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Investment Thesis
Shopify (NYSE:SHOP) has experienced severe multiple contraction since the 2021-2022 stock market bubble burst loosing approximately 80% of its market capitalisation from the peak. I believe the company possess unique characteristics since it has developed a robust economic moat which the company reinforces by sharing its economies of scale with its merchants. This translates into high stickiness and robust network effects giving Shopify an exceptional edge compared to its competitors.
Business Overview
Shopify is a cloud-based e-commerce platform that enables small merchants and enterprises to design, build, and manage an online store, sell their products and services, and manage various aspects of their business in one place. The company’s platform is designed to be easy to use and accessible to a wide range of users, regardless of their technical expertise or experience with e-commerce.
One of the key features of Shopify’s platform is its ability to provide users with a single view of their business and customers across all of their sales channels. This includes integration with a wide range of sales channels, such as online marketplaces like Amazon and eBay, social media platforms like Facebook and Instagram, and physical retail locations. By providing a single view of their business, users can easily track their sales and customer data, analyze their performance, and make informed decisions about their business.
In addition to providing a single view of their business, Shopify’s platform also includes a range of tools to help users manage their products and inventory, process orders and payments, and build and enhance customer relationships. Users can easily add and manage products, set up payment and shipping options, and track inventory levels, all from within the platform. They can also use the platform’s customer relationship management tools to track customer data, send targeted marketing campaigns, and manage customer reviews and ratings.
One of the major benefits of using Shopify’s platform is the ability to easily perform analytics and financial reporting. The platform includes a range of tools to help users track key performance indicators (KPIs) and understand the performance of their business. This includes tools to track sales and customer data, measure marketing and advertising performance, and analyze financial data such as expenses and profits.
Competitive Advantages
As the leading player in the e-commerce space, Shopify has a number of competitive advantages that have helped the company achieve its current position. One of these advantages is the company’s ability to benefit from economies of scale in its research and development (R&D) efforts. As a software business, Shopify is able to invest more resources in developing new products and features, and can leverage its size and expertise to create better outcomes for its users.
Another advantage I believe that Shopify can leverage is the high level of customer switching costs that the company’s platform has created so far. The platform is designed to be easy to use and provides users with a wide range of tools and features that enable them to design, build, and manage an online store, sell their products and services, and manage various aspects of their business in one place. This creates a high level of customer loyalty, as users who have invested in setting up their online store on the Shopify platform may be reluctant to switch to a different provider.
In addition to these advantages, I think Shopify has also developed a deep partner ecosystem of third-party apps and integrations that enhance the functionality of its platform. This allows users to easily access a wide range of additional tools and services, and provides the company with a competitive advantage by making its platform more attractive to users.
Finally, Shopify also has a unique ability to leverage the data that comes with its large customer base to drive better outcomes for its merchants. The company has visibility into how its merchants spend their marketing dollars and the behavior of consumers that land on its merchants’ pages, including what they put in the cart, what they buy, and how they pay. This data can be used to inform the development of new products and features, and to create targeted marketing campaigns that drive better ROI for its merchants.
Economies Of Scale Shared
As Nick Sleep wrote in his letter several years ago:
Scale Economics Shared operations are quite different. As the firm grows in size, scale savings are given back to the customer in the form of lower prices. The customer then reciprocates by purchasing more goods., which provides greater scale for the retailer who passes on the new savings as well.
Shopify’s management team is proceeding in that direction by sharing its “scale savings” with its merchants. This helps to increase the stickiness of its merchants to its services and create stronger network effects. As a result, merchants are more likely to use Shopify’s platform, which helps to increase their loyalty and stickiness to the company’s services and create a stronger network effects. Overall, this competitive advantage has played a significant role in helping Shopify become a leading player in the e-commerce space and provide its merchants with the tools and services they need to grow effectively and manage their business in the most clear and simple way. On the second quarter earnings call, CFO Amy Shapiro highlighted the above mentioned aspect:
By helping merchants find more buyers on more surfaces, saving them money by passing along our economies of scale and empowering them with mission-critical tools.
Third Quarter Results Beat Expectations
Overall, I believe Shopify had a strong third quarter, with earnings exceeding expectations. Market analysts expect that the company will continue to perform well in the fourth quarter, despite a tougher year-over-year comparison, with projected revenues of $1.64 billion and earnings per share of -$0.02. This indicates a year-over-year growth of 19.1% in revenues and a decrease of 116.2% in earnings per share. The company’s strong performance in the third quarter and positive outlook for the fourth quarter suggest that it is well positioned for continued growth and success. Factors contributing to Shopify’s success in the third quarter may include upbeat economic indicators, such as the October Consumer Price Index, and high sales during Black Friday and Cyber Monday.
Valuation
I expect Shopify to compound its revenues at 25% over the next 5-years, resulting in $16.9 billion in 2027. I believe this to be a fairly conservative estimate considering the company’s ability to compound revenue at 64% over the past 5 years and its competitive advantages Shopify has over competitors.
| Year | Revenue | CAGR |
|---|---|---|
| 2022 | $5.54 | – |
| 2023 | $6.92 | – |
| 2024 | $8.66 | – |
| 2025 | $10.82 | – |
| 2026 | $13.53 | – |
| 2027 | $16.91 | 25% |
Figures are in billion
Then, I consider two different scenarios with 25% and 30% EBIT margins, which I think are reasonable as the company continue to scale at high rates and expand its business solutions.
| EBIT Margin | Absolute EBIT at Year 5 | Tax rate | NOPAT |
|---|---|---|---|
| 25% | $4.22 | 21% | $3.33 |
| 30% | $5.07 | 21% | $4.00 |
Figures are in billion except for percentages
If we apply a 21% corporate tax rate, we obtain two NOPAT equal to $3.33 billion (25% EBIT margin) and $4 billion (30% EBIT margin). Valuing the two NOPAT at 30x would give us the two following intrinsic values: $99 billion and $120 billion, which divided by the company’s diluted shares outstanding (1.27 billion) give us the two per share values: $77.9/share and $94.5/share. From today’s price, those two fair values are a 2.3x and 2.8x providing 18.2% and 23% CAGR respectively.
Risks
It is highly likely that the United States will enter a recession in 2023, as 91% of US treasury curves have inverted so far. As a result, I believe that Shopify’s customers may soon begin to feel the effects of a turbulent economic environment. Additionally, it’s worth noting that even though the company currently has a margin of safety, it still trades at high multiples, which carries a significant risk of compression in the coming year. Due to these factors, long-term investors should exercise caution when considering opening a position in Shopify.
Conclusion
Based on the above calculations, I believe there is a margin of safety in the range of 56.7%-64%, which translates into a nice cushion for the patient investor over the next 5 years. Despite this, I believe the company will continue to experience a significant multiple contraction in the first half of 2023 as the stock market bubble continues to deflate. For this reason I assign a hold rating as I prefer to see a better price opportunity before I consider investing into this industry disruptor.
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