Shopify: Buy The Dip For The Long-Term

Summary

• Shopify has had a rough start to 2022 due to fading tailwinds related to the Covid-19 pandemic.
• SHOP is a long-term winner in becoming the preeminent e-commerce platform for merchants to grow and promote their brand.
• The company is entering its next building phase of its Shopify Fulfillment Network to establish two-day delivery coverage.
• SHOP has a unique product offering that differentiates the company from competitors.
• Assuming a CAGR of 5% for SHOP’s top-line in FY22 through FY25 and discount rate of 12.5%, my DCF model arrived at an intrinsic value of $700.51 (85.57% upside).

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Investment Thesis

I rate Shopify (NYSE:SHOP) a buy due to their differentiation of product offerings, continued improvement of their Shopify Fulfillment Network, and expansion of their point of sale capabilities. Shopify has had a rough start to 2022 with shares down over 70% year to date. Similarly to Amazon, SHOP was significantly over-valued due to the significant tailwinds attributed to Covid-19.

Shopify continues to reinvest in its fulfillment capabilities, merchant solutions portfolio, and international expansion. These investments have put SHOP in a position to thrive against other dominant players in e-commerce such as Amazon (AMZN) or Alibaba (BABA). Unlike competitors, SHOP is an all-in-one platform that makes it simple for people to start, operate, and grow their own e-commerce business.

Financials

Shopify has a strong balance sheet with more than enough liquidity to continue making capital investments in their Shopify fulfillment network, which will aid in their international expansion. Currently, SHOP has almost 6x more cash than total debt. The company could consider taking out more debt to reduce costs attributed to the capital structure of the company.

Gross margins did shrink y/y due to more of their revenues being attributed to Merchant Solutions (MS) than Subscription solutions (SS). As of 1Q22, SS has gross margins of 73%, while MS has 43% margins. Overall, SHOP's margins for MS and SS have been fairly stable. Over the last 3 years, SS margins ranged from 77%-82%, while MS ranged from 37%-45%.

To begin FY22, Shopify was possibly one of the most overvalued stocks due to the significant tailwinds caused by the Covid-19 pandemic. At FYE21, SHOP was trading at 60x earnings. It currently trades at 16x earnings. AMZN currently trades at 43x earnings (see below), even after their abysmal earnings call. Relative to AMZN, SHOP appears to be undervalued. Relative to Salesforce (CRM), which trades at 70x earnings, SHOP appears to be undervalued as well. The company is currently trading just above the industry average of 13x earnings, which I believe is unwarranted due to the value proposition SHOP offers to business owners.

Differentiation From Competitors

Unlike Amazon, SHOP allows merchants to create their own e-commerce website with their own unique brand. The company differentiates itself from competitors because of the platforms solutions portfolio that is designed to help merchants grow and promote their store. Amazon has a reputation for pitting retailers against one another via price wars, while SHOP allows retailers to sell online, in-store, on social media, or even on-the-go by offering end-to-end services from billing to shipping.

SHOP gives merchants total control of their online store. Merchants can choose how their store is presented, what their storefront looks like, how they advertise, how they capture data, and how they sell their goods. In contrast, Amazon can change their terms of business or recommendation algorithms at anytime. While creating your own online store may seem time consuming, SHOP's tools offer merchants the opportunity to create a powerful online asset that can deliver robust top-line growth.

Improvements in Fulfillment and POS

SHOP continues to focus on improving its POS and fulfillment capabilities to position itself for sustainable growth. This expenditure is likely to remain a drag on near-term profitability and free cash flow. There is also a lack of transparency on FY22 guidance, which provides additional uncertainty among investors in SHOP.

SHOP has entered the next build phase of the Shopify Fulfillment Network (SFN). The company is looking to establish two-day delivery coverage for 90% of the United States. SHOP is investing in major hub warehouses that it will operate with its own warehouse management software, and continues to enlist partners when needed. CAPEX related to SFN improvements is expected to ramp up in FY22 with an expectation that there will be $1 billion in CAPEX for FY23 & FY24 combined.

