My thesis is that Shopify (SHOP) is under-monetized with a flywheel in full gear such that future economics will be extremely different from what we see today.
Looking at the competitive landscape, BigCommerce isn't yet public. WooCommerce is a WordPress plugin and it requires some do-it-yourself work on the front end along with integrations on the back end. Demandware was acquired by Salesforce (CRM) in 2016. Magento was acquired by Adobe (ADBE) in 2018 and CEO Tobi Lütke answered a question about them in the 2Q18 earnings call. Among other things, he doesn't think Magento is adequate for the modern internet:
If I just sort of say, Magento hasn't been that big of a factor, right? I mean, Magento comes up a lot at the Shopify offices as a sort of latent potential acquisition source of Plus customers, and this is the context we usually talk about. There isn't strength in the product, there's no -- most of the reasons why someone would use Magento over Shopify are because of internal politics and poor decision making, frankly, or misguided ideas about wanting to do your own hosting for e-commerce.
I make comparisons to eBay (EBAY) and Amazon third-party marketplace (3P) (AMZN) but the reality is there is no pure play public competitor identical to Shopify. Amazon 3P and eBay are marketplace channels whereas Shopify is a single back-office system for multiple channels like eBay, Amazon 3P, Instagram and others. In the Shopify 4Q17 earnings call it was revealed that about 60% of their merchants use more than one channel to sell. Amazon 3P and eBay are apples and oranges with respect to Shopify in many respects but it is interesting to compare their gross merchandise volume (GMV).
The 2018 annual report says Shopify has more than 4,000 employees/contractors.
An important development discussed in the 2Q19 earnings call is the Shopify Fulfillment Network. Approximately $1 billion will be invested in it over the next five years. And on September 9th Shopify announced that they are acquiring warehouse fulfillment solution provider 6 River Systems for $450 million.
One should be familiar with the Shopify flywheel before I explain my thoughts on churn. CFO Amy Shapero explains the flywheel at the June 2019 Investor Day saying that when less successful merchants leave, they often take little or no GMV:
The flywheel starts with keeping a wide funnel. Seeing commerce through as broad a lens as possible ensures multiple voices contribute to the future of commerce. And it informs our product road map on how we can make our platform more powerful for all merchants. Next, leveraging that information and keeping merchants' operation simple, we attract more merchants by providing them with the tools to easily manage their business. More channels, more partners, more capabilities. Lastly, all of that results in keeping merchant sales growing. By simplifying their operations and giving them great tools, we help them to be more efficient. By being more efficient, they're able to devote more resources to growing their business.
Here is a visual of the flywheel:
Image Source: CFO Amy Shapero from the June 2019 Investor Day Slides
The first flywheel objective above about keeping a wide funnel is crucial. Parts of the Wall Street churn discussions can be minutiae with respect to the big picture. Churn isn't zero so the number of merchants in past cohorts declines over time but the overall revenue from older cohorts has been increasing:
Image Source: CFO Amy Shapero from the June 2019 Investor Day Slides
Merchant accounts tied to unsuccessful experiments fail to survive but many of the remaining merchant accounts get massively stronger over time. At the November 2017 Credit Suisse Conference, former CFO Russ Jones says they don't focus on unit churn and he ostensibly points out that the best way to improve churn is to stop adding people to the platform. Obviously this would be a terrible business decision and it goes directly against the first flywheel objective of keeping a wide funnel. Former CFO Jones reveals the monthly billing retention number is a more important metric than churn and that it is over 100%. This means that as merchants leave, the remaining cohort more than offsets those losses.
Ronald Bookbinder from IFS Securities asks about churn in the 2Q18 earnings call. He states that the market may be concerned about churn and the possibility of Shopify running out of merchants. But Bookbinder notes that entrepreneurs experiment frequently such that they can have multiple websites/accounts as they tinker. He asks what the average number of websites is for each entrepreneur on the platform. CEO Lütke gives a telling answer saying that pivots and changes are part of the entrepreneurial process:
Of course, we have internal estimates on it, but it's lossy because the way Shopify, probably one of the regrets I had when I wrote the initial version of Shopify, is that I didn't really anticipate this sort of creation and trial, and therefore what I didn't do is allow people to create one account under which you could create any number of stores and sort of track them against each other. If I had a time machine, this would be one of our little changes in the data model that I would have done. Now we will retrofit this, this is something we've already said we would do at Unite. So once we do that, we will have a much better idea because you can really sort of track the entrepreneur process across different attempts. So this is like, the churn, there's a lot of focus on it. And it's really -- we haven't found the right language to describe why it's simply not a problem.
It is significant that database architecture can affect the unit churn definition such that some discussions are a matter of semantics. Under the old architecture a merchant may have ten accounts and delete nine of them. Under new architecture a merchant may have one account the entire time with ten stores at one time and one store at other times. The number of experiments that are canceled and the number of "duplicate" account cancellations don't tell us much. The key number number that matters is the revenue by cohort shown in the above chart.
