Summary
Shopify recently reported a quarter that was significantly above prior expectations and provided upside guidance as well.
It has substantially reprioritized its corporate strategy, abandoning its quest to match Amazon's logistics, and focusing instead on cutting-edge e-commerce technology.
Notionally, Shopify's valuation, after its share price hike, is not cheap.
To support the investment case, market share gains, mainly from penetrating the large enterprise are crucial.
The company has the team to remain on the leading edge of ecommerce by adapting technologies - likely including AI - as part of the stack it offers to merchants.
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Can Shopify regain its growth mojo through reprioritization?
This has been a humbling period for more than a few high growth stalwarts in the IT/ecommerce space. As a corollary, it has been a humbling period for analysts such as this writer who have had bullish calls on many companies in the space. While the sentiment about "it's a long road that has no turnings" is one that comes to mind, that doesn't erase the sting of the last 18 months. In particular, Shopify $Shopify(SHOP)$ as a business has gone from hyper growth to something above that in the pandemic, and then to roadkill as consumer habits returned, in part, to pre pandemic behavior. One commentator on a recent SA article about the company, called the company's CEO a clown, one of the more misbegotten comments about a well-respected industry pioneer that I have seen. Tobi Lutke, that CEO, is one of the more serious, intelligent and engaged CEOs in the industry. The company's latest quarterly results were better than feared-something that has been typical for many IT companies this past quarter.
But of more importance, at least in my opinion, is that the company essentially turned the page on its erstwhile strategy to challenge Amazon $Amazon.com(AMZN)$ in the logistics space, to focus on what it calls "main quests" abandoning many "side quests" of which logistics is by far the most noteworthy. In particular, in this era of rapid change in the ecommerce landscape, the company is focusing on areas such as "headless commerce" and "composable components" which facilitate the acquisition of Shopify software by much larger merchants than it has heretofore been able to address, a key part of the company's strategy to return to hyper growth status-and also a key pillar of the company's push to reach sustained and substantial profitability and free cash flow generation.
I first wrote about Shopify 7 years ago for SA soon after it first went public. While I am a long-term investor for the most part, I certainly wasn't able to keep my finger away from the sell trigger-several times as it turns out-since I first recommended the shares. It can be sad to revisit some of these recommendations.
I have written many articles about the company since then with my latest article appearing on SA last summer. It turned out to be a fortuitous moment to recommend the shares; the shares then were down more than 80% from their pandemic induced peak. While the shares went lower still, reaching a nadir of $23 last October, they have recovered substantially, and spiked noticeably in the wake of the company's earnings report, and probably of more importance, its reprioritization of investments, and exit from the logistics business through a sale of that operation to a partner, Flexport.
Shopify has refined its strategy that is more focused now than in the past. The company has abandoned a key initiative, and, in conjunction with that move, it is laying off 20% of its staff. That can be life changing for a high growth company with what had been a corporate culture of growth without great regard for profitability. The company, acknowledging one of the overarching industry trends, has indicated that part of its reprioritization is to develop solutions that incorporate AI technology, but really the priority is to get in front of the trends that are of most significance to large merchants in the ecommerce world.
Will this new direction suit the organization and provide returns for shareholders? Is it too late to consider Shopify shares? This is not any kind of a short term trading call. In the current environment, the odds on a company…any high growth tech company seeing a sustained rally of months rather than weeks is low. Certainly, while the sub-headlines in this latest CPI report (released 5/10) coupled with a benign report on producer prices and some signs of a less tight labor market may signal a favorable backdrop for a Fed policy pivot, I wouldn't recommend buying Shopify shares based on such an expectation-I offer no prognosis as to when such a pivot might occur.
While there have been a few upgrades of the shares by brokerage research teams in the wake of earnings with both the teams at Bank of America and UBS moving from sell to neutral, there are still plenty of other neutral ratings, and changes in those ratings could be a short term potential catalyst. On the other hand, some analysts, responding to the share price hike have indicated valuation concerns already. And in this phase of the market, I can't rule out the potential for an aggressive short seller to develop and publicize a negative thesis that upends valuations between now and the next quarterly earnings. Equally, investors may get recessionary signals about the economy and read those through to the short term operational performance of Shopify.
Don't buy Shopify shares to chase a new dream. But do consider starting or growing a position because the company's new strategy resonates and has a better chance than most of reestablishing a pattern of rapid growth built on market share gains.
Is it too late to buy Shopify shares? Hardly, in my opinion. I see the new commerce initiatives as a multi-year growth driver as yet nascent and under appreciated by investors. But do take pains to buy prudently, i.e. with a scaled approach to acquiring a position.
