In this market, the easiest way to miss out on gains has been to argue that a stock is “too expensive,” and Shopify (NYSE:SHOP) has been no exception. Shopify stock has looked expensive for years — but it has been one of the market’s best plays over that stretch.
Indeed, Shopify stock has almost quadrupled from December 2018 lows. It’s gained over 2,800% from its 2015 initial public offering price of $17. For much of its time on the public markets, skeptics — myself included — have decried its valuation and believed a reversal was imminent.
Of course, SHOP stock isn’t alone. Particularly in tech, there is no shortage of stocks that have climbed the proverbial “wall of worry” relative to valuation: Netflix (NASDAQ:NFLX), Amazon (NASDAQ:AMZN) and Roku (NASDAQ:ROKU) are just three of the most well-known examples.
And for these names, multibagger gains aren’t a sign that the market “isn’t paying attention” or “doesn’t care about valuation.” Yes, valuations have been, and still are, seemingly expensive. But the growth potential for these companies is enormous.
In fact, in many cases, the bulls are paying closer attention to valuation than the bears, for instance by focusing on underlying profitability at Amazon instead of dismissing the stock based on near-term price-to-earnings multiples.
The catch with Shopify stock is that even taking the detailed perspective and giving the company credit for its impressive performance, it’s increasingly difficult to support a share price nearing $500. This is a wonderful business, and it’s worth repeating: bears and skeptics have consistently been wrong about this stock. Perhaps that will continue — but at some point, SHOP has to slow down. Right?
Just looking at the near-term fundamentals, Shopify stock looks like a classic bubble. The company’s guidance for 2019 projects roughly $1.55 billion in revenue and an adjusted operating income of $27 million to $37 million.
We’ll assume, as has historically been the case, that Shopify is guiding conservatively, and peg 2019 revenue at $1.6 billion and operating profit at $50 million. Using those figures and backing out its roughly $2.7 billion in cash and investments, SHOP stock trades at about 1,000x operating profit and over 30x sales on a trailing basis.
Those are staggering multiples. But they don’t mean that Shopify stock is a sell per se. Again, it’s shortsighted to dismiss a stock based solely on trailing multiples. Although it’s also a bad idea to buy a stock simply because of a low price-to-earnings or price-to-sales ratio.
But that’s what those multiples mean. Even taking the long view, even giving Shopify credit for perfect execution, it’s simply difficult to grow into that kind of valuation.
The Long-Term View
SHOP bulls have to believe the stock can at least double over the next decade. Such performance would suggest annualized returns just above 7%. It’s easy to forget in this market, but 7% annual appreciation is excellent, particularly when 10-year Treasury bonds are yielding less than 2%.
Roughly speaking, Shopify has to reach a market capitalization over $100 billion to hit that bogey. That in turn suggests at least $2 billion in net income in 2029, giving credit for a 50x P/E multiple at that point.
Again, Shopify is generating $1.6 billion in revenue this year. That figure will rise exponentially, of course. It could rise tenfold over the decade, in fact: that would require a roughly 26% annualized growth rate. Wall Street sees revenue increasing 36% in 2020, and the company’s move into fulfillment offers another top line boost. Growth will slow over time, but there’s certainly a path to $16 billion in 2029 revenue.
But how profitable will it be? Even assuming revenue does grow to $16 billion, Shopify needs operating margins around 15% to hit that $2 billion after-tax target. That too, is doable — perhaps. Shopify’s operating margins this year probably will be close to 3%. Sales and marketing spend, currently 29% of revenue on a non-GAAP basis, will decline as a percentage of sales as the top line grows. So will general and administrative expenses.
All that said, gross margins here are 56% so far this year due to the heavy proportion of payment processing revenue. Software plays can get operating margins over 20%, but Shopify is only a partial software play. The payment processing business simply doesn’t scale the same way software businesses do. Shopify might get to 15% operating margins — but it’s not guaranteed to get much further.
Another Way to Look at Shopify Stock
Looking at that model, it’s simply difficult to justify Shopify stock’s current price. 26% annual revenue growth for a decade would be a stunning achievement. 15% operating margins would be an impressive accomplishment (though, to be fair, PayPal Holdings (NASDAQ:PYPL) has an adjusted operating margin nicely past 20%). Even the 50x out-year P/E multiple is hardly conservative. Move that figure to 30x and Shopify stock returns less than 5% a year.
But even coming from a different angle, the rise in SHOP stock is problematic. In trying to make the fundamental case last year, I noted that market share figures relative to Amazon and eBay (NASDAQ:EBAY) did suggest potential upside, or at least supported what was then a stock price around $375. SHOP has gained another 25%-plus since then. Its valuation now is nearly double that of eBay and Square (NYSE:SQ).
And while it’s tough to model much upside, downside hasn’t been modeled in either. We still have zero idea what Shopify looks like in a recession — but we do know that small businesses, still the company’s core clients, are the first to struggle in a macro downturn. Even that issue aside, growth is likely to slow if the economy does.
Even a market downturn can have an effect. SHOP tumbled in 2018’s fourth quarter, declining over 25% in a matter of weeks starting in late August.
Again, the answer to all these concerns is simple: they’ve existed in some form for years now, and Shopify stock keeps climbing. The bears have been wrong, while bulls have profited greatly. Perhaps that will continue for the time being — but I’m skeptical it will continue forever.
As of this writing, Vince Martin has no positions in any securities mentioned.