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I just finished making the shortest trade of my investing career. After buying Shopify Inc. (SHOP) at $1,400, I sold it a mere two days later, at around the same price. While I am normally a “buy and hold” guy who is willing to wait out market downturns, my Shopify position was causing me a great deal of unease, and I decided to sell rather than wait for fourth quarter earnings.
SHOP, as you may know, got absolutely ravaged on Thursday, falling 9% in a single day. Like most growth stocks, it was hammered by macro concerns, with the Federal Reserve having committed to multiple interest rate hikes just days prior. I was aware of these issues when I bought the stock but I bought it anyway, with the company’s illustrious revenue growth record in mind.
It was about a day later that I started having second thoughts. What gnawed at me was the company’s massive gross merchandise volume (GMV) and how little of it was translating to revenue. In its most recent quarter, SHOP did a whopping $41.8 billion in GMV, which produced $1.123 billion in revenue. So we’ve got about 2.7% of Shopify’s merchant sales converting to revenue. This is consistent with what we know about SHOP’s business model, which involves subscription fees plus a 0.5% to 2.9% cut of sales. Unlike Amazon (AMZN), a company it is often compared to, SHOP does not hold and sell much inventory. Instead, it processes payments and provides other miscellaneous services to independent vendors. As a result, it collects less revenue per vendor than Amazon does.
None of this prevents Shopify from growing as a business. If you do $10 trillion in GMV and 2.7% of that becomes revenue, then you get $270 billion in revenue. That gets us pretty close to Amazon’s revenue level. The problem is that the entire eCommerce market was $4.8 trillion in 2021. In order to justify the thesis that SHOP is the “next Amazon”, we need its GMV to approximately double all the eCommerce sales in the world last year!
It could be the case that SHOP becomes the next trillion-dollar eCommerce giant, but it will require very good execution-in fact, it will require the company to roll out totally new revenue streams that become a sizable percentage of sales. If management executes really well, that could happen. But it’s no guarantee. Given that I had purchased the stock with the intention of it vastly outperforming, I decided that the company’s prospects did not support what I aimed to achieve by holding it. In the end, I sold the entire position.
Which isn’t to say I consider SHOP a bad business. To the contrary, it is a very good business, but the stock itself is extremely expensive, and in this environment of rising interest rates, investors may not have the patience for that. In this article, I will outline a neutral thesis on SHOP, arguing that it will need truly world-class execution to rise from these levels.
To really see where Shopify is headed as a business, we need to look at the industry it operates in. That is, the eCommerce industry–a massive space with dozens of players. SHOP’s most direct competitors are other payment companies like:
Website builders like Squarespace (SQSP) and Wix (WIX).
These companies all offer online payment processing solutions similar to those offered by Shopify. Among them, SHOP is by far the biggest player, with 27% market share. It’s also the fastest growing website builder, going from 0.1% of online stores in 2014 to 3.2% in 2021. So SHOP is well-positioned in its industry. However, it has a much larger indirect competitor to deal with:
Amazon is not a shopping cart company like Shopify. It is primarily a vendor that sells through its own website. Whereas Shopify vendors are responsible for hosting their own websites, Amazon’s vendors just sell straight through Amazon.com. It’s much easier to get started selling on Amazon than on Shopify, because you don’t have to build anything or pay for traffic. The tradeoff is that you have to pay much higher fees with Amazon: for some product categories, referral fees alone can go as high as 45%.
So Amazon and Shopify are not exactly the same type of business. They are, however, indirectly in competition.
Any individual store running on Shopify is competing with a small part of Amazon’s business. Let’s say we have two stores, Johnny’s Widgets and Jamie’s Widgets. We’ll assume they’re the only two stores in the world selling Widgets. Johnny’s Widgets sells on Amazon, Jamie’s Widgets sells on a Shopify store. If both Widgets are identical and are selling for the same price, and there are no supply problems, then any sale gained by one store is a sale lost by the other. Therefore, whenever Jamie’s Widgets makes a sale, Shopify gains a bit of revenue at Amazon’s expense.
So, Shopify’s network of vendors is collectively competing with Amazon. It’s for this reason that people often talk about Shopify “taking on Amazon” or being the “next Amazon.” Shopify powers a massive network of stores that could easily eat Amazon’s lunch. Or perhaps more accurately, a part of Amazon’s lunch. Amazon.com has massive brand recognition and is a convenient “one-stop-shop” for just about any product you can imagine. On top of that, it has a logistics network that can fulfill orders in just three days. Shopify will probably never run such a well-oiled machine into the ground, but its vendors could slowly chip away at AMZN’s market share. And with over two million stores running Shopify, they could make a big dent. That looks good on the surface. However, when we look at Shopify’s business model, it becomes clear that a massive amount of potential GMV will not necessarily translate to huge amounts of profit.
