A Threat To Shopify That All Bulls Must Consider (NYSE:SHOP)

Shopify (NYSE:SHOP) started off as offering subscription services to digital merchants, enabling them to set up and run their own e-commerce websites. Overtime, Shopify has been rolling out numerous other services, known as ‘merchant solutions’, to constantly meet merchants’ evolving business needs, and creating new monetization avenues for the tech giant. E-commerce rival Amazon (AMZN) has taken note of the proliferating number of merchants opting to set up independent e-commerce websites, instead of listing on its marketplace. In the interest of monetizing this growing base of Direct-To-Consumer [DTC] merchants, Amazon rolled out the ‘Buy with Prime’ program last year, extending various e-commerce solutions like fulfilment and advertising to third-party merchants. Research indicates a large proportion of Shopify’s merchants are considering enrolling in the program, threatening Shopify’s ability to generate ‘merchant solutions’ revenue. The implied risks has induced Nexus Research to change its rating on the stock from ‘buy’ to ‘hold’.

Shopify’s merchant solutions revenue threatened by ‘Buy with Prime’

Shopify offers various forms of merchant solutions, including payment processing, order fulfilment, and business lending facilities. In 2014, merchant solutions revenue contributed around 30% to total revenue. In stark contrast, the segment made up 72.5% of total revenue in the last reported quarter (Q3 2022), testament to just how important this revenue segment has become over the years. Shopify Payments and Shopify Fulfilment Network are two key components of merchant solutions revenue.

Amazon introduced ‘Buy with Prime’ last year, to make its e-commerce solutions more accessible. The e-commerce giant was already offering third-party merchants the ability to utilize its well-established fulfilment network, and has been continuously advancing what the program has to offer, in order to attract more merchants and optimize monetization through the program. One of the most concerning aspects of the program is Amazon’s requirement that any sales facilitated through ‘Buy with Prime’ be processed through Amazon Pay, a direct threat to Shopify Payments revenue. The dual attack on Shopify Fulfilment Network [SFN] and Shopify Payments poses a serious danger to the company’s merchant solutions revenue.

So far the ‘Buy with Prime’ program was only accessible to a select group of merchants, but will become available to all US-based merchants from 31st January 2023. Analysts at UBS have expressed concerns over how ‘Buy with Prime’ threatens Shopify’s revenue potential, as 74% of surveyed Shopify merchants would consider using ‘Buy with Prime’ once it becomes available to them, posing “risks toward Shopify Fulfillment Network adoption as well as GPV growth as more transactions begin to happen outside of Shopify’s platform”.

Amazon proclaims that early adopters of the ‘Buy with Prime’ program have witnessed improvements in conversation rates by an average of 25%. Note that this average is based on a select number of merchants (from various e-commerce platforms including Shopify, BigCommerce, etc.) specifically cherry-picked by Amazon to join the program earlier on. Amazon will undoubtedly have been savvy in selecting merchants that would evidently deliver strong conversion rate improvements through ‘Buy with Prime’. Actual conversion rate enhancements resulting from ‘Buy with Prime’ may differ from merchant to merchant. Amazon is trying to win merchants’ trust by displaying how initial members are indeed benefitting from the program.

In the interest of protecting its merchant solutions revenue, Shopify has been striving to discourage its sellers from joining the program, by issuing a warning message to merchants that highlights the risk of data misuse by Amazon. Data protection has indeed been a key consideration among merchants that seek to join the program, as reflected below by the list of FAQs on Amazon’s ‘Buy with Prime’ website.

Amazon has been pushing hard to win merchants’ trust through their responses, such as the following re-assurance:

Amazon prohibits the use of non-public information received or collected when providing Buy with Prime to make sourcing, inventory level, and pricing decisions for products in our own store, including for offerings of Amazon’s store brand products. Amazon also prohibits the use of non-public information about products Buy with Prime shoppers purchased or viewed on your site for merchandising or personalization in the Amazon store.

Amazon is well-known to have undermined its own internal policies in the past regarding this matter. Nevertheless, given that 74% of surveyed Shopify merchants are considering to join the ‘Buy with Prime’ program once it becomes available to them, Amazon is indeed succeeding at winning their trust. Despite Shopify’s attempts of discouraging ‘Buy with Prime’ enrolment through highlighting trust concerns, the allure of conversion rate improvements is encouraging most sellers to give it a try.