This company has a talented and visionary management team. The company's president and CEO were co-founders of the company and have a depth of experience that is probably unique in this space. This is a product oriented company, and the recent addition of Kaz Nejatian as Chief Product officer was a significant addition to the C-Suite. Looking further, the company has some unique talents like its VP of Product, Glen Coates, who went from being a game developer to run US distribution for an eco-products company and then founded Handshake, a SaaS B2B e-commerce platform that was acquired by Shopify in 2019. This leopard isn't changing its spots so much as running off in a new direction.
Shopify's results: E-Commerce is showing signs of life after its reset
Shopify grew its revenues by 25% last quarter, with its merchant solutions growth of 31 % substantially greater than the growth of GMV which rose by 15%, which compares to the prior consensus expectation of 11% growth for that metric. Revenue growth of 25% compared to the company's prior forecast of revenue growth in the high teens percentage. Merchant solutions continues to benefit from the broad adoption of Shopify Pay, whose penetration rose from 51% to 56% with a 25% increase in GMV using the service. The company reports a metric it calls attach rate. Basically, this metric, calculated by dividing GMV by revenue, measures the success of the companies numerous software products. The attach rate last quarter was 3.04%, the highest in the history of the company and up from 2.85% in the year earlier quarter. Shopify Plus, the service offering that is focused on the enterprise continues to grow at rates significantly faster than the overall company; at this point Plus merchants represent 34% of GMV, up from 33% last quarter and up from 30% in the year earlier period.
The company's non-GAAP operating margin was 1% last quarter, and the company had non-GAAP EPS of $0.01. This compared to the prior consensus of a non-GAAP EPS loss of $.04. Guidance was increased as well, although it can be hard to see because of the pending sale of the company's logistics business. The company will be selling that business at the end of the quarter, and so the forecast for revenue growth in the period of 25% includes revenues from most of its logistic offering for the period offset by the impacts of the previously announced price increase which is starting to impact revenues.
What is unambiguous is that the company is now anticipating stronger earnings, and will be generating free cash flow-in every quarter of the year according to the company forecast. Based on company guidance, analysts have increased their Q2 EPS forecast; the current published 1st Call consensus is $.0.05 from a prior estimate of a loss of $0.01 and that probably doesn't include estimate revisions from all covering analysts. While Shopify doesn't provide full year guidance at this point, consensus earnings estimates for the year have gone from about $.04 to $.25, and given the construction and inputs into the consensus, most analysts are probably looking for an even greater level EPS. My model suggests that non-GAAP EPS will be in a range of $0.35-$.0,40
The better than feared growth of Shopify was part of a broad industry trend. Obviously, Amazon had stronger than anticipated ecommerce sales, but even some of the smaller ecommerce web site companies such as BigCommerce $BigCommerce Holdings(BIGC)$ saw revenue growth that was at least better than feared, although given the absolute numbers, that was hardly a great accomplishment. My point here is not that I expect some return to the growth percentages brought on by the pandemic, but that long term growth in the e-commerce space is returning to something like a normal, multi-year trend.
Like much else about the future, there is a fair bit of controversy regarding the overall growth of e-commerce. Depending on which source is considered growth will be either a slow upward slog as a percentage of total retail sales, or a fairly rapid reacceleration. I have linked here to an article that considers both views. My guess is that ecommerce will accelerate as a percentage of retail sales-it has advantages in terms of economics, and consumer preferences in a world where more and more people prefer the on-line experience to physical shopping. Just how fast will the overall market grow? I think a middle of the road analysis, compiled by Statista, is for a CAGR of about 14% over the next several years. I certainly have no way of 2nd guessing that kind of forecast, and I expect that most analysts who follow Shopify and the space would find such a forecast to be most likely.
But for Shopify stock to work as an investment it has to exceed industry growth rates-certainly by 1000 basis points and probably more than that. How might that happen is the subject of the next section of this article.
Shopify after logistics-What's the new strategy?
For the past few years Shopify has focused on building out a logistics capability to match that of Amazon. Logistics is obviously a key component of e-commerce, and the company tried several strategies to try to achieve a differentiated capability. It was a fairly expensive "side bet" and it simply never was able to provide Shopify users with a differentiated solution that was not available elsewhere. The strategy discomfited many analysts and investors, and was a major consumer of cash. I confess that after the latest strategy pivot, i.e. the recent merger with Deliverr, I had thought the company was getting a grip on its initiative but that turned out not to be the case.
