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Shopify (NYSE:SHOP) is a blisteringly expensive stock and currently trades at 20.2x consensus EV/Sales. The serious questions about the company's valuation have been well covered on Seeking Alpha in recent months, and this article is primarily concerned with evidence of how reliant the company is on drop-shipping - but it is worth covering a few key points about the extreme valuation at which the company is trading at before we begin.
Not only is this a very high multiple compared to profitable software and e-commerce businesses (Adobe is trading at 11.7x, Alibaba is at 6.2x, Amazon is at 3.2x, eBay is at 3.2x), SHOP is a perennially unprofitable company - and as its revenues have grown, so have its operating losses (i.e. increased scale doesn't appear to be resulting in increased profitability).
Source: Company filings, Noster Capital
Although by all accounts SHOP's core product is quite good, it is operating in an increasingly crowded space, and it does not have a dominant market share and does not have a significant technology advantage over its competitors.
Although revenue is growing reasonably fast (consensus expects 43% growth in 2019), it is moderating sharply from the almost 60% seen in 2018 and slowing revenue growth on a very high EV/Sales multiple is rarely a good sign.
Management is also investing significant capital in a series of projects outside the company's core competency - all of which are potential boondoggles. The company has recently spent $450m on a warehouse robotics business (not especially helpful if the company is, as we suspect, heavily reliant on drop-shippers), and has ambitious plans to build its own fulfilment network.; it is investing in television and film content; and in unproven AR/VR technology - all of which suggests that management is concerned about the growth of the core business, and is looking for ways to keep the revenue growth rate up.
At the same time, there are persistent questions about the company's disclosures on user numbers, its lack of disclosure on customer churn, and the apparent reliance of the business on 'drop-shippers' - Shopify stores which simply re-sell cheap Chinese merchandise, ordered directly from Aliexpress - at huge mark-ups - a practice which appears to be not only endorsed, but encouraged by SHOP.
These questions have been around for a while - and we are not accusing SHOP of fraud - but if it is the case that a material percentage of SHOP's clients are this kind of business, then the sustainability of the growth rate, and perhaps of the entire business could well be threatened.
Poor Disclosure of Customer Numbers:
The way in which SHOP discloses information about its customers makes it difficult for investors to have any meaningful insight into their customer base.
It seems clear from the disclosures that SHOP provides that they are not keen on investors having any meaningful insight into their customer base.
SHOP discloses the overall number of merchants on the platform, which at FY18 was "over 820,000".
Source: SHOP, 2018 Form 40-F
Unfortunately, they decline to provide investors with any information about the rate of churn of these customers:
Source: Text Search for "Churn", SHOP, 2018 Form 40-F
It is always a red flag for a company like SHOP to fail to disclose a metric as simple as churn - but they do give another number which investors can use to get some insight into the customer base - the Gross Merchandise Volume - or GMV.
From this, investors can make a very simple calculation, dividing the GMV by the reported number of merchants on the platform to see how much volume is passing through the store of the average merchant.
Source: Company filings, Noster Capital
This is obviously a very crude calculation. SHOP serves a series of notable e-commerce brands (Allbirds, Kylie Cosmetics, etc.) which we can be certain are processing many multiples of this $50k average. If we had reliable revenue numbers with which we could exclude these, then the average user would be seeing rather less than $50k in average revenue.
To be charitable to SHOP, we can give the average user full credit for the $50k in revenue. If we put this on a 25% gross margin (which again seems to be highly charitable to SHOP, as 25% is a relatively good gross margin for an undifferentiated retailer), we get gross profits for the average store of $12.5k.
Doing this suggests that the average store on SHOP, using generous assumptions, is generating less gross profit that would be necessary to support even a single worker at the Federal minimum wage.
The very clear implication of this is that the average customer of SHOP must be an extremely small business; or a hobbyist; or a tiny e-commerce operation attached to another business (or there is a problem with SHOP's reported numbers).
This should be highly concerning for any investor in SHOP shares - and especially concerning at the astronomical multiple at which they are currently trading
Investors following the SHOP story will already be aware that the platform serves a significant number of 'drop-shippers'.
These are merchants who instead of producing their own products simply re-sell products from other merchants - usually directly from Chinese manufacturers via Aliexpress. Usually, these merchants sell their products at an extreme mark-up to the price they pay to source them from Alibaba, and almost without exception, these merchants are primarily selling low-quality, low-utility goods.
