Shopify's Stock Price Was Down Almost 50% In January; Should You Buy Or Sell?

Seeking Alpha2022-02-19

SummaryShopify is one of the best and most solid of the growth stocks with low current earnings and an extremely high valuation.Rising interest rates have undercut the premise of these stocks by ...

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2022-02-21
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it helps customers in many ways, including lower shipping costs.Shopify may not recover quickly, but if high growth resumes and valuation declines a little more, it could be a survivor and a good long term holding. Don't buy much right now.JHVEPhoto/iStock Editorial via Getty ImagesThe central question with a young hyper-growth/hyper-valuation stock like Shopify (SHOP) is whether it can maintain growth to the extent that its growth rate can continue to overpower the inevitable decline in valuation. These two things, growth and valuation, must eventually stabilize at a point where the stock is fairly priced as a successful growth stock. Some time in a company's middle life cash dividends and share buybacks must begin to be a possibility. If that never happens, the only consolation for current investors is that they helped capitalism to work by allowing early investors like the founders and venture capitalists to cash out. Meanwhile individual investors hold the bag. I like business innovation as much as anybody, but I'm not happy with the prospect of holding the bag with an investment that ends up having made money only for the first few investors aboard.The market provides a couple of examples which serve as measuring sticks for two different stages which come later in the growth/valuation calculation. Alphabet (GOOG)(GOOGL) is perceived to be enough farther along in the curve that using price earnings ratio as a quick and easy measure it is less expensive than no-growth/low-growth companies like Coca-Cola (KO) and McDonald's (MCD) which have P/Es of 24.49 and 25.12 respectively. What this suggests is that the market is pricing Alphabet with its 23.15 P/E with a bet that it will have trouble reinvesting its huge cash flow. This implies that risks to its main business from tech/media competitors or government regulation are closely matched to opportunities. It is treated like a company closer to the static payout phase of its life than you might think. I am more optimistic about that than the market and own Alphabet. I am pretty sure that it has a lot more growth left in its future than KO or MCD.Amazon (AMZN), though older than Alphabet, is treated by the market as if it is in an earlier stage of its life. It's is clearly in a much later stage than Shopify. Amazon's forward P/E is about 65. One likely reason for this is that Amazon is a collection of several businesses. It has shown the capability to apply its business model to branch out and create or buy new businesses with a return equal to or greater than that of its present businesses. Thus it has a valuation by the easy measure of P/E on a log scale about halfway between Shopify and Alphabet. Shopify's forward P/E is given at SA as an astronomical 151, but only a few years ago Amazon traded at a P/E like that. The question for Shopify is whether the ultimately declining growth rate and declining P/E ratio meet at an agreeable point in the future. That future properly discounted must justify buying at the present price.Is Shopify Presently Overvalued Or Undervalued?The answer to this question is in the eye of the beholder and involves an as -against what factor? How do you measure the value of the whole cluster of high-growth/little-or-no earnings companies? SHOP is perhaps the exemplar of such companies. The numbers for SHOP may seem extremely high but they are nothing like what they have been at times over the past year. The place to start is with the numbers themselves. The most important number for SHOP is the crucial revenue line. Here's the data provided in SA Financials updated through Q4 2021:201220132014201529162017291820192020TTM23.750.3105.0205.2389.3673.31,0731,5782,9294612Dividing Shopify's market cap, now down to $94 billion, by the TTM revenues of $4.612 billion shows SHOP now trading just over 20 times revenues. Midway through 2021, selling at a price of $1463, more than double the current price, SHOP was selling at 56 times lower revenues. Since that point revenues continued to increase while the price was more than cut in half. Great opportunity, right? Maybe. Maybe not. Bear in mind that Amazon sells at 3.4 times revenues.Why Did Shopify Stock Drop So Hard In January?The market sometimes seems to have second sight and the ability to see future events in advance. Did it see problems on the way for Shopify? Since the middle of last year a couple of new factors have come into the valuation equation. The first was higher interest rates and the prospect of further increases in interest rates. This has had a devastating impact on high growth stocks with little in the way of present earnings and cash flow but presumed great prospects for the future. Here's why. The best way to calculate the long term value of a stock is a number series based on long term earnings, cash flow, and sometimes dividends with future estimates in each case discounted back into the present.This number series is structured as e/(1+d) + e1/(1+d) squared...en/(1+d) to the n power. The letter e can be estimates of earnings, cash flows, or dividends. The academic study for dividends goes back to the 1930s, but earnings and cash flows are more common in modern estimates of fundamental stock value. The letter d represents discount rate. The discount rate is the critical factor. For a decade the discount rate has been very small as the Fed sought to protect the