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The quarter reported and the share price implosion: some context and background
It seems like another eon. In preparing to write this article, I looked at my history of Shopify articles that I have published on Seeking Alpha over the last 8 years. When I wrote my first article, Shopify shares were at a split adjusted price of $2.64. Confession here: while I have owned the shares much of the time during the last 8 years, I have not come close to the 20+X return I could have had just buying and holding. I chose to trade it, and while most of the trades were profitable, the right strategy, obviously would have to buy and hold. I didn’t follow my own mantra to my cost. And I do not own the shares at the moment based on portfolio constraints rather than anything else.
Interestingly, while the shares have risen by 2,056% since that first article according to the SA calculation, the increase wasn’t primarily a factor of a valuation expansion. In 2016 when I first wrote about Shopify, its revenues were $390 million, and it made an adjusted operating loss and burned cash. Over the next 12 months, I am projecting that the company will report about $9 billion in revenue with a free cash flow margin in the mid-teens. So revenue has grown by 23X and cash burn has become free cash flow. Of course in 2016 Shopify was projecting a CAGR of over 80%, and now the CAGR, adjusted for the disposition of the logistics business is about 22%-24%.
So much for a walk down memory lane, although one that I believe to be relevant to a current investment thesis. By that, I mean that Shopify has adapted well to a variety of changing ecommerce environments and has managed to provide customers a positive experience. This has enabled the company to become the largest competitor in its space which can be broadly defined as providing an e-commerce infrastructure for brands and merchants. The company’s leadership team has been remarkably stable over the years and its founder, Tobi Lutke is still the CEO, and Harley Finkelstein is still the president. Glen Coates has run a part of the product organization for many years now. Part of the reason for my recommendation is that the company’s management team has successfully surmounted many challenges and has been successful in evolving the offering substantially and consistently.
The ecommerce space has certainly not grown by 23X over the past 8 years, and Shopify hasn’t made many substantial acquisitions. Most of its growth has come by making the right strategic choices, sometimes very painful choices as when it exited the logistics business about a year ago.
More recently, Shopify shares have tested the patience of investors with extreme share price volatility. From the end of October 2023 through the middle of February, the shares rose by 100%. And then in the following 3 months, their valuation has imploded by 37%. If moves like that are going to be off-putting, don’t bother to read further. Shopify shares have been volatile for all the time I have followed the company both because of the sector in which the company operates and because of its own operational ups and downs coupled with many stories, both positive and negative that seem to flow from the ether.
Most recently, and the reason for me to write this article, is that the latest earnings report and guidance were judged by investors and some analysts as a significant disappointment. In the wake of that earnings report, the shares had fallen by as much as 32%, over the last 3+ weeks, before a modest bounce, and have created what I believe to be an attractive entry point for long-term growth investors looking for one of the strongest investments in the e-commerce space.
Shopify shares have rarely had such a compressed relative valuation with the current EV/S ratio of about 8X. The combination of my estimate of a 3 year CAGR of 24%, a free cash flow margin rising from the mid-teens level, and the 8X EV/S ratio has brought the shares to a valuation that is no longer a premium to its growth rate cohort. And there are many potential upsides to what I believe to be prudent forecasts. This is an article recommending the purchase of Shopify shares at this price and at this time.
There have been some analysts who have questioned the valuation of Shopify because of its lack of GAAP profitability. Last quarter, the company did report a GAAP loss, but reported a modest positive GAAP operating margin. Most of the GAAP reported net loss last quarter was a function on the valuation of Shopify’s investment in various businesses in which it has derivative or direct equity investment. On an operating basis, the company is GAAP profitable.
About 68% of Shopify’s shares are owned by institutions. My own experience is that institutions are far less focused on GAAP results and stock-based compensation than is the case for some SA contributors. But regardless of that, almost all institutions will eliminate the swing of almost $600 million in the calculation of the valuation of Shopify’s investments in a variety of companies. Margins were quite strong in Q1, and on an operating basis, margins continue to grow. The upside in reported non-GAAP EPS was quite real and related to operating factors rather than anything else.
It makes sense to start by reviewing the last quarter earnings release and trying to understand potential reasons for the massive share price implosion that followed in its wake. I doubt that the issue for most investors would have been the company’s Q1 performance. Overall, Q1 ran at or a bit above the company’s prior forecast. This company no longer makes specific quarterly or annual forecasts that are presented to investors. It does provide a reasonable guidance framework. Specifically, at the start of the year, the company had provided a forecast for revenue growth in Q1 in the low 20% range, for a gross margin increase of 150bps compared to Q4 of 2023, for GAAP operating expense dollars to rise in the low teens percent sequentially and for free cash flow to be in the high single digit range.
