Shopify's Road To $200 (NYSE:SHOP)

326 Followers

Summary

While Shopify is a well-run company with a strong balance sheet and respectable growth, its valuation makes the hyper bubbles of the Dot Com era look cheap.
Lost $125 million on $1.578 billion revenue in FY19. With a market cap of $89.25 billion, this represents a mind-blowing 56.5 years of trailing revenue.
Growth has been slowing by nearly 20% with losses increasing over 60% per year since IPO. It has also pulled guidance and diverted resources away from growth.
Seeing more subscription downgrades, less app spending, decreased margins, and other signs of further decelerating growth in Q120. This is largely a reason for the pulled guidance.
Price target of $117.57 with an upside of $185.96.

What is Shopify

Shopify (NYSE:SHOP) is often compared to the e-commerce giant Amazon (AMZN), typically as justification for its inflated and completely unsustainable valuation. It's not a very good comparison though, and Shopify isn't even in the retail business. Furthermore, Shopify sells store management software which is deployed on countless separate domains, all with their own unique design. There's no central outlet like Amazon - you have to know where each store is.

What it does is offer a hosted solution for e-commerce, meaning it provides the software to run a branded store as well as managing the server it's hosted on. The software itself includes a suite of services to both manage and run an online business, from branding and design to shopping cart and payment processor, along with an app store to enhance functionality or find new themes.

Business

Shopify has two separate revenue streams. The first of these is known as subscription solutions and is what makes up its core offerings. Primarily consisting of monthly fees collected for providing an online storefront in the Shopify ecosystem, but also includes other digital sales such as themes, apps, and domain names.

The company's second revenue stream is known as merchant solutions and provides supplementary services on top of its core offerings. This includes things such as shipping services, transaction fees, and point-of-sale hardware sales. Unlike subscription solutions, margins here are much lower as well as more reliant on the success of businesses in its ecosystem.

20Q1 Source	Subscription Solutions	Merchant Solutions
Revenue	$187.609 million	$282.451 million
Cost of Revenue	$37.712 million	$175.339 million
Gross Profit	$149.897 million	$107.112 million
Margins	80%	38%
Growth YoY	33%	57%

You may notice that merchant solutions is growing 72% faster than subscription solutions while also having 47.5% the margins. In fact it now makes up over 60% of total revenue and climbing, which of course means lower margins moving forward. The software sector has some of the best margins in any industry, in fact averaging at over 77%. Even the $1.5 trillion behemoth Microsoft (MSFT) has a 68.17% gross margin, 25% higher than Shopify at 54.54%. As noted earlier, this margin is going to continue moving in the wrong direction as its fastest-growing operations have a significantly lower margin of 38%.

Technology

Shopify is arguably one of the best choices for any business wanting an online storefront, but most of its core services highly leverage Free and Open Source Software (FOSS) and it's far from the only option. Competitor Wix.com (WIX) provides nearly all the same services, including drop shipping, and is growing at half the rate but with 33% better margins and only 27% as expensive. There are plenty of other alternatives, some of which are entirely free. There are also many open source solutions to create an online store at zero cost outside of hosting and domain fees, but of course the tech barrier makes solutions like Shopify a lot more attractive.

At its core, Shopify is primarily a website builder with a content and store management system as well as built-in payment solutions and seamless scaling. I have heard it said before that Wix is like WordPress while Shopify is like Amazon, but it's more accurate to say that Shopify is like WordPress specially designed for business. None of this should take away from all the technology it developed (and contributed) to tie everything together into such a well-functioning, stable, and scalable ecosystem. Rather it should only serve as a reminder that it primarily sells hosted software to manage an online catalogue, nearly everything else is a variety of partnerships, third-party integrations, and FOSS.

Service	Powered By
Content Delivery Network	Fastly (FSLY)
SSL	Let's Encrypt
Shopify Payments	Stripe
Domain Registrar	Mark Monitor
Point of Sales Hardware	BBPOS
Fulfillment Network	Shopify
Hosted Online Store	Shopify
Mobile App	Shopify

Let's Talk Value

Shopify is a phenomenally well-run business, has very little debt, strong cash position, a fantastic product, and solid growth. So what's the problem? As of today, it is trading at more than 55 years of FY19 revenue with decreasing growth and increasing losses. That is simply mind blowing on its own, but let's take a deeper look at the numbers. Note that the bullet points below are using trailing 12 months as of 20Q1 while the table compares full fiscal year up to 19Q4.

Revenue of $1.728 billion, a 46.65% increase YoY.
Net loss of $125 million, a 71.64% increase YoY.
Market capitalization of $88.5 billion, more than 50 years of revenue.

FY15-FY19 Source	2015	2016	2017	2018	2019
Sales Growth	100%	85.71%	71.54%	54.26%	46.80%
Growth Decline		14.29%	16.53%	24.15%	13.75%
Net Loss	$19 million	$35 million	$40 million	$65 million	$125 million
Loss Increase		84.21%	14.29%	62.5%	92.3%

This is clearly unsustainable; its growth is decreasing by an average of 17.2% per year while the losses are increasing by an average of 63.3%. Management made a smart move to do a secondary at $700, it raised $1.3 billion which more than doubled the cash on hand and isn't much less than it made in total sales in FY19. This puts the company in a comfortable position to continue eating losses, but the massive growth in losses will need to come down substantially or it will only have a few years of solvency.

