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Shopify – a dispassionate look from a onetime shareholder
The last time I personally owned Shopify (NYSE:SHOP) was during 2019. The last time I wrote on the company for SA was back in April 2020. It was just at the end of the pandemic induced market swoon and the shares were at an adjusted price of $42, on their way to as high as $180 last November before plummeting to current levels. The shares have bounced a bit since they made a low near the middle of June. Part of the bounce was a function of the release of earnings on July 27, 2022-not that the results were good, but that they weren’t any worse than feared. And of course there was an initial sign-although just that-about peak inflation having been reached, with a path that many expect to be downward from this point. Other factors in the bounce of the shares may be their oversold nature, or maybe some realization that the specifics of the quarter really don’t provide much in the way of guidance as to the ultimate future of ecommerce or the leadership role of Shopify in that trend.
This is not intended to be some kind of trading call on buying Shopify shares. In the course of writing this, the latest inflation reports-both CPI and PPI-proved to be much cooler than anticipated. And not terribly surprising, markets spiked, and the valuations of growth shares expanded. In addition, the analyst at Atlantic Equities, Kunaai Maide, has raised his rating for Shopify shares to the equivalent of buy, although the $46 price target he has set seems a bit at variance with the recommendation. I am not suggesting that there is some urgent need for investors to buy Shopify shares immediately, rather that this is a reasonable entry point for long-term investors.
And I might add, Shopify shares exist both as part of the entire consumer economy and as a high growth IT stock. There are many who contend that the stock market rally since May is a typical bear market rally. The view has been expressed on the pages of SA, and elsewhere, and I am not going to try to litigate the point. If this is a bear market rally, and if investors are not prepared for earnings revisions, then Shopify shares are not going to defy gravity. It is not my purpose here to suggest that Shopify is going to report some growth spurt and free cash flow generation in the next one or two quarters.
At the moment, it seems as though analyst opinion is fairly divided on the outlook for Shopify shares, with 1st Call Indicating 24 buy ratings, 19 holds recommendations and 1 underperform rating. If I were simply to look at Shopify shares based on the most recent earnings report, or even consensus expectations for revenues, earnings and free cash flow in the next couple of quarters, I would give the shares a pass. They are by no means remarkably cheap on an EV/S basis and even after the company’s layoff, it is not going to generate free cash flow of any substantial level, or any at all, for at least the next year.
But in my view, Shopify as a company has huge opportunities that are not appropriately recognized in the current valuation of the shares. Simply put, negative analysts are looking at today’s Shopify and finding a picture with plenty of warts. I am trying to look out 12-24 months and I see opportunities as well as the issues. If Shopify executes well and achieves the promise of the opportunities the shares will be double or triple where they are before analysts catch up to a changed reality.
Shopify as a company does not exist outside the rest of the economy. Right now, with consumers hurting, and with overall consumer behavior reverting to some degree to pre-pandemic patterns, the company’s growth has slowed dramatically. But it is still outpacing growth in retail sales, and the company is still growing its share of the ecommerce market. I don’t imagine that the growth of GMV which was 11% last quarter (8% growth in ecommerce revenues) has seen a percentage growth trough, but because of the many demand tailwinds the company is experiencing as part of its merchant solutions offering, I think that the 16% year on year revenue growth seen last quarter, may be the minimum value for that metric.
This is the leading company, other than Amazon (AMZN) in ecommerce, it has a well-experienced management team, and it has launched the kinds of initiatives that can, over time, kick start growth. And that is why I have chosen to reconnect with Shopify and to write this article at this point. I would like to say I know how to call bottoms, and on rare occasions I have, but that is more chance then analytical expertise. Shopify’s recent low of around $30 seems likely to be a bottom since all the negative news about the company is on display; that said, the environment for ecommerce and for retail in general has certainly deteriorated from where expectations had been 6 months ago. (Perhaps today’s earnings reports from Walmart (WMT) and Home Depot (HD) might suggest a trough performance for retail sales, but that is not something I wish to discuss further in this article.)
