I keep seeing bearish comments about Shopify (NYSE:SHOP) and other SaaS-related articles on Seeking Alpha. I believe many of these comments are without merit, written along the lines of: “I knew/I told you it was going to crash.” If you are long Shopify and bought near the top, believe me, I feel your pain.
Before we get going and to cheer you up a bit, let me tell you how I came across the company. I learned about Shopify back in 2017 when I was at business school. An MBA professor who also runs a successful e-commerce website based in Prestashop mentioned how wonderful of a business it was and that it was outpacing its competitors by a wide margin (WooCommerce, Prestashop, Magento, etc.). To complicate things a bit, he also mentioned that it was a sure thing that Google (NASDAQ:GOOG) was going to enter this market, becoming the dominating force when combined with Google Analytics. When I first looked at the stock, it traded around $100 per share (or 15x EV/sales). At the time of writing, Shopify trades at $650 (or 16.5x EV/sales). It has gone up more than 6x and is a widely known multibagger (including the >60% drop from the top). The genius inside me listened more to the Google side of the story and never bought the stock (ouch!).
As I said, a 50% drawdown on your investment might feel horrible, but it is way worse to miss a multibagger. So, if by any chance you’re reading through Shopify articles looking for answers, please consider reading mine and avoiding the pointless comments (this of course excludes well-reasoned and well-written commentary, regardless of their view; that is very welcomed and respected).
With that, here I present you with five reasons why you should consider adding to your Shopify investment (at least, don’t sell any shares).
Reason 1: E-commerce Trends
Let’s be honest, e-commerce growth was already a trend before 2020, it accelerated during the pandemic and will continue to grow in the future. As per eMarketer, “The global e-commerce TAM is projected to grow to $7.4 trillion by 2025.” Just in the U.S., e-commerce represents a huge market:
In fact, as Shopify outlines, only the SMB segment represents $160 billion in 2021. This is the result of multiplying their $2,354 in ARPU times 68 million retail businesses globally.
As you can see, the secular trend is clear and e-commerce growth is far from finished. The market opportunity is significant and there is still plenty of growth ahead. Together with Amazon (NASDAQ:AMZN), I believe Shopify is at an outstanding position to capitalize on these trends.
Reason 2: Entrepreneurship
Perhaps you were not expecting this one. Entrepreneurship is currently at its best. Many people are having real issues when entering the jobs marketplace. They either dislike their day-to-day or simply struggle to find the right opportunity. Consequently, many consider entrepreneurship a real alternative to “traditional” career paths. Needless to say, starting an e-commerce business is something considered by many. Starting as low as $29 per month, Shopify enables anyone to create a minimum viable product (as per Eric Ries’ book The Lean Startup) for their online store. So, no matter if you have a full-time job or you are at university, if you ever consider starting an online store, you can consider Shopify, as their platform is designed for simplicity and reliability.
To provide a personal example, I co-founded an AI startup in 2020. We are lucky enough to be based in Lanzadera, one of the leading business accelerators in Spain (yes, if my writing didn’t tell you already, I’m Spanish). There, we see many startups and have the opportunity to exchange experiences with other entrepreneurs. Sometimes people ask me where to invest their savings. Inspired by Peter Lynch, I answer them with another question: What software does your startup use? Their answer typically includes HubSpot (HUBS), Stripe (STRIP), and you guessed it, Shopify (if they run an online shop, of course). This is not my opinion, but pure facts.
Of course, many of these entrepreneurial projects and small businesses will fail, but others will emerge. One way or another, Shopify will continue to help entrepreneurs and thrive in the SMB segment.
Reason 3: Competitive Moats
It is widely known how difficult it is to migrate a preexisting online store from one platform to another. If you never had to go through this painful process, perhaps you can compare it to the complexity of moving your client data to another CRM provider, changing your accounting software or migrating your cloud infrastructure. Of course it’s possible, but not a pleasant task.
Similar to HubSpot and Bill.com (BILL), high switching costs have enabled Shopify to nail their land and expand model. Over time, happy customers sign up for extra functionalities (cross-sell) and/or consume more as their business grows (upsell). As per Shopify’s 2021 annual report (PDF file):
When our merchants grow their sales and become more successful, they consume more of our merchant solutions, upgrade to higher subscription plans, and purchase additional apps. We consider our merchants’ success to be one of the most powerful drivers of our business model.
This is why most of these companies’ services start at a marginal cost (sometimes for free). They know that once a client integrates their solution, it’s difficult for them to switch and rarely churn.
Shopify has created a successful community with their App Store and Partner Ecosystem.
App developers and partners work with Shopify because they have an amazing and growing client base. Conversely, clients will consider Shopify because of its outstanding offerings. You get the point – network effects are difficult to create, but unstoppable when successful. Just ask yourself why your debit/credit card has Visa (V) or Mastercard (MA) printed on it.
To provide a recent success story related to Shopify App Store, we can look at Returnly, a leader in online return experiences and post-purchase payments. Returnly has a plug and play integration for Shopify. And yes, we can’t know the exact amount of revenue derived directly from Shopify apps, but I think it’s fair to assume it’s a significant percentage of total revenue, as these integrations sit at the very top of their list. In fact, if you navigate to plans, and click Install App under their basic plan, you will be redirected to the Shopify app store.
Returnly was acquired by Affirm (AFRM) in 2021 for an amount close to $300 million in cash and AFRM shares:
Returnly serves more than 1,800 merchants, has helped process more than $1 billion in returns, and has been used by over eight million shoppers.
To me, this a great story that proves how other businesses create mission critical software, such as reverse logistics, and leverage their position by partnering with a true e-commerce leader such as Shopify.
