Description

I’m pitching Shopify (SHOP) as a long mainly to put this company back on everyone’s radar following an excellent but unfortunately timed write-up on the company posted on 11/15/21. I’m not going to rehash the business overview or main selling points of the thesis and forecast as virtualodin did a great job with that in the original write-up. Anyone interested in this investment idea should read that write-up first, along with the robust Q&A.

A handful of things have changed since then, however, that are worth discussing:

1.       SHOP reported Q4 2021 and Q1 2022 earnings.

2.       Amazon made some threatening moves.

3.       SHOP announced proposed governance changes.

4.       CEO Tobi Lütke bought $10 million worth of stock personally.

5.       The stock price dropped from $1,657 to $399, or 76%.

Earnings reports.

In mid-February 2022, SHOP reported Q4 2021 results. By that point the stock had already dropped to around $900 a share, and the earnings release took it to about $650. The biggest news to come from the release was around SHOP’s investment in Shopify Fulfillment Network (SFN). They greenlighted a build phase that included consolidating their network to larger facilities and operating more of those themselves. They will also unify the warehouse management software they’ve been building and testing over the last year and a half. These changes would provide for package delivery in 2 days or less to more than 90% of the US population, while reducing inventory investment for merchants. They will continue to leverage third party partners to fill in the network (for spoke warehouses and sort centers, and to handle freight, carrier and last mile delivery). Over the next three years, SHOP plans to increase 1-day delivery coverage and enhance returns functionality, as well as improve capabilities to handle larger merchants.

SHOP originally launched SFN in mid-2019 with an asset-lite plan that included spending $1B through 2024, mainly to fund operating losses. They had spent $117M as of Q4 2021. The new expectation laid out in February is for $2B of total spending through 2024. This includes $1B in capex over 2023-2024 as they build out self-operated leased warehouse hubs in key geographies. They expect fulfillment volumes to scale toward the back of 2023, at which point the unit economics will become favorable. They believe the higher upfront spend will pay off through increased operating efficiencies and lead to a higher margin than operating solely through partners. By operating more of the warehouses themselves, management can better control cost and quality.

While the SFN investment brought out fears of an unknown return on increasing capital intensity, SHOP’s growth outlook for 2022 further confounded investors. Calling their revenue growth range wide would be the understatement of the year, as they effectively said it would be greater than zero but less than 57% (though they also said it would be “rapid and outpacing the growth of e-commerce”). They saw continued penetration of retail by e-commerce and continued secular tailwinds for entrepreneurship and digital commerce transformation but set against a more measured macro environment as Covid lockdowns and government stimulus would be largely absent. They also flagged near-term caution around inflation and consumer spending. They saw the growth rate accelerating throughout the year. The backend loading of revenue growth, though based on legitimate reasoning, likely didn’t sit too well with investors.

In addition, SHOP announced its intention to reinvest “aggressively,” deploying all gross profit dollars back into the business. This included increased investments in sales and marketing for sales personnel, offline performance marketing, and international marketing, as well as hiring more engineers in R&D. Furthermore, gross margins would continue to be pressured by the ongoing shift in mix from higher margin Subscription Solutions to lower margin Merchant Solutions.

In addition to all the above, SHOP missed earnings expectations in Q4 amid slowing merchant growth. They attributed this at least in part to the extremely tight labor market.

In May 2022, SHOP followed up with Q1 2022 earnings. Both earnings and revenue missed estimates in Q1 2022, and the stock dropped from close to $500 down to about $320 in the ensuing week or so. Along with earnings they announced the acquisition of Deliverr for $2.1B (80% cash and 20% shares, most of which will go to management subject to vesting), their biggest acquisition to date. The purchase price compares to a $2B valuation set during a $240MM funding round in November 2021 (which was double the level of the previous round). Deliverr fulfills more than 1MM merchant orders per month using an asset-lite software-driven model to connect merchants across the US to their supply chain, managing distribution and fulfillment across all merchant channels. Their focus is on inventory inbounding and inventory distribution (within the distribution network and across channels), utilizing a range of sites from Fulfillment by Amazon to their own warehouses or even garages in some cases, rather than the big warehouses the largest retailers rely on. This deal accelerates SHOP’s broader goals around SFN, though it will be dilutive to profitability in 2022. They expect it to be only slightly dilutive to gross margin, and 80% of Deliverr’s opex is headcount (they currently have 400 employees). Growjo estimates Deliverr’s revenue at $123MM.