The road back or forward, depending on the lexicon, is going to be long and arduous. The company, as the CEO acknowledged, made a wrong bet on the durability of the spike in ecommerce growth as the impacts of the pandemic waned. Paying the price for that, and resetting goals and strategies, is likely to be a complex undertaking with many moving parts. Not only does Shopify have to deal with its own miscues, but it is also subject to the headwinds of the retail space as a whole, as consumers pivot their shopping to food and fuel as inflation devours their discretionary income. But presumably lots of questions about the company’s future are baked into its valuation, and while not likely visible in the next couple of quarters, most of Shopify’s opportunities have been ignored or undervalued, in my opinion.
I will discuss valuation in more detail later in this article. It is a difficult discussion because Q2 results were so weak. Right now, based on a 4 quarter sales estimate of $6.05 billion, the company’s EV/S ratio is a bit greater than 7X.The sales estimate is a bit less than the published consensus for the next 12 months and does include the addition of Deliverr-an acquisition that closed last month. it is also likely, at this point, that many analysts have not entirely adjusted their current estimates to account for macro weakness, and the strengthening of the USD. The company burned cash last quarter, and it will probably do so for this calendar year. Shopify’s EV/S ratio is about average for a company with a 3 year CAGR of 27%, my current estimate. Of course, right now, Shopify’s growth is far less than that; the purpose of this article is to point out just how the company can reaccelerate growth, return to profitability and cash generation, and justify my purchase recommendation.
I want to make clear that this article is neither a catalyst watch-positive, to use a rating popularized by Bank of America analysts, or is it some call that the bottom is in at this point. After the last 9 months or so of merciless valuation compression, some of it more driven by extreme negative sentiment as opposed to considered analysis, at least in my opinion, it would be silly for this author to claim that kind of prescience. But the fact is that the shares have lost more than 75% of their value in less than 9 months, and there is no particular evidence that I have seen to suggest that the company has lost its position as the leader, if not the leader in retail e-commerce outside of Amazon (AMZN). While the price alone doesn’t make the shares worth a look, the combination of the price decline, coupled with the many elements of the company’s offering as well as a visionary management team do suggest that it might be time to do a deep dive on the prospects for the company-not just in the next 2-3 quarters but over the next 2-3 years.
There are more than a few issues that will have to be resolved before this company can resume a trajectory to sustained hyper-growth and profitability. Obviously, a significant issue is the future of e-commerce. Ecommerce sales these days are estimated to be around 22% of total retail sales; they were 15% of total retail sales before the pandemic, and some surveys suggest that by 2026, ecommerce sales will be 27% of the total. That works out to an ecommerce CAGR of about 14% over the next few years. No one is buying Shopify shares for a 14% revenue CAGR so the next issue to be considered is its strategic initiatives.
What are the strategic pieces that can restore the company’s growth from the levels just reported? The company offers an off-line solution, i.e. a solution for bricks and mortar merchants which is starting to ramp. The company has developed some partnerships with various social media companies; yes, those companies whose results were so disappointing most recently. Shopify Plus is the company’s enterprise platform that has become a significant part of the company’s overall business. Within Plus, is a set of tool called Shopify Audiences which help[s merchants target their campaigns toward likely purchasers.
Shopify has cross border management tools, some developed in partnership with Global-e (GLBE) that exist within Shopify Markets. Localizing an ecommerce experience is a significant demand driver for Shopify merchants. It is also a differentiated service that is not offered by the many Shopify competitors. The company has continued to expand its Shipping and Capital offerings and has facilitated customization through Functions.
Shopify’s business since the company’s foundation has essentially been focused on providing ecommerce solutions to enable entrepreneurs to open stores on its platform to facilitate an ecommerce shopping experience. But the company has aspirations to move beyond its roots of facilitating B to C ecommerce by facilitating B to B ecommerce Certainly, many of the company’s larger Shopify Plus customers are already engaged in selling in that space, and Shopify is attempting to add to its stripes by developing B to B solutions.