To further prove my point, please read the following quote from SHOP’s annual report (linked to above):
To attract the best developers in the world, in 2021, Shopify changed its revenue share model with app and theme developer partners to offer a zero percent revenue share on the first million dollars that they make annually on the Shopify App Store. App and theme developers pay a 15% revenue share on earnings after the first $1 million, a threshold that resets annually, down from the previous 20% revenue share on their overall revenue.
So, if you are a developer, perhaps you should consider building apps for the Shopify Marketplace.
Again, taking it back to the personal side, in our startup we consider e-commerce as one of our main client segments. Clients connect to our platform via API, which is fine for now, but rules out many small merchants who don’t have the technical skills to understand and implement APIs. To counter this, we could launch a plug and play solution. Essentially, an app to easily integrate with any e-commerce, regardless of their tech savviness. This app could be listed in the Shopify Marketplace.
High switching costs and strong network effects provide Shopify a wide and deep economic moat.
Reason 4: Business KPIs
Obviously Shopify has been one of the main beneficiaries from COVID-19. Sales growth accelerated to almost triple-digit numbers and hence the sales multiple skyrocketed. However, we must be fair and acknowledge that the company was at high growth before the 2020.
It is probably too soon to guarantee we will leave the pandemic behind in 2022; that it still to be seen. With or without COVID-19, Shopify will continue to grow and eventually exhibit “normal” growth rates, comparable to those of more mature software companies such as Salesforce (CRM) and ServiceNow (NOW). In fact, Shopify’s Founder and CEO, Tobias Lütke, recently acknowledged the company will be growing at lower rates in 2022:
Our financial outlook anticipates revenue growth for the full year 2022 that is lower than the 57% revenue growth achieved in 2021, but still rapid and outpacing the growth of e-commerce.
Not Only a SaaS Play
Over time, Shopify has introduced new offerings. We could consider the company a fintech play with a layer of SaaS underneath. As Jason Lemkin puts it: “If you add a fintech layer to your SaaS product, magic can happen.”
An additional comfort sign is the fact that Shopify’s client portfolio is very well diversified, not only merchants belong to different retail verticals, but they come in different sizes. More importantly, their single logo concentration is negligible, as no single customer ever represented more than 5% of total revenue.
Reason 5: Valuation and Price Action
Shopify fell in December and January together with its SaaS peers due to high valuation and inflation fears. Then in February, the sell-off accelerated as the market expected e-commerce trends to soften due to COVID-19 recovery. And if this was not enough, the geopolitical tensions between the NATO and Russia added selling pressure, causing stocks and other “risk on” assets to fall as a whole. All this combined, has compressed the valuation to levels not seen since 2019.
The sales multiple is unchanged, but the stock is up 3.5x since 2019.
That’s why cheap and expensive are the biggest curse words. A stock could be at the 100x EPS and go from one to infinity. And vice versa, a stock can be a 5x EPS, be considered “cheap,” fall 90% and still be at the same P/E.
In terms of price action, please take a look at the chart below:
As you can see, the current drawdown is the worst in Shopify’s trading history, followed by the drawdown in 2016, when it was a much younger company with more volatile financial results. Can it go lower? Yes, of course it can; however, the current valuation of 16.5x is fair enough to consider, specially after a 60% drawdown.
With the above in mind, no matter how wonderful Shopify might be, we must decide what valuation makes sense for the company.
I am aware that Venture Capital funds (at least in Europe) are paying 10-12x ARR in Series A and B rounds. Obviously these companies exhibit very high levels of top-line growth (usually greater than 2-3x per annum), but also come with very high levels of operational risk. Therefore, one might argue that paying 15x EV/Sales for a “safer, more stable company” might be fair. This multiple also happens to be in line with average pre-pandemic levels for Shopify.
To calculate my five-year base case price target, I am using a simple multiples valuation method with the following assumptions:
- Sales CAGR of 40% (in line with pre-pandemic growth), reaching $24.5 billion by 2026.
- Sales multiple of 15x (in line with pre-pandemic average levels)
- An increase of 3% in shares outstanding (per year).
- Net cash position to remain unchanged as a percentage of market capitalization.
Therefore, my base case five-year target for Shopify is around $2,718, representing an upside of 313% and an IRR of 32.8% if reached by 2026 (at the time of writing, Shopify traded at $657.9). With all that in mind, I rate the stock a buy.
If your brokerage account is well capitalized, you might want to consider selling naked puts to complement your entry point. For example: buying 100 shares in stock at $650 and selling one March 4th naked put (strike 600) for $16 credit. If assigned, your net entry would be $617 ((650 + (600-16))/2). If not assigned, at least you keep the stock position and the option premium for a net entry of $634 (650-16).
Is this reasonable? Please let me know what you think in the comment section below.
No investment comes with an absence of risks. Here I state some risks that could potentially harm your investment:
- Slower than anticipated sales growth due to deterioration in product perception, leading to higher customer churn. I consider this to be highly unlikely due to the Shopify’s track record. They are very customer-centric and, as such, the probability of this occurring is marginal.
- Sales multiple compression due to increased tensions in the Ukraine-Russian conflict. Despite the risk being real, I think it’s already reflected in the price.
I strongly believe all fears associated to high inflation and the Ukraine are already priced in. Do your own research and consider becoming a long-term beneficial owner of an outstanding business at a fair price. At the current valuation of 16.5x EV/sales, I believe Shopify is a very compelling opportunity and is due for a strong rebound in the coming years.
Remember that stock prices move for fundamental reasons. If you decide to invest, buy with caution and be prepared to add a lower levels as the sell-off might be far from done.