the best time to buy is on down gaps, as these produce an expected return of $2.87 during the day after the gap. Down gaps fill 80% of the time.

Up gaps are the next best, but they lead to reversals almost half of the time (reward is still higher than the risk). This is because the “dumb money” tends to buy SHOP when it opens higher. The smart money tends to sell SHOP after the stock overextends itself during the day:

(Source: Damon Verial; data from Yahoo Finance)

The obvious day-trading strategy here is to buy SHOP on down gaps and hold until the first white candlestick, at which point you take your profit, waiting for the next down gap. Overall, the price action shows a strong dip-buying habit in SHOP traders and investors. Profit-taking tends to occur only on big jumps.

Sentiment Analysis

For a longer-term analysis, SHOP seems to be moving in line with its management sentiment. SHOP’s management has shown slightly below-average (roughly one-third below the market average) sentiment up to Q4, 2018, at which point, sentiment jumped 160%. Sentiment remained the same quarter over quarter, as per my financial lexical analysis of the company’s earnings calls:

(Source: Stockcharts.com)

The recent earnings call shows that management sentiment is still highly positive. This predicts excess returns over the coming quarter. For some insight into management optimism, we check some of the statements flagged by my sentiment analysis:

“Merchant adds in the first quarter, which is typically a slower period nearly matched merchant adds in our fourth quarter, typically a stronger period.”

  • SHOP has managed to overcome seasonality in its business cycle. Either that, or growth is much stronger than expected, implying that Q4 2019 will be extremely impressive in merchant acquisition. Management believes that this growth can be attributed to its premium Shopify Plus platform, echoing the idea from SHOP bulls – namely that the successful stores are giving high ROI to the company to the extent that churn is offset:

Description: Image result for shopify plus

(Source: Shopify)

“This quarter we plan to launch Shopify Payments in The Netherlands, which features an integrated local payment method that allows for bank transfers, which are more popular there in addition to credit card payments.”

  • Many investors believe that Shopify’s growth is almost exclusively in acquiring new merchants. However – and this can still actually be taken as an aspect of merchant acquisition – an important growth aspect is also in helping merchants reduce the barriers to acquiring customers. By focusing on local markets’ idiosyncrasies and allowing those markets access to features in response, this opens up more revenue paths. The addition of payment methods in specific markets reduces barriers for both merchants eyeing Shopify as a platform and for customers browsing Shopify stores.

“But we feel really positive with our continued investments in international and brand, so we're optimistic and that is one of the reasons why we increased our guidance for 2019.”

  • The focus on international growth is often one of the safer parts of a growth stock’s expansion phase, as the US market is usually quite stable before international expansion efforts are emphasized. SHOP is in its beginning phases of international growth, and this should be viewed as optimistic to SHOP bulls who believe the growth story is not over.

“Now it's a little bit of a different issue but cross-border selling is this year's challenging and accepting currencies are under good to see as challenge and showing up in the right language and all these kinds of things.”

  • Management has mentioned many times that international issues will be the main issues in this fiscal year. We might see some snags here, but should the process be smoothed out, merchants will gain the huge benefit of easily converting local businesses to global businesses. Clearly, this would be a large draw to the platform and allow for extra revenue for SHOP and its merchants alike.

Summary

Overall, SHOP’s sentiment shift seems to be one of excitement in a new growth phase. As its US side of the business is streamlined, the company can repeat its growth phase abroad. This would give us a “phase 2” of the growth we have seen over the past few years, supporting the bullish thesis.

The main fears at present are the same fears for any growth stock: Is growth enough? Will the company be able to convert that growth into real earnings? In addition, some are fearful of the US-China trade war, and with a large proportion of Shopify merchants sourcing from the Chinese manufacturing sector, this could be a legitimate fear.

However, these fears are currently unquantifiable, while the growth trends are quantifiable. At least for the coming quarter, SHOP should see continued growth, especially abroad. I do not think the growth story is in trouble, at least for the next couple quarters, analyst downgrades be damned.

Trade Idea

If you are to ask “long/short” at this point, most signs point to “long.” If you really think SHOP is overextended, perhaps buy carefully. Options can help here; I recommend a broken wing butterfly with puts, with a long call tagged on for a conservative way to play SHOP in the long direction:

  1. Buy 1x Jul19 $180 put
  2. Sell 2x Jul19 $250 puts
  3. Buy 1x Jul19 $260 put
  4. Buy 1x May17 $250 call

This strategy is of roughly 100 delta. However, the strategy is opened at parity (roughly); the broken wing butterfly spread finances the long call. Essentially, you are mimicking holding 100 shares of SHOP at no cost and lowered risk.

You can roll the long call over weekly, and depending on market conditions. The put spread can be rolled over quarterly. Happy trading.

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.