I’m intrigued by ecommerce platform operator Shopify (NYSE:SHOP) but not quite compelled. Underlying Shopify stock is an attractive, and fast-growing business. But SHOP stock also seems to be pricing in at least a large chunk of that growth potential, with a valuation of about 13x revenue.
Indeed, I’ve laid out the bull case for SHOP in the past. But more recently, I’ve advised some caution. And the market as a whole seems to roughly share that sentiment. After explosive gains from an IPO price of just $17, Shopify stock has settled into a wide range from $120 to $170 over the past ten months.
At some point, SHOP stock will break out of that range. Personally, I’m not confident enough on either side to bet on the direction. Shorts have taken some aim at the stock, with short interest nearly doubling so far this year. But shorts, most notably Citron Research, have been way wrong on Shopify stock in the past.
That doesn’t mean they’ll be wrong in the future, however. And there are a number of questions surrounding SHOP stock – two of which seem particularly intriguing at the moment.
Is Shopify Stock Benefiting from a Bubble?
One of the assertions that Citron made in its bear case last year was that Shopify had a large number of customers of questionable value. The company pointed to aggressive activity from affiliates promising “multi-million dollar” Shopify businesses as a potential violation of FTC (Federal Trade Commission) rules.
That advertising, the firm said, was bringing in customers who weren’t really interested in running an online business but rather looking for something close to a get-rich-quick scheme. But regardless of the legality of the advertising, Citron raises a broader interesting point.
Shopify ended 2017 with 609,000 merchants on its platform, according to its 40-F. That figure continues to rise, and it’s powering a decent part of the overall revenue growth here. The Subscription Solutions business has generated about 60% of gross profit dollars so far this year. And per management commentary, the growth in that business is coming “primarily” (per the Q3 release) from increases in the merchant base.
In other words, Shopify is adding more merchants but those merchants aren’t necessarily growing their own sales all that fast. And so it’s worth asking: of the likely 700,000 or so merchants now on the platform, how many truly are viable businesses?
Viable Businesses and Shopify Stock
The answer is obviously not 100, but, as Citron pointed out, Shopify doesn’t disclose churn. Without that figure, it’s hard to even guess if the number is 80% – or 20%.
That said, there is an obvious risk here that the figure is higher than investors believe at the moment. Shopify no doubt is getting $29 or even $79 a month from thousands of customers whose online businesses are going to fail. With revenue for the year guided to just over $1 billion, those customers are material.
Assuming 20% of the businesses depart within a year, at an average price of even $29 per month (the Basic plan), roughly $50 million in high-margin sales go out the door. If the figure is higher than 20% – and it very well might be – the impact starts to becoming significant.
And the little government data we have suggests that many more people are trying to start businesses and many are unlikely to succeed. The U.S. Census Bureau itself noted in February that, since the financial crisis, “there is recovery in the quantity but not so much in the quality of [new] business applications.”
With the idea of building an online business so new (and so simple) there are no doubt merchants being caught up. How many there are is hard to tell. But if an investor believes the number is high (and I can see that case), he or she should flee from Shopify stock.
Is SHOP Stock Cyclical?
The other intriguing question when it comes to Shopify merchants is what will happen in a recession. Shopify’s revenue growth has been stunning. The company generated $23.7 million in revenue for all of 2012. It’s guiding for roughly $1,050 million this year, a 44x increase in six years.
But small businesses are notoriously cyclical and tend to be wiped out in a recession. So it’s an interesting question as to how the Shopify merchant base will perform when the economy inevitably turns south at some point.
Will businesses perhaps making $100,000 – or $45,000 – a year hold up? Perhaps. After all, thanks to Shopify, they don’t have the same high monthly expenses of rent and service fees that a traditional small business might.
It’s even possible that Shopify could be somewhat countercyclical. With jobs more scarce, individuals might be more likely to start their own online businesses if prospects for external employment are bleak.
Or will small businesses fail by the hundreds, , as historically has been the case, with larger companies able to withstand the cyclical downturn? Will jewelry designers and T-shirt merchants and handmade snack manufacturers be the first victims of lower consumer spending?
Truthfully, it’s impossible to answer that question. The industry is too new. The timing of the downturn is too uncertain. But here, too, an investor needs to at least have a sense of how such a scenario would play out. Because the answer is hugely important to Shopify stock.
If SHOP is cyclical, then the recent growth is getting at least some help from the economy. And there is inevitably a stumbling block ahead in the future when the current ten-year economic expansion pauses. If it’s not, then the growth story here has a runway that can extend for another decade, at least.
The Bottom Line on Shopify Stock
Again, neither question will be answered any time soon. But they are worth considering now. How the market believes they will be answered matters. And SHOP stock is still trading on sentiment.
At the moment, that sentiment actually is pretty strong, even with recent flat trading. Flat, in this market, isn’t bad. Fellow ecommerce play Square (NYSE:SQ) fell 30%+ in two weeks last month on no news.
But at the end of the day, from a long-term standpoint, SHOP stock is going to depend on Shopify merchants and mostly small businesses. Any investor even considering SHOP needs to trust the long-term health of that base. Truthfully, at this price, I’m not sure I have quite that much faith.
As of this writing, Vince Martin has no positions in any securities mentioned.