SHOP also updated investors on SFN, claiming “considerable progress” towards inventory balancing, delivery and simple returns functionality. They also said the warehouse management system was up and running with an expectation to have it handling all SFN order volume by the end of Q2 2022. In addition, they introduced a new offering called Shop Promise, whereby consumers will see a badge on products they browse that indicates a 1- to 2-day delivery promise, consistent across all merchant channels.

Another primary emphasis of the call was SHOP’s POS offering, which management is emphasizing as the shift away from online pandemic shopping and towards in-person retail becomes more pronounced. They highlighted YoY growth of 80% for offline GMV, 6x market growth per management. That said, they continue to believe e-commerce will grow and that SHOP will take share. SHOP’s online GMV grew at a 51% CAGR since the start of the pandemic, which management claimed was faster than overall e-commerce growth. They grew online GMV faster than the market in Q1 2022 as well, which management pegged at 10%. They also talked up strong growth in Shopify Plus and an initiative to build out partnerships with systems integrators to attract bigger customers to the platform.

Revenue grew 22% in Q1 2022, which is impressive given the comp was 110% growth in Q1 2021, when pandemic effects were in full force (2-yr CAGR of 60%). GMV grew 16% on top of 114% growth in Q1 2021. Subscription Solutions growth was only 8% in the quarter, though it would have been 15% if not for some revenue accounting changes and a change in terms offered to theme developers. Merchant Solutions grew 29% in the quarter as merchants continued to increase take rates on various SHOP offerings.

In the quarter management introduced a new component of guidance, indicating that they expected the number of merchants joining the platform in 2022 to be comparable to 2021. They also said they expect Merchant Solutions revenue to be more than double Subscription Solutions revenue.

Amazon moves.

The biggest news from Amazon came in April, when they announced they would extend some of their Prime membership offerings to merchants off its platform by embedding their payment and fulfillment options onto third-party sites. Amazon has already offered Multi-Channel Fulfillment (MCF) for several years, which lets sellers store and ship products using Amazon’s services regardless of whether they’re selling on Amazon’s site, but the new offering is bigger. Called “Buy with Prime,” the service allows merchants to show the Prime logo and offer Amazon’s 1- and 2-day delivery options on products they list on their own sites, with checkout through Amazon Pay. Amazon would also manage free returns for eligible orders. Buy with Prime will start by invitation only for existing Amazon sellers in 2022, and will roll out to other merchants, including some that don’t sell on Amazon, in 2023 and beyond.

Here is some of what Lütke said when asked about it on the Q1 2022 earnings call: “So we are actually thrilled with Amazon making a decision to take the amazing infrastructure that they've built because they have a second to none infrastructure and want to share this broadly with small merchants across the Internet. And so we are happy to integrate this into Shopify, just in the same way how we integrated what -- the infrastructure that Meta built, the infrastructure that Google built and the infrastructure that TikTok built and so on. So this fits perfectly into our world view. And it's not nearly as zero-sum as some people make it out to be. Whatever is good for merchants is -- that will cause more entrepreneurship, which is exactly -- helps the vision of a company.” Whether you agree with him or not, it is an indication of how he thinks about these things.

Amazon also quietly bought a company called Veeqo. Although the deal closed in November, it wasn’t widely known until March that Amazon acquired the Welsh e-commerce startup, which has 60 employees and was founded in 2013. Veeqo’s software helps retailers manage shipping, returns and inventory tracking for their online businesses across e-commerce platforms, including Amazon, eBay, Shopify and Walmart. Veeqo could allow Amazon to integrate more tools into its MCF and Buy with Prime program.

Amazon also announced it is launching a $1B venture program to invest in fulfillment, logistics and supply chain companies.

Collectively, these moves are a threat to SHOP (thought what Lütke said is also true) and underline the importance of the work they are doing around SFN. However, it is worth remembering that a key differentiating factor for SHOP is its promotion of the merchant and the merchant’s brand rather than its own. While Buy with Prime provides merchants with valuable services to offer their customers, it leaves the branding power with Amazon. SHOP’s SFN is more of a behind-the-scenes service that allows the merchant to look like the hero to its customers.

Governance.

In April SHOP announced proposed changes to its governance structure that requires shareholder approval at the meeting to be held next week. Currently SHOP has Class A shares with one vote per share and Class B shares with 10 votes per share. Class B shareholders control 51% of total voting power. The proposal includes a non-transferable new share class, called the Founder share, that would be granted to Lütke and, together with his existing share ownership, would give him 40% voting power. The Founder share would sunset if he no longer serves the company as CEO, director or consultant whose primary engagement is with SHOP, or if he no longer holds Class A and B shares equal to at least 30% of the Class B shares he currently holds. At the time of a sunset he would also convert his remaining Class B shares into A shares. Lütke would also be prohibited from transferring his Class B shares without retaining voting control over them, which prevents intergenerational transfer of voting power. In addition, SHOP director John Phillips would convert his Class B shares to Class A, which would reduce the Class B voting power to 41%.