Of course the biggest bet that Shopify is making is Shopify Fulfillment. It is one of the more controversial, and yet one of the more significant opportunities for the company. Shopify President, Harley Finkelstein, has laid out a rather elaborate and comprehensive vision of just how Shopify intends for its fulfillment offering to function, both in this latest conference call but in a series of “fireside chats”. It is a multi-year aspirational journey that is going to cost quite a bit before the ultimate success of the bet is known.
During the course of the conference call, Tobi Luedtke, Shopify’s CEO talked about how a founder led organization like his winds up taking bets.
And I think, sort of founder-run companies in general tend to be very bets-driven. And therefore, the growth patterns are different, right? Like especially this week, I feel it, why more managerial-run companies tend to not engage in bets. Mathematically, they make a lot of sense. Obviously, you ought to take a 20% chance at a 10x increase. But it’s — you feel it when they don’t work, and it tends to be a somewhat public thing.
Ultimately, I believe, that the investment thesis for this company is a bet. I acknowledge that for a variety of reasons I think bets like the ones that this company has teed up are worth taking in the ecommerce space. To frame the investment case in a rather simplistic fashion: the question is can the initiatives described above coupled with the expected growth in the overall ecommerce space result in a 3 year CAGR of 25%-30% with consistently positive operating margins and free cash flow? That, of course, is not the consensus projection. If it were, I wouldn’t choose to write this article.
Not all of the financial analysis in the world is going to tell investors whether they should buy these shares at this time and at this price. At this point, Shopify shares aren’t that kind of investment. For the record, the EV/S ratio based on the growth rate that has been projected by the consensus for the next 12 months is about 7.3X. based on the $39.58 share price as of Tuesday afternoon, August, 16, 2022 And the company is going to have a cash burn this year, and may still burn cash in 2023. Those metrics are far from providing the basis of a positive investment recommendation, and I certainly don’t expect much positive alpha in the next couple of quarters, or perhaps a bit longer.
Of course, I will provide projections and my take on what they mean for the discounted present value, but the issue is going to be just how the bets the company is taking are going to work out. If a preponderance of them, and the largest amongst them work out well, then the shares have huge upside. The downside for the shares is years of underperformance, although probably not the catastrophic fall of the last 9 months. Not all of these initiatives are going to be equally successful. And the largest initiative, that of Shopify Fulfillment, is a multi-year project.
Writing recommendations for a broad audience can be a fraught undertaking. This is not a trading call that says to buy Shopify shares today. It is a call that suggests that for longer-term investors, and those interested in playing a recovery scenario, this is a fair entry point with an upside that could yield 2X-3X over a period of a couple of years.
Taking a look at the latest quarter and guidance – not the most pleasant reading
It has been a few weeks since Shopify reported its most current quarter. In this economy, many things change in a few weeks and of course narratives also change, sometimes more than real facts. But I look at Q2 results as a baseline-although perhaps not a trough, so the results need review. Simply put; the results weren’t pretty. It should be noted that at this point, Shopify is not giving explicit quarterly guidance because of its inability to forecast how the macro environment will wind up impacting the company’s business results.
Total revenue in the quarter was $1.3 billion, growth of 16% and showing continued deceleration. Revenue growth in Q1-2022 had been 22%. Sequential growth as well as of the other sub-headline metrics showed similar deceleration. In particular, gross merchandise value on the platform rose just 11%, compared to growth of 16% in Q1. Sequential growth was a bit greater than 7%, although that is far less than a typical Q1 to Q2 upside. Management called out the growth in off-line GMV of 47%, but that meant that on-line GMV rose just 8% and as far as it goes, the percentage growth rate of the company’s off-line GMV slowed substantially from the prior quarter when it was 80%. The sequential growth of ecommerce GMV was about 9%.
