I understand the bull case for Shopify (NYSE:SHOP). The company’s platform is powering small business – and driving impressive revenue growth. Fundamentally and qualitatively, there are plenty of reasons to be bullish on Shopify stock.
Indeed, I’ve made the bull case for Shopify stock in the past on more than one occasion. But I’ve backed off the bull case of late, citing valuation and market worries as reasons to avoid SHOP.
At the moment, that caution looks foolish. Shopify stock is at all-time highs once again. But my skepticism still isn’t completely gone, particularly at the new, higher valuation. The ‘risk-on’ trade in stocks like SHOP clearly has returned. At some point, that likely will reverse. And at some point, bulls will have to justify a valuation that seems to incorporate an awful lot of success.
The Story Behind SHOP Stock
Again, there’s a great story behind SHOP stock. As CEO Tobi Lütke pointed out in the company’s Q4 release earlier this month, no SaaS (software-as-a-service) company has reached $1 billion in revenue faster than has Shopify. After clearing that milestone, Shopify is guiding for close to 40% top-line growth in 2019, putting in a track to reach $2 billion in annualized sales by 2020.
That growth should continue for years to come, given that Shopify has two ways in which to drive higher sales. It can add more merchants, as it did in 2018. According to the company’s 40-F filing, the number of merchants on its platform rose from 609,000 to 820,000 in 2018, an increase of 35%.
In a consumer space where smaller clearly is better (the collapse in Kraft Heinz (NASDAQ:KHC) the most recent piece of evidence) that merchant growth should continue. In addition, Shopify can generate increased revenue per merchant by offering more and better services, such as Shopify Shipping and Shopify Capital.
Add in the potential for international expansion (30% of 2018 sales came from outside the U.S..) and there’s little reason to see growth slowing any time soon.
The Risks to Shopify Stock
That said, there’s an obvious question as to whether that growth is priced in. Even backing out $2 billion in year-end cash, SHOP stock trades at 12x 2019 revenue guidance. Again excluding cash, it trades at 200x 2020 EPS estimates. Those are simply enormous multiples, and multiples which just a few months ago investors no longer were willing to pay.
That sentiment clearly has changed. As I pointed out this week, fellow small business play Square (NYSE:SQ) has soared off its lows. Enterprise SaaS plays like Salesforce.com (NYSE:CRM), Workday (NASDAQ:WDAY), and Splunk (NASDAQ:SPLK) have made new highs in 2019.
That same bullish sentiment needs to hold for SHOP to maintain current multiples, which is one obvious risk. But it’s not the only concern here. Amazon.com (NASDAQ:AMZN) has taken aim at Shopify’s space with its Storefront offering. Square has designs on some of Shopify’s customers as well. Shopify remains top of the heap – but there will be no shortage of competition.
The biggest risk, however, remains the one I pointed out in November. From a broader standpoint, Shopify’s exposure to small and medium-sized businesses is a good thing. That’s where consumer tastes, in particular, are moving. And Shopify, through its Plus offering, is trying to get larger customers on board as well, with some success.
Still, this is a SMB-heavy business and that raises real cyclical risk, as I argued last year. And small businesses, in particular, generally are the first to get hurt in a recession and the last to recover. When macro worries hit the market in Q4, Shopify stock unsurprisingly slid. And when those worries return, and they will at some point, SHOP likely will do so again.
Will Valuation Matter?
Valuation is a terrible reason to short a stock and perhaps a questionable reason to sell one. The story here remains intact, even if 2019 guidance actually was somewhat disappointing. Analyst estimates for 2019 EPS, for instance, have come down sharply.
It’s certainly possible SHOP stock will keep rising on top of the 50%+ gains seen just since mid-December. But it will take a lot to go right. Shopify needs to hold off its competition. The macro picture needs to hold up. And investors have to be willing to pay 10x+ sales and 200x+ earnings.
As good as the Shopify story is, Shopify stock seems to require something close to perfection, both in terms of execution and external factors. It seems like an awful lot to ask.
As of this writing, Vince Martin has no positions in any securities mentioned.
