Shopify (NYSE:SHOP) is rallying again. Shopify stock has gained over 5% in each of the last two sessions and seems as if it might challenge all-time highs above $400 reached in August.
At this point, the gains in Shopify stock seem almost ridiculous. Shares have more than tripled from their 52-week low. They’ve risen 170% so far this year. Only three of the 700-plus stocks with a market capitalization over $10 billion — Roku (NASDAQ:ROKU), Sea Limited (NYSE:SE), and Carvana (NYSE:CVNA) — have done better.
And after those gains, the valuation, too, looks close to ridiculous. Based on guidance, SHOP stock trades at about 28x this year’s revenue. More incredibly, it’s valued at over 1,000x adjusted operating income. As a result, many investors, myself included, have expected Shopify stock to come back to Earth. It hasn’t.
To be fair, there is some support for the seeming nosebleed valuation, as I detailed in August. The revenue multiple is enormous, but so is Shopify’s margin potential.
Shopify’s revenue only includes its fees — not the total value of products and services sold through its platform. So while operating margins for Amazon.com’s (NASDAQ:AMZN) retail business top out in the mid-single-digits, at scale Shopify’s margins could easily exceed 20% or go even higher. That alone justifies a higher price to revenue multiple.
Meanwhile, earnings multiples are inflated by the fact that margins at the moment are exceedingly low: less than 2% this year, based on guidance. Fundamentally, SHOP stock isn’t cheap, but it probably shouldn’t be.
That doesn’t mean Shopify stock is without risk. In fact, coming out of the company’s third quarter, there’s one key risk that investors should watch closely. It might define how the stock trades from here.
The Growth Driving SHOP Stock Higher
Shopify stock receives among the highest multiples in the market because Shopify offers one of the best growth stories in the market. Revenue grew 59% in 2018, clearing $1 billion for the first time. According to the company’s outlook, it should rise another 45% this year.
It’s thus not surprising that SHOP stock is so dearly valued. That kind of growth at scale is going to get investor attention, and investor dollars. (AMZN stock is an excellent long-term example of that fact.) And so while it looked like SHOP’s bubble had burst just a few weeks ago, shares look set to at least challenge this summer’s highs.
But it’s worth considering how Shopify is driving that impressive growth. The answer is through more merchants, not necessarily more sales per merchant, and that might be a problem going forward.
Revenue Per Merchant and Shopify Stock
According to its 40-F, Shopify’s paid user count increased to 820,000 at the end of 2018 against 609,000 at Dec. 31, 2017, a 34.6% increase. Revenue increased 59% over that period, to $1.073 billion from $673 million the year before.
Those two figures suggest that revenue per merchant increased by about 18% in 2018. In Q3, the company trumpeted the milestone of 1 million merchants on the platform, which suggests paid user growth this year should be in the high 20% range (25% growth would get the year-end figure to 1.025 million). With full-year revenue expected to increase by 45%, it seems likely that revenue per merchant will grow in the range of 13% year-over-year, roughly speaking.
That seems like good news for Shopify. Not only is the company adding more merchants, but its existing merchants are creating more revenue — and making more sales. GMV (gross merchandise value), which measures those sales, jumped 48% year-over-year in the third quarter, well above a likely ~30% increase in the number of merchants.
But looking closer, it’s not clear that Shopify’s merchants are doing quite as well as that number suggests. For one, a portion of the per-merchant revenue increase is coming from higher subscription fees.
Monthly Recurring Revenue (MRR) rose 37% in the third quarter, above the likely merchant growth rate Shopify doesn’t break out exact user numbers in quarterly releases). In addition, merchants are using more platform features, whether it’s Shopify Capital or Shopify Shipping.
The most important factor, however, is that Shopify increasingly is adding larger merchants. Shopify Plus, which costs over $2,000 per month, drove 27% of MRR in Q3 against 24% the year before. It took a higher share of GMV as well, per the Q3 conference call. Bigger merchants unsurprisingly are driving more sales and more GMV. But what does that mean for existing, smaller users?