In fact, revenue growth was 23% for the quarter, gross margins increased by 190 bps, GAAP operating expense dollars rose by 13% and the company’s free cash flow margin was 12%. Overall, the led to non-GAAP EPS of $0.20 compared to the prior estimate of $0.17. Essentially, in the wake of Q1 and the company’s forward guidance the vast percentage of covering analysts raised their non-GAAP EPS forecasts both for this year and 2025, although there were a couple of outliers who lowered their estimates. There were 3 ratings upgrades including most recently that of Goldman Sachs whose price target has gone to $74, and no downgrades in the wake of the earnings release, and the average price target is now $76/share in a range that goes from $60/share to $100/share. Today, however, the analyst at MoffettNathanson downgraded the shares from buy to hold, based on “too many negative catalysts for the shares.” I respectfully disagree.
So what was displeasing and led to the valuation implosion. The company’s guidance for Q2 is for annual revenue growth in the high teens percentage, or about 23% organically. It forecast that gross margins would decrease by 50 bps, that GAAP operating expense dollars would rise in the low/mid-single digit range sequentially and for free cash flow margin to be similar to Q1. The reason for the forecast decline in gross margins relates to the lapping of last year’s price increase coupled with a lower contribution from high-margin, non-cash partnership revenue agreement that is now fully amortized. In other words, nothing operational.
Because of the decline in gross margins, some analysts slightly decreased their forecast for this current quarter. The company typically doesn’t update full year guidance and that was the case with this earnings release. Most analysts, with the kind of input actually provided by Shopify, wound up increasing their full year estimates.
One SA contributor talked about emotional attachments as a reason for many positive articles on these shares. I don’t think that emotional attachment is a reasonable description of what makes a recommendation.
I try to disaggregate income statements carefully, look at those metrics that are trending, and disregard one time metrics that have little to do with the most likely operating trajectory for the company. I did my trip down memory lane earlier in this article-I am trying to assess the future outlook for Shopify.
Shopify: One of the more agile $9 billion (revenue) companies in the e-commerce space
Shopify’s premium valuation is a function of its ability to grow market share in the e-commerce space consistently. The company has been able to achieve an organic CAGR of greater than 25% for the last 4 quarters; this latest quarter, organic revenue growth was 29%. Perhaps the statistic that I found most interesting in the conference call transcript was that in which the CEO talked about increasing new merchant acquisition by 180% while the customer acquisition cost (CAC) has risen by 60%. That really doesn’t show up in any income statement metric, but increasing new customer acquisition at an accelerated rate, particularly for a company of this size, is impressive, at least to this writer.
The company’s playbook has been based on providing a wide variety of merchants the software tools that they need to optimize their business operations. The company releases literally hundreds of new capabilities each year, and it has broadened its platform to include a substantial presence in bricks and mortar stores, a major initiative in the B to B space that is achieving substantial success, offerings through partners such as (Global-E) (GLBE) in the direct to consumer, cross border ecommerce space, and Affirm (AFRM) both front office and back office software for retailers, merchant services-basically the tools that retailers use to accept credit cards, debit cards and other electronic payments.
The company has moderated its research and development expense ratio materially and sharpened its focus. Last quarter, the company’s R&D expense ratio fell to 14% from 23% in the prior year. In absolute dollars, non-GAAP research and development fell by more than 25% year-on-year. That said, research and development spending is starting to increase from its low point and was up by about 8.5% sequentially.
Most readers, including this author, are ecommerce users. And some of us have used Shopify as a tool in businesses we have operated-that’s me, also. As a consumer, ecommerce seems simple. We find an appropriate web site, choose our merchandise, choose a payment methodology, check out, and wait for our merchandise. But the nuances of ecommerce become apparent if one wants to operate an on-line store, either as part of a bricks and mortar facility, or on a standalone basis.
Shopify has been a pioneer in helping aspiring merchants and brands facilitate ecommerce. It has 10% market share of US ecommerce and a 6% share of ecommerce in Western Europe. Over the years it has moved up-market. Its Shopify+ product has been developed to service larger, well established brands. These days, about 32% of Shopify’s MRR comes from its upmarket offering and customers that I recognize using the service include Steve Madden, Tetley Tea, Heinz, Molson Coors and Crate and Barrel.
The latest earnings call featured the comment, “You’re seeing the strongest version of Shopify in our history.” Is that true? And what differentiates the Shopify stack from the many other offerings in this space. These days, in speaking of an ecommerce stack, most builders consider 4 layers. These consist of what are called “primitives’, basically what most of us think about when we consider ecommerce. Above that layer comes extensibility, followed by developer tools and finally by distribution, which consists of an App Store and a Theme store.