We include a 'Extreme Mark-Up Hall of Fame' below, but for now, a single example will suffice.
Humblehousehold.com lists a "Gold Rose" product at $59.85 - although graciously claims to be offering at a discounted price of $19.95, allowing customers to "SAVE $39.90".
According to our reverse-IP search research (described in more detail below), Humblehousehold.com is listed as the 143rd most popular store run on SHOP (based on daily user traffic). This suggests that it is in the top 0.02% of SHOP stores - right up there with the most popular on the platform (we expected drop-shippers to appear much later in the list, but clearly they are more prevalent than expected).
Unfortunately for customers of this store, they are paying an extraordinary mark-up over the price at which the exact same product is available on Aliexpress:
In fact, taking the bottom end of the range shown on Aliexpress the mark up on the SHOP store is an astounding 4,333% - or to put it another way, a customer unwittingly paying $59.85 for the exact same product they could by on Aliexpress for $1.35 is paying an "ignorance tax" of 97.7% for not thinking to shop around.
Citron Research, the well-regarded short-seller published a 2017 article on this problem Citron Exposes the Dark Side of Shopify The FTC will Take Notice and various articles have commented on it since.
With such a concerning allegation out in the public domain - albeit in an article that is now a couple of years old, we thought it would be interesting to look into the current state of drop-shipping on SHOP and to see if we could find evidence of how big a problem it currently is.
The first task was to check YouTube to assess the current level of video-makers pushing the idea of individuals starting a business on SHOP that attempts to make money simply buy drop-shipping cheap goods from Aliexpress.
Surprisingly - given that this was exposed by Citron Research several years ago and given the serious questions it raises about the customer numbers reported by SHOP, the pushing of drop-shipping as a kind of "get rich quick scheme" on YouTube is alive and well.
Worse than this, many of these video-makers are attempting to sell training or coaching services on the back of this "drop-shipping opportunity".
Many of these video-makers are paid commissions by SHOP under its affiliate marketing program - although the company does not disclose exactly how much it is spending on pushing these drop-shipping schemes.
A good way for anyone offered the chance to pay for an investment method or business plan is to ask himself: "If this plan really produced the promised results, would those generating these results really be bothered to teach courses on it?".
In the case of these video-makers, the answer is obvious. If the producer of the video that claimed to demonstrate $51,573 within the first month of drop-shipping on SHOP was really generating such results, then they would have no rational reason to spend their time on providing services to others - not only would it be a waste of their clearly highly valuable time, it would also be introducing competitors in what (for the courses and lessons to work) is a business with no barriers to entry.
Worse than this, SHOP itself is producing high-production-value videos trying to push drop-shipping in a way that appears dangerously close to being "get rich quick scheme".
In Q2 2017, SHOP acquired a company called 'Oberlo', which has as its main product a tool for dropshippers to import Aliexpress listings into their SHOP store.
Oberlo - which is in effect SHOP using the name of one of its subsidiaries - also makes drop-shipping videos, some of which are, extraordinarily, literally tutorials on which products drop-shippers should select from Aliexpress, and how aggressively drop-shippers should mark them up.
Our favourite video from Oberlo was produced in late 2018 is titled "Realistic Dropshipping Startup Budget for 2019" (link: Realistic Dropshipping Startup Budget for 2019).
This video purports to reveal the necessary 'startup budget' for someone looking to start drop-shipping on SHOP. The video explains that to drop-ship at higher volumes will require a larger investment, but "if you just want to make one-hundred extra dollars a month your budget can be much more modest… today we will focus on the more modest budget".
The total start-up budget that the video suggests is $387.99, and the presenter claims that this kind of drop-shipping is "a low risk business model for new entrepreneurs".
We invite readers to think about this for a moment.
This is a video produced by a company owned by SHOP (as shown in the screenshot from the 40-K above), using the same logo that is used by Oberlo on SHOP's own app store. The high production values of the videos imply that they are being made at some cost to SHOP. These videos seem to be suggesting that for an initial investment of about $400, a user can expect to earn "one-hundred extra dollars a month".
Grossing up the monthly cost of the SHOP store to 12 months, and ignoring the fact that Oberlo is only free if a user is selling less than 50 items a month (which will surely be necessary to make any such business viable), the numbers provided in this video produced by SHOP seem to suggest that for an annual cost of $718, a drop-shipper can make $1,200 in income a year. This is a one-year return of 67.2% on these start-up costs.
