3 Reasons to Sell Shopify


SHOP stock - 3 Reasons to Sell Shopify

Source: Shopify via Flickr

I’ve been very bullish on Shopify (NYSE:SHOP) for some time now. But even with SHOP stock having pulled back sharply of late, I’ll admit to having some second thoughts.

To be sure, my qualms have little to do with Shopify’s performance. Investors sold off SHOP stock after its second-quarter report at the end of last month. However, the results were good, as Luke Lango pointed out. Investors believed that the company’s guidance was a little light, but Shopify has a history of guiding conservatively. And the company’s projections still suggest that its revenue will jump 50%-plus this year.

Given that I’ve touted SHOP repeatedly — most recently in April — stepping away now would seem like a potential overreaction. That’s particularly true given that SHOP stock has pulled back some 20% from its July highs. But I have concerns, and even after the pullback, SHOP stock is up about 14% in just four months. For a stock that has gained as much as Shopify has – it’s risen more than 700% in the three-plus years since its IPO – 14% doesn’t seem like much. But that might just be the point.

The Valuation of SHOP Stock

Even after the pullback, SHOP is trading at about 12 times revenue, which is an astronomical multiple, no matter what the price-earnings ratio is.  (SHOP stock is trading at 235 times the  consensus 2019 earnings per share estimate.) Valuation alone isn’t a reason to sell, but it’s at least a reason to be cautious.

Admittedly, the multiple can expand. It was at 15 times barely a month ago. Square (NYSE:SQ), another high-growth company which targets small businesses, trades at 19 times its adjusted revenue. Double-digit multiples in software-as-a-service plays aren’t uncommon in this market, nor are huge multiples in general. Salesforce.com (NYSE:CRM) trades at 54 times its forward earnings, some 19 years after its founding.

But there’s a key difference when it comes to SHOP stock: its gross margin is much lower than those of other SaaS companies. Square’s adjusted gross margin was 82% in Q2; platform provider Etsy’s (NASDAQ:ETSY) margins are in the mid-60s; even eBay’s (NASDAQ:EBAY) gross margin is over 80%.

By contrast, Shopify’s gross margins are just 57% so far this year. And that’s an issue that affects our assessment of its enterprise value-revenue multiple. The reason SaaS and platform-as-a-service stocks trade at such high valuations is because of their huge margins. One more Salesforce user or Etsy seller costs little and  contributes the same amount of revenue as all of their current customers.

But as Shopify’s mix continues to shift towards the sales-driven Merchant Solutions segment, as opposed to its fee-based Subscription Services business, its gross margins are actually coming down. And that limits the profit contribution of future new users and the bottom-line growth potential of Shopify.

That’s not a huge problem relative to Shopify’s potential. Its margins will improve in the future, as Shopify is spending a great deal at the moment to drive growth. But at this valuation, that tiny distinction matters — and it’s my biggest concern about the company’s fundamentals over the long-term.

Are High-Growth Stocks Going to Hold Up?

Admittedly, I had SHOP stock on my list of 18 high-growth stocks just this month. But the caveat in that article was that investors need to be upbeat on the outlook for growth stocks in this market. Personally, I’m not sure I’m quite there, particularly after the past few sessions.

This is a market that simply seems like it can’t make new highs. A number of former darlings, from Facebook (NASDAQ:FB) to Twitter (NYSE:TWTR) to Alibaba (NYSE:BABA), to even chip plays Nvidia (NASDAQ:NVDA) and Micron (NASDAQ:MU) have pulled back sharply lately. SHOP stock has also dropped significantly recently.

I’m certainly not ready to run to cash, and trying to time the market can be dangerous. There have been plenty of periods in the nearly ten-year bull market in which the rally seemed to be out of gas and then resumed. But clearly investors are somewhat nervous about growth stocks right now, raising hopes that SHOP stock might be available for a cheaper price later this year or in 2019.

Shopify Seems to Have Little Room for Error

The worries about the market seem to be affecting SHOP stock. Again, the stock has sold off, even though there has been little news about it. SHOP bulls no doubt see that as a positive. Its growth trajectory is basically the same as it was in July, when investors were paying $175 per share instead of $139 per share.

From here, at least in the short term, the selloff is actually a negative development because there’s really not that much left for Shopify to do. It’s operating at a high level. The company’s growth is impressive. The argument about ‘churn’ and low-quality sellers made by Citron Research last year seems to have quieted down,  if it hasn’t been dismissed. If a Q2 beat led to a selloff, what happens when the company reports its results for Q3 and the seasonally key Q4?

Longer term, I still think there’s some upside in SHOP stock. But it does seem like the big gains have been made, while the near-term risks are material. It might be too “cute” to try to trade the stock, and it’s certainly possible that the stock’s declines are over. But I can’t help but think that SHOP stock might see some choppy trading over the next couple of quarters — and I think it may fall sharply if the market declines or investors’ fears rise.

As of this writing, Vince Martin has no positions in any securities mentioned.

After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.

Article printed from InvestorPlace Media, https://investorplace.com/2018/08/3-reasons-sell-shop-stock/.

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