Extensibility basically refers to Shopify’s tools to convert checkout into actual sales. The company has a suite of tools it calls Checkout Extensibility for app-based customizations. The company suggests that the use of Extensibility and Shop Pay can yield conversions more than 50% better than guest checkout. That is, perhaps, a loaded comparison given that guests in checking out on a site are not regular customers.
Shopify has a broad library of developer tools and a substantial cohort of Shopify developers who have a significant practice based on customizing and implementing Shopify for all sizes of enterprises. I don’t want to begin to pretend that I know the utility of all of the tools that the company offers. It has recently been focusing efforts on composable commerce elements as a means of penetrating large, new name accounts. An example of that this past quarter was Coach which has begun to implement elements of Shop Pay as a precursor of moving its entire ecommerce infrastructure to Shopify. Having the tools and the developers to implement and customize Shopify is a significant, albeit, unheralded competitive advantage for the company.
Shopify also offers an extensive set of offerings that are global and cover most channels including on-line, in-person direct to consumer, B to B and 1st and 3rd party. Within those channels, the company offers capabilities for the front office, the back office, mobile desktop, core and analytics.
The company claims that sites built with its technology have 15% higher conversion, that ShopPay has 10% higher conversion than other digital wallets. It also makes claims that the sites built with its tools have 50% lower customer acquisition costs, and it offers a lending/capital facility for customers.
I have no real way of validating these claims. Doubtless, other competitors have different sets of data that show their web site builder technology in a favorable light. My own personal experience using Shopify was favorable, although its support wavered on occasion.
Ecommerce market growth
Ecommerce is a growing component of the overall retail sales market, but it is not growing fast enough to sustain Shopify’s growth ambitions. The latest report I have seen on ecommerce is one that I have linked here. Overall, it says that the US ecommerce market should achieve a CAGR of 9% over the next 4 years, while the ecommerce market has been forecast to have a CAGR of 9%. As this report shows, ecommerce growth paused in 2022 reflecting a reaction to the hyper-growth during the Covid pandemic, but its growth has recovered and is back on what appears to be a sustainable trend. Within that CAGR mobile ecommerce is still growing much faster than desktop; the growth in mobile commerce is estimated to be 29% compared to 7% for desktop.
There are a couple of statistics in the linked report worth noting. One is that even by 2027, online commerce will represent just 23% of total retail sales in the US and less elsewhere. That compares to a 19.5% penetration currently. Currently, the cart abandonment rate is 70%.
Overall, some of the trends reported in this survey such as that of cart abandonment, market penetration and growth of newer forms of ecommerce would seem to bode well for Shopify’s ultimate success. That said, it is fairly evident that Shopify’s ability to sustain growth above a 20% CAGR requires both market share gains, gains in the attach rate of additional features-particularly Shopify Pay and the successful impact of some of the company’s partnerships such as that with Global-e and Markets Pro, with Klaviyo (KVYO), and with Affirm as well as success with its international initiative, its B to B offering and its bricks and mortar/POS initiative.
In addition, the concept of using composable stacks has been gaining momentum amongst brands and stores and is one in which Shopify has a significant offering. The latest composable stacks offer something called a “headless” stack which has nothing to do with the Legend of Sleepy Hollow. I have linked here into a description of Shopify’s most recent blog on the subject.
Shopify’s AI and looking at the sum of its growth drivers
Shopify introduced an AI service it calls Magic that its customers can use to improve product descriptions, answer FAQs, to optimize email delivery times and to improve messaging during live chats. Shopify also has a service that is the same as the co-pilots available from many software vendors. In the short term, AI will probably have more of a discreet benefit on Shopify’s operating expenses rather than in terms of revenue growth-Magic is currently free for Shopify users.
Over time, I anticipate that Shopify will enhance Magic, and offer other commerce elements. At some point, it seems likely that it will be able to discreetly monetize AI, but for the moment, it will be other features and initiatives that carry the load of differentiation and generating revenue to get the company average to greater than 20%.
Perhaps the single most important aspect of Shopify’s differentiation has been and is likely to remain its ability to add new merchants at an accelerated pace. This is mainly a function of the company’s overall lower total cost of ownership. It may seem strange to readers that Shopify’s core business, after all this time, is a differentiating factor and driving revenue growth above expectations-but so it is.