If such returns really were possible from drop-shipping, then the rational thing for SHOP to do would be to stop paying for any marketing and devote itself solely to being a drop-shipper.
If the returns available to an individual drop-shipper are so high, imagine the astronomical returns that SHOP could earn if they were to do this themselves with all the benefits that scale could provide! How strange it is that they are devoting shareholders' capital to marketing this opportunity to individuals on the internet instead of capturing this opportunity!
The SEC provides basic advice to investors on how to avoid bad investment opportunities. We are certainly not suggesting that SHOP is involved in any sort of fraud - but it might be interesting for readers to reflect on the kind of returns that the Oberlo video suggests are possible, and the suggestion that this is "a low risk business opportunity for new entrepreneurs", and compare them to the following advice from the SEC.
Source: SEC, 2015
How big is SHOP's Drop-Shipping Problem?
Due to SHOP's very limited disclosures about its user numbers, there is no data from the company about how much of the user-base is made up of drop-shippers.
However, there is some evidence that we can look to in order to get a sense of the scale of drop-shipping within SHOP's user-base.
We searched YouTube for "shopify dropshipping", and checked the subscriber numbers (note, this is the number of people who have elected to subscribe to every new video from a particular video-maker, rather than the number of views for individual videos) for the first 25 different video makers that appear.
Because we have used a simple YouTube search and have not attempted to weed out video-makers with relatively low subscriber numbers, this is necessarily a fairly conservative view of the number of people signed up to receive such videos. It is not only possible but likely that this method is materially understating the number of people subscribing to these videos.
This non-targeted sample of 25 video-makers demonstrates that there are just under 3m subscriptions to these videos - when the SHOP merchant count is 0.82m.
Source: YouTube, Noster Capital
Now, it is clear that not every subscriber to these videos is actually drop-shipping on SHOP (because the subscribers are a multiple of SHOP's users), and it is also highly likely that there will be a material overlap between the subscribers to each video (although this will be limited by the fact that several of the video-makers in the sample present in languages other than English).
The table below shows what percent of SHOP's reported users might be drop-shippers under various assumptions about what percentage of subscribers are actually involved in the practice, and how great an overlap there is of subscribers between the different video-makers.
For example, if we were to estimate that only 30% of the viewers of each video are actually involved in drop-shipping (and this feels generous to SHOP - because having watched several hours of these videos we can earnestly state that they have minimal entertainment value and are unlikely to be interesting to anyone not involved in dropshipping), and that only 30% of the viewers are 'unique viewers' (i.e. not subscribed to multiple video-makers), this non-targeted sample of a few YouTube accounts would suggest that 32% of SHOP's reported merchants could be simple drop-shippers.
The argument here is not that we are sure that 30% unique viewers and 30% of viewers drop-shipping are the correct numbers - it is not possible to know exactly which inputs are correct. However, readers can use this table to see how much of the user base could be drop-shipping even if we assumed that the vast majority of subscribers to these videos were overlapping, and not drop-shipping themselves.
Source: Noster Capital
This isn't conclusive evidence, however. To get more conviction on the size of the drop-shipping product requires deeper digging.
Luckily, despite SHOP's reluctance to provide its investors with meaningful detail on its user-base, there are ways to get an insight into the make-up of their merchants.
There are several websites that allow a user to perform a search of hosting data for all websites hosted on a particular IP (in fact this is a method used by drop-shippers to do research on their competitors), and the method we used is described here: How to find best Dropshipping sites on Shopify Stores| Dropshipping Agent.
SHOP appears to use the same Canadian IP address for its users (even when they have paid for a unique domain name), and so it is possible to generate a list of SHOP stores ordered by daily user traffic using this kind of search.
We performed such a search, and manually checked the top 1,000 stores (listed in terms of daily users), and the results weren't pretty.
In the top 1,000 stores (or the most popular 0.1% of SHOP's user-base), there were at least 35 drop-shippers (we have screenshots to document each of these - although we do not present them here as the evidence runs to more than 50 pages).
We say "at least" - because our definition of 'drop-shipper' for the purposes of this research was "a store on SHOP which has on its front page a product that can be found on Aliexpress at a much lower price in a few seconds of searching". We also ignored all shops selling only clothing (as evidence of drop-shipping of these is more difficult to gather).