Learning From Recessions
The economy has been doing fine since the Great Recession of 2008 and early 2009. We'll face more recessions in the decades ahead and I like to look back on this last one to think about the ways companies operate under different conditions. For example, CarMax (KMX) reduced capex in 2010 following the Great Recession such that we have insights as to what their maintenance/replacement capex looks like when they aren't investing in growth. Shopify wasn't public around the time of the Great Recession but we can still learn about the way it shaped their history.
CEO Lütke talks about migrations in the March 2019 Tim Ferriss podcast. He reveals that around the time of the financial crisis in 2008 or 2009 they had people converting from systems that were around nine hundred thousand dollars a year to the Shopify plan of just $59 per month! 90 minutes into the April 2019 podcast with Shane Parrish, CEO Lütke explains that the Great Recession sort of saved Shopify. He explains that the software was good enough at that point for merchants to replace really expensive e-commerce systems with the cheaper but better Shopify solution. In some respects Shopify is antifragile. GMV will likely decline during the next recession for a year or two but they should add a large number of merchants without additional customer acquisition costs (CACs) whose lifetime values (LTVs) will be substantial.
The World Is Changing
A March 2019 Forbes article talks about the way Kylie Cosmetics uses social media platforms like Instagram powered by Facebook (FB) for marketing along with Shopify for sales and fulfillment. 2018 revenue for Kylie Cosmetics was an estimated $360 million!
In the 2018 Code Commerce interview, CEO Lütke says that Facebook and Instagram channels are large drivers of purchasing traffic. He acknowledges that there are some bad Instagram brands but he enthusiastically points out that some of them will be the new Nikes in 20 years. Shopify has removed the intimidating learning curve that was previously required for starting a business:
The possibilities for small businesses are massive because of the way platforms work. 20 years ago we only had television - television and billboards. It's like, how would you have even created a relationship with all the billboard companies, like you couldn't have, right? Would you have done television? Do you know how capital intensive the TV ads are?
What Shopify does is, we have successfully, I think, built a business model around helping people get a part of that slice, like preserving the ability for people to actually start online businesses.
Gross merchandise volume is now massive and the yearly growth rate has been slowly declining every year since 2014 as the base increases. In 2014 the GMV y/y growth rate was 133% and by 2018 it was "only" 56%:
Image Source: Shopify 2018 Year in Review
We can see quarterly GMV is now in the big leagues with eBay and estimates for Amazon 3P:
*The Amazon 2018 annual report disclosed that 3P GMV for the year was $160 billion but on a quarterly level we make rough estimates based on a multiple of 3P sales.
There is a small amount of overlap with the GMV above. In the 4Q16 earnings call, Shopify said they didn't count Amazon marketplace GMV in their total at first. Per Investor Relations, Shopify began including GMV from Amazon marketplace in the GMV they report in the second half of 2017. I'm guessing eBay GMV is included in the Shopify GMV figure as well.
Shopify has grown quarterly GMV from $5.8 billion to $13.8 billion in just 2 years while the quarterly GMV for eBay has hovered near $23 billion. If we conducted a facile analysis and looked at things through the GMV lens alone then maybe there wouldn't be much outcry about the fact that Shopify has higher market cap and enterprise values than eBay. Of course we have to look at more than just GMV but the growth here on the part of Shopify has been impressive and their flywheel remains strong such that GMV growth should continue for the foreseeable future.
Shopify shows some global e-commerce statistics that are eye opening:
Image Source: Shopify global e-commerce statistics
I haven't been able to find Shopify GMV by geography but the 2018 annual report does show revenue by geography (in thousands $):
Image Source: Shopify 2018 annual report
We see that four English speaking countries account for 88% of the 2018 revenue. One would think there is an opportunity to expand GMV and revenue in places like Japan and Germany seeing as the 4Q18 earnings release says they have launched Shopify Payments in those countries.
In the 4Q17 earnings call, CEO Lütke says that the combination of Advanced Marchants and Shopify Plus merchants accounts for over 50% of the GMV. I haven't found a chart that explicitly breaks GMV down with Advanced Merchants but they are probably most of the Plus Upgrade group and a substantial part of the Core group. Shopify does have a chart showing GMV by Core, Plus Upgrade and Plus New Business:
Image Source: CFO Amy Shapero from the 2019 Investor Day Slides
The 2018 annual report says there are only about 5,300 Plus merchants which makes their large contribution above impressive.