While clearly the logistics initiative was a bad decision for the company and one that cost literally billions of dollars, acknowledging that Shopify couldn't, itself, create a differentiated logistics offering and maintain its focus on fostering commerce for its client seems an appropriate conclusion. It might be an embarrassing admission, and one that clearly was a difficult decision for the company's senior management, but in my view it is the mark of a mature management to accept that it can't do everything in its space and develop partnerships that ultimately provide its merchants with the breadth of offerings they want, while focusing on developing solutions larger customers are actually willing to buy. And taking a major additional move to downsize the company's staff, is, while an extremely painful and emotional decision, seems to be appropriate considering the current visible opportunities, and the need to provide positive economic returns for shareholders.
The financial implications of these moves, at least in the short term, are, on some basis, laid out in the consensus. What will exist after the transaction is completed at the end of Q2, will be a somewhat smaller business, that is more profitable and asset light with the ability to generate a substantial free cash flow margin, a new priority for the company. The 19% growth projected by the consensus for 2024 is actually more like 22% organic when excluding logistics revenue in both periods. Analysts are looking for further margin improvement next year; the consensus forecast for EPS in 2024 is $.49, again, probably a consensus that does not yet reflect all revised analyst forecasts.
Are those estimates good enough to recommend the shares? For me, the straight forward answer is no. Interestingly, some analysts (those at both Atlantic Equities and DZ Bank) have actually downgraded the shares as I write this, and their basic reason is essentially is the belief that Shopify's growth and margins aren't enough to support a share purchase recommendation after the recent valuation spike. My view is that the consensus doesn't really take account of the multiple growth levers the company has, and its ability to focus on those growth levers in the absence of its logistics business.
How can Shopify grow fast enough to justify a buy rating?
Earlier in this article I linked to an analysis that presented two poles of projections about the growth of e-commerce for the next several years. I suggested that a reasonable baseline for ecommerce growth was the 14%+ CAGR being projected by Statista. As a business, even from its inception, Shopify has been architected to achieve growth significantly above market levels, and despite some bumps and twists over the last several years, it has done that.
These days, many investors are looking at AI as a technology that will boost IT growth and the CEO of this company mentioned AI in his shareholder letter announcing the sale of the logistics business and the substantial company layoff. While I certainly believe that the technology represents a revolution, and there are use cases for AI in a Composable Commerce Stack, it is not the growth end-all/be all that it might be in other segments of the IT landscape.
Shopify has already starting using AI in some of the features it offers on its platform. One such feature is Shop at AI which is a shopping concierge that can help a user determine curated products for a specific need. The company uses AI to write some of its product descriptions. Neither of those bits of functionality is going to move either the growth or cost needles significantly. I certainly don't know or can't imagine all of the potential use cases for AI that Shopify may develop and make part of their stack. It is the fashion these days to talk about AI in relation to just about every company engaged in the IT space. About all I can offer at this point is my belief that Shopify will probably be a net beneficiary from the AI revolution, primarily because of its team of talented product managers who are likely to envision and develop cutting edge use cases ahead of competitors.
That said, the growth opportunity that I see which is far more visible for Shopify is the company's push to sell ecommerce solutions to larger enterprise. No doubt, Shopify will always be a company with a platform that supports millions of smaller ecommerce merchants and it will continue to expand that base, and to sell that base additional functionality. And the many partnerships that the company has with businesses such as Affirm $Affirm Holdings, Inc.(AFRM)$, Global-e $Global-E Online Ltd.(GLBE)$, Klaviyo (that is a hot private marketing automation company that may soon go public) and others will also be growth drivers of some significance.
But in my opinion, the opportunity for Shopify to gain share in the ecommerce market, and thus to grow at rates in the mid-high 20% range are the company's initiatives to sell to larger merchants who in the past have been reluctant to engage with the company.
Shopify Plus was introduced by the company in 2014. It was designed then to appeal to larger, more established merchants who wanted a fully featured web site that was both cost effective in terms of development and deployment, and offered a great deal of scale. The service starts at $2000/month, although larger users pay significantly more, based on a volume charge. Over the years, Plus has attracted some fairly large merchants such as Staples/Canada and Rhone.
About 3 years ago, Gartner coined a term called Composable Commerce. Here is a link to an article that might help readers better understand the concepts of composable commerce. Gartner is often on the cutting edge of inventing catchy terms, but composable commerce is a real thing, so far as I can tell. Basically, composable commerce is about solutions that might be considered akin to a box of Legos, so-called best of breed solutions that can be assembled into a customizable stack. This concept has been refined further into what is called headless commerce in which there is a separation of a website's front end from its back-end ecommerce functionality. It gives retailers the ability to customize and to try to make their ecommerce storefronts standout from the competition.
