SHOP - Shopify: Strong Competitive Advantage And Growth Potential But Stock Is Fair Valued

2023-10-16 10:40:28 ET

Summary

• Shopify is recommended as a hold due to its strong growth potential but already high valuation.
• The company's competitive advantage lies in its ability to penetrate various verticals and leverage data for better outcomes.
• Shopify's growth is supported by a large and expanding market, innovative solutions, and strategic partnerships.

Investment action

Based on my current outlook and analysis of Shopify (SHOP), I recommend a hold rating. I have full confidence that the business will continue to grow; however, the valuation has already priced in my growth expectations.

Basic Information

SHOP is the world's leading cloud-based commerce engine that allows SMBs and enterprises to conduct commerce digitally. SHOP provides great value to SMBs as it allows merchants to design their online store, obtain a single view of their business, manage inventory, process orders and payments, build customer relationships, and perform analytics - an all-in-one solution. Therefore, it is not surprising to see SHOP grow its revenue at a staggering pace throughout the past 10 years, from a mere $24 million revenue base to $6.3 billion as of TTM 2Q23. While growth has slowed significantly post-COVID to 21% in FY22, growth has accelerated back to 30.8% in 2Q23, indicative of a normalization in growth. More importantly, SHOP is on track to turn EBITDA profitable over the next couple of quarters as it is already dipping its toes into the positive EBITDA region (4Q22 of $24 million and 2Q23 of $17 million). SHOP balance sheet as of 2Q23 is strong enough to sustain the business operation for the next few quarters easily as it has $3.6 billion in net cash. Below, I review SHOP's competitive advantage and why I believe it is set to continue growing.

Competitive advantage

SHOP is effectively replicating the classic playbook of being very good at a single product and, over time, extending itself into other verticals like B2B sales or payments which is a large opportunity as SHOP can target larger merchants. We have seen this work in other businesses, such as Amazon (AMZN). A big part of why SHOP is able to extend into other verticals easily is because many of these verticals are often filled with products that are starved of attention (Magneto under ADBE and Demandware under CRM), hence allowing SHOP to penetrate. As SHOP continues to execute and solve pain points that a merchant faces, it means that every line item in the merchant's P&L is a source of opportunity for SHOP to penetrate.

Moreover, SHOP scale and vertical integration now only allow it to benefit from the traditional competitive advantages that SW enjoys, such as R&D economies of scale and high switching costs. They also give merchants visibility into how they spend their marketing dollars. The ability to have visibility into how its merchants spend their marketing dollars and the behaviors of consumers is a great advantage that enables them to leverage the data and drive better outcomes for merchants. There is a good precedent for how SHOP can leverage the data it has on consumers and turn it into a strong-margin business, and the business is Amazon, which has turned the collected data into a 37-billion-dollar high-margin ad business.

Key competitors include Etsy, Amazon, eBay, Squarespace, etc.

1. For Etsy, I believe SHOP has a strong position against them given its top-of-the-funnel advantage (discussed below)
2. For AMZN and eBay, SHOP differs in value proposition as merchants can own the website and be more modular in how they want to design their page to attract buyers.
3. For Squarespace, it is more of a website builder that has e-commerce function inbuilt, which makes it weaker than SHOP as SHOP is built for e-commerce functions (has payment and logistics solutions )

Review

In the recent quarter, SHOP GMV grew 18% on a constant currency basis. Growth was balanced between existing merchants and new merchants, with particular strength in Europe. I believe SHOP is set to continue growing for two reasons. Firstly, SHOP is a very large market that will continue to expand, in my opinion. To be honest, it's actually pretty hard to gauge the size of SHOP's TAM as it is literally global, excluding China, but one could see how big and fast-growing TAM can be if we believe that a majority of offline retail is moving towards online. Using IMARC Group research, the global e-commerce market was valued at $16.6 trillion in 2022 and is set to grow at a 27% CAGR until 2028. To be fair, not all of it will be addressed by SHOP, as there will be ingrown solutions, competition, etc. Nonetheless, the sheer size of the market and growth potential give a flavor of the SHOP growth runway ahead. SHOP is well positioned to capture this TAM because of its leading position at the top of the funnel. SMEs that want to set up a shopfront digitally would likely Google for help, at which SHOP will be offered as the top few options.

