Is Shopify Stock A Buy On The Dip?

Shopify Inc. (NYSE:SHOP$Shopify(SHOP)$ ) has taken investors on a wild ride over the last five years. Depending on the price an investor paid for the company, one could be sitting on massive gains or eye-popping losses. One thing is for sure; Shopify has leveledthe e-commerce playing field for small and medium enterprises around the world. When Iwroteabout Shopify last November, I discussed how the company was nearing an inflection point aided by successful business partnerships and new investments in products and technology. At the same time, I invited investors to be cautious because of the unfavorable margin profile. The objective of this analysis is to discuss certain aspects of Shopify’s business to estimate the company’s intrinsic value.

Is Shopify Profitable?

From revenue of just $50.3 million in 2013, Shopify has grown exponentially to bring in close to $5.6 billion in revenuein 2022. The company’s rise was supported by aggressive marketing campaigns to lure SMB users, a high-quality product suite that has retained these users, and macroeconomic tailwinds resulting from the continued growth of e-commerce adoption. The company, on the back of a 57% and 85% YoY increase in revenue in 2021 and 2020, respectively, turned profitable in 2021. Before we move forward, it’s important to understand the massive role played by Shopify’s equity investments in 2021. The company carries equity investments in Affirm Holdings, Inc. (AFRM) and Global-e Online Ltd. (GLBE), and according to GAAP principles, unrealized gains and losses from these investments are recorded on the income statement of the company. With stocks delivering handsome returns in 2021, Shopify’s equity investments increased in value, resulting in massive paper profits. As illustrated below, these unrealized gains accounted for the bulk of Shopify’s net income in 2021.

Exhibit 1: Unrealized gains from investments

The company would have reported a marginal profit in 2021 even without the positive impact of its equity investments. In 2022, this positive impact reversed with stocks retreating, and the company reported an unrealized net loss of approximately $3 billion from its equity investments. Even without the impact of these paper losses, Shopify was still unprofitable in 2022 from an operating profit perspective as well. The operating loss of $822 million was driven by a 61% YoY increase in operating costs against a 21% increase in revenue.

From an operating profit perspective, it is evident that Shopify’s massive investments in expanding the business are taking a toll on margins today at a time when revenue growth is decelerating. The company’s fulfillment strategy, back in 2019, was toacquire 6 River Systemsfor $450 million to offer a fulfillment offering to its merchants. Contrary to the initial strategy of using third-party warehouses for the fulfillment process, Shopify is now focused on managing the warehouses on its own to add more value to its users, which is where the acquisition of Deliverr comes in. To power up the Shopify Fulfillment Network, the company is planning to invest $1 billion in 2023 and 2024. These planned capital investments will exert pressure on the company’s free cash flow profile. As illustrated below, Shopify has not been a company to spend billions of dollars in capital investments in the recent past as its focus has been to build asset-light, software businesses. The company’s focus on expanding SFN, however, will not be possible without a meaningful uptick in investments.

Exhibit 2: Capital expenditures by year

Shopify is yet to turn consistent profits, and with a ramp-up in investments on the cards, the company is likely to find it difficult to break through to profitability in 2023 as well.

Expenses Will Remain Elevated

For Shopify to become profitable, keeping costs low is a must. However, this is easier said than done. One of the main reasons behind Shopify’s stellar revenue growth in recent years is the aggressive marketing strategy of the company. As the below chart illustrates, Shopify’s sales and marketing expenses have increased in each of the last three years, and in 2022, marketing expenses grew at a faster clip than revenue with the company facing growth hurdles due to macroeconomic headwinds.

Exhibit 3: Sales and marketing expenses YoY growth

Shopify now focuses on enterprise customers to drive growth (more on that in the next segment) but the company’s fortunes are still closely tied to attracting and retaining SMB customers. To be fair, Shopify’s rise as an e-commerce giant was triggered by the company promoting entrepreneurship among small-scale investors. One downside to this strategy is that there is no guarantee about the quality of merchants onboarded by Shopify, which leads to a higher-than-average churn rate. Due to various reasons including macroeconomic challenges and a lack of interest, many small businesses do not survive long, which is well documented. The Globe and Mail recently found that the survival rate of Shopify stores has declined in recent years, which does not come as a surprise given that many online businesses that had a great start at the height of the pandemic are now finding it difficult to survive let alone grow (Shopify has claimed that Globe and Mail’s findings are different from the internally available data).

