2023-06-16 12:23:31 ET
Summary
- Shopify is currently trading for a large premium compared to Block, Inc., with a 28.5x vs. 6.0 Market Cap/Gross profit.
- Shopify, however, does have a lower debt burden and much less share dilution compared to Block, Inc., which could be a catalyst for its premium.
- All things considered, Shopify is valued too highly for it to be comfortable to invest right now.
- If the two companies had the same Market Cap/Gross Profit ratio of 28.5x, it would imply almost a 5x increase in Block, Inc.'s stock price.
Introduction: Reasons For This Comparison
Shopify (SHOP) has increased over 100% in value over the past year. Enthusiasm for the company has been driven by positive commerce trends, strong execution, and the sale of the company's logistics business. In this article, I would like to put Shopify's valuation into perspective by comparing it with that of a close peer Block Inc.
To kick off, I would like to explain why I am choosing to compare Shopify with Block Inc ( SQ ) in this article. There are a plethora of competitors in the payments, commerce, merchant solutions industry though no one is exactly the same. PayPal ( PYPL ), Shift4 Payments ( FOUR ), among others are notable competitors for example. But, the reason why any one comparison between these companies is difficult is due to the varying level of vertical integration and diversification within each company. Shopify is an extensively integrated commerce platform that offers a website platform, its own payment integration, short term loans, shipping integrations, POS stands, and more - essentially everything you need to run a commerce business.
While Shift4 Payments and the others listed in the link are primarily focused on POS systems, PayPal is vertically integrated to an extent similar to Shopify. PayPal offers POS systems with Zettle, peer to peer transactions & neo-banking with Venmo, and online payment solutions with their popular PayPal checkout. Although PayPal is a competitor to Shopify, I am not going to put these companies head-to-head for two reasons. One, PayPal has a much stronger focus on payments than Shopify and they don't operate as a website platform builder. Two, the growth potential of PayPal is much lower than that of Shopify. Block Inc is a much better peer comparison to Shopify due to its strong growth potential and its focus on commerce.
With regards to growth profile, Block Inc sufficiently matches Shopify - and even surpasses the company with regards to gross profit growth.
Growth 21-22 | Shopify | PayPal | Block Inc |
Revenue | 21.4% | 8.5% | -0.8% |
Gross Profit | 11% | -2.3% | 36.5% |
Furthermore, Block Inc is in direct competition Shopify's various businesses, both having a strong focus on commerce.
- Shopify POS vs. Square POS.
- Shopify Online vs. Square Online (Weebly).
- Shop Pay vs. Cash App Pay.
- Shop vs. Cash App.
These are the reasons for why evaluating Shopify with Block Inc is a good starting point to get a relative valuation for the company.
Relative Valuation
I. Market Cap Comparison: The Recent Divergence
Since July of 2020, Shopify has steadily been trading at a premium compared to Block Inc. At their all-time highs the companies were trading around $180 billion and $120 billion respectively, representing a premium of 50%. However, during the market downturn the companies' market caps were essentially following each other. Notice how closely the companies followed each other since the spring of 2022. The two market caps followed one another up until December of 2022, officially, and Shopify's market cap has risen with even more rigor since February of 2023. Therefore, Shopify is now selling at a premium of 100% to its nearest competitor. Is this valuation really merited?
II. Relative Growth Comparison
In this section I want to give financial context for both companies. To begin with, since these two companies are growth stocks let's look at some growth rates.
Both of these companies focus heavily on driving gross profit and revenue growth. Block Inc however began focusing more on gross profit growth ever since their Bitcoin trading business took off on Cash App during 2020 and 2021. Nonetheless, the two companies have grown gross profit and revenue by almost the same amount over the past five years.
This begs the question: how have these companies financed their growth? Shopify had a slightly positive operating profit during 2020 and 2021, Block Inc in 2019 and 2021. Despite hardly being profitable, the two companies have been able to finance their growth with positive operating cash flow (which excludes a huge income-statement cost: stock-based compensation, among other things).