economy from deflation and depression. Because of these very low rates, the value of rapid growth companies became so large that mathematically they approached infinity. Then rates began to increase. As rates increase, the value of future earnings declines sharply. This isn't so bad for companies with solid present earnings, but the value of companies with returns largely in the future fall sharply. This explains the current market bifurcation with value stocks winning and growth stocks like Shopify losing.On July 28, 2021, I wrote this article on a value investor's view of three such hyper growth companies, SHOP, Palantir (PLTR), and Snowflake (SNOW). I stated that SNOW was the only one I might buy on a dip because I had conviction that they would grow fast enough and sustain their growth rate long enough to resist a valuation decline. I did indeed buy the recent dip in SNOW. The future is nevertheless precarious for all such companies. All of them are probably one quarterly report away from following the course of Shopify's horrible January.My conclusion six months ago was that SHOP was a real and solid business, but its valuation was absolutely absurd. It seemed to me that there was little chance that it could sustain anything like its present price if rates continued to rise. This risk was exacerbated by the risk that would come if it had the slightest hiccup in prospects for revenue growth. That's where the second factor caught up with Shopify. The operating story has changed a bit with SHOP as many investors had clearly been expecting gangbusters growth and a clear path of that growth into the future. The second shoe dropped with the February 16 Q4 earnings report. What astute observers had already factored in was the fading boost from the pandemic. The 2021 results had clearly made some of 2021 growth the outlier result of a one-time external event. It would present a challenge to Shopify's growth at least in the near future. The backward looking numbers were fine, but Shopify president Harley Finkelstein indicated that revenue growth would decelerate in Q1 2022. Here are his words which he expanded upon a bit on CNBC:\"Our outlook for 2022 assumes continued secular tailwinds for entrepreneurship and digital commerce transformation against a more measured macro environment relative to 2021. While we believe that the COVID-triggered acceleration of e-commerce that spilled into the first half of 2021 in the form of lockdowns and government stimulus will be absent from 2022, and there is caution around inflation and consumer spend near term, for the full year, we see economic growth supporting the continued penetration of retail by e-commerce.\"That's putting a brave face on a forecast which was sure to hit the market hard. The market had already begun to suss this out by January 1.There Are Still Two Sharply Opposing Views On ShopifyIn the present market environment, when hyper growth companies disappoint the market, the results can be brutal. In yesterday's market action SHOP was down over 16%, dropping its market cap by $16 billion, and it is down hard again today. None of Shopify's investors can be very happy with that. On the other hand, it is indisputably cheaper. It is still a rapid growth stock. Does that make it a buy? Two members of theBarron's2021 Midyear Roundtable laid out the opposing views:Henry Ellenbogen, a well known growth investor put the case this way:Its two-year compounded growth rate was 70%. In 2018, I pitched Shopify as an early-stage growth company with the potential to be much larger. At that time, U.S. e-commerce was a $500 billion business, growing 14% a year.Amazonhad a 32% share, and Shopify had only 3%. Four years later, e-commerce has grown to $900 billion. Amazon has gained nine share points and Shopify has gained eight, so it now has about 11.5% of the market. We believe Shopify will truly become a platform company...Increasingly, e-commerce companies are switching their internal or third-party platforms to Shopify. The company is highly profitable while also growing rapidly. Shopify has transitioned from an e-commerce seller service to an omni channel company. Its GMV [gross merchandise value] in the third quarter of 2021 was up 35%. We estimate that Amazon’s U.S. GMV was up 11%. Shopify’s POS [point of sale] system has more than doubled its addressable market in the U.S. Thirty percent of its revenue this year will be outside of North America...Shopify’s take rate is only 160 basis points [1.6%]. New product offerings will allow Shopify’s revenue to grow much faster than GMV. One example is Shopify Payment, Shopify’s answer toPayPal PYPL-3.13%[PYPL]. PayPal has been around for more than 20 years. It had 400 million users in the latest quarter. Shopify Pay had 120 million. PayPal’s valuation is 50% higher than Shopify’s. Shopify could have close to $4 billion in revenue in 2024. It is scaling toward long-term margins of 40% to 45%. We believe it should trade at 30 to 40 times underlying Ebit, resulting in a price target of $1,350 to $2,000, compared with a recent $1,144.Shopify Payment is indeed a cornerstone element in Shopify growth, a relatively new and highly successful one. On the Q4 earnings call it was a subject of strong management focus. Here's president Harley Finkelstein again:The benefits of Shop Pay also extends to our Shop App, our digital shopping assistant that offers buyers a delightful end-to-end commerce experience. In addition to in-app checkout with Shop Pay and our buy now, pay later product, Shop Pay Installments, shop provides buyers with real-time order tracking and delivery updates and relevant product recommendations from their favorite brands. In Q4, millions more buyers enjoyed fun and easy shopping on Shop, and by the end of the year, Shop Pay had facilitated a cumulative $43 billion in GMV since its launch in 2017. The benefits of Shop Pay also carry over to Shop Pay Installments, the most transparent installment product on the market with no hidden fees and no late fees. GMV through Shop Pay installments more than doubled quarter-over-quarter as did the number of repeat buyers using our products. I'm pleased to report that Shop Pay Installments is now the largest installment provider for Shopify merchants in the U.S. after only six months of being generally available.