If a large proportion of Shopify merchants indeed become ‘Buy with Prime’ members, it would incur a notable hit to Shopify’s merchant solutions revenue. The company does not disclose how much revenue is generated by each individual merchant solution (such as Shopify Payments and Shopify Fulfilment Network), but investors will likely get a better sense of their granular contribution over the next several earnings reports as the impact of ‘Buy with Prime’ adoption starts to take hold on merchant solutions revenue. A hit to Shopify’s largest revenue segment would inevitably undermine the P/S ratio that the stock is able to command. The stock was trading at a P/S ratio as high as 63.90x in September 2020, and is currently trading at around 10.64x.

Furthermore, a hit to the top line would subsequently contract the amount of income available to spend on its Capex endeavors. This includes the build out of the Shopify Fulfilment Network, a crucial e-commerce service if it wants to competently challenge Amazon. Simultaneously, the company is also seeking to develop its own marketplace through the Shop App, to subdue its reliance on third-party partnerships to offer sales avenues/ marketplaces to its merchant base. These ventures require significant investments, and diminished revenue/ income growth may require the company to take on debt to finance these endeavors, in a relatively high interest rate environment. This could indeed put further pressure on the bottom line, undermining the Forward P/E ratio that the stock is able to command. The stock is currently trading at a Forward P/E multiple of a staggering 1.43k, leaving it vulnerable to significant downside risk amid rising competitive threats.

Reasons to be optimistic

Keep in mind that on 31st January 2023, ‘Buy with Prime’ will only become available to US-based merchants, with plans for international expansion still unclear. In its last annual report (2021), Shopify disclosed that 55% of its revenue was derived from North America (unclear how much specifically derived from the US), while the rest was generated in various other regions. Shopify will soon release its 2022 annual report, which should reveal better geographic diversification away from North America, as the company has indeed been focused on international expansion to drive future revenue growth. Hence, to a certain extent, Shopify’s international growth subdues the impact of the ‘Buy with Prime’ US rollout on Shopify’s overall revenue, and grants Shopify executives more time to strategize how they deal with the amplifying Amazon threat.

Furthermore, the rollout of ‘Buy with Prime’ actually eliminates the need to list on the Amazon marketplace to be able to benefit from Prime advantages like fast shipping and the loyal Prime membership base. In fact, the program could indeed further encourage digital merchants to set up and run their own e-commerce websites through platforms like Shopify and BigCommerce, as they are still able to access the Amazon prime network through the ‘Buy with Prime’ program. Hence, while ‘Buy with Prime’ undermines Shopify’s merchant solutions revenue growth, it does not threaten Shopify’s subscription revenue, and in fact could potentially be a boon to the segment if ‘Buy with Prime’ indeed induces more merchants to explore the DTC route.

Though in order to truly benefit from higher subscription rates, Shopify would need to make ‘Buy with Prime’ integrations as seamless as possible, in order to stay top of mind among digital merchants seeking to access Amazon perks through ‘Buy with Prime’. Moreover, competitor BigCommerce has already partnered with Amazon to develop a ‘Buy with Prime’ app, easing the integration process, and therefore more likely to gain preference among e-commerce entrepreneurs seeking access to Amazon Prime advantages while running their own web stores. Contrarily, Shopify has been trying to discourage its merchants from enrolling in ‘Buy with Prime’, in the interest of defending its merchant solutions revenue. If competitors continue to embrace ‘Buy with Prime’ through easing integrations, Shopify could potentially lose out on new customers as other platforms are perceived to be easier gateways to Amazon Prime perks. Shopify executives will need to decide whether to ease integrations to avoid losing digital merchants to competitors, or continue discouraging ‘Buy with Prime’ enrolment to defend its merchant solutions revenue.

