Shopify (SHOP): Expansion Into Advertising Makes It A Buy

Shopify Inc. (NYSE:SHOP) is a force to be reckoned with in the e-commerce industry, with around 2 million merchants using the platform to power their webstores. The increasing number of commerce transactions being facilitated using Shopify’s solutions, such as Shopify Payments, generates valuable first-party data that enables the company to continuously advance its offerings, or even roll out new services. Recently, Shopify decided to leverage its first-party data to introduce Shopify Audiences, an advertising solution that offers promising potential.

Shopify Audiences

Shopify Audiences is aimed towards enabling merchants to better target high-intent buyers. Essentially, Shopify uses consumers’ purchase history data to determine what type of products they are likely to buy going forward. The data feeds into the algorithms determining which adjacent product ads to show to shoppers on ad platforms. For example, someone who has recently purchased a snowboard from a Shopify-powered store could be targeted with ads for warm winter clothes from other Shopify-powered stores. Currently, Shopify Audiences can only be integrated with Meta Platforms/Facebook/Instagram (META) ads and Google (GOOG) ads, and will expand to other platforms like TikTok and Pinterest (PINS) going forward. It is exclusively available for Shopify Plus merchants only, enabling the company to upsell merchants towards its higher-end subscription plan.

Shopify Audiences strives to boost “top of funnel” marketing campaigns. ‘Top of funnel’ marketing campaigns are intended to raise product awareness across the public, which may reach a mix of high-intent shoppers and non-intent people. This could lead to ad dollars being wasted as merchants may end up paying for impressions that have low chances of conversion, aggravated by the degradation of third-party data making ad targeting more difficult. Shopify is using first-party purchase data to determine the likelihood of a consumer purchasing an adjacent product, thereby striving to improve conversion rates and reduce advertising costs for merchants.

President Harley Finkelstein had shared on the Q2 2022 earnings call:

It’s essentially a 3-step process. A Shopify Plus merchant selects the product they want to sell more of. Machine learning algorithms build an audience of high-intent buyers tailored for that product, and the audience list is directly and securely exported to the merchant’s ad network of choice…

Merchants are finding that audiences makes a real difference. They are seeing a meaningful increase in conversion rates and return on ad spend [ROAS]. For example, early access merchant, BlenderBottle, has seen its return on ad spend increasing as high as 6x. Another fast-growing merchant, L’AMARUE, saw a 48% uptick in its click-through rates, a 2.5x return on ad spend on its targeted campaign, and 73% of revenue from paid acquisition attributed to Shopify Audiences. All this, plus a 26% decline in customer acquisition costs. Audiences is off to a very promising start, and we’re excited to see what it will do for merchants, especially ahead of the holiday selling season.

Shopify Plus merchants must opt into Shopify Audiences to use the service, requiring them to activate data contribution from their own stores to be able to leverage the power of data aggregation across all merchants that opt in. Merchants also need to enable Shopify Payments to join Shopify Audiences, which enables Shopify to collect data on shoppers that use Shopify Payments to make purchases. Note that merchants’ customers have the option to opt out of their data being used as part of ad targeting initiatives. “Audiences are created using lists of authorized email addresses from recent buyers” that opt into the service.

“When an order is processed, Shopify checks if the email on the order matches any customer in (the merchant’s) audience. If so, the order will be attributed to Shopify Audiences.” Given that Shopify Audiences is based on an authorized list of consumer email addresses, attribution is easy and “resilient to changes in user-tracking regulations due to privacy laws.” This makes it a more appealing and sustainable advertising solution while other major ad platforms are reeling from the degradation of third-party data, including Apple’s iOS changes in April 2021. Shopify had rolled out early access to Shopify Audiences to select merchants in late 2021, before launching it to Shopify Plus merchants based in the U.S. or Canada in May 2022. The launch of Shopify Audiences marks a timely introduction of an ad solution powered by first-party data, at a time when digital merchants are witnessing “return on ad spend drop, reflecting the growing difficulty of using digital marketing to find new buyers.”

Shopify Audiences can be managed from Shopify admin, the same place as a merchant’s other activities. The aggregation of advertising activities with other commercial activities within Shopify admin makes it easier for merchants to handle their businesses from one place, and enables Shopify to more deeply imbed Shopify Audiences into Shopify Plus merchants’ core operations, thereby making Shopify Plus stickier.

