Shopify (NASDAQ:SHOP) has been a huge winner. Since its 2015 initial public offering, SHOP stock has gone up more than tenfold, making it one of Canada’s most successful tech companies to date. Recently, however, SHOP stock has lost some steam as investors have questioned the valuations of tech companies in general and cloud/Software as a Solution names in particular.
In September, Shopify stock fell as much as 25%. Though shares have started to recover, the recent correction has caused investors to wonder whether Shopify’s valuation is sustainable up at these levels.
High Price for Slowing Growth
At 30-times sales and hundreds of times forward earnings, SHOP stock is undoubtedly expensive. Few people would dispute that fact. Over the past five years, however, Shopify has grown revenues at an average of 84% annually. That sort of growth rate supports an extremely high valuation. But with revenue growth now trailing off to around 50% annually, Shopify must start posting significant profits, or the company’s valuation ratios will significantly decline.
Investors should consider the impact of the trade war with SHOP stock. Many business models on Shopify rely on Chinese-sourced goods. Drop shipping, where sellers keep no inventory, is a particularly popular approach. Here, the Shopify seller only needs to get a product once a buyer orders one; these just-in-time models tend to rely on Chinese-produced goods. The longer the trade war drags on, the more pressure it will put on many of Shopify’s clients.
It’s also worth noting that Shopify generates much less cash flow than even other high-growth low earnings businesses like Amazon (NASDAQ:AMZN) and Square (NYSE:SQ). As a result, Shopify is continually forced to raise money by selling stock, which dilutes shareholders. While the company doesn’t need to generate big earnings-per-share numbers tomorrow, it’s a bit troubling that the company hasn’t started producing much cash flow yet despite the massive revenue growth.
Shopify May Be Heading Down the Wrong River
In September, Shopify announced that it was buying 6 River Systems for $450 million. Shopify stated that this acquisition will allow the company to start providing logistics and fulfillment services for its clients and customers.
This is a seemingly logical expansion. Amazon made its Kiva robotics acquisition years ago. Analysts were skeptical at the time. However, that move has paid off in spades. Amazon’s push into robotics has given the company a large edge as it plowed into broader logistics services such as cargo transportation.
That said, I’m not sold on Shopify’s move yet. They could prove the skeptics wrong, like Amazon did. But merely copying Amazon isn’t always a great idea.
Shopify’s model is built on having tons of small vendors on the site. It’s not clear there will be quite as many economies of scale in trying to centralize logistics. As it is, already much of Shopify’s activity involves drop-shipping or other means of fulfillment that won’t require Shopify’s assistance. 6 River co-founder Jerome Dubois said that:
By joining Shopify, we’re changing the game of fulfillment. Together, we will help thousands of businesses improve their fulfillment operations, with an easy-to-learn solution that can more than double productivity and improve accuracy.
If Dubois’ sentiment plays out, this move could be a long-term winner for SHOP stock. It’s unclear, however, that Shopify will gain the same benefits from logistics across its disparate customer network that Amazon has gotten so far.
Another Way to Play Fast-Growing Shopify Stock
SHOP stock has been a huge winner in recent years. But its former success will make future gains more difficult. As we see with the expansion into the logistics business, Shopify is needing to diversify beyond its core business.
As it does so, its growth rate and profit margins will come down, perhaps sharply. Generally, mixing high-margin and low-margin businesses leads to a significant drop in the overall valuation of a stock.
One alternate way to profit from Shopify’s growth is to buy other cloud/SaaS names that benefit as Shopify attracts more clients. An example would be Avalara (NYSE:AVLR) which offers software that can calculate sales tax across all U.S. states and counties and various foreign markets. As the world’s commerce increasingly takes place online, there will be more sales, excise, VAT, and other such taxes to collect.
In a world where Amazon and a couple other large players dominated the whole market, the need for services such as sales tax software was smaller, as the giants can do this in-house. E-commerce is getting more niche, however. Now, someone with a big Instagram following can set up a store via Shopify, Wix.Com (NASDAQ:WIX), or other such services that all offer built-in Avalara tax collection services.
SHOP Stock Verdict
Just as mall owners made great money last century regardless of which retailers did best, Shopify, Avalara, and other such companies that provide services to emerging online retailers will prosper in the new economic environment. For a long-term growth investor, you can definitely make the case to buy SHOP stock today, despite the big run-up over the past year.
That said, with Shopify stock specifically, I wouldn’t be surprised if shares struggle for the next few quarters. The combination of its high valuation, less attractive mergers and acquisitions activity, and short-term headwinds make shares less appealing than other alternatives.
For example, SHOP stock is selling at 30x revenues. Facebook (NASDAQ:FB), which through Instagram drives a huge portion of Shopify’s client traffic, is selling for 8x revenues. Shopify stock may keep rising, but there are more immediately promising alternatives if the whole sector continues to surge. And if tech stocks contract, Shopify would have more downside than its other peers.
At the time of this writing, Ian Bezek owned FB and AVLR stock. You can reach him on Twitter at @irbezek.