Exhibit 4: The survival rate of Shopify stores after 365 days

Approximately 36% of stores opened in 2019 survived a year while only 32% of stores opened in 2021 achieved this feat. These findings underline a problem that Shopify has grappled with ever since its founding; a high churn rate among small-scale business owners. The high churn has led to another problem; the company has been forced to aggressively invest in marketing to lure new customers to replace the old ones. In the foreseeable future, these marketing expenses are unlikely to come down as the company will not trade growth for an improvement in its short-term financial metrics.

Investing To Attract High-Value Merchants Could Drive Growth Sustainably

Shopify has been vocal about its ambitious plans to attract high-value merchants, and this strategy seems to be the right way forward. Shopify’s evolving app store and the new features offered by Commerce Components including inventory management systems and access to flexible APIs will likely help the company gain traction among enterprise users in the future. Shopify Plus members who pay upward of $2,000/month on their subscriptions are stickier than SMB merchants who pay substantially lower subscription prices, and for this reason, it makes sense to invest in improving the overall experience of these high-paying users. As illustrated below, the Globe and Mail’s findings (which are not verified or approved by Shopify) reveal that the survival rate of Shopify Plus customers is significantly higher than its SMB counterparts.

Exhibit 5: The survival rate of Shopify Plus members

Shopify management has revealed a survival rate of over 90% for Shopify Plus customers in the past, which is a confirmation that high-paying customers stick with Shopify for longer.

The bulk of Shopify’s planned investments are targeted at attracting and retaining large-scale businesses and going by the above data, this strategy seems the right way forward. Investors, however, will have to remain patient until these investments start yielding the desired results, which could take a couple of years even in the best-case scenario.

Is Shopify Stock A Buy?

In modeling revenue growth for Shopify, I expect a further deceleration of growth this year resulting from challenging macroeconomic conditions. Pandemic-related mobility restrictions accelerated the growth of the e-commerce industry, and it is reasonable to expect the waning effect of these tailwinds to pull industry growth as consumer spending habits normalize. Contrary to the Wall Street consensus that points to a notable uptick in Shopify’s revenue growth in 2024, I have modeled a rather modest acceleration in growth in 2024 as I believe consumer spending will exhibit choppy growth through 2024. Below are my revenue growth projections for Shopify.

Source: Author’s estimates

From a margin perspective, I do not see any meaningful improvements until fiscal 2025. I expect the margin profile of Shopify to dramatically improve beyond 2025 as the customer mix shifts more in favor of high-value members while the company’s investments in products continue to moderate after reaching new highs in 2024. By 2027, I expect EBITDA margins to reach 11.5%. Using a discount rate of 11.7% (close to the cost of capital for the software categorycalculatedby Prof. Aswath Damodaran in January 2023) and a terminal growth rate of 3%, Shopify’s intrinsic value comes to $16.60.

Does this mean Shopify is substantially overvalued? To draw such a conclusion was not the idea behind this valuation exercise. Regardless of the robustness of a valuation model, it would be impossible to predict long-term stock prices because of the many variables involved in the valuation process. I build models with the sole intention of identifying stocks that trade with a large margin of safety. Shopify’s valuation struggles stem from the fact that all of the company’s earnings are expected in the future, meaning that we will be discounting those cash flows at a higher discount rate today to account for rising interest rates, which results in lower present values for those cash flows. To put things into perspective, let’s go back to when interest rates were zero. Using a WACC of 5.5% would result in an intrinsic value estimate of $51.5 for Shopify.

Takeaway

In conclusion, Shopify does not offer a meaningful margin of safety for me to initiate a new investment in the company today but at the same time, I believe the company has a long runway for growth aided by its planned investments in improving the product suite and logistical capabilities. For this reason, Shopify will remain on my watchlist.

Source: seeking alpha