Shopify’s Shares are Flying High: Is it too Late To Buy Now?

Shopify is one of the hottest stocks in the market right now. The e-commerce platform has seen its stock rise 18-fold since it went public in 2015, with much of that gain coming in the past 13 months.

But the past is the past. What investors need to know is whether the stock has the legs to keep up its market-beating performance. With that said, here’s an analysis of Shopify, using my blogging partner Ser Jing’s six-point investment framework.

1. Is Shopify’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?

Canada-based Shopify is a cloud software company that empowers entrepreneurs and even large enterprises to develop online storefronts to sell their goods. 

It earns a recurring monthly subscription from retailers that use its platform. In addition, Shopify collects other fees for merchant solutions such as payment processing fees, Shopify Shipping, Shopify Capital, referral fees, and points-of-sale hardware. 

All of Shopify’s services essentially make the entire e-commerce experience more seamless for the retailer. From the building of a website site to the collection of payments and the shipping of the product to the user, everything can be settled with a few clicks of a button.

Based on the way Shopify charges its customers, there are two factors that are needed to drive growth: (1) Increasing the number of users for the company’s platform and (2) higher gross merchandise value (GMV) being sold by Shopify’s retailers.

In 2019, Shopify generated US$1.578 billion in revenue. Of which, US$642 million was from its subscription service and US$935.9 million was from merchant solutions. Shopify also breached the 1 million user milestone in 2019.

On the surface, these figures may seem big but it’s still small compared to Shopify’s total addressable market size.

The global online retail market is expected to grow from around US$3.5 trillion in 2019 to US$6.5 trillion in 2023. Comparatively, Shopify’s gross merchandise value for 2019 was only US$61.1 billion, which translates to just 1.7% of the total e-commerce market.

Shopify is well-positioned to grow along with the wider industry and also has the potential to gain market share.

This growth is likely to be fueled through the company’s international expansion. Shopify only increased the number of native languages on its platform in 2018 as it begun to target the international market.

The number of merchants outside its core geographies of the US and Canada are also growing much faster and will soon become a much more important part of Shopify’s business. 

2. Does Shopify have a strong balance sheet with minimal or a reasonable amount of debt?

Shopify is part of a rare breed of high growth companies that have no cash problems. As of December 2019, the software company had US$2.5 billion in cash and marketable securities and no debt.

It is also generating a decent amount of cash from operations. Net cash from operations was US$70 million in 2019, despite it reporting a GAAP loss. Shopify also turned free cash flow positive in the year.  

A large part of the diversion between cash flow and the GAAP-loss is that a large portion of Shopify’s expenses are in the form of stock-based compensation, which is a non-cash expense.

In September 2019, Shopify also raised around US$600 million in cash in a secondary offering of shares at US$317.50 apiece. The cash was immediately put to use to pay 60% of its acquisition of 6 River Systems, which makes robotic carts for order fulfillment centres. The acquisition will automate part of Shopify’s nascent but growing fulfillment network, enabling it to compete with the one-day shipping that Amazon is offering.

3. Does Shopify’s management team have integrity, capability, and an innovative mindset?

Tobi Lutke, Shopify’s CEO and founder, has proven to be a capable leader. 

Shopify was born after Lutke himself tried to start an online shop selling snowboards. He realised that there were many challenges involved with selling a product online and that a solution to make the whole process easier was needed. 

So far, Lutke’s focus on the customer experience has increased Shopify’s market share even though it operates in a highly competitive environment, which includes Amazon and Adobe’s Magento.

I think Lutke has taken the right steps to make Shopify a force to be reckoned with. His decision to focus on the core English-speaking geographies at the start proved sensible as Shopify increased its presence in those markets first before pursuing international growth.

Shopify has also made sensible capital allocation decisions in the past. I think 6 River Systems looks to be an astute acquisition – it should improve Shopify’s competitiveness in terms of the speed and cost of fulfilling orders.

In addition, Shopify’s compensation structure for executives is tilted towards long-term objectives. Lutke received US$586,000 in base salary in 2018 and US$8 million in shares and options-based awards that vest over a three-year period.

It is also worth noting that Shopify has consistently beaten its own forecasts. As an investor, I appreciate a management team that is able to over-deliver on its promises.

4. Are Shopify’s revenue streams recurring in nature?

If you’ve read our blog before, you know that Ser Jing and I love companies that have recurring revenue. Recurring revenue provides a consistent platform for businesses to build on. A company that does not have to worry about retaining existing revenue can focus more of its efforts on growing its business.

Shopify ticks this box.

Its subscription service is a monthly auto-renewal contract that is recurring in nature. As of December 2019, monthly recurring revenue for its subscription service was US$53.9 million. That translates to a run rate of around US$650 million, which is around 35% of its projected 2020 revenue.

Shopify’s merchant solutions are less consistent and more dependent on the gross merchant value (GMV) sold by merchants using its platform.

That said, the GMV sold by merchants on the company’s platform has risen considerably in the past and looks poised to continue doing so.

In 2019, merchants selling on the Shopify platform for 12 months or more grew their GMV year-on-year by an average rate of 21%. The more successful its partner-merchants are, the more Shopify can earn from its merchant solutions.