Tale of Two Earnings

Like so many other companies that have reported since the rise of Covid-19, there are really two separate stories. Growth was solid, seeing a 47% increase in revenue YoY and 62% increase in stores between Mar 13 and Apr 24 as compared to the prior six weeks. With everybody desperate to find companies that may potentially thrive in a post Covid-19 world, it makes sense it's exploded in value, gaining 97% YTD and 125% since March. Everything sounds good, so what's the other story? Let's look at a few remarks made by management in the Q1 report (emphasis added).

We anticipate a portion of this funding to go toward business continuity instead of growth activities, as we saw merchants downgrading subscription plans and decreasing their spend on apps in March and into April.

MRR as of March 31, 2020 was $55.4 million, up 25% compared with $44.2 million as of March 31, 2019. Shopify Plus contributed $15.3 million, or 28%, of MRR compared with 26% of MRR as of March 31, 2019. MRR growth was impacted in the quarter by several factors, including the removal by Shopify of thousands of stores from the platform due to violations of our Acceptable Use Policy; lighter international merchant adds; and, an uptick of subscription cancellations and merchant downgrades to lower-priced subscription plans in March related to COVID-19.

On April 1, 2020, Shopify suspended the financial expectations it had provided on February 12, 2020 for the full year 2020, as our financial results for the rest of the year are contingent on the duration and scope of the COVID-19 pandemic and the economic impact of actions taken in response, all of which are unknown.

Shopify is leveraging our merchant-first business model and strong balance sheet to adjust our 2020 plans to address these changes. This includes redirecting spend from certain areas, such as brand and marketing, to product initiatives that directly support our merchants' ability to adapt to an emerging environment, one where we believe multi-channel selling and direct-to-consumer fulfillment are more important than ever.

Guidance was pulled but that's not unexpected; every other company did as well due to the uncertainty. What's more important is the directional changes being made and the reasons given. The company is already seeing subscription cancellations, downgrades, fewer app purchases, etc. All of this data suggests what we already know from the current economic climate - small- and medium-sized businesses are being disproportionately affected.

As a response management has decided to redirect resources away from growth into maintaining its existing clients, which is likely to further decelerate growth in the medium term. I do believe this is the correct, long-term approach, and management is directing resources exactly where it should be - maintaining clients and providing assistance during a period of significant economic turmoil. However, as an investor, this means a one two punch of decreased growth with lower margins.

Final Thoughts

Shopify is a well-run company that provides a top tier service, but it's certainly not the next Amazon, which oddly seems to be a very common misconception in the market. I like the company about as much as I dislike the valuation. It's just priced beyond perfection, even several years in the future. Using the previously determined 17.2% decline in growth, we can extrapolate several years out for a rough estimate.

Historical Extrapolation	Revenue	Sales Growth
FY19	$1.57 billion	46.80%
FY20	$2.18 billion	38.75%
FY21	$2.88 billion	32.08%
FY22	$3.65 billion	26.56%
FY23	$4.42 billion	21.04%
FY24	$5.10 billion	15.52%
FY25	$5.61 billion	10.00%

Note that its original guidance, before being pulled, was actually for between $2.13 and $2.16 billion in revenue FY20, so my own projections are actually slightly higher than management. I've also laid out another extrapolated chart below that significantly reduces the historical growth decline of 17.2% by using 10% instead. This is beyond any hope of expectation, particularly given the redirected resources away from growth activities, but I'm including it anyway just to get the most unrealistically bullish outcome.

Bullish Extrapolation	Revenue	Sales Growth
FY19	$1.57 billion	46.80%
FY20	$2.23 billion	42.12%
FY21	$3.07 billion	37.91%
FY22	$4.12 billion	34.12%
FY23	$5.38 billion	30.71%
FY24	$6.87 billion	27.64%
FY25	$8.58 billion	24.88%

Assuming the company maintains its fairly consistent growth trajectory since IPO, it will be generating just over $5.6 billion in total revenue by FY25, while the market cap is already near $90 billion. I expect growth to more or less stabilize closer to 30% with slower declines, but even using the bullish extrapolation which uses a flat 10% reduction YoY rather than the 17.2% 5Y average, it would still be trading at over 10x sales using FY25 numbers. This is madness!

Conclusion

Shopify is far too expensive to buy anywhere near these levels. In fact, it's the ninth most expensive large cap in the entire market and number one for NYSE. Growth has also been consistently declining at a 5Y average of 17.2% with losses increasing at a 5Y average of 63.3%. While it provides a top-tier service, the subscription solutions side of the operations has an incredibly low barrier to entry with plenty of competition and open source alternatives. One of these open source alternatives, PrestaShop, has over 300,000 merchants with 5,000+ modules, themes, and services from its app store. Interestingly one of its clients is Stripe, who, if you remember, powers Shopify Pay.

The absolute most expensive valuation I can give to Shopify is $185.96. This represents 10x FY20 projected revenue and, if you remember, my projections are actually slightly higher than the guidance was prior to being pulled. A more reasonable figure, albeit still expensive, would be $117.57 which represents 8x trailing 12-month sales as of Q120. Anything above $200 is nearly impossible to justify, and the downside risks are significant with the upside being priced for years of growth beyond any reasonable expectation. With growth decelerating, losses accelerating, diverting resources from growth, and priced at more than 55 years FY19 revenue, I can't rate Shopify as anything short of a strong sell at this price.

This article was written by

Oracle Of Alpha

326 Followers

Fundamental investor focused on finding extreme disconnects between market price and fair value, reading lots of SEC filings along the way. Outside of investing I'm a software developer and reverse engineer, working most often with C/C++ and x86 machine code.

Analyst’s Disclosure: I am/we are short SHOP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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