Cash Flow
Operating Cash flow | 2022 | 2021 | 2020 | 2019 | 2018 |
SHOP | (136.4) | 535.7 | 425.0 | 70.6 | 9.3 |
SQ | 175.9 | 847.8 | 173.1 | 327.6 | 295.1 |
Block Inc has generated a significantly larger amount of cumulative operating cash flow over the past five years. However, Shopify has relatively lower CAPEX costs. Below is the quarterly free cash flow for the two peers over the past three years. As seen this figure varies significantly for both companies and since they are growing so fast, it is not so insightful to look at this measure. However, investors should be glad that both are able to generate positive free cash flows to finance parts of their businesses. The alternatives are debt, equity, and working capital which we will explore below.
Debt & Equity
Block Inc has $4 billion more in long-term debt compared to Shopify. Shopify's only debt is in the form of convertible notes, whereas Block Inc. owes $2 billion worth of 2026 & 2031 senior notes, ~$2.5 billion of convertible notes, and roughly $500 million in revolving credit facilities. It is evident that Block Inc. has needed a substantially larger amount of debt to grow. Furthermore, let us look at equity issuances. In the graph we can see that both companies have increased their shares outstanding over the past five years. Notably, Block Inc had a jump in dilution in 2022 since it issued 113,617,352 shares in order to acquire Afterpay ( 10-K, 2022 ).
We can measure the dilution of both companies more specifically using financials data from seeking alpha:
Shares Outstanding | 2018 | 2022 | % Dilution |
SHOP | 1,106.4 | 1,276.6 | 15.4% |
SQ | 419.7 | 602.0 | 43.4% |
From this, we can conclude that Block Inc has diluted shareholders by a substantially larger amount than Shopify. But, this is in large part due to the acquisition of the BNPL platform Afterpay. When excluding the shares issued for the purchase of Afterpay, Block Inc dilution is 16.7% instead. To conclude this section, Shopify has much more favorable financing dynamics in which the company only has ~$900 million convertible debt outstanding, while only diluting shareholders by 15.4% over the past five years. This dynamic could be the explanation for the diverging market capitalization between the two companies. While both companies have been growing at similar rates over the past five years, Block Inc has needed to raise a substantially larger amount of debt and equity financing to support its growth.
III. Relative Ratio Comparison
We can constitute from earlier that free cash flow metrics are not very useful since these companies are in a high growth phase. However Block Inc has cumulatively generated more cash flow than Shopify, hence with the former's lower valuation we can conclude that Block has a lower Mkt Cap / FCF premium. However, two metrics that I believe are important are Gross Profit and Operating Income adjusted for R&D expenses. Gross Profit is a reflection of both growth and margins, while Adj. Operating Income is a measure of operating efficiency while excluding investments for the future. It is common to adjust R&D expenses by expensing them over x years of useful life in valuation models, but for simplicity I have added the expense back completely.
Here are the results.
Relative Multiples (The Author )
It is evidently clear that Shopify is overvalued with regards to these two metrics in comparison to Block Inc. Usually we would see this dynamic when the higher premium-company has a higher growth rate than the other. But, remember in 2022 Block Inc grew gross profit by 36.5%, Shopify 11%. Although the accelerated growth for Block Inc is in part due to the acquisition of Afterpay, the underlying business also performed well.
The craziest part to me is that Block Inc would have about the same gross profit premium as Shopify if the market cap increased 5x (that's a ~$200 billion market cap). Furthermore, Block Inc's market cap could 3x and still have a lower Adj. Operating Income premium compared with Shopify.
Although Shopify is not as heavily debt and equity financed, investors should be weary of the significant premium that the company is selling for compared with one of its closest peers.
