Shopify CEO Tobias Lutke, center wearing hat, is celebrated as he rings the New York Stock Exchange ... [+] opening bell, marking the Canadian company's IPO, Thursday, May 21, 2015. Shopify Inc. works with merchants who want to offer their own online checkout services, providing a platform for small- and mid-size businesses that sell products online. (AP Photo/Richard Drew)ASSOCIATED PRESS
Global e-commerce sales have soared by 22% compounded annually over the past two years, and the COVID-19 disruptions to physical retail operations have amplified e-commerce growth. As a result, the stocks for companies that facilitate e-commerce have soared, too. One such firm’s stock is up 145% year-to-date. However, despite positive industry trends, fiduciaries should beware of the abnormally high level of risk in Shopify (SHOP).
While Shopify’s stock performance is attractive to many momentum investors, investors with fiduciary responsibilities should take notice of how quickly high-flying tech stocks can come back down to reality and should consider the deteriorating fundamentals, increasing competition, and the unrealistic increase in profits implied by the current valuation.
This report helps investors of all types see just how extreme the risk in SHOP is based on:
- Slowing revenue growth
- Numerous, fierce, deep-pocketed competitors
- Doing the math: Shopify must facilitate five times more e-commerce sales than Amazon did in 2019 to justify the current valuation
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I recently highlighted Tesla (TSLA), Uber (UBER), Wayfair (W), Carvana (CVNA), and Beyond Meat (BYND) as firms that fiduciaries should avoid, in large part because each of these businesses possess very few sustainable competitive advantages. Shopify is another example of a business with limited barriers to entry that is attracting lots of competition.
Shopify aims to provide a unique, integrated e-commerce platform – not exactly an original idea. Many other firms also host online stores and process payments at competitive prices. With very little technological advantage, Shopify will have a difficult time protecting its market share from larger competitors or new entrants.
Figure 1 shows just a sample of the many firms involved in facilitating e-commerce transactions and how many provide the same services as Shopify. I classify these services as:
- Web Content Management – a system that allows users to easily create their own websites and administer website content with little programming knowledge (e.g. WordPress)
- Payment Gateway – a service that allows merchants to securely accept credit card payments
- Marketplace – an online platform to sell products and/or services from multiple third parties
I think Shopify’s operating segments, subscription solutions and merchant solutions, correlate most closely to the web content management market (projected by Prescient & Strategic Intelligence to grow at 18.4% per year) and the global payment gateway market (projected by Grand View Research to grow at 21.5% per year). Using these growth rates, the total addressable markets for these two markets are estimated to be $22.8 billion and $71.2 billion in 2027, respectively. Therefore, I estimate the TAM for Shopify to be $94 billion in 2027. This calculation plays an important role in the valuation section of this report below.
Figure 1: E-commerce Service Industry Is Filled With Competition
Shopify Competitor Comparison ChartNew Constructs, LLC
Heavy competition will not only make adding more merchants more difficult, but it also puts a limit on how much Shopify can charge for its services. Shopify has not increased the price of its monthly subscriptions on any of its three existing plans since 2017, which as we’ll show below, has been a drag on profitability. One of Shopify’s biggest competitors, WooCommerce, is keeping the pressure on by offering its e-commerce plugin for free to all WordPress users.
Despite stiff competition, Shopify has grown its top line in recent years. The gross merchandise value (GMV), or value of all sales Shopify’s merchants generate on the firm’s platform, increased from $26.3 billion in 2017 to $61.1 billion in 2019. The firm’s 2019 GMV represented 1.7% of the global e-commerce market, which was up from 1.1% in 2017.
Competitive pressures have slowed Shopify’s YoY GMV growth rate, though. Per Figure 2, Shopify’s GMV growth rate declined YoY from 2017 to 2019. While the GMV growth rate is improving in the TTM, I believe this bump is temporary and related to COVID-19 temporarily boosting online sales (as I saw with Wayfair).
Figure 2: Shopify’s YoY GMV Growth Rate Since 2016
SHOP YoY GMV Growth RateNew Constructs, LLC
E-Commerce Tailwinds Aren’t Enough
Over the long term, Shopify will find it difficult to maintain the year-over-year (YoY) growth it is experiencing in the TTM period, largely due to a secular slowdown in the overall e-commerce market. The market already expects Shopify will not sustain its current revenue growth rate. Figure 3 shows Shopify’s consensus estimate YoY revenue growth rates for 2021 and 2022 are much lower than the 2020 consensus estimate.