Looking at the Booking Holdings (BKNG) 10-K along with the Expedia (EXPE) 10-K, we see that more than GMV is needed in order to value a company. Concentrating on the fragmented European market with the agency model, Booking Holdings had 2018 gross bookings of $92.7 billion and top line revenue of $14.5 billion for a 15.6% take rate. Adjusted free cash flow (FCF) was $4.6 billion. Meanwhile, Expedia had gross bookings of $99.7 billion and top line revenue of $11.2 billion for a take rate of 11.2%. Adjusted FCF was $0.9 billion. Booking Holdings was able to monetize GMV better with a higher take rate to the top line and they have higher FCF margins on top line revenue. Their take rate was 15.6% vs 11.2% and their adjusted FCF margin was 32% vs just 8%. Considering other factors apart from GMV, we begin to see why the market cap of Booking Holdings is over four times higher than the market cap of Expedia despite the fact that Expedia has higher GMV (note that adjusted FCF treats stock based compensation like cash and deducts it from net cash provided by operating activities).
Revenue by stream is shown at the June 2019 Investor Day:
Image Source: CFO Amy Shapero from the June 2019 Investor Day Slides
The two revenue buckets above are subscription solutions and merchant solutions.
Starting from the bottom of the chart, the subscription solutions bucket is made up of subscriptions in red and apps/themes/domains/platform fees in orange. The plans for subscriptions in red are shown on the Shopify pricing page where we have monthly plans including Basic Shopify for $29, Shopify for $79 and Advanced Shopify for $299. Things get more complicated with the Shopify Plus plan that starts with a monthly fee of $2,000 per month. This $2,000 goes in the red subscriptions stream above. The 2Q19 earnings call reveals that the fixed $2,000 component of Shopify Plus has ranged from 23% to 26% of MRR (the red subscription stream above) over the last year.
Shopify Plus also has a monthly variable component which is 25 basis points of GMV up to $40,000 per month. This variable component is also referred to as platform fees and it is in the orange revenue stream above which is still inside the subscription solutions bucket but outside of the red MRR/subscriptions area. A January 2019 Magento 2 Commerce vs Shopify Plus analysis implies that Shopify Plus is under-monetized. It shows that the three year cost of ownership for Magento can be over two times more expensive than the Shopify Plus cost.
The merchant solutions bucket is made up of financial services in green, shipping in dark green and transaction/partner referral/other in yellow. Shopify principally generates financial services revenues via payment processing fees from Shopify Payments. Looking at the 2018 annual report, Shopify Payments revenue grew by $176 million or 64.4% from 2017. Doing a little algebra, that means Shopify Payments revenue was about $273 million in 2017 and $449 in 2018. Merchant solutions revenues were $363 million in 2017 and $608 million in 2018 so Shopify Payments makes up about 3/4ths of merchant solutions revenue.
Merchants are highly incentivized to use Shopify Payments, it is required for options like Fraud Protect and Shopify Capital. There is a fee of 15 basis points for merchants who do not use Shopify Payments. Like Shopify Payments, this fee of 15 basis points is part of merchant solutions revenue. The 2Q19 financial statements show that quarterly Shopify Payments penetration was 42% or $5.8 billion GMV out of $13.8 billion total quarterly GMV. Merchants using Shopify Payments often have a smoother experience than if they were to outsource this process. And Shopify has economies of scale when it comes to negotiating on behalf of their Shopify Payments merchants. This space should continue to evolve, in the 3Q18 earnings call COO Harley Finkelstein said it is estimated that by 2021 most online transactions won't use a credit card.
Regarding the timing of these revenue streams, the 4Q18 earnings call reveals that they launched Shopify Plus in 2014, Shopify Shipping in 2015 and Shopify Capital in 2016. A smooth merchant experience, economies of scale and product integration are key factors that have made Shopify Payments and Shopify Shipping successful.
At the June 2019 Investor Day, COO Finkelstein talks about the fact that Shopify Plus can be better monetized in the future:
The balance of value to cost on Shopify Plus is so far away in the side of value. Can we increase price? Is there a price elasticity of demand unequivocally? Is it the best deal in enterprise commerce? Probably. That is completely intentional.
And so there will be an opportunity again in the future where we will increase pricing for Plus. I don't think the time is right now. In the same way that Shopify in the relating was in land grab mode, Plus is in land grab mode. Shopify is 15 years old. Plus is barely 5 years old. So I do think there's a chance to increase eventually. I don't think the time is right for that right now.
CEO Lütke makes some points about being under-monetized at the June 2019 Investor Day:
I think it's obvious. Shopify has always been sort of slightly under-monetized, which I think is actually where you want to be. I think that's much harder to compete with, for everyone else.
So the amazing thing about Shopify is that due to the scale and the size of the ecosystem, what we can do is, we can now build this and we can charge our customers less than they have been charged before and yet at a good amount of margin to [where] our company should we be successful.