Shopify reports two business segments and has since it has been a public company. Subscription Solutions revenue is about 28% of the total, and essentially is related to the number of users who are paying the company a monthly charge for the use of the platform. Subscription services revenue growth of 10% was the lowest in years. Some of the slow growth relates to a change in terms that went into effect in Q3-2021; the sequential change in subscription services revenues was greater than 6%.
The growth of Merchant Solutions was a bit higher at 18%. Merchant solutions is most correlated to the payment volume on the SHOP platform but it also relates to increasing percentages of transactions using Shop Pay, Shop Capital and the cross border solution of Shopify Markets. The impact of an 11% increase in GMV, coupled with a rising proportion of GMV transacted using Shop Pay, and the other offerings drove this result. The sequential growth in Merchant Solutions revenue was 8%.
As mentioned, the company doesn’t provide an explicit forecast for revenues and earnings. What it has said in the matter of providing a forecast is that Merchant Solutions growth will be significantly greater than growth of Subscription Services. The company is betting that its localized subscription offering will boost the number of new merchants joining the platform going forward. Overall, Merchant Solutions revenue growth will continue to be greater than the growth of GMV. Merchant Solutions which will include the impact of an acquisition will have lower gross margins than Subscription Services.
The CFO also discussed the view that “both GMV and total revenue in 2022 to be more evenly distributed across the 4 quarters”. The CFO forecast an increase in customer acquisition in 2H, perhaps because of the offering of localized content for its merchants.
This has led to a consensus forecast for growth to reaccelerate to about 20% in the next two quarters. Part of the expected growth “reacceleration” really is a function of the huge deceleration of sales growth that occurred in the last half of 2021. Given the expense growth moderation, and the less seasonal pattern being forecast, consensus EPS forecasts for the current quarter show a non-GAAP EPS estimate of a $.09 loss, followed by a non-GAAP EPS loss forecast for Q4 of $.04. Revenues in Q3 and beyond will include Deliverr which probably is adding between $40 million-$50 million to quarterly totals. Just as aside, the 1st Call consensus for revenue, as published on Yahoo is inaccurate-the real consensus revenue forecast for the current year is just a bit less than $5.7 billion-not $7 billion, which is actually the consensus revenue expectation for 2023.
Not terribly surprisingly, profit numbers proved to be even worse than the revenue reported. Gross profit dollars grew by 6%, so non-GAAP gross margins contracted to 51% compared to 56% a year ago. GAAP operating margins went from 12% of revenue to a kiss if 15% of revenue. The result of these cost spikes drove the non-GAAP operating loss to 3% of revenue compared to a non-GAAP operating margin of 25% in the prior year.
The company’s cash flow trends were also uninspiring. Overall, the company burned $177 million in cash last quarter, a burn margin of 13.7%. That’s despite an SBC expense that ballooned to 20% of revenue from 13% in the year earlier period.
While I have presented the financial information, it should be viewed in context. The results for the prior year represented a peak period for e-commerce with revenue growth in that quarter of 57%. It was that kind of growth that enabled the company to report strong margins. Shopify’s mantra is to look at a 3 year CAGR to discern trends. While I can’t dispute the logic, it doesn’t take away from the company’s miscue of improperly forecasting that ecommerce trends would continue at elevated levels as shoppers returned to patterns in which anxiety about in-person shopping has abated with a concomitant return to shopping in physical as opposed to virtual locations. Taking nothing away from the management team, it ought to be evident that their forecasting skills are not anywhere close to perfect.
The question isn’t what Shopify has reported. Those results were just as dreadful as had been feared. The question to consider is whether the company will be able to right the ship in the next year or two. Despite the puts and takes of cash flow. Shopify won’t be running out of cash any time in the near future. It had a bit more than $7 billion in cash before paying a bit less than $2 billion in cash to acquire Deliverr, and while it does have a senior convertible note outstanding, the maturity is not for a few years.
In this kind of environment, the company, given its position, is likely to be able to enhance its market position in the ecommerce space. While the company has made the difficult decision to lay off 10% of its staff, and to cut back on some initiatives, it has the scale to continue to invest in key components of its platform. Many of its competitors, of whom there are many, will simply not be in a position to make the required investments to provide additional functionality for aspiring ecommerce merchants.