The Same-Store Question
What we don’t know is how fast existing users are growing their sales on the Shopify platform. This was one of the points made by Citron Research in its ill-fated short of SHOP stock back in 2017.
Citron argued that questionable sales tactics by affiliates were resulting in a significant number of low-quality users. Those users were being attracted by promises of something close to a “get rich scheme”. Citron argued that the Federal Trade Commission would be forced to act, Shopify’s user growth would decelerate, and Shopify stock would plunge.
Obviously, those predictions have been wrong. But the underlying worry has a bit of validity looking at the numbers. We simply don’t know how much organic growth — something like the ‘same-store’ figures reported by traditional retailers — Shopify users are generating.
But what we can calculate doesn’t look all that impressive. Again, revenue per merchant should increase by about 13% this year. MRR growth from higher subscription fees probably is worth a few points. The addition of larger Plus merchants, most of whom are selling products from established businesses, likely drives GMV and so-called “merchant solutions” revenue. So do the ancillary products.
Indeed, as even one bullish analyst calculated after Q3 earnings, GMV per merchant has accelerated — to 8% year-over-year. Some of that growth is coming simply from a higher mix of Plus customers. The average ‘core’ Shopify small business (or home business) user maybe is growing her sales 5% a year. The figure might be even lower.
That growth comes amid a strong economy in the U.S., which drove about 70% of revenue in 2019. It’s with a huge tailwind toward eCommerce as a whole. And it’s in an environment where small, unique, and local continues to win over large, bland, and corporate. In that context, that growth might not be good enough.
The Merchant Risk to Shopify Stock
In a presentation earlier this year, Shopify estimated its total addressable market just in small and medium-sized businesses at $70 billion. With revenue at roughly $1.5 billion, there’s seemingly a huge runway for years, if not decades, of further impressive growth.
The $70 billion figure, according to the company, is based on an estimate of 47 million businesses worldwide. As noted, Shopify has a little over 1 million of those businesses as current customers.
But if existing SMB customers are posting minimal growth, it’s fair to ask if the opportunity really is that big. Certainly, Shopify’s earlier customers are its best customers, with the most motivation to sell online and likely the best ideas. Capturing incremental merchants should get incrementally more difficult going forward.
There’s also the question of how those businesses will perform in a recession, as I detailed last year. Again, Shopify’s merchants at the moment are operating in an exceedingly favorable environment. That will change at some point.
That, in turn, creates an issue with SHOP stock at this valuation. Current multiples on both revenue and earnings are pricing in a tremendous amount of growth. But that growth, in turn, remains heavily reliant on attracting new merchants, much more so than better monetizing existing customers. So what happens if merchant growth slows?
The Bottom Line on Shopify Stock
Shopify has levers to pull relative to getting more revenue from existing customers, whether raising prices (as platform play Etsy (NASDAQ:ETSY) did so successfully ) or adding services like Shopify Fulfillment. Still, this is a valuation that assumes that merchant growth is going to continue at a 20% or 25% rate for several years to come.
There’s a possibility that it won’t. An economic downturn would hit that growth. If existing merchants aren’t doing that well, new potential users may not follow.
To be sure, SHOP bulls can, and likely do, see it differently. It’s that enormous addressable market that underpins the bullish outlook for Shopify as a potentially legitimate rival to Amazon. (It is the “anti-Amazon”, as some have noted.) International markets admittedly provide a huge opportunity even if U.S. customer acquisition slows.
Still, there’s a risk here which highlights the problem with Shopify stock here. It remains priced for perfection. As seen in the 25% slide that began in September, it doesn’t even really take much in the way of news for shares to stumble. Any real long-term change in expectations would have a deleterious impact on SHOP’s fair value.
And those expectations still seem to include a path for the number of merchants to double in the next 4-5 years. It’s possible they will; Shopify offers an impressive platform with real value. But if existing merchants aren’t doing quite as well as headline numbers suggest, it’s at least fair to wonder how many businesses will rush to join them, and for how long.
As of this writing, Vince Martin has no positions in any securities mentioned.