\"This relatively new part of Shopify does seem a major addition still in its early stage. Another area which was emphasized was international expansion. But a look at overall numbers is still important. The table below shows earnings per share on the first line and shares outstanding on the second. The table shows the explosive growth in earnings as they jumped into positive territory. The second line shows that shares outstanding rose sharply through, but their growth has slowed in the last four years.201320142015201620172018201920202021($0.13)($0.57)($0.30)($0.42)($0.42)($0.61)($1.10)$2.67$23.3837.238.961.784.095.8105.7113.0119.6123.8In Barron's 2021 Midyear Roundtable value investor Scott Black said that SHOP's valuation was such that he called it \"Stupify.\" Case closed. Ellenbogen made it one of his two top picks. One of these very smart guys is very wrong. Ellenbogen cites such things as the network effect in which acquiring more customers enables Shopify to gather more data and build a better product model. He believes its annual growth will eventually settle at around 30%. It will be interesting to see in the Barron's 2022 Midyear Roundtable whether Black and Ellenbogen have stuck to their opinions or converged somewhere in the middle.What's The Business Model? Some Things I Learned From My Wife's Use Of Shopify In Her BusinessI have managed to get a decent grasp of Shopify's business model because my own wife began using it in her own small business about a year ago. She owns an institutional bakery, a very tough business which she has had for over thirty years. Using Shopify was one of her moves to engage the problems presented by the pandemic.There's nothing like seeing how a business works from the inside. My 29 year old stepson (my wife's sales chief) persuaded her that e-commerce is essential to modern selling and that Shopify is the only way to go. A few months ago I asked my wife what she really thinks and she said it may well work, but it's very expensive. When I spoke with her recently she had become much more positive and didn't make a big deal of the cost.Her first comment was the brilliance of their business model from their own perspective. Like all small business owners she has struggled from time to time with collecting accounts receivable. What do you do when a customer drags about paying you? You can hound them and risk losing their business or give them slack which may only make the problem worse, or you can stop sending them product outright. Shopify doesn't have this problem. They have built the collection of receivables into their formula. The money comes to them and they deduct their share then send the rest to you. Done. No problems. My wife spoke of this as if it were the eighth wonder of the world. If your own credit card has something wrong with it (she gets hacked about once every year) you are immediately unable to do things with Shopify like printing essential labels.My wife's business pays Shopify an annual fee plus a 2.6% fee when using Shopify Payments. What I saw when reconciling credit card payments, a task I do for my wife's business, was that they had one charge per month until December when they had four much larger credit charges. This conformed with the much higher level of e-commerce billings in December. It also showed why their gross margins are high with little incremental cost. Did they actually increase her business? Both my wife and stepson said maybe a little bit. What they did a great job of was simplifying their internet presence and getting their name out there at places like Facebook, Instagram, and now TikTok.Another thing my wife pointed out was that while they had shipped with UPS (UPS) for decades Shopify got them UPS shipping at a much improved rate by being a buyer of shipping service on an enormousscale. Thatrelated to the question I asked about small clients versus large. My stepson said that some large businesses preferred to perform the functions Shopify provided in-house. That might mean a little different picture for SHOP in future growth prospects with larger businesses. He couldn't estimate by how much. He added the well known fact that large businesses are currently doing much better than small businesses.My stepson also told me that Squarespace (SQSP) was its major competitor. I noticed that its stock was down over 20% today, perhaps from fear of the same receding pandemic business which is apparently affecting SHOP. Squarespace is tiny compared to Shopify with a market cap under $5 billion and has so far produced an ocean of red ink. Squarespace is very unlikely to topple Shopify. I asked if Amazon was a competitor, and my stepson said, \"No, not really.\" Then he paused and said, \"In some ways, I guess.