Understanding a couple of the company initiatives
Shopify, these days is a relatively sizeable business-overall revenues, despite the growth slowdown are running at a rate of $7 billion adjusted for typical seasonality. Many of the company’s initiatives are more incremental than significant in the context of the company’s revenue size. There are basically two ways for the company to achieve a growth rate in the mid-high 20% range, the level that I believe necessary to rekindle investor interest and to restore investor faith in management and in the relevance of Shopify as an investment. One, it needs to enhance the appeal of the company’s offering to larger merchants. And two, it needs to capture a greater proportion of the transaction value of its GMV. In my opinion, the two key initiatives that are worth looking at in that regard are Shopify Plus and Shopify Fulfillment.
Shopify Plus
Shopify Plus is Shopify’s solution for the enterprise. It has been around in its current format since 2017, although it is only in the last couple of years that it has been a significant component of the Shopify offering. While, as shown earlier, last quarter was certainly one in which the company dealt with several significant challenges, Shopify Plus has been seeing steady growth quite a bit faster than the rest of the company. Monthly recurring revenue on the platform rose to 31% of the Shopify’s total ARR. Overall, that means that Shopify Plus ARR was up by more than 33% year on year and rose by more than 6% sequentially, while total ARR rose by less than 2%.
Shopify Plus plans start at $2000/month for access to the platform. There is a revenue share fee as well for sales greater than $800k/year. There is a typical credit card processing fee, in the event that a user isn’t using Shop Pay. Further, it is typical for Shop Plus customers to buy some third party functionality such as loyalty programs and more elaborate search capabilities.
When many investors think of Shopify, they think of it as a home for smaller entrepreneurs looking to sell products and services on the internet. It is certainly that, but for the last few years now, the company has been focusing some of its effort on acquiring much larger customers, and despite the overall results last quarter, it is self-evidently having some success in that endeavor.
One example of a well known brand that has chosen Shopify Plus has been Heinz in the UK. Heinz is probably not the kind of brand that one associates with Shopify, but it felt the need to have a direct to consumer offering and it used the Shop Plus platform to launch Heinz to Home in the UK. The offering has apparently been successful; the company has added product bundles of additional foods to the site.
Staples is another brand that might be considered as a surprising customer for Shopify. The company’s Canadian operation had been using a home grown platform. Home grown platforms, almost by definition, require lots of support, and because of how they have been built, they often crash in high volume periods. They also are fairly inflexible given they often were built being cost constrained, rather than optimized for modern ecommerce standards. Most of those issues were resolved by moving the Staples Canada ecommerce platform to Shop Plus. The competition for the replatforming deal included Salesforce, Oracle and SAP Hybris. Their solutions would have taken twice as long to implement and were more than twice the cost.
Finally I will mention UNTUCKit, another relatively prominent brand. It is a brand I know, but I can assure users it is a brand my body shape will never permit me to use. UNTUCKit is probably a brand whose presence on the platform is less of surprise, although it is, to be sure, a far larger business than what are considered to be Shopify’s core customers. It is the kind of brand that never could have successfully used the core Shopify offerings. But with Plus, and with Shop Pay, which is used to transact more than 50% of the GMV on the platform, the company had significant sales success. Last quarter new Plus customers included POND’s, Tetley Tea, Gold’s Gym as well as a raft of celebrities who use the platform to sell their own line of clothing.
One of the more recent components of the Plus offering is that of Shopify Audiences. The technology of the tool is based on AI and machine learning. Audiences is a tool to optimize and direct marketing and to improve the efficiency of advertising spend. Initially the lists created by Audience are exported directly to Facebook and Instagram, and that will be extended to a more comprehensive list of ad platforms over time. It is now included as part of Plus and is intended to accelerate new customer acquisition of the Plus offering.