Although Shopify’s GMV growth has been incredible, it will not necessarily make an enormous amount of revenue off of the sales it is processing. Why is that? Because Shopify is not nearly as closely tied to its revenue source as Amazon or even eBay (EBAY).
In its earnings releases, Shopify mentions two main sources of revenue:
Subscription solutions. These are the monthly plans per vendor that range from $29 to $2000+ per month.
Merchant solutions. This includes a number of things, the most important of which is payment processing, which generates the “revenue cut” mentioned earlier. The “cut” ranges from 0.5% to 2.9% plus a small flat fee per sale.
In addition to these, Shopify has other revenue streams like a POS system and a retail store in Los Angeles. As of the third quarter, these businesses were too small to merit separate mention in Shopify’s earnings releases.
The problem with Shopify’s “core” business activities is that you need an absolutely enormous GMV in order to generate much revenue from them. The company did $1.123 billion in sales on $41 billion in GMV in its most recent quarter. Sales were 2.7% of GMV. As of this writing, SHOP had a $140 billion market cap. Amazon had about that market cap in late 2013, when its revenue was $74 billion. So SHOP is trading at an absolutely sky-high multiple to sales compared to Amazon when it was last at the same market cap. Now, this isn’t exactly an apples-to-apples comparison, because SHOP has much higher gross margins than Amazon does. Still, Amazon in its $140 billion market cap days beat SHOP on gross profit as well: the former had $20 billion in 2013, the latter had $2.3 billion in the trailing 12 month period!
Since we’ve been talking about SHOP’s financials, we can now turn to a deeper dive on that topic. We’ve already explored the company’s GMV and revenue, and how one relates to the other. Now it’s time to look at the picture as a whole.
In its most recent quarter, SHOP delivered:
$1.123 billion in revenue, up 46%.
$41 billion in GMV, up 35%.
$616 million in adjusted gross profit, up 49%.
Operating loss of $-4.1 million, down from a $50 million profit.
$140 million in adjusted operating income, up 7.6%.
$0.81 in diluted EPS, down 27%.
As you can see, the company’s revenue and gross profit grew by considerable amounts. However, some profit metrics declined, including the bottom line, and GAAP operating income was negative. One standout metric from the report was $9 in GAAP EPS, which was way above analyst estimates. However, that was almost entirely due to gains on the company’s massive stock portfolio. Since growth stocks have been selling off in 2021 and early 2022, we’d expect that same factor to have a negative impact in the upcoming Q4 release. For example, Shopify owns stock in Global-e Online (GLBE), and that stock fell 22% in the third quarter. That will be reported as a mark-to-market loss.
Shopify, going by GMV, is already an eCommerce “giant.” Amazon’s $110 billion in Q3 sales works out to $440 billion on an annual basis. Marketplace Pulse writes that Amazon had $490 billion in GMV in 2020. Walmart (WMT), for whom sales and GMV aren’t substantially different, had $559 billion in sales in its most recent fiscal year.
SHOP’s $41 billion in fourth quarter GMV is already rapidly catching up with these figures. $41 billion in a quarter is equivalent to $164 billion in a year. Grow that at 35% a year, and you catch up with Walmart’s 2020 GMV in just four years! That sounds like a good thing, but remember:
SHOP’s staggering amounts of GMV lead to much less revenue than Walmart or Amazon bring in. In the third quarter, sales were about 2.7% of GMV. If Shopify’s business model remains unchanged, then we should expect that figure to be consistent. So, how many sales does Shopify need to power to get to Amazon’s revenue when it was valued at $140 billion?
And how much to get to Walmart’s 2020 revenue level?
My friends, you’re going to want to take a seat. Perhaps even put on some calming music. Because in order for Shopify to reach $559 billion in revenue with sales at 2.7% of GMV, we’re talking $20 trillion in sales powered by the Shopify ecosystem!
To put that in perspective, the entirety of Alibaba’s (BABA) massive eCommerce network powered $1.2 trillion in GMV in fiscal 2021.
Of course, not every SHOP bull is expecting the stock to become an Amazon or Walmart tier giant. Perhaps, some investors would be content with 10% CAGR from this point on. But much of the buzz surrounding the company does come down to “next Amazon” hype. And remember: even to get to Amazon’s 2013 revenue level, Shopify will need $2.7 trillion in GMV.
So the conclusion is inescapable:
Shopify is going to need absolutely phenomenal execution to justify the price tag it commands today. The company’s “core” business model simply doesn’t support the valuation the market assigns to it. Either management will need to raise prices or produce really significant results from one of its side businesses like POS, to keep the momentum going. Because unless it can figure out a way to crank out $2.7 trillion in GMV, this company won’t generate enough revenue to make its current valuation work.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of BABA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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