Figure 3: Shopify’s Revenue Growth Rate
SHOP YoY Revenue Growth RateNew Constructs, LLC
Grand View Research expects the global e-commerce market to grow by 16% compounded annually from 2020 to 2027. While this tailwind may help Shopify grow revenue over the next few years, it is not enough to produce the above-market growth rates necessary to meet the expectations baked into its current stock price, as we’ll show later.
Competition Is Much More Profitable
Shopify’s growth, and ultimately, its path to profitability, are hamstrung by the firm’s lagging operating efficiencies relative to competitors. While Shopify’s net operating profit after-tax (NOPAT) margin improved from -9% in 2015 to -3% TTM, it remains well below peers, per Figure 4. Peers include the following firms: Etsy Inc (ETSY), Adobe Systems, Inc. (ADBE), Oracle Corporation (ORCL), Square, Inc. (SQ), SAP SE (SAP), GoDaddy Inc (GDDY), salesforce.com Inc. (CRM), and Wix.com, Ltd. (WIX). I do not include BigCommerce (BIGC) because I do not cover it. However, with BigCommerce reporting -$5.4 million in adjusted EBITDA in 2Q20, it is safe to say that its inclusion in the peer group would only lower the group’s average NOPAT Margin and ROIC.
Shopify’s invested capital turns, a measure of balance sheet efficiency, are better than its peer group.
Nevertheless, Shopify’s superior capital efficiency is not enough to offset its negative margins. The firm has never generated positive NOPAT in any year of my model (dates back to 2015), and Shopify’s return on invested capital (ROIC) fell from -10% in 2017 to -12% in 2019. However, over the TTM, the firm’s ROIC improved to -5%, far below the firm’s peer group market-cap-weighted average ROIC of 15%.
Figure 4: Shopify’s NOPAT Margin, Invested Capital Turns, and ROIC vs. Peers
SHOP Profitability Vs. PeersNew Constructs, LLC
*WIX earns a bottom-quintile ROIC as its NOPAT and invested capital are both negative
Shopify’s Losses Are Growing Too
The hope for this high growth company is that it will eventually become profitable once it reaches a certain scale. Shopify does not appear to be heading in that direction, unless one believes the COVID-19 boost will be permanent. Per Figure 5, Shopify has grown revenue by 67% compounded annually since 2015. Shopify’s rapid revenue growth has come with little regard for actual profits. Shopify’s core earnings have fallen from -$18 million in 2015 to -$46 million over the trailing-twelve-months (TTM).
Figure 5: Shopify’s Revenue & Core Earnings Since 2015
SHOP Revenue And Core EarningsNew Constructs, LLC
Shopify Is Also Burning Through Cash
Shopify has a history of significant free cash flow (FCF) burn that is unlikely to change anytime soon. Since 2016, the firm has burned a cumulative $1.6 billion (1% of market cap) in FCF. What’s worse, the firm’s FCF burn is accelerating. Shopify burned $1.1 billion in FCF in the last two years combined and $759 million in the TTM period. While the firm has ample liquidity to continue operating, investors that care about fundamentals and shareholder value will not fund such a significant cash burn forever.
Doing the Math: SHOP Must Take a Large Share of Its Addressable Market
Despite the deteriorating fundamentals and tough competition, Shopify is priced as if it will achieve massive growth in revenue and profits and grow to be 50% of its total addressable market (TAM).
To justify its current price of ~$949/share, Shopify must:
- Grow revenue by 53% compounded annually (which includes 66% growth in 2020 and 51% each year thereafter – vs. consensus estimates of 66% in 2020, 30% in 2021, and 46% in 2022) for the next eight years
- Immediately achieve a 17% (equal to peer group TTM margin) NOPAT margin (compared to -3% TTM)
See the math behind this reverse DCF scenario. In this scenario, Shopify’s revenue in 2027 would be more than 29 times higher than its 2019 revenue.
Figure 6 shows the revenue growth expectations baked into the stock price compared to the firms historical revenue. In this scenario, Shopify will grow revenue from $1.6 billion in 2019 to $46.9 billion in 2027, or 50% of Shopify’s TAM of $94 billion, as calculated above.
Figure 6: Current Valuation Implies Unrealistic Revenue Growth
SHOP DCF Implied Revenue Growth Vs. TAMNew Constructs, LLC
While the revenue growth implied by the stock price is 50% of the projected TAM, the implied GMV growth is even more astonishing. Last year, Shopify generated a total of $1.6 billion in revenue from a total of $61.1 billion of GMV – or $1 of revenue from every $38 of GMV. In the scenario outlined above, assuming the same revenue to GMV rate, the firm must generate $1.8 trillion in GMV in 2027 – or 29% of Grand View Research’s 2027 global B2C e-commerce market forecast of $6.2 trillion.