The roll-out of Shopify Audiences is indeed an appealing enhancement of Shopify Plus. Shopify Plus revenue accounted for one-third of the company’s Monthly Recurring Revenue (MRR) in Q3 2022, marking a year-over-year growth rate of 18%.

The timely introduction of its advertising solution emboldens Shopify’s ability to sustain this growth trajectory through inducing merchants to upgrade to the premium subscription plan, as well as bolstering its merchant acquisition strategy from competitors. As Shopify Plus increasingly contributes to the e-commerce giant’s top-line growth, it enables the Shopify stock to command a higher Price to Sales ratio. The stock is currently trading at a P/S ratio of 8.7x, marking a considerable contraction from the 63.9x multiple it was trading at in September 2020. The market is currently underappreciating Shopify’s revenue growth potential amid advancements in Shopify Plus.

Counteractive considerations

Firstly, while Shopify Audiences is certainly a great use of first-party data to augment the appeal of Shopify Plus, this solution can indeed be replicated by other e-commerce platforms, undermining the exclusivity of the solution. For example, Meta has been striving to transform its platforms into e-commerce destinations for years, allowing merchants to set up storefronts for free and even enabling shoppers to checkout within Facebook or Instagram. Hence, Meta is also able to collect first-party data on consumer purchases to enhance its own advertising solutions. Therefore, merchants could access similar advertising solutions elsewhere, undermining Shopify’s ability to upsell towards Shopify Plus.

That being said, trust from both merchants and their consumers is key to the ultimate success of such advertising solutions, as they indeed have a choice of whether to opt in or out of their data being used for ad targeting efforts. In fact, according to the FAQs page of Shopify Audiences, one of the most frequently asked questions from merchants is: “Can I exclude competitors from using my data for their audiences?” Shopify Audiences can indeed include competitors’ consumer data (email addresses), but is encrypted to ensure secure data transmission. Furthermore, “to protect buyer privacy, merchants cannot download a list of the hashed emails exported from Shopify to target a competitor’s list of customers.” Merchants that ultimately opt into Shopify Audiences do so because they trust the Shopify brand, and the company’s ability to uphold data privacy standards. “Trust” is a valuable asset that not every company enjoys. For example, Facebook’s brand image has been dented by various data mishandling cases, such as the Cambridge Analytica scandal in 2018, which erodes merchants’ (and consumers’) ability to trust Meta’s data management practices, undermining the company’s ability to encourage data sharing among merchants and consumers to advance its advertising solutions.

The point is, ‘trust’ will play a key role in determining the success of Shopify Audiences. The more merchants and consumers trust the Shopify brand, the more willing they will be to opt into data sharing, advancing the effectiveness of Shopify Audiences. Shopify will need to maintain and consistently enhance brand image/ trust in order to bolster the competitiveness of its advertising solutions.

Secondly, Shopify is giving away targeting enhancements (based on its own first-party data) by integrating with ad platforms’ advertising solutions, in turn augmenting the effectiveness and use of Facebook/ Instagram ads and Google ads. Shopify also plans to expand Shopify Audiences integration with other “platforms such as TikTok, Snap, Pinterest, Microsoft Advertising, Criteo, and others.” Meanwhile, Shopify is still building up the Shop app, Shopify’s own shopping app connecting shoppers and merchants. From an investor’s standpoint, it would indeed be more preferable to see Shopify leverage the power of Shopify Audiences to augment the appeal of advertising on its own marketplace in the future, rather than boost the effectiveness of other platforms’ ad solutions through integration with Shopify’s first-party data.

Summary

The digital advertising industry is still reeling from the degradation of third-party data, making the introduction of Shopify Audiences a timely ploy, to capitalize on the need for ad solutions powered by first-party data. “Trust” is a key component underpinning the potential of Shopify Audiences. The more willing merchants and consumers are to opt into data sharing, the more first-party data feed into the algorithms driving the effectiveness of Shopify Audiences. Given the early success, Shopify Audiences is delivering in terms of improvements in customer acquisition costs and ROAS, it indeed augments the appeal of Shopify Plus, improving the company’s ability to upsell, as well as encourage large enterprises to migrate to its higher-end subscription plan.

Shopify Inc. stock is a buy at this contracted P/S multiple of 8.7x, as the growing contribution of Shopify Plus to the company’s MRR improves the quality of its top-line growth.