I don't purport to be an expert on all things ecommerce, but Shopify and its competitors battle over territory far beyond that of selling merchants a monolithic solution. Monolithic solutions in which one size is supposed to fit all have numerous problems for large retailers, and for the most part they simply will not buy that kind of offering from Shopify or from anyone else. And yet it is these large retailers that represent the largest growth opportunity for Shopify and are the key to achieving market share gains of a magnitude sufficient to create the kind of growth rate necessary for the company's shares to make sense.
A few months ago, the company introduced Commerce Components by Shopify [CCS]. This is an offering that breaks out some of Shopify's most demanded features in a form that is accessible by even larger retailers. Most large retailers already have their own infrastructure, and regardless of benefits, they have not, for the most part, been willing to entertain Shopify solutions that require them to go all-in on the Shopify platform. CCS enables retailers to acquire pieces of the Shopify platform such as the company's checkout and storefront modules. The company called out some significant retailers-some that even this writer recognizes including Tim Horton's and Ted Baker-as new Shopify users based on the CCS offering. In addition, the company has signed up additional enterprise implementation partners such as Cognizant $Cognizant Technology Solutions Corp(CTSH)$ and extended its relationship with IBM $IBM(IBM)$.
The company has been one of the pioneers in offering what is called headless commerce solutions. Despite the name, this has nothing to do with the "Legend of Sleepy Hollow" which is what first came to mind when I read about the concept. I have linked here to Shopify's primer that provides an overview of how headless commerce actually works. Shopify Plus has headless ecommerce capabilities and it appears as though headless commerce is one of the reasons Shopify plus revenues have been growing so rapidly. The link calls out several Shopify reference users including Allbirds, Kotn and Babylist.
Needless to say, there are many ecommerce vendors offering components and headless commerce solutions. I really have no way of assessing who has a better offering in the space. There are many competitors, and almost as many analysis that try to rank these competitors. I have linked to one such analysis here. As a note of interest, I was surprised to see Shift4Shop $Shift4 Payments, Inc.(FOUR)$ considered as a leader in this space-basically because its tools are free if you choose that company's payment processing capabilities.
This is a rapidly evolving space-and it seems to be changing at an accelerating rate at this time than in the past. In considering why Shopify sold its logistics business and instead has chosen to partner with Flexport, it is important to understand how competition in ecommerce is playing out these days. The absolute necessity for Shopify is to be the leader in both headless commerce and in composable components. Anything that might distract from that priority simply had to be dropped. I can't say with any level of assurance that Shopify will now outperform its commerce rivals in these newer technologies. But at one level, dropping logistics efforts to focus everything on these new technologies appears to be the right move and this heightened level of focus gives Shopify a better chance to be the winner in these new segments of web site creation than it had before. It is this new found focus that was one of the animating factors in causing me to write this article at this time, even after the significant share price spike that has been unsettling to some analysts.
In order to achieve the growth that the company needs to justify a buy rating on the shares, Shopify has to grow faster by some significant percentage than the overall ecommerce market. I believe that the combination of its new focus on composable components and headless commerce, coupled with a focus on selling to much larger merchants with the Shopify Plus platform, in addition to several significant partnerships as well as the steady increase in Shop Pay as a percentage of GMV is a strategy that is likely to yield the market share gains necessary for the company to achieve the kind of growth) at least in the mid-high 20% as a CAGR for some time that undergirds a positive investment recommendation.
Shopify's Business Model-A rapid evolution
Profit and free cash flow have never been priorities for this company. While it did a level of adjusted operating income in the two years most affected by the pandemic, last year the company's adjusted operating results were at a break-even level, and its operating and free cash flow margins were negative for the year.
For Shopify to work as an investment in this environment that has to change and it appears that management is indeed focused on profitability-in the latest conference call the CFO was quite forthright in telling investors that free cash flow was now a priority for the company.. The company will be generating free cash flow-every quarter this fiscal year, according to the CFO.
Before embarking on a more detailed evaluation of the company's expense profile, I should point out that Shopify uses and will continue to use stock based comp. Last quarter, stock based comp. was 9% of revenue, compared to 10% of revenues in the prior quarter. 9% of revenues is quite a bit below average for a software company, but it should be noted that business model is not one of a typical software company as so much of its revenue relates to a take rate on its GMV. The company's most recent annual dilution has been a bit less than 3% and that is the dilution factor I use in my valuation analysis.
Because Shopify basically has the same seasonal patterns as other retailers, typically Q4 is very profitable and the other quarters in the year are less so. That seasonality is a bit less for Shopify; software subscription revenues are a bit less than 25% of the total and by definition do not have seasonal patterns.