That being said, while Shopify is not keen on merchants using ‘Buy with Prime’, it nevertheless still allows them to join the program. Additionally, there are of course other factors at play when merchants decide on an e-commerce subscription plan. Shopify offers numerous valuable e-commerce solutions, including through its well-established Shopify App store, which augment the appeal of Shopify subscription plans. In fact, an increasing number of well-known brands are choosing to migrate to Shopify, testament to its highly-sought e-commerce capabilities. Therefore, despite easier Amazon integrations through other platforms, Shopify has a lot of value to offer to digital merchants, bolstering its ability to drive subscription revenue growth.

Another important factor to consider is pricing. While ‘Buy with Prime’ does not require any fixed-term contracts or subscriptions, it does entail various types of commission fees, making it an expensive service. Amazon charges a 3% Prime service fee per order, fulfilment and storage fees, and an Amazon Pay processing fee of 2.4% + $0.30 per transaction. On its website, Amazon offered a breakdown of fees through three different examples, as seen below.

To make better sense of the pricing structure, the table below indicates the total fees as a percentage of product prices/ sales, for each example from above.

The ‘Buy with Prime’ fulfillment and payment processing fees are certainly not priced competitively, with merchants giving up over one-fifth of their sales revenue per order facilitated by Amazon. Keep in mind that these fee breakdown examples do not include Amazon advertising solutions, which would be additional expenses for merchants to try and drive traffic towards their own e-commerce websites.

Shopify’s own fulfilment service can offer two-day deliveries in select US areas. While it does not yet match Amazon’s same-day/ next-day delivery prowess, Shopify is offering various pricing perks to induce SFN utilization, including free storage for six months, as well as discounted fulfilment fees for multi-item orders.

Amazon’s ‘Buy with Prime’ pricing strategy suggests that the program is primarily intended for monetization and to make more efficient use of its assets, as opposed to engaging in cut-throat pricing wars with e-commerce rivals. Nevertheless, there is certainly the risk that Amazon may decide to engage in price wars, especially once Shopify is better positioned to compete with Amazon in terms of fulfilment capabilities. One may indeed fear Amazon’s superior ability to engage in price wars, which would put downward pressure on Shopify’s revenue growth and profit margins.

That being said, there are certain factors that impede Amazon’s ability to lower ‘Buy with Prime’ prices, which work in Shopify’s favor. Firstly, lowering ‘Buy with Prime’ service fees risks displeasing current Amazon marketplace sellers that are part of the Prime network, and could even induce them to abandon the Amazon marketplace to start their own e-commerce websites, if ‘Buy with Prime’ indeed offers more preferential pricing. Alternatively, Amazon would need to lower fees for Amazon sellers as well to maintain consistency, which would be a significant hit to their own revenue.

Secondly, not all e-commerce platforms are building out their own fulfilment networks, but instead are embracing ‘Buy with Prime’, encouraging their merchants to take advantage of the program. Hence, if Amazon were to decide lower fulfilment and storage fees to specifically undercut Shopify’s prices, they would need to lower fees across all merchants to maintain consistency and avoid displeasing other e-commerce partners. This would entail a significant missed revenue opportunity. More generally, ‘Buy with Prime’ entails immense resources for Amazon to be able to logistically facilitate the increased use of its fulfilment infrastructure, and the company will need to prove to its shareholders that the expenditure is worth it in terms of Return on Investment. Trying to put giant competitors like Shopify out of business would be a strenuous endeavor, and it would be a painful journey for Amazon if it were to engage in such loss-making price wars. The overarching point is, there are various impediments to Amazon engaging in a price war, taking some heat off the table for Shopify.

Shopify can use this to its advantage, particularly as its fulfilment network becomes more established and better positioned to compete with Amazon. Over the near-term, Shopify risks losing out on fulfilment revenue, and subsequently payment processing revenue, as more merchants decide to join ‘Buy with Prime’. Though once SFN is better established, Shopify can induce merchants to make greater use of Shopify’s fulfilment services, as well as Shopify Payments, through preferential pricing, and attractively bundling it within Shopify’s subscription plans. In fact, Shopify Payments becomes cheaper for higher-end plans, and is free for Shopify Plus merchants. Offering its own services more cost-effectively can indeed induce merchants to display Shopify fulfilment/ Shopify Payments options more prominently over ‘Buy with Prime’ options to shoppers, in the interest of improving their own margins. There is of course a limit to how attractively Shopify can price its services, as it would come at the expense of its own margins. Nevertheless, Shopify is adept at deeply integrating fulfillment/ payment services seamlessly with the rest of the Shopify ecosystem, which can help discourage ‘Buy with Prime’ usage overtime.