5. Does Shopify have a proven ability to grow?

Shopify certainly does well here too. The chart below illustrates the company’s immense track record of revenue-growth since 2012.

In 2019 (not pictured in the graph), Shopify’s revenue increased by 47% to US$1.578 billion, and revenue is expected to top US$2 billion in 2020.

Although growth has decelerated of late, Shopify is still expected to grow by double digits for the foreseeable future.

Not only are the number of merchants using the platform increasing, but existing clients are also seeing more sales. The chart below illustrates the revenue earned by annual cohort:

Shopify’s existing clients have increasingly paid more fees to Shopify. Shopify describes the trend saying:

“The consistent revenue growth coming from each cohort illustrates the strength of our business model: the increase in revenue from remaining merchants growing within a cohort offsets the decline in revenue from merchants leaving the platform.”

6. Does Shopify have a high likelihood of generating a strong and growing stream of free cash flow in the future?

Shopify already turned free cash flow positive in 2019. That’s a good achievement for a company growing as fast as Shopify is.

It’s also important that there seems to be a clear path toward profitability. Shopify’s subscription revenue and merchant solutions have a gross margin of 80% and 38%, respectively. 

The high gross margins will enable the company to profit when it reins in its marketing expenses. In 2019, sales and marketing made up about 30% of revenue. However, that has been trending down in recent years. For instance, in 2018, sales and marketing expenses were 35% of revenue.

Although Shopify is still spending heavily on international expansion, based on its 2019 results, I think that it will start to see more consistent profit and free cash flow generation in the future.

It is also heartening to note that management seems sensible in its approach to growth. In a recent interview with the Motley Fool, CEO Lutke said:

“Shopify had an ambition to be a profitable company for its first four years, and then it accomplished this in years five and six. Only afterwards (when) the venture capital and then into an investment mode which we’re still in.

So I know what it feels like to run a profitable company. I loved it. I really want to get back there at some point. Not a lot of things are much better in life than the company you’re running happens to be profitable. But I think it would have been also a grave mistake to not change gears back then, because clearly the opportunity was the right one. We needed this investment money. We needed to invest.”

Risks

Competition

One of the biggest risks I see with Shopify is competition. The e-commerce enabler is fighting with some of the biggest tech companies on the planet. Amazon has its own market place that enables third-party merchants to sell products. Amazon’s fulfilment network also provides merchants with the ability to ship its products within a day.

But unlike Amazon, Shopify enables entrepreneurs to build their very own virtual storefront. Amazon sellers, on the other hand, have to sell their products on a common market place and are also competing with Amazon’s own products. This is why Shopify has been able to attract a growing number of retailers to its platform each year.

Other players such as Magento (owned by Adobe), Woo Commerce, and Wix also provide startups with the necessary tools to build their very own online store.

I believe Shopify currently has an edge over its competitors due to its integration with numerous apps and other services it provides such as payment, fulfillment, and referrals etc. But the competitive landscape could change and Shopify needs to continue innovating to stay ahead.

Key-man risk

Another big risk is key-man risk. Tobi Lutke has led the company from a young start-up to one that is generating more than a billion in revenue each year in a relatively short amount of time. That’s an amazing feat and his leadership has been key to Shopify’s success.

Although I don’t see him stepping down anytime soon, a change in leadership – if it happens – may be detrimental to Shopify’s vision and progress.

Stock-based compensation

Anothing thing I am keeping my eye on with Shopify is its stock-based compensation. Although stock-based compensation could align the interests of the company’s employees and leaders with shareholders’, Shopify’s stock-based compensation has been very high relative to its revenue. 

In 2019, stock-based compensation was US$158 million compared to revenue of US$1.57 billion. That means that almost 10% of all revenue generated is being paid back to management in the form of stocks, diluting existing shareholders in the process. Ideally, I want to see revenue grow much faster than stock-based compensation in the future. Stock-based compensation was up by 65.5% in 2019.

Valuation

This is where I think Shopify fails. The e-commerce enabler has a market cap of US$60 billion. That’s a whopping 30 times next years’ sales-estimate. Even for a company that is growing as fast as Shopify is, that number is hard to justify.

Shopify’s valuation today looks pricey even if we assume that (1) it doubles its market share, (2) total GMV grows to US$6.5 trillion, (3) merchants on Shopify’s platform doubles by 2022, and (4) the company generates a 10% profit margin.

If all the above assumptions come into fruition, Shopify’s current shares still trade at a lofty 12 times projected revenue and 120 times earnings.

The Good Investors’ conclusion

There are so many things I admire about Shopify. It is led by a visionary leader who has grown Shopify into a dominant e-commerce player. Besides Shopify’s impressive top-line growth, it is also one of the rare fast-growing SaaS (software-as-a-service) companies that are already free cash flow positive. Moreover, its untapped addressable market is immense.

However, while I would love to participate in Shopify’s growth, the company’s stock seems too expensive at the moment. 

I think the market has gotten ahead of itself and the long-term returns on the stock do not look enticing due to its frothy valuations. As such, I prefer waiting for a slightly lower entry point before dipping my toes in this fast-growing SaaS firm.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.