There are plenty of competitors for Shopify Plus and each one has its own share of features. I have linked here to a list of the most significant competitors as compiled by G2. Included in the list are the likes of Adobe (ADBE), SAP (SAP), Salesforce (CRM) and Oracle (ORCL). All of these competitors cost far more than a Shopify Plus subscription, and they take much longer to deploy and start producing results. Shopify Plus continues to enjoy a significant growth runway and I expect that will be the case for the for the foreseeable future.
Fulfillment by Shopify
Fulfillment by Shopify is the most important current initiative and opportunity the company has to reaccelerate growth, according to company founder, Tobi Lutke. The company announced its fulfillment network in July 2019.It has been the major focus of the company since it was announced and it has been quite controversial amongst analysts and investors. Overall, in the company’s most recent investor presentation, it has indicated that the build out of the fulfillment capability would cost $1 billion over the next couple of years, and with the purchase of Deliverr, that investment will reach more than $3 billion.
One of the principle advantages larger retailers have when compared to merchants on the Shopify platform is their ability to deliver product within a day or two on a guaranteed basis. Obviously, both Amazon and Walmart have offered guaranteed 2 day delivery to their on-line customers for some time now. For a smaller merchant, the ability to offer guaranteed 2 day delivery is a key factor in being able to successfully compete with the retail behemoths in the ecommerce space.
Another advantage enjoyed by larger merchants relates to their ability to optimize their supply chains. The process of moving a product from procurement to a buyer is far more complex, and can come with many issues that were highlighted during the disruptions caused by the pandemic.
Shopify has been providing shipping services to its customers for years. The fulfillment service is different in that Shop’s customers can have their inventory sent to Shopify fulfillment centers and then packed and shipped with a guaranteed delivery date. Part of the service involves balancing inventories to optimize the supply chain to prevent running out of product, but to minimize investment in product. Shopify’s technology attempts to optimize for location and quantity vs. demand.
Last month, the company closed its largest acquisition thus far, a company called Deliverr. Deliverr was founded in 2017. The company had been offering fulfillment services to a variety of ecommerce companies including Walmart, eBay (EBAY) and Amazon. 80% of the $2.1 billion consideration was paid in cash, and will be reflected in the Q3 balance sheet. The balance of the consideration consists of SHOP shares and will be accounted for as stock based compensation and will vest over time. While Deliverr is obviously strategic for Shopify’s fulfillment network aspirations, and seems likely to be used by a substantial cohort of Shopify’s current and future merchant base, it probably will lose some of its more prominent clients who are obviously SHOP competitors, over time. There are certainly are other companies, including a couple that are a bit larger who offer a comparable service to that available from Deliverr.
The company launched a pilot program with Flexport which offers SHOP customers the ability to ship inventory at a pallet-level on pre-booked container ships. While that kind of thing sounds remarkably pedestrian for a growth company, it resonates with merchants who have experienced incredible shipping issues during the course of the pandemic and its aftermath. Shopify was an investor in the latest Flexport funding round.
At this point, Shopify hasn’t broken out the revenue contribution from its offerings of fulfillment services nor has it made a projection as to what kind of revenue might be anticipated in any kind of granular sense. While the CFO does provide a metric with regards to payments and calls out its Capital and Marketplace offerings, she hasn’t provided any granular perspective on the size of its current shipping and logistics revenues.
Fulfillment at Shopify is based on technology that allocates inventory based on machine learning/predictive analytics. The technology predicts where and what quantities of inventory are needed in the company’s distribution locations. With the addition of the Flexport service and Deliverr, the company has now put into place an end to end logistic capability that can level the playing field for its merchants in a cost effective fashion.
