Is Shopify in value territory?

Fallen by more than 80% in a span of 8 months, from its all-time high price of USD$169 back in November 2021. Trading at USD$32 per share, it begs the question. Is Shopify a buy now?

Shopify business model

To quickly summarise, Shopify is an easy-to-use build-to-go e-commerce store that encourages brand ownership for merchants. The company aims to provide a smooth and frictionless e-commerce experience for its merchants’ customers, with an increased focus on the mobile front. To attract quality merchants, Shopify has in-built tools, and dashboards to aid in streamlining merchant business operations. Additional plugins and business solutions are introduced to increase “lifetime value” and “value extraction” from existing successful merchants looking to scale. One advantage Shopify inc claims to have is the enormous Data gathered from more than 2 million(based on 2021 annual report statics) live Shopify stores.

Shopify Inc’s success ties in with the success of its merchants.

Shopify runs primarily runs a SaaS business model, with two revenue streams.

  1. subscription solutions – a recurring subscription component. Subscription solutions revenue include

    • Recurring Platform fees
    • Subscriptions to Point of Sale (POS) Pro offering.
    • Sale of themes.
    • Sale of apps. 
    • Registration of domain names. 
  2. merchant solutions –  a merchant success-based component. Merchant solutions include Shopify Payments generating revenue from payment processing fees & currency conversion fees.
    While transaction services, referral fees, and advertising revenue from Other Shopify business solutions like Shopify App Store, Shopify Capital, ShopPay Installments, Shopify Balance, Shopify Shipping, and Shopify Fulfillment Network.

Hence, the success of Shopify is reliant on its ability to attract new merchants, increase lifetime value & value extract more revenue from its existing merchants’ pool.

Reason for the stock price death spiral

#1- Subscription solution declining margin

Figure 1

As we can see from the graph above, there were periods of declining margin.

  •  A sudden dip in 2020 Quarter 2.
    2020 Quarter 2 dip can be attributed to the COVID lockdown shock. Everyone thought the world economy can to a halt until stimulus aid came in.The rapid growth from 2020 Quarter 3 to 2021 Quarter 1, was due to a series of events. During Q2 the whole world paused, and people had a lot more free time to entertain their ideas and passion.Came Q3 companies adapted for remote work, enough people found spare time to participate in side-hustle culture, and there is also a great resignation wave. Shopify was in a great position to capitalize on these social changes
  •  A slow gradual decline from 2021 Quarter 1.
    One reason is In 2021, Shopify reduce its ask for “revenue share on earnings” after the first $1 million from partnering developers & designers from 20% down to 15%.Another reason is likely due Shopify team scaling up the business operation in anticipation of continued growth. However, it was met with economic inflation and stagnant growth numbers. Thus inflating their cost

#2- A higher Merchant Acquisition Cost & A declining revenue growth.

Figure 2

Figure 3

From Figure 2&3 above, we can see that the sale and marketing expenses increased from $602 million in 2020 to $901 million in 2022. To state the figures clearly:

  1. In 2020, $602 million were spent to achieve a 75% growth rate in the number of merchants.
  2. While in 2021, $901 million were spent on merchant acquisition. The resulting yield was only an 18% growth rate.
  3. You might argue that the 18% growth is a representation of a bigger base, so a lower growth number can be justified. Hence, I would like to point out that in 2019  $472 million were spent on sales and marketing to attend a merchant growth rate of 22%.

Another point is revenue from subscription and merchant solutions has been “choppy at best” or experienced declining growth. In 2022 Q1, revenue from both solutions actually fell. 

#3-Operating Loss.

The death spiral for Shopify began in DEC 2021 before the Q4 and 2021 annual report was announced. This can be attributed to the overall bearish market sentiment particularly tech stocks in anticipation of interest rate hikes. Shopify was also hit particularly hard due to the 2021 Q3 Operating loss and overall unsatisfactory results. During the start of the sell-off, 2021 Q4 results were not released yet presumably investors just assumed another negative quarter. 

Coming into 2022, Shopify experienced 2 consecutive operation losses due to an increased cost in “Sales & marketing” and “R&D”.

Business development

It seems that Shopify’s business development direction has remained constant and can be summarised into 4 categories:

  1.  Enabling a more frictionless payment system between their merchant and merchant’s customers(increase checkout conversion)
  2. Provide a streamlined channel of business operations services & support(eg fulfillment centers, loans, customer analytics) for their merchant to use.
  3. Partnership with Facebook, TikTok, Walmart, etc…to increase the reach of their merchants.
  4. Participate and establish a  strong presence in the “local” commerce scene
What can we conclude from Shopify’s business development?

Shopify Inc aims to be a premier choice for businesses’ digital footprint. The goal for Shopify is to cast a wide net to attract merchants of all sizes, and tactfully rope the successful/establish business with its Shopify in-house integrated solutions and logistic infrastructure. This is evident from the “Merchant solutions” revenue seen below.

Figure 4

As we have established above, the Merchant solution would only generate income if the merchant opts to continue renewing their services. This implies that Shopify’s merchants are financially successful and the service provided is genuine of value to them.

Another noteworthy point is that the Merchant solution carries a heavier weightage in Shopify’s revenue than subscription solutions.


What would determine Shopify’s success?