There is also a peculiarity in Amazon’s ‘Buy with Prime’ promotion that is worth noting. As part of ‘Buy with Prime’, Amazon is also allowing third-party merchants to buy Amazon ads in order to direct shoppers towards their own websites. In fact, a key selling point of ‘Buy with Prime’ was enabling independent merchants to drive more traffic towards their own websites using Amazon’s brand power and consumers’ trust in the ‘Prime’ service. In fact, one of the most frequently asked questions by merchants to the Amazon sales team is “How can Buy with Prime help attract the right traffic to my site?”. Interestingly, Amazon’s response on its website refuses to offer statistical insights into site-traffic improvements as a result of ‘Buy with Prime’ advertising solutions. This indeed suggests that Amazon does not have meaningful traffic improvement statistics to share, otherwise it would have proudly proclaimed it on their website, similar to how they highlighted average conversion rate improvements.

Furthermore, advertising solutions will also become increasingly expensive due to Amazon sellers and ‘Buy with Prime’ merchants bidding for the same solutions simultaneously. Hence, even if traffic to merchants’ own websites increases and convert into sales, Return on Ad Spend may indeed be compromised due to advertising solutions becoming increasingly expensive. Access to the loyal 200 million Prime members was a key selling point of ‘Buy with Prime’, but if traffic to merchants’ e-commerce websites is not meaningfully increasing through Amazon, it may encourage merchants to reconsider the true value of the program. ‘Buy with Prime’ merchants also face the risk of natural web visitors being reminded of the Amazon marketplace to look for similar products, due to the ‘Buy with Prime’ badges next to merchants’ products. It is one thing if Amazon advertising solutions are not resulting in meaningful traffic towards their own websites, but it is another issue altogether if merchants’ own web visitors become inclined to check for similar products on Amazon.com. If higher conversions through fast & free shipping is the only selling point of ‘Buy with Prime’, it is only a matter of time until Shopify catches up to offer its own fast, free shipping services, which would undermine the value proposition of ‘Buy with Prime’ overtime.

Summary

Shopify’s merchant solutions revenue, including Shopify Payments and Shopify fulfillment, has become an increasingly important source of growth, contributing over 70% to total revenue in the last reported quarter. The wider rollout of Amazon’s ‘Buy with Prime’ threatens to eat into this crucial source of revenue for Shopify, especially as 74% of surveyed merchants are considering joining the program once it becomes available to them. The subsequent hit to revenue and income inevitably undermines the P/S ratio and Forward P/E ratio that the stock is able to command.

Nevertheless, ‘Buy with Prime’ is certainly not a perfect service, as commission fees are quite costly, and improvements in conversion rates/ site traffic will vary from merchant to merchant. As Shopify’s own fulfilment network becomes more established overtime, it will better position the firm to competently challenge Amazon, and the value proposition of ‘Buy with Prime’. That being said, the journey there will be very capital intensive, compromising profitability over the foreseeable future.

Nexus Research is adjusting its rating on Shopify stock from a ‘buy’ to a ‘hold’. More clarity is required on the financial implications of wider ‘Buy with Prime’ utilization across its merchant base. More importantly, greater clarity is needed on how Shopify management decide to deal with the ‘Buy with Prime’ threat. They could choose to embrace the service through easing integrations, thereby bolstering subscription revenue potential among merchants interested in ‘Buy with Prime’. Alternatively, they could double down on their efforts to discourage merchants from utilizing ‘Buy with Prime’ by highlighting the program’s short-comings, in the interest of defending the company’s merchant solutions revenue. Shopify’s strategic moves addressing ‘Buy with Prime’ will prove crucial to its performance going forward.

Shopify remains a compelling long-term growth story, and Nexus Research continues to hold its long position in the stock. However, turbulence from ‘Buy with Prime’ implications could indeed put downward pressure on the stock over the near-term.