On the back end of these capital expenditures, the company expects fulfillment to scale and revenue to ramp up due to greater operational efficiencies. These efficiencies will expand SHOP's margins, making the company more profitable to fund future growth initiatives. In the short-term, I do not expect margin expansion or robust FCF generation. However, these investments will serve as a good foundation for margin expansion and robust FCF generation in the long-term.

As e-commerce normalizes in FY22, SHOP is looking to increase international expansion and POS penetrations in their brick and mortar locations. The company has seen a healthy adoption of their POS software in North America and 8 different countries as of 4Q21. SHOP's omni-channel POS offering differentiates the company from competitors. These investments will help grow gross merchandise value. Additionally, further integration of Shopify payments will increase gross payments volume.

Discounted Cash Flow Model

SHOP's Revenue Projections at a 5% CAGR (Excel)

For my discounted cash flow model, I made assumptions of a 5% CAGR in revenue for FY22 through FY25 (see above). After inputting these assumptions into my DCF analysis, I arrived at an intrinsic value of $700.51 per share (85.57% upside from current price of $377.49). Regarding costs and expenses, I used the 3-year historical averages as a % of sales.

Over the past three years, SHOP's average cost of revenue was 46.24% of sales. Their 3-year average of operating expenses was 47% of sales. Non-operating expenses were 1% of sales. And finally, changes in net working capital were 2% of sales. Regarding terminal value, I used the 10 Yr Treasury Note as the perpetuity growth rate. For Capital expenditures, I made assumptions of increased CAPEX to 7.5% of revenues for FY22 through FY24, attributed to SHOP's significant fulfillment investments (see below). CAPEX is expected to normalize to 2% of revenues in FY25.

SHOP's CAPEX Forecast (Excel)

After placing these assumptions into my DCF model, I arrived at the following cash flows for FY22 through FY25:

SHOP's Forecasted Cash Flows (Excel)

For my discount rate, I calculated SHOP's WACC to be 12.02% using their current market capitalization and current market value of debt (see below). To calculate SHOP's Cost of Equity, I arrived at a market risk premium of 5.09% for their cost of equity by taking the difference between an expected market return of 8% and risk-free rate of 2.92% (US Treasury 10Y). To calculate the market value of debt, I used the interest expense from 2021, total debt (book value) from YE21, and a period of 4 years. I added a risk premium of .50% on top of the WACC to arrive at a discount rate of 12.52%

SHOP's WACC Calculation (Excel)

After applying a WACC of 12.52% to my forecasted future cash flows for SHOP, I arrived at an intrinsic value of $700.51 per share (pictured below). This represents 85.57% upside from the current share price of $377.49. My price target is above the median of Wall Street's 12-month price targets, which vary from $375 to $1250 per share.

SHOP's Intrinsic Value (Excel)

Investment Risks

There are several risks to consider before investing in SHOP. Despite the healthy state of the consumer balance sheet, the risk of recession is steadily increasing and may come sooner rather than later. Bloomberg sees the current probability of recession at 25%, while Goldman Sachs is even more pessimistic as high as 35%. This is very much a possibility soon given the geopolitical turmoil, inflationary environment, high oil prices, and potential corporate tax hikes. Given the healthy state of the consumer balance sheet, the next recession will hopefully be not as bad as the dot com bubble or sub-prime mortgage crisis.

SHOP faces heavy competition from other e-commerce behemoths such as Amazon and Alibaba. In terms of fulfillment, both companies are miles ahead of SHOP. If SHOP does not execute in developing their fulfillment network and international expansion, companies such as AMZN and BABA will continue to acquire a large portion of market share. Over the next two years, SHOP will have a significant increase in CAPEX to improve fulfillment in order to remain competitive.

Closing Remarks

SHOP will take a while to rebound after an abysmal start to 2022. However, I do see long-term growth potential given the significant CAPEX the company is making in FY22 through FY24 to further improve their Shopify Fulfillment Network and merchant solution portfolio. Shopify differentiates itself from Amazon with their wide array of merchant solutions and their omni-channel POS. If you plan on buying SHOP, I would plan on holding for at least 3 or 4 years before seeing significant capital gains given the drag of their CAPEX on profitability and free cash flow. Long SHOP.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.