Shopify’s success would be determined by its ability to capture

  1. New merchants with an innate ability to be successful.
  2. Existing small brick and water businesses looking to expand their market reach.

This statement is further backup by their bar chart  “Revenue by Cohort.

Figure 5

From this bar chart, it is extremely telling that revenue increased from merchants acquired from the previous batches.  The implication is that when Shopify is successful in courting “High-quality merchants”, the company has proven it has the ability to funnel these merchants toward the Shopify ecosystem. Thus, enabling value extraction from the same merchant pool.

Shopify’s new Fulfilment network to help its merchants succeed.

With a fulfillment network, Shopify can offload some of the business complexity for new merchants. If this network is a success, Shopify can expect to see a growth in revenue in their merchant solution. 

Key Financial Metrics

Figure 6

In my opinion, the figures presented in 2021 are distorted and unsustainable. The inflated figures are mentioned above primarily due to social change, and more people trying out their side hustle business, as evident by the 75% increase number of merchants in figure 3. 2020 positive operating margin could be attributed to the surplus of cash from the stimulus package and lockdown which inadvertently increase consumer online spending. 

As for 2021 Q1, it is impressive that the Net margin and Operating margin remain in the green despite the tough economic situation for the consumers. Do keep in mind that Walmart, Target, and other retailers are reporting higher inventory turnover days. Since most of Shopify’s revenue is generated from a subscription plan with a minimum of 1~3 months lock-in periods. The net positive results might be because of deals made in the previous months.

The good news is from the Quick Ratio, the company is in good financial health and is likely able to withstand these unforgiving market conditions.

Taken from Gurufocus.

As of 2022-07-28, Shopify’s WACC % is 8.74%. Shopify’s ROIC % is 1.85%. Shopify earns returns that do not match up to its cost of capital. It will destroy value as it grows.

Is “Buy with Prime” a threat to Shopify

Buy with prime (BwP) by amazon represent fierce competition for Shopify. BwP allows the existing 200 million Amazon Prime members to shop directly from retailers’ online stores with the same benefits they get when shopping directly from Amazon, such as fast and free delivery, easy checkout, and free returns on eligible orders. Merchants not on Amazon can also participate in the BwP program. This program will roll out in phases. Here is a youtube video by Nick explaining BwP.   

The reason why BwP is a huge problem for Shopify is because

  1. America represents more than 50% of its merchants’ base.
  2. BwP is currently working with Shopify competition only
  3. Their terms for service are much better than what Shopify fulfillment is offering now,( E.G no minimum fee, no lock-in period…)
  4. Even if it is roll-out to Shopify, BwP would cannibalize revenue from Shopify Payment and Fulfillment. Shopify payment makes up a huge part of its revenue.

Shopify’s inherent systematic risk

In my opinion, Shopify a built-to-go e-commerce shop does not build brand loyalty with their merchant. It is my belief that merchants would jump platforms if it makes business sense for them. 

The current Shopify strategy for value capture is to be the platform of choice for e-commerce merchants of all sizes. 

To achieve this goal, Shopify inc has to balance its aggressive “marketing & Sales” campaign with R&D and “Strategic acquisition”.   

The aggressive marketing & sales campaign is a necessary expense at this stage of the company’s growth. Why?

By casting a wider net, it would increase the chance of incubating High-value merchants (or merchants who are likely to succeed) into their Shopify merchant solution ecosystem to maintain a positive operating margin. As evident by the points made earlier in the post, High-value merchants contributed more to revenue. 

The revenue generated would continue to be funneled into “marketing & sales” and “ R&D on solutions and logistic infrastructure”. 

In order to reduce “marketing & sales” & retain public preference as the premier affordable e-commerce solution, Shopify must built-up its ecosystem it becomes synonymous with a “successful eCommerce Platform” and “Merchant friendly business solution”. 

To summarize, Shopify like Netflix is facing competitors with deep pockets, wide-reaching influence, and resources. It must acquire enough high-quality merchants to fund its development of solutions & infrastructure expeditiously and with near-perfect execution. Critically, before amazon establish a foothold in the “merchant’s e-commerce” space.

Is Shopify a buy for me now?

Not for me. Shopify faces a significant headwind In the form of 

  1. a rising interest rate environment.
  2. reduced consumer spending.

With an ROIC and WACC indicating value destruction from growth, this investment is too risky for me to stomach. 

The encroachment of Amazon as a direct competition toward Shopify’s revenue subscription model is also a cause for concern. 

The current slowing revenue growth performance and the ever-increasing aggressive sales & marketing expenditure carry too much Financial risk for me too.

During Q2 earning release(27 JULY 2022), Shopify also announced it will lay off 10% of its global workforce. CEO Tobi Lutke acknowledged he had misjudged how long the pandemic-driven e-commerce boom would last, and amid a broader pullback in online spending, Shopify would move to cut a number of roles.  This isn’t necessarily a deal breaker. Because the resources saved could be diverted back to the north America market.

With all this, in mind, I would only start considering adding Shopify into an investment if there is an increase in

    • Net margin 
    • revenue from the earlier batch increase
    • Merchant growth Particularly in the US. Why? Because they need volume to ensure their Merchant solution infrastructure can retain a healthy gross margin and expand/refine their existing north-America based logistic infrastructure to compete with Amazon. 

This is to gauge the execution of the management business directive and development