Next, management is pressing hard to improve its value proposition to SMBs by rolling out innovative solutions and leveraging partnerships to drive growth. Regarding new solutions, in addition to ongoing efforts in marketing automation and logistics, SMB has access to SHOP Magic, which I believe has eased the operational burden on SMB to a whole new level. SHOP Magic, launched earlier this year, offers AI capabilities including automated text generation, an AI-enabled commerce assistant, and app review summaries. The typical SMB is usually a small team, with each member wearing multiple hats. While some SMBs have great copywriters and a proper IT team, most do not. As such, Shop Magic is a wonderful tool for SMBs. As for partnerships, at the September tech conference , management noted that SHOP has been consistent in looking for ways to work with partners that will benefit its merchant base. AMZN is the most prominent partner of late. SHOP merchants will be able to offer Buy with Prime to their customers in a streamlined manner thanks to the Buy with Prime partnership, and the SHOP dashboard will handle the aggregate dashboard.

After growth, the biggest question is: what is the terminal margin for SHOP? It is hard to exactly pinpoint where it could land given the wide array of new products but using a mature software company operating cost structure as a benchmark (Oracle has a gross margin of 72% and an EBITDA margin of 40%, implying a cost structure of 32%), SHOP potential EBITDA margin should be easily north of 10% (SHOP gross margin is 42%; deducting 32% implies 10%). Moreover, note that SHOP's historical gross margin was in the mid-50s; as such, using the same calculation, EBITDA margin could be way higher. The good news is that management is on track to drive profitability (as seen in the RIF situation). After this year's RIF, management expects to see measured hiring drive small changes in quarterly operating expenses.

Valuation

While I am convicted that the business will continue to grow, the current valuation is not attractive for equity investors to take advantage of this growth. Based on my outlook, I believe SHOP can grow at 25% (TTM growth is 26%) for the next 2 years given the large TAM, management efforts to continue rolling out innovative solutions and finding accretive partnerships to drive growth. While 8x forward revenue is a high figure, remember that SHOP is growing much faster than its peers (29% vs 18%, please refer to the snapshot below) and should continue to grow faster given the traction it is gaining. That said, based on my model, SHOP is fairly valued at $73.

Risk and final thoughts

The upside risk to my hold rating is that the valuation multiple could surge to higher ground. Historically, SHOP has traded as high as 20+ forward revenue, setting precedents that it could go back to that level. However, I don't think it is likely given that rates are no longer at the same level as in the previous few years. In addition, as SHOP deals with SMEs, it is vulnerable to economic cycles. In a major recession, SMEs get hurt much more than large enterprises due to their weaker balance sheet. In this instance, SHOP will be impacted.

Overall, I recommend a hold rating for SHOP. Shopify, as a leading cloud-based commerce platform, has consistently demonstrated impressive revenue growth, signaling a normalization in post-COVID growth. With a wide market reach and a portfolio of innovative solutions, the company is well-positioned to continue expanding. Shopify's global total addressable market (TAM) offers substantial growth prospects, as the e-commerce industry is expected to grow at a rapid pace. Management's commitment to enhancing its value proposition for small and medium-sized businesses through innovative solutions and strategic partnerships bodes well for future growth. While Shopify's terminal margin is challenging to pinpoint, it has the potential to be significantly higher based on the wide range of new products and its historical gross margin. Furthermore, management's focus on profitability adds to its positive outlook. However, the stock's current valuation, while supported by growth prospects, may not be attractive for equity investors. With the fair value estimate at $73, it appears to be fairly priced.

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