At the same time, the company announced a 10-for-1 stock split.

Insider buying.

In mid-May, Lütke tweeted that he bought $10MM worth of SHOP stock personally. VP Kaz Nejatian also bought stock around the same time. They were buying around the bottom of recent trading, when the stock nearly touched $300.

While $10MM is not a lot of money relative to Lütke’s net worth, I view his purchase positively as I don’t believe he is the type of manager to buy stock as a promotional headline. His comments around how he views the stock price (see, for instance, the recent interview on Invest Like the Best) points to someone who is not especially concerned about where his stock trades. I believe he views it as a good investment (though he has said the company has better uses for cash than buying back its stock).

Stock price hammered.

Many of the headlines discussed above contributed to significant share price weakness since virtualodin’s November post. In addition, high-flying growth names have been unceremoniously hammered across the board in 2022 amid the backdrop of a tightening fed, pandemic boom hangovers, absent fiscal stimulus, war in Ukraine, and Chinese Covid-zero lockdowns. All these have increased the odds of a recession, or worse yet, stagflation. E-commerce names have been particularly hard hit.

For SHOP in particular, recession fears raise some interesting questions. Investors have long been concerned with the company’s exposure to SMBs, many of which could go under during a prolonged or severe recession. On the flip side, a recession could lead to more job loss which might encourage increased entrepreneurship. SHOP was too young in its development during the 2008 crisis to learn anything about how the business reacts to a recession, and the Covid-induced recession had unique attributes that favored SHOP’s positioning but are unlikely to be repeated. Recession fears are a good reason to avoid most stocks, and SHOP is no exception, but we don’t believe it is especially exposed relative to the average stock.

Although SHOP still sports heady growth multiples, today’s discounted stock price sets up for a much more interesting valuation. With the stock hovering near $400, the market cap comes in around $51B. Netting out net cash and the after-tax value of equity investments (primarily two publicly traded stocks) produces an enterprise value of $42B. At that level, we’re paying 8.7x LTM revenue, and nose-bleed multiples on whichever profit measure you choose to look at.

Virtualodin did a nice job laying out the more detailed growth case, so I’m going to approach it super-simplistically. Prior to the pandemic, SHOP posted revenue growth of 73%, 59% and 47% in 2017, 2018 and 2019. Clearly, we are in for a couple of slower years after the rapid growth during Covid (86% in 2020 and 57% in 2021), though after the world normalizes, we could easily see growth move back up on the backs of SFN, POS, international and other growth initiatives. If we assume that revenue can grow at a CAGR of 15-40% over a 5-year period, we would have out-year revenue of $10-$26B. To put the lower end of the range in perspective, current consensus is for nearly $8B in revenue in two years’ time. If we further assume an EBITDA margin (including appropriate charges for stock comp) of 10-40%, SHOP would produce EBITDA in year five of $1-$10B. Again, to put the lower end of the range in context, SHOP posted an EBITDA margin of 8% in 2021, before even trying to make money. On the upside, we can look again to Virtualodin’s write-up, which settled on a 40% EBIT margin after laying out some thinking that pointed to margin potential approaching 50%.

If we then conservatively assume cash flow accumulates on the balance sheet (with an appropriate charge for SFN capex), and that the market capitalizes SHOP earnings at 20-40x, it would produce a stock price in the range of $185-$2,775. That is a 5-year IRR of negative 14% in the downside scenario to 47% in the upside scenario. Clearly that is quite a wide range, though one that seems to skew significantly more positive than negative.

So where is it most likely to shake out? I think 25% revenue CAGR with 25% EBITDA margins and a 30x P/E seems like a reasonable place to end up. That points to a $785 stock in five years, or a 15% IRR. If things go well, it is not hard to imagine SHOP captivating the imaginations of many investors again. That scenario could easily see a stock price well above a conservative fair value and on a faster timeline than what I’ve laid out here.

Disclosures

The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved.  All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis.  The user of the information assumes the entire risk of any use it may make or permit to be made of the information.

Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.

The adviser, through accounts that it advises, may hold an investment in the issuer's securities.

Catalyst

Continued strong financial performance