Shopify’s other growth initiatives
As I have mentioned, the key to Shopify as an investment relates to the ability the company has to grow its revenues at a rate significantly greater than the rate of the projected 14% e-commerce CAGR. Besides the 2 major opportunities, the company has many other offerings that are helping it grow revenues at rates significantly faster than the growth of GMV. At this point, ShopPay has been around for years. Last quarter, shop pay reached a 53% penetration rate, up from 48% a year ago, and total payments processed rose by 23%, despite a 200 bps headwind from FX. The company doesn’t provide specific figures for the use of Shopify Capital on a quarterly basis. It’s not a central element of the company’s business as it has become for Block (SQ). At the end of 2021, merchant cash advances were just $324 million, which suggests that its contribution to revenue is no more than 2%. Another interesting initiative is that of ShopPay Installments, the Buy Now/Pay later offering that is a result of the Shopify’s partnership with Affirm (AFRM).
Perhaps the biggest potential initiative is that of Shopify Markets which is a relatively recent launch. Some of the technology for the offering which offers cross border, business to consumer functionality is apparently based on the technology that is part of the partnership that Shopify has struck with Global-e. Shopify Markets offers most of the functionality available through Global-e including local currency and payment methods, local pricing., product availability per market, local languages and the automatic calculation of duties and custom fees which are shown at checkout.
The offering just became available in late May, but the CFO talked about good traction in select international markets and proclaimed that she was very excited. The company is forecasting a reacceleration in the number of new merchants on the Shopify platform and the functionality offered by Shop Markets has been suggested to be the key driver in that expectations.
The results of Global-e reported as I have composed this article suggest that the cross-border opportunity is alive, well and being realized, and the technology integrations between Shopify and Global-e are proceeding as planned. While of course the partnership means more to Global-e than to Shopify on a relative basis, the commentary from GLBE management was very supportive of the notion that Shopify Markets will be a significant growth driver for the company in future years.
Finally, the company has been engaged in building its presence in the traditional, bricks and mortar retail space with its POS Pro offering. The offering was initially made available as a commercial solution in the fall of 2020. It is an omni-channel solution that includes POS hardware, a full suite of retail software that includes most of the features that are available from other vendors of retail software such as Oracle and SAP, and of course complete integration into the Shopify ecosystem. Initially, much of the POS Pro volume has been coming from existing Shopify customers who wanted to have a single software/IT platform. Shopify does present the percentage growth of POS pro, but not its actual dollar contribution. That said, the numbers can be approximated since the company does offer percentage growth for both on-line and off-line sales. At this point, while Pro GMV has been growing substantially in terms of percentages, its actual contribution to SHOP GMV and its revenue is relatively minimal.
It is almost inevitable that not all of these initiatives will achieve equal success. The biggest initiative, Fulfillment by Shopify is still a work in progress, while the same is basically true of Shopify Markets. It will probably be another year before Shopify is able to achieve significant revenues from its fulfillment offering. But I think a holistic view of the company’s initiatives is supportive of a forecast that the company can return to growth in the mid-high 20% range, with one or more years above that kind of growth in an expanding economy.
Shopify’s Competitive Position
Shopify’s largest single competitor has been, and will remain Amazon. Amazon has a more than 40% share of the ecommerce market, compared to a 10% share for Shopify and a 5%+ share for Walmart based on reported GMV metrics. While of course, Shopify doesn’t compete directly with Amazon, its merchant do, and the initiatives I have outlined above are designed to enhance the competitive position of its merchants vis-à-vis Amazon and Walmart. As has been the case for some time, Shopify on-line commerce revenues have been increasing more rapidly than its two rivals, and that should continue to be the case for the foreseeable future. While of course Amazon and Walmart are retail behemoths, and are likely to remain so, Shopify offers some significant advantages for some brands. Shopify Plus, for example is far less costly and provides brands the ability to use highly targeted marketing to achieve objectives.
While it will be years, if ever, before Shopify can match the logistics capability of either Amazon or Walmart, the combination of Deliverr, Flexport and the buildout of Shopify’s distribution facilities is likely to provide brands and merchants with a platform that can effectively compete with Amazon and Walmart if execution is handled properly.