Of course, there are many other factors driving Shopify’s above average growth. Shop Pay continues to grow significantly and penetration levels continue to rise at a steady cadence. I mentioned composable elements as a demand driver, and the company announced a significant win in that area. The company is getting some growth from its POS offering. Overall, offline GMV rose 32% year over year, albeit from a small base. The company has had an initiative in the B to B segment for some time. That has continued to grow rapidly, with GMV rising by 130% year-on-year, actually accelerating from growth of 100% in 2023. International revenues are growing more rapidly than revenues in North America. Some of this is doubtless a function of the strong growth of Markets Pro, and the other integrations the company has with Global-E. European GMV grew 38% last quarter and that is the 3rd quarter in a row for that kind of performance.
This isn’t meant to be a commercial for Shopify, and at the moment I do not own the shares, and have not owned the shares for some months at this point. But the company really does have many unheralded points of differentiation that are driving growth above the average for e-commerce. This quarter, the company actually called out its partnership with Affirm as a contributor to strong growth. It has an advertising channel that is starting to show growth. It has been able to construct a value proposition for large merchants that shows up in the growth of Shopify+. It has some pricing power, and part of its above-average growth has been a function of a price increase whose benefits are contributing to revenue growth this year.
The current consensus revenue growth estimate for Shopify is 21% for this year, or the equivalent of 24-5%, net of the disposition of the company’s logistics business. Expectations are for that growth to slow to 20% next year. Shopify is a $9 billion revenue company which while not huge in terms of revenues in the retail space as a whole, is still at a level in which macro trends are likely to be felt. And the overall macro environment in terms of growth has been grinding lower. The most recent JOLTS and ADP report continue to suggest that employment gains are decreasing.
With the macro in some question, and likely to have a discrete impact on Shopify’s growth, I find myself in a position of having to guess about Shopify’s most likely growth in 2025. I am comfortable forecasting that the company will exceed the current consensus revenue estimate of $8.54 billion by a noticeable amount as has been typical for this company. But percentage growth in 2025 will most likely be somewhat constrained by a deteriorating retail sales environment. In terms of the valuation models that I look at, I have estimated Shopify’s 3 year CAGR to be around 24%, although I think the odds are that it will exceed that, and will exceed the 21% consensus revenue growth estimate for next year despite macro headwinds based on growth in the attach rate, growth of Shopify’s bricks and mortar (POS) offering and the growth of B to B along with continued growth of Shop Pay.
Shopify’s Business Model-Consistent Improvement overall with some variability of specific expense buckets
Shopify reports its revenues in two buckers; one of these is subscription services and the other is merchant solutions. Subscription services is the core functionality that is used to build an on-line store. It also includes Shopify+, a service aimed at more sophisticated, enterprise users. At this point, subscription solutions is about 27% of total revenues and grew by 34% last quarter. Merchant solutions grew by 20% last quarter; this relatively modest growth as reported was a function of the sale of the company’s logistics business, offset by the positive impact from the growth in GMV, the rising penetration of Shopify Payments, and the growth of what the company calls its scaled products, or services beyond the basic Shopify platform for which merchants pay additionally.. But as mentioned earlier, the company also benefitted from increasing growth in new customers. MRR, which is the sum of current monthly subscription revenues rose by 32%, with MRR for Plus, at 32% of total MRR. MRR for Shopify’s POS offering that includes physical stores grew by 50%.
Shopify is obviously a retailer, with a very seasonal pattern of revenues, which peak in Q4 and are at a relatively low ebb in Q1. So, looking at expenses on a sequential basis from Q4 to Q1 is likely to be somewhat misleading. Gross margins rose from 52% from 49% in the year earlier period. Part of this increase reflects the impact of the previously announced pricing changes, offset by lower recognized non-cash revenues from certain partnerships. The company’s guidance reduction in gross margins was primarily a result of less of an expected tailwind from price increases.
Sales and marketing expense rose from 18% to 19% year-on-year and rose by about 15% sequentially. Some analysts were a bit troubled by the strong growth in non-GAAP sales and marketing expenses. Basically, the company believes that it has identified some significant opportunities which are those that are already showing outsize potential percentage growth such as sales efforts directed to the enterprise, to the POS/Bricks and mortar initiative and to international expansion and the company’s B to B offering.
Cost ratios in other expense categories showed improvement. In particular, research and development expense was 14% last quarter compared to 23% in the year earlier period. That was primarily a function of ending development of the company’s logistic platform. The non-GAAP research and development cost ratio was 14% last quarter and in dollars rose from $242 million to $263 million sequentially.