Looking at the Shopify 2Q19 financial statements and the eBay 2Q19 10-Q, we see that the 2Q19 quarterly revenue is $362 million for Shopify and $2,687 million for eBay. Obviously this is a huge difference but Shopify GMV is growing rapidly and over time they should increase the percentage of revenue relative to GMV.
We have to talk about the disparate types of top line revenue before we work our way down to the bottom line. The subscription solutions revenue bucket has high gross profit margins. Some parts of the merchant solutions revenue bucket have high gross profit margins and others do not. Specifically, the Shopify Payments revenue does not have high gross profit margins, especially in North America where interchange fees are high (Stripe gets the headlines but the bulk of the cost is interchange). Shopify is the merchant acquirer with Shopify Payments so revenue is recorded on a gross basis. The Capital and Shipping revenues in merchant solutions are recorded on a net revenue basis so they have high gross profit margins.
The 2Q19 financial statements explain that despite Shopify Payments not having great gross margins (especially in North America), this revenue requires little in the way of sales and marketing or research and development:
Gross profit margins on Shopify Payments, the biggest driver of merchant solutions revenue, are typically lower than on subscription solutions due to the associated third-party costs of providing this solution. We view this revenue stream as beneficial to our operating margins, as Shopify Payments requires significantly less sales and marketing and research and development expense than Shopify's core subscription business.
At the June 2019 Investor Day, CEO Lütke brings up the point that the incremental cost of adding a new merchant is practically zero:
There are some very important decisions that Shopify has made in the way its own architecture is developed that came from our desire to be able to make it so that someone signing up for a new store ends up being no more costly for us than someone adding a product to the database and so on.
In the 2Q17 earnings call, Deepak Mathivanan of Barclays notes that gross profit is around 1.5% of GMV and he asks if it will increase given the value proposition to large merchants with cloud infrastructure and payment processing. He also asks about the percentage of Plus merchants on Shopify Payments. Former CFO Jones doesn't give an exact percentage for the second question but he notes that merchants including Shopify Plus merchants sometimes move to Shopify Payments in order to be eligible for Shopify Capital. As for the first question, he says there are good opportunities ahead. CEO Lütke comes back to the flywheel in his response:
I just have to say, like from the perspective of building a business, we never manage the company against these sort of financial ratios or goals. Like the way we think about our business is that we have our core product, which is of enormous amount of value to the people who use it. We are constantly working on thinking about how to make it better. We have a pretty clear idea of what the future of retail might look like and what kind of stuff that requires.
All of these things go on the flywheel that hopefully then spins faster and faster and faster. And from that, we look at opportunities to get some revenue, especially in places where our customers are already spending money, like payment gateways and so on. And that combination then creates a really, really robust growth story, where the revenue is then reinvested into allowing us to take advantage of more opportunities to build better product, and that all kind of feeds back into each other.
The question above was about gross profit so it hadn't even explored what happens further down on the way to the bottom line. But the answer tells us that massive growth investments are being made inside income statement expense lines such that net earnings are much lower than they would be if growth was absent. In this sense Shopify has similarities to Amazon.
We see amazing growth in the quarterly income statements:
Image Source: Shopify 2018 annual report
Gross profit grew from $100 million in 3Q17 to $205 million in 2Q19. Meanwhile, sales and marketing expenses grew from $58 million to $119 million. At this point in time I think gross profit is more instructive than net loss. The CAC spend in sales and marketing will be a smaller percentage of revenue in the future when the company is no longer in rapid growth mode. As such, the bottom line economics will be completely different.
The qualitative considerations of having Lütke as CEO are enormous.
In a perfect world we'd know what the per-share economics will look like in five or ten years and then discount that back to today. In the real world there are many things that are unknowable. Shopify is a wonderful company but there are many unknowns on the valuation side.
This is what I get for enterprise value:
$40,400 million market cap 
$109 million lease liabilities
$6 million current lease liabilities
$(669) million cash
$(1,344) million marketable securities
 The 2Q19 financial statements show that as of July 26, 2019 there were 100,335,518 Class A shares along with 12,231,344 Class B for 112.6 million total. Multiplying this by the September 9th share price of $358.67 gives us a total of $40.4 billion.
The Shopify flywheel has been a wonder the last five years and it should continue to bear fruit in the years ahead. Shopify is clearly a wonderful company but it isn't easy to answer the question as to whether or not the price is fair. The actionable information here is to study Shopify deeply even though it appears to be expensive based on standard metrics like price to sales.
At the time of this writing Shopify is just a library card "position" for me consisting of one share. They are an amazing company led by a special CEO but it is difficult to know what the per-share economics will look like five or ten years from now.
Disclosure: I am/we are long SHOP, FB, AMZN, BKNG, GOOG, GOOGL, KMX, VOO. 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.
Additional disclosure: Any material in this article should not be relied on as a formal investment recommendation. Never buy a stock without doing your own thorough research.