While Amazon and Walmart are not typically listed as competitors, the fact is that brands can sell their merchandise or their services on-line or even off-line through a variety of channels which include all 3 vendors. The business opportunity for Shopify is to capture more brands, and more of the retail value chain, as well as finding new entrepreneurs who want to establish their stores on the Shopify platform. The company’s investment strategy is very focused on providing the brands and the merchants using its platform with features and benefits that are beyond what those brands might realize selling through Amazon.
In terms of e-commerce site builders competitors include Wix (WIX), BigCommerce (BIGC), Square on-line and Woo Commerce. The difference in scale between SHOP and its most direct competitors is enormous. That makes competition for these vendors very difficult in an environment in which slowing growth is challenging everyone to conserve resources. I have linked here to a list of some of Shopify’s direct competitors.
I believe that a significant component of the positive investment thesis for Shopify is its opportunity to gain substantial share in the ecommerce market and to develop some level of penetration in terms of the software/hardware that it is offering for bricks and mortar retail operations. The competitive environment seemingly supports the realization of market share gains.
Wrapping Up: Shopify’s business model, its valuation and some final thoughts
While Shopify shares have rallied considerably from the low that was made under $30/share in June, the shares are still down by almost 80% from the peak they reached in mid-November. The decline was partially driven by the implosion in the value of many high growth IT names, but a significant component of the valuation compression relates to a far different outlook for the growth of ecommerce. Shopify misjudged the durability of the spike in ecommerce, and thus has faced not just a falling growth rate, but severe margin pressures as well. As a result of the mismatch between rapid cost growth and much slower revenue growth, margins have disappeared. The company has taken significant steps to restrain the growth of its costs, but the real impact of that remediation won’t be seen until Q4, and most completely in 2023. Thus, the company’s current margin profile is not indicative of long term business model trends.
I can’t imagine that there are any readers who anticipate that the share price rebound is suggestive of a turn in the near term growth prospects for this company. This isn’t the place to dissect the probability or duration of a recession or of Fed policy. But the numerous headwinds with regards to consumer discretionary spending are impacting the opportunities of all retail operators this year, and perhaps into some part of 2023.
At this time, Shopify shares have an EV/S ratio of around 7X. That is not a remarkable bargain, but neither are the shares “insanely over-valued.” But the reality is that the shares should be considered as a bet on the many growth initiatives the company is pursuing. Of these, the most existential is probably Fulfillment by Shopify, but the company’s solutions that allow its merchants to support a direct international ecommerce presence, its foray into providing merchants with a platform for bricks and mortar retailing and its Shopify Plus offering are all providing the company with considerable growth tailwinds.
I believe that these initiatives, coupled with and concomitant with ecommerce market share gains will provide the fuel to restore Shopify’s CAGR to the mid-high 20% range with the probability of one or two years actually above that estimate. And with more rapid revenue growth, the company should be able to restore its business model to one that generates a consistent double digit free cash flow margin.
This isn’t going to happen in the next couple of quarters. The fulfillment initiative is really just in its nascent stages, and Shopify Markets is just a little bit further on. And while the results of Walmart and Home Depot reported today may suggest that retail sales performance is bottoming, I still expect some macro headwinds to limit the growth of Shopify revenues for the balance of this year.
It is not uncommon for analysts to talk about waiting until a certain transition is visible before recommending shares. The problem with that is that when something is visible, and recognized, the shares have probably already reflected that positive inflection. If Shopify were to announce, for example, some quantitative measure detailing positive results for its fulfillment initiative, its shares would almost surely rise by 25% in short order. The same might be said as well with regards to the market for IT shares as a whole. The current macro headwinds are all well recognized, and despite bounces, the valuation of most IT companies certainly reflects that reality. The question is not the current presence of well recognized headwinds, but when they will subside and lose their ability to constrain demand.
It is my expectation that several of Shopify’s growth initiatives will start to produce visible results in the next 12 months, while I also anticipate that the growth in Shopify Plus will continue to exceed 30%. While I have not yet reestablished a position in Shopify shares, I plan to do so shortly. I believe it will be able to produce positive alpha, not immediately perhaps, but over the next 12 months.
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