The general and administrative expense ratio wound up falling from 7% to 5% year-on-year. Overall, the company had a 5% GAAP and an 11% non-GAAP operating margins last quarter compared to a GAAP loss of 13% and a non-GAAP loss of 2% in the year earlier period.
As mentioned, the company did report a GAAP loss primarily because of the net loss it recognized on its equity in investments of its various partners. That was a swing of almost $600 million year-on-year. In looking at free cash flow, the recognized loss is, of course, excluded.
Overall, the company’s free cash flow rose to $232 million, up from $86 mil, and the company’s free cash flow margin rose to 12%, a level that the company is projecting for Q2 as well. Given normal seasonality for this company, I have forecast a free cash flow margin for the year of 14%.
Shopify does use stock-based compensation, but the amount fell last quarter. The SBC expense ratio was about 5.6% of revenue last quarter, and is expected to continue at that level this quarter. I prefer to look at dilution as a better indicator of the actual expense of SBC. There has been no dilution in the last year, and the diluted share count has fallen sequentially by a bit less than 1%.
Risks to the investment thesis
Shopify is a retailer, and as such is not immune to trends in retail sales. Retail sales growth stalled last month and employment data suggests that income growth to support growth in retail sales is slowing. In my mind, that is the single biggest threat to the investment thesis and one which has been hard to measure or predict.
The company has chosen to ramp sales and marketing expense significantly. It has done so based on opportunities, and those opportunities are readily apparent in the recent results. Still, some investors may be concerned about expense discipline on a go forward basis.
The key to the investment thesis for this company is its ability to grow significantly faster than the overall ecommerce market. Some of the faster growth is the functional differentiation that Shopify’s basic platform offers-in particular faster check-out. This is a competitive space with a ton of competitors. In the interests of managing the length of the article, I didn’t list all of the competitors in this space. The company has navigated through competitive shoals adeptly for some years now, but I think it prudent to point it out as a potential risk.
Shopify has made a number of strategic choices as a company that are going to be key in its long-term ability to grow faster than the overall ecommerce market. B to B, bricks and mortar, international, and the success of the company’s partnerships with Affirm, Global-e, Klaviyo and others will be significant drivers for the company’s growth and its ability to continue to grow at rates of greater than 20%.
I believe that Shopify has had advantages over competitors due to a strong, flexible culture. Maintaining that as the company continues to scale is also a risk.
Most of these risks can also be construed as opportunities for the company to grow faster than the consensus, and overall, I think that is more likely than not to be the case.
Valuation
Shopify’s valuation has compressed significantly since it released its latest earnings. Based on the share price as of today (6/5), I have projected that Shop’s EV/S is about 8x. My valuation methodology includes looking at a 3 year CAGR-I am estimating 24% on an organic basis, a free cash flow margin projection which, as mentioned, is 14% in my current model and the EV/S ratio. The combination of these elements puts Shop’s valuation slightly below average for its growth cohort. I look at some of the other companies with similar growth estimates. For example, MongoDB (MDB) has a huge valuation premium compared to Shopify. Presumably this is a function of some investors believing that Mongo will soon return to hyper growth. Shopify shares are now valued similarly to Atlassian (TEAM), and are selling at a marked discount to ServiceNow (NOW). Of course these are not competitors, but in looking at valuation, I like to look at how markets are valuing those companies with comparable growth rates.
I see the potential for Shopify shares to rerate higher and I also think there are potential upsides to my margin and growth rate estimates.
Summarizing the case to buy Shopify shares
Shopify shares tumbled precipitously in the wake of a poorly received earnings report. While the shares have most recently begun to show some relative strength, currently they remain more than 20% below where they were before earnings were announced and they are up by just 5% over the last year despite significant revenue growth and a substantial inflection in profitability.
My thesis here is that the company has a number of substantial initiatives that are likely to keep the company’s growth engine humming at a significant pace. The potentials for growth in B to B, Bricks and Mortar/POS, international expansion, Shop Pay, and the several partnerships that the company has are likely to accelerate growth.
Shopify probably is gaining market share in the basic ecommerce space. Its customer acquisition strategy has produced some substantial results, and it is making strides in using its composable commerce capabilities to capture some noteworthy enterprise customers such as Coach.
Shopify Magic is in its earliest incarnation as the company’s AI offering for its customers. At this point, Magic and Sidekick, essentially Shopify’s co-pilot offering, are included as part of the basic monthly Shopify price. AI means more to Shopify on the cost side currently. Over time, that is likely to change, of course, but any quantification I might make would be in the nature of an unsubstantiated guess. Despite my concern about macro headwinds slowing down growth in the retail segment, overall, I believe that Shopify shares are likely to produce significant positive alpha from current levels.