Figure 7: Current Valuation Implies Unrealistic GMV Growth
SHOP DCF Implied GMV vs. AMZN & EBAYNew Constructs, LLC
Figure 8 shows the NOPAT growth expectations baked into the stock price compared to the firms historical NOPAT. In this scenario, Shopify will grow NOPAT from -$122 million in 2019 to $8 billion in 2027. For reference, Amazon generated an average of $5.7 billion in NOPAT over the past five years and eBay averaged just $1.9 billion in NOPAT over the same time.
Figure 8: Current Valuation Implies Unrealistic NOPAT Growth
SHOP DCF Implied NOPAT Justification ScenarioNew Constructs, LLC
Significant Downside Even If Shopify Grows Faster Than E-commerce Market
Even if I assume Shopify can grow revenue and NOPAT at above industry average rates, SHOP still has significant downside risk. In this scenario, Shopify:
- Grows revenue by 30% compounded annually for the next decade and
- Immediately achieves a 17% (equal to peer group TTM margin) NOPAT margin
See the math behind this reverse DCF scenario. In this scenario, Shopify grows NOPAT from -$122 million in 2019 to $3.7 billion 10 years from now, and the stock is worth just $355/share today – a 63% downside. In this scenario, the firm grows revenue to $21.8 billion in 2029. If I assume, as I did in the previous scenario, that Shopify will generate ~$1 of revenue for every $38 of GMV, then the firm reaches $826.7 billion of GMV a decade from now – nearly 2.5 times Amazon’s 2019 GMV.
Figure 9 compares the firm’s implied future NOPAT in this scenario to its historical NOPAT.
Figure 9: Shopify Has Large Downside Risk: DCF Valuation Scenario
SHOP DCF Implied NOPAT Valuation Scenario 1New Constructs, LLC
Further Downside If Shopify Grows In-Line With TAM Growth
If I assume Shopify can grow revenue at the same rate as its TAM, SHOP has much more downside risk. In this scenario, Shopify:
- Grows revenue by 21% (equal to the TAM growth rate) compounded annually for the next decade and
- Immediately achieves a 4% (equal to Square’s TTM margin) NOPAT margin
See the math behind this reverse DCF scenario. In this scenario, Shopify grows NOPAT from -$122 million in 2019 to $389 million 10 years from now, and the stock is worth just $44/share today – a 95% downside. In this scenario, the firm grows revenue to $8.5 billion in 2029. If I assume, as I did in the previous scenarios, that Shopify will generate ~$1 of revenue for every $38 of GMV, then the firm reaches $398 billion of GMV a decade from now – 19% above Amazon’s 2019 GMV of $335 million.
Figure 10 compares the firm’s implied future NOPAT in this scenario to its historical NOPAT.
Figure 10: Shopify Has an Even Larger Downside Risk With Realistic Expectations
SHOP DCF Implied NOPAT Valuation Scenario 2New Constructs, LLC
Each of the above scenarios also assumes Shopify is able to grow revenue, NOPAT and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows us to create best-case scenarios that demonstrate how high expectations embedded in the current valuation are. For reference, Shopify’s invested capital has increased by an average of $331 million (21% of 2019 revenue) over the past four years.
Acquisition Would Be Unwise
Often the largest risk to any bear thesis is what I call “stupid money risk”, which means an acquirer comes in and pays for Shopify at the current, or higher, share price despite the stock being overvalued. While I think competitors would be off building rather than buying e-commerce capabilities, its plausible that a competitor could decide to buy Shopify. However, given the highly negative margins and overvalued stock price, I think it would be unwise for a larger firm to acquire Shopify at current levels.
The likelihood of someone acquiring Shopify is further reduced by the low barriers to entry in e-commerce. The firm does not have a substantial technological or behavioral advantage which means other firms can replicate its business model easily. Nevertheless, I think it helps to quantify what, if any, acquisition hopes are priced into the stock.
Walking Through the Acquisition Math
First, investors need to know that Shopify has large liabilities that make it more expensive than the accounting numbers would initially suggest.
- $2.3 billion in outstanding employee stock options (2% of market cap)
- $419 million in operating leases (
Source : https://www.forbes.com/sites/greatspeculations/2020/09/23/dont-add-shopify-to-your-cart/