\"It's important after two pandemic years to understand that recent numbers may be distorted by events outside the company. For Shopify's first four years as a public company its sales doubled annually. Then they fell to a five year average of about 70% annualized. For 2020 its growth rate returned to a year over year double, but that now seems to be a clear outlier having to do with online sales during the lock down. In fact, it may have pulled future sales into the present. At the same time, of course, Shopify may have set up a new phase of growth with its increasing focus on new products and larger businesses.Factor Grades And Quant RankingsWhat would you do if your kid brought home a report card with an A+ in one area and an F in another? That's the case with Shopify, and it can lead to binary views. You can't exactly get yourself another kid. Not only is this frowned upon, but in the case of Shopify, all the kids in its neighborhood - all the hyper-growth/hyper-valuation/low-to-no-earnings companies - have the same problem. The same interest rates and operational risks have gotten to most of them. Don't expect straight As.Below are recent Shopify Value Grades from this site.Sector Relative GradeSHOPSector Median% Diff. to SectorSHOP 5Y Avg.% Diff. to 5Y Avg.P/E Non-GAAP [TTM]F276.2726.76932.58%NMNMP/E GAAP (FWD)F158.5831.15409.09%NMNMEV / EBITDA [TTM]F444.9420.352,086.61%NMNMEV / EBIT [TTM]F521.6626.511,867.84%NMNMPrice / Sales [TTM]F56.024.301,203.80%27.32105.04%Price / Cash Flow [TTM]F308.0421.911,305.99%1,054.74-70.80%Is that enough to turn you away from SHOP? Its top line growth has been fabulous of course, so it gets great marks on that (A+) and very good marks (A) on Profitability. The thing to do about that difference from the F in Value is to reconcile the two grades very carefully and understand that there is a potential for error in doing so. Valuation has been locked on F for six months at the same time Growth has been locked on A+. Profitability has improved from A- to A over the last three months. Momentum, previously strong, has dropped from A- to D while Revisions have dropped from B to C-.Here are SA Quant Rankings:Ranked in Industry (Information Technology) 14 out of 24Ranked in Sector (Internet Services and Infrastructure) 400 out of 570Ranked Overall 2851 out of 4236Stock PerformanceHere's the chart of Shopify performance since its IPO:Data by YChartsThe chart shows a price history which is all too common for similar hyper-growth companies. It rose sharply starting in 2019 when superior growth was the fashion, peaked in late 2021, and crashed. The crash was the result of the two usual factors: a severe valuation reset as a rise in rates became increasingly probable and the vulnerability of high growth companies to any slight disappointment in results or negative forecast for the future.The Usual Lingering Questions RemainHow long will the present growth rate be sustained? Henry Ellenbogen, the super bull, sees the growth rate declining to a stable 30%. That's about where Amazon has settled at this point. If SHOP achieved that over an extended period it might deserve a valuation similar to that of Amazon.Will free cash flow begin to grow more rapidly than revenues? Or at least keep up? Amazon achieved that, but few low-profit-low-cash-flow companies do.What are the potential future challenges from competitors? Cutting edge tech-based businesses face the live-by-the-sword-die-by-the-sword problem: other startups not yet visible may be capable of leaping over what they are doing. Your guess is as good as mine.And, by the way, Shopify's share count has doubled since 2015 - five years and a quarter. That's nothing like the share count increase of a Palantir where share count more than keeps up with its operating results, but it's significant. Will the share count continue to grow at a rapid rate or will it eventually stabilize?Will SHOP find other businesses in which to apply its methods? This was the true secret of Amazon which did not get stuck in its first business as a disruptor of the bookseller industry. Shopify clearly has an excellent business model within its niche, but will its well respected software find a way to invade another niche or two? Again, your guess is as good as mine.Should You Buy, Sell, Or Hold? Two ViewsBroken stocks and sectors don't usually come back instantly with a V-shaped bottom. Looking back to the dot.com bubble which ended in 2000, the majority of such stocks never came back. The major exception was Amazon. The larger problem for Shopify and all the hyper-growth stock group is rising interest rates and the possibility of a long term normalization of rates at a level much higher than it has been for the past decade. You would have to bea little crazyto deny the distinct risk that stocks in this sector have had their time in the sun, at least for a while. That's the bad news for Shopify. Its present valuation is still quite high, and the market is likely to continue pressuring valuations of that sort. If you hold a large position you might consider selling it down a bit.On the other hand, it is entirely possible that the cautionary forward guidance has to do with a passing one timeproblem. Thepandemic was a bit like the elephant passing through the boa constrictor. It's possible that Shopify's growth rate will pick up from where it was before the one time bump. That might make it a very good investment in the long run, but for long term investors it would be best to buy it at a suitable price. With an upward reset of interest rates that may mean waiting a bit for a further reset in SHOP's stock price.To take a middle way between Shopify's excellent growth and the concern that it may still be overvalued it might make sense to take a very small position as I did with Snowflake. A small position makes you pay attention to a stock because you own it, but limits the risk to your overall portfolio. When I do this I have some rules in place for future action. You might have a plan to add at certain price points, averaging down (which I only do if I expect volatility) or averaging up. You should also probably have a rule to sell on any evidence of a further decline in revenue and earnings growth after Q1 2022. 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