Had we gone through the top 1,000 stores in more detail, were more persistent in checking Aliexpress for products that appeared to be drop-shipped but did not immediately appear in the search results, and were not excluding all stores selling apparel we are certain that we would have found a rather higher preponderance of drop-shippers.
35 out of the top 1,000 - or 3.5% - is not a number fatal to the SHOP bull case. However, these were the top 1,000 stores when listed in terms of popularity (and we are satisfied that the popularity numbers are at least basically reliable, as the big-name SHOP clients - Gymshark, Allbirds, Jeffree Star, Kylie Cosmetics - all appeared at the top of the list).
We then set out to find out at what point in the list a significantly concerning percentage of stores were drop-shippers.
Using the list of SHOP stores in order of popularly, at various intervals we checked 50 stores for evidence of being a 'drop-shipper' (using the definition explained above).
The results are shown in the chart below. We stopped when we reached more than 25% of stores that were drop-shippers - which occurred for the first time within the top 10,000 stores - or the top 1.2% of SHOP's reported merchant numbers.
Source: Noster Capital
Even within the top 3,000 stores, our samples were including more than 15% drop-shippers - and despite the lull in the samples between 4,000 and 6,000, the trend is clearly upwards.
If within the top 1.2% of reported customers, samples are coming up with 28% drop-shippers, and the trend is upwards, imagine how prevalent they must be in the other 98.8% of the company's user-base!
Drop-shippers are not a sustainable userbase for SHOP:
At this point, it might be worth asking how serious a problem this high concentration of drop-shippers actually is for SHOP. These merchants must be generating revenue for SHOP, and so even if all they are doing is acting as middle-men between consumers and goods sold on Aliexpress their presence is still a net benefit to SHOP shareholders?
This argument doesn't stand up to scrutiny:
Other Curious Findings:
An interesting side-effect of manually checking the top 1,000 SHOP stores listed by the reverse IP search was the discovery of a series of weird and wonderful merchants. Each of these can only be serving a customer base that is vanishingly small (how many buyers are there, even in a global market, for t-shirts based on esoteric numerology?), and unless these websites are suffering a serious problem with fake traffic, and if the reverse IP search is even close to accurate, then the fact that these stores appear to be in the top 0.1% of SHOP's clients by traffic is extremely concerning.
A selection of the most unusual SHOP stores in the top 1,000 by traffic is below.
Spiritual Numerology Accessories:
Supplies for Russian Magicians (note: the website is entirely in Russian and is unlikely to be selling to a global audience):
"The paradigm-altering discoveries of quantum science":
$12 Wedding Rings:
"God's Marvelous Protective Provisions for the Coming Nuclear & Solar Storm Crisis":
Steam Train Whistles:
An incoherent mix of cheap jewelry, and sex toys that we found so disturbing we felt the need to report them to the relevant authorities:
Source for all: Myip.ms
What are we left with?
SHOP is an extremely expensive stock at 20.2x EV/Sales - trading at a significant premium even to other hot tech stocks. It is not a profitable business, and management is investing significant capital in a series of non-core projects.
The disclosures the company makes about user numbers are of minimal use to investors, and the lack of disclosure on churn is a red flag.
It seems probable that a significant percentage of the user-base is made up of drop-shippers who provide negative value to their customers, are surely not a high-quality source of revenue for SHOP, are too small to be sustainable, and unlikely to survive an economic downturn.
Investors should be demanding from SHOP full and complete disclosure of its user base, its churn, the scale of any reliance on drop-shippers. Without this, it is difficult to see how the shares can be considered investable - let alone to command such an astronomical multiple.
Appendix - The Extreme Mark-up Hall of Fame:
The mark-ups attempted by some of the SHOP drop-shippers that we have seen while researching this article are so extreme - and so audacious - that it seems only fair to recognise some of them here so that readers can admire quite how brave they are.
1: "Animal Baby Playmat" from "shopbabychild.com".
Price on SHOP: $60
Price on Aliexpress: $6.81
Ignorance Tax = 91.4%
2: "Talking Hamster Toy" from "zplus.store"
Price on SHOP: $59.99
Price on Aliexpress: $4.89
Ignorance Tax = 91.8%
3: iPhone Case from "Expressdeal.net"
Price on SHOP: $15.75
Price on Aliexpress: $1.59
Ignorance Tax = 89.9%
This article was written by
Disclosure: I am/we are short SHOP.