SHOP - Shopify: Business Performance Has A Muted Impact On The Share Price

2023-12-07 05:35:07 ET

Summary

• Shopify's stock has more than doubled in value this year, but this has little to do with the actual business.
• A drop in the term premium since late October has been the major contributing factor for returns this year.
• Even if one is willing to ignore current volatility brought by outside factors, the business would struggle to achieve high and sustainable GAAP profitability.

Shopify ( SHOP ) has been among the most exciting growth names in recent years and even though the stock plunged nearly 80% in 2022, the optimism among investors seems to be gradually returning.

So far for this year, SHOP has more than doubled in value as the growth narrative remains strong. Topline figures in both merchant and subscription solutions continued to grow at nearly 30% during the last reported quarter.

Consequently, non-GAAP earnings noted a large increase in recent quarters that was even better than the consensus estimates by sell-side analysts.

With that in mind the aforementioned return appears logical as business fundamentals bounce-off from their 2022 lows.

But as we all know a business could do well for a very long period of time and its share price could continue to disappoint, provided that the relationship between the two has been broken for far too long. A very good and often mentioned example is Cisco (NASDAQ: CSCO ) in early 2000s.

Having said that, it appears that SHOP would not be returning to its previous highs anytime soon (and by anytime soon I mean probably decades) and on top of that the stock does not appear attractive at its current levels either.

There are a number of reasons for that, but my main argument gravitates around the stock's heavy exposure to the term premium and the need for the long-end of the yield curve to come back to near zero in order for SHOP to return to its previous highs.

High Duration Exposure

The overall exposure to the term premium and the exceptionally high duration of a stock is something that investors rarely think about. Instead, everyone is focused on business fundamentals and assume that the current share price is supported by those.

In the vast majority of cases this is true, however, for high growth names that benefited heavily during the recent monetary experiment this relationship does not necessarily persists. That is why we observe such a strong relationship between the price of SHOP and the yield on 10-Year Treasuries.

Over the 5-year period we see above, movements in Shopify's share price have been largely influenced by changes in the stock's multiple. The sales multiple, for example, went from below 20 to above 60, back down to single digits and nearly 15 at present in a matter of only a couple of years.

Rapid contraction/expansion of multiples is expected for growth stocks but such a violent movements in the opposite direction of long-term yields is a sign that the stock is heavily exposed to changes in the term premium.

One of the reasons for this is Shopify's high expected revenue growth rate, which is nearly twice as high as those of most large cap software companies.

Based on the graph below, there are a number of observations that should be made:

• firstly, cross-sectional differences in sales multiples could be largely explained by differences in forward revenue growth rates
• the slope of the trend-line above is dynamic and tends to change with fluctuations in the term premium (I covered that if a lot of detail here )
• Shopify has by far the largest exposure to the term premium
• deviations from the trend-line are to be expected based on differences in profitability.

The last point is illustrated by the gross margin ranking of all the companies shown on the graph above. The reason why Adobe ( ADBE ) is way above the trend-line is because the company has by far the highest gross margin with the peer group, while Amazon ( AMZN ) is on the other end of the scale and hence is rewarded with much lower sales multiple to what its expected revenue growth rate would suggest.

The trouble for SHOP is that the company's gross margin is also among the lowest within the peer group and as such is experiencing significant multiple contractions when topline growth slows down. What's even worse is that as the company grows and expands into adjacent service offerings, its gross margins are slowly declining.

Even in this scenario, operating margins should be improving as the company grows and economies of scale are realized. This, however, does not appear to be the case as the company is still loss making on a GAAP basis and relies heavily on stock-based compensation. This reliance is so extreme that Shopify's cash flow from operations is actually less than the company's stock-based compensation expense for the past 12-month period.

On top of all that, the management does not excel at long-term capital allocation either as the company needs to fully utilize both organic and inorganic growth opportunities in order to sustain its current premium valuation.

Just a year ago, SHOP was supposed to compete with Amazon in fulfillment and the expensive acquisition of Deliverr was supposed to be a major move in that direction.

This, however, is not the case anymore after the recent announcement that Shopify will sell its logistics business. This was followed by a large goodwill impairment of the Deliverr business, which had a goodwill balance of $1.4bn as of the end of fiscal year 2022.

Making The Matters Worse

Everything said above is usually enough for a stock price to detach from business fundamentals and move largely in-line with changes in the term premium.

The case of Shopify, however, is so extreme for yet another reason. In recent years, the company has begun to invest heavily in debt and equity securities and these investments significantly outpaced the company's research & development expense in the two years prior to the unfortunate 2022.

Just as fixed income and equity markets fell sharply in 2022, Shopify's annual cash outflow for investments in marketable & equity securities turned into an inflow which was a very bad timing for the company.

Fair value of held-to-maturity debt securities stood at a staggering $4.2bn in FY 2022 which was down from £5.8bn in FY 2021.

Even though these are mostly short-term investments they fell sharply as short-term yields skyrocketed in 2022.

Shopify's liquid equity Investments or in other words those with readily determinable fair values have also experienced a sharp drop during 2022.

The same was true for the less liquid equity investments as well.

So far in 2023, these equity investments have once again turned positive and resulted in a notable improvement of the company's bottom line figure. This, however, only highlights the extreme volatility of Shopify's earnings and the significant downside risk during periods of falling asset prices.

Conclusion

Optimism around Shopify's stock is slowly returning as business fundamentals seem to be improving, but in reality it is the drop in term premium since late October that has been in the driver's seat. The stock is still heavily exposed to outside factors and GAAP profitability will be hard to achieve. Thus, as we are likely entering a more turbulent 2024, SHOP shareholders are taking a significant downside risk.

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