Shopify (NYSE:SHOP) was among the best performers in 2019, posting an almost-200% gain for the year. There is no doubt that the rally was triggered by positive business developments rather than just irrational exuberance. However, analysts and investors agree that SHOP stock valuations look stretched.
With that in mind, I believe that Shopify stock is likely to trade sideways to lower in the new year. While I maintain a positive outlook on the business, I am bearish on the stock for the coming quarters.
Talking about valuations, consensus estimates suggest that SHOP will report earnings of 86 cents a share for 2020. At a current stock price of almost $408, SHOP stock is trading at a forward price earnings ratio of 443. Valuations are clearly expensive on a standalone basis.
Looking at the broader industry, it makes sense to compare the company’s valuations with that of Square (NYSE:SQ). For Square stock, consensus estimate for 2020 earnings is 95 cents. At a current stock price of $62.50, Square stock is trading at a forward PE of 65.8.
It is also worth noting that for Shopify, analyst expect average earnings growth of 25% for the next five years. For Square, average earnings growth is expected at 35%. Therefore, there is little doubt that SHOP stock is ripe for a correction.
Another factor worth mentioning here is that for Q3 2019, SHOP reported top-line growth of 45% as compared to Q3 2018. However, the company’s top-line growth for Q3 2018 was 58% as compared to Q3 2017. Growth has been slowing and this should concern the markets at some point.
Growth in Monthly Recurring Revenue
Among the various long-term positives, growth in monthly recurring revenue (MMR) is worth noting. For Q3 2019, SHOP reported MRR of $50.7 million as compared to a MRR of $37.9 million for Q3 2018. This implies a 34% year-on-year growth in MRR.
Further, annualized MRR as of Q3 2019 was $203 million. Even if 30% annual growth is assumed over the next five years, SHOP is positioned to increase MRR to $750 million by 2025.
The point I am making here is that the business model will ensure healthy recurring cash flows in the coming years. As merchants increase along with growth in subscription for Shopify Plus, recurring revenue can be a cash flow machine. Launch of 3D and augmented reality shopping experience is likely to help SHOP in increasing the merchant network.
I want to add that $750 million in MRR might be a conservative estimate. Shopify is not limited to the United States or Canada. The company is on a global expansion spree with Shopify Admin available in 19 languages. Shopify Payments is also available in 14 countries. Therefore, the company has a large addressable market, which should translate into swelling cash flows.
Another factor that will trigger merchant subscription growth is the company’s fulfillment network. In Q3 2019, 44% of merchants in the United States and Canada used Shopify Shipping. With technology factors (intelligent inventory and order routing) and competitive rates, more merchants are likely to adopt end-to-end solutions from SHOP.
In September 2019, Shopify acquired a warehouse technology provider for $450 million. Further, the company is planning to invest $1 billion over the next five years on warehousing network. This will boost the integrated offering to merchants and should help in sustained growth in subscription revenues.
Final Thoughts on Shopify Stock
I also want to add a final thought on the company’s balance sheet. As of September 2019, the company reported a healthy cash buffer of $2.6 billion. This makes Shopify fully financed for the medium-term.
Overall, SHOP does have a robust business model with a large addressable market. Inroads in India, China and Southeast Asia should help in boosting long-term growth.
However, SHOP stock is ahead of business fundamentals and I expect a relatively sharp correction in 2020 before upside resumes. In-sync with this view, I believe that profit booking can be considered and investors should stay on the sidelines.
As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.