Last quarter non-GAAP gross margins were 49% of revenues down from 54% in the prior year. This decline in gross margin was primarily driven by the impact of the acquisition of Deliverr, which Shopify had previously acquired and will now be selling. In addition, Merchant Solutions, was a higher percentage of revenue this past quarter, and within Merchant Solutions, Payments, which has lower gross margins was a larger percentage of the total than the year earlier period. Gross margins will rebound after the sale of Deliverr is completed; beyond that the key to gross margin trends will be ability the company has to sell additional subscription solutions, mainly as more merchants subscribe to Plus, and as the company acquires large merchants for its Composable Components and Headless Commerce offerings as part of the Plus set of solutions.
Non-GAAP sales and marketing expense last quarter was 18% compared to 24% the prior year. This was basically offset by a sharp increase in non-GAAP research and development expense which rose to 23% of revenue compared to 18% the prior year. Some of the change in these expense ratios is related to the acquisition of Deliverr, but some of it is a reallocation of company resources. The company is concentrating on developing a more substantial software offering, and it is showing up in the expense ratios. General and administrative cost were flat at 7% of revenue. Overall, non-GAAP operating expense remained at 51% of revenue. On a sequential basis, non-GAAP operating expenses were $769 million compared to $758 million in Q4-2022. For the last 3 quarters, operating expenses have been maintained nearly flat as some of the first impacts from the company's pivot toward profitability become evident.
With the substantial layoff that has been announced, Shopify expects opex to fall by mid-single digits this current quarter or about $40 million. Sequentially, revenues are forecast to increase by about 8%, or $120 million, which should add $60 million to non-GAAP gross margins. Thus, overall, profits should rise about $100 million or about $0.07/share-that yields an EPS estimate of $.08 for Q2.
As the layoff was only announced at the start of May, the full impact will be felt in Q3 and beyond. Depending on the course of business over the next couple of quarters, and the impact of the divestiture of the logistics business, I think Shopify will report full year non-GAAP EPS of between $.35-$.40 with adjusted free cash flow of perhaps $425-$450 million. That would be a very modest free cash flow yield of less than 1%, but it is at least a start.
The real question is what comes for 2024. I don't want to suggest that I have some kind of omniscience when it comes to the success and cadence of the company's ecommerce initiatives. Over the years, when it comes to ecommerce, Shopify has been far more successful than not, and the opportunities it has in terms of selling composable components and headless commerce solutions are as large as any it has addressed. It is those opportunities that make Shopify shares worth considering.
Wrapping Up-Making sense of the valuation
Shopify shares, even after pulling back a little from their recent spike, are not for the faint of heart. The nominal EV/S ratio is a rather elevated 9.5X. That is certainly not a bargain, when looking at a growth rate that might be projected at somewhere in the low 20% range organically by many analysts.
Much of the short-term performance of Shopify shares and its business has to do with elements not really in the control of the company. The outlook for the growth of ecommerce in an environment with macro headwinds is murky, to say the least. And the market is still more risk-off than anything else. The company at last report, had a modest short interest ratio, so for the shares to appreciate, institutions, who own a relatively small percentage of the shares-63% at last report-will have to reconsider their investment position.
Despite the recent price spike, I think investors probably undervalue the company's initiatives in terms of composable and headless commerce as a part of a continued pivot to attract enterprise customers. The stock will work if those initiatives achieve the kind of success for the company that many of its other initiatives have achieved. Jettisoning its logistics goal was a necessary precursor for that to happen. The company, even after its layoffs, has a talented team of developers who ought to be able to continue to create solutions…ones that appeal to enterprise customers. And while the company is not, at this current time, an obvious significant beneficiary of the AI revolution, I think its team will develop as yet unknown commerce components that utilize that technology.
Owning or recommending Shopify shares today is not because of some undiscovered valuation metrics. The analysts who downgraded the shares recently did so because essentially they don't want to take the risks involved in recommending a company whose future rests on a pivot that is in process rather than one with great visibility.
I believe that the odds favor Shopify pulling off its pivot to sell more and more to larger enterprises-it has much to offer that most enterprises simply can't create in a timely or economic fashion. My guess is that the company has and will have the most talented and imaginative developers in this space and talent will be nurtured by an experienced and focused senior management team. And should that happen, then growth estimates that are in the consensus will be bettered dramatically, and in turn that will lead to a rapid, and as yet unforecasted rise in free cash flow margins. It is a bet to be sure, but one I am willing to take and to recommend. Others may not be so sanguine. This is not, to repeat, an investment for the faint of heart but one for those who are looking for a multi-bagger, and are willing to take a risk to achieve that. My bet is that the company will enjoy positive alpha over the coming year-indeed years to come.
Source: Seeking Alpha
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