IV. GMV/GPV & "Attach Rate" Comparison
For both Shopify and Block Inc, volumes drive growth. The more merchants and consumers that are using their platforms to transact, the more revenue they retain. The difference between the two companies, though, is that Shopify primarily measures its business based on Gross Merchandise Volume (GMV) - a measure of the value sold on its platform - and Block Inc primarily measures Gross Payment Volume (GPV) - a measure of how many payments were processed through its platform.
These measures are different but similar. GMV processed through Shopify is subject to a revenue sharing agreement with the company in which it takes a small share of the transacted volume. GPV processed through Square and Cash App for business comes with transaction fees ( 2023 Q1 Block Inc ). In this sense, both fees retained by the companies from volumes of transaction. With the introduction of Shop Pay, Shopify also retains GPV which will lead them to retaining an even larger share of profit for each transaction.
GMV/GPV is usually complemented with a measure of "Attach Rate". The attach rate is a measure used by Shopify specifically ( 2023 Q1 Shopify ). It is defined by the company as the total revenue in a quarter divided by the total GMV of that corresponding quarter. For the sake of comparison, I have created a similar measure for Block Inc based on its revenue and GPV volume. Let's dive into these important measures for the two companies!
Shopify claimed in its Q1 presentation, linked above, that they had a record attach rate this quarter of 3.04%. In Q1 of 2018 the company had an attach rate of 2.70% so this increase has driven substantial revenue contributions over time. It is also a reflection of the fact that more merchants are using SaaS products offered by Shopify in exchange for a monthly payment. These solutions have a gross margin of 78% ( Q1 Financials ) for Shopify and 80.7% for Block Inc ( Q1 Financials ). If we measure an attach rate for Block Inc in a similar way to that of Shopify, then the company had a huge 9.77% take rate in the previous quarter. If we exclude revenues from the bitcoin business (that only have a 2% gross margin), then the attach rate goes down to 5.54%. I think this comparison offers and interesting perspective, but I must admit that it is not like comparing apples to apples. The reason is that Block Inc has substantially higher service revenues that come from transactions made with the Cash Card. Since Cash Card transactions don't have anything directly to do with GPV, it can be misleading to base a comparison solely on this "attach rate" developed by and for Shopify.
In an earlier article I wrote about Block Inc, Block's Start-Up Ecosystem Will Drive Growth , I sourced an article by Ark Invest that lays out the take rate the company has. This is a measure of transaction revenue divided by total GPV. In 2022, Block Inc had a take rate of 1.15%, which is much lower than the attach rate of Shopify. But, this is also not a comparison of apples to apples. For one, margins on payments are lower than the revenue sharing rate the Shopify has with its merchants. Second, Shopify includes services in its attach rate. Therefore, I believe both Block's attach rate and take rate provide context together as to how the company fairs in relation to Shopify.
Conclusion
Block Inc is the closest peer that I could find to Shopify. First, both companies have a similar growth profile. Second, they are both trying to encompass the same industry but from two different directions. Shopify began with a commerce focus - the goal being increasing GMV through their website platform - while Block Inc has focused on the payments processing in-store. The two companies have diversified into POS and online channels which means that competition between them will only be increasing. Shopify has taken a further step to compete in 2018 by introducing Shop Pay, which means that both companies are processing payments and competing for online checkouts.
Shopify has an incredible premium in comparison to its peer. Recently the company's valuation has more than doubled while Block Inc has lagged significantly behind. But, when looking at performance metrics Block Inc is actually outperforming Shopify. This is reflected in a $1.5 billion higher GPV compared to Shopify GMV in the most recent quarter, higher software margins, and a higher gross profit growth. Although the variation in relative valuation can partly be explained by high investor dilution for Block Inc as well as a $4 billion dollar higher debt burden, investors should be weary of Shopify's valuation. The company is clearly dominant in the online space, but its 28.5x mkt. cap/gross profit and 74.3x mkt. cap/adj. operating income lead me to rate the company a hold.
For further details see:
Shopify: Selling For A Huge Premium Compared To Its Peer Block Inc.