Mar 26 2020 - Shopify In A Global Depression

We are facing a black swan event of unprecedented proportions that may result in the biggest economic depression of modern times.

Some companies will benefit from the COVID-19 pandemic and some companies will be clobbered.

The e-commerce business, in general, will benefit from the COVID-19 pandemic.

Shopify is in a precarious situation, and its benefit from the COVID-19 pandemic will be limited because of the nature of the vast majority of the Shopify stores.

What prompted writing this article and what is its thesis?

Over the last few weeks, I have been receiving many questions about the impact of the COVID-19 pandemic on Shopify (SHOP), and how it may change my opinion about Shopify. Just as a disclosure, I have always maintained that Shopify’s business model (catering mostly to small businesses that sell discretionary products based on impulsive buying) is bound to be impacted negatively as the buyers change their buying behaviours and become wiser in their online buying habits.

Further research led me to believe that Shopify has a very interesting combination of both positives and negatives running for it. As a result, I decided to conduct further research and present my research in an article that addresses the questions I have been receiving.

The article is primarily a set of questions and answers that address Shopify’s position as it relates to the COVID-19 pandemic. It starts with an explanation of why we are facing a serious economic depression for the foreseeable future, proceeds with the answers to the questions of what is going for or against Shopify and concludes with a summary of what Shopify’s prospects are.

Why are we having a global recession? Or, is it a depression?

What we faced in the last couple of months with the COVID-19 pandemic is a black swan event that a very limited number of people expected. One of these people is Bill Gates in his Ted 2015 talk about The Next Outbreak. I do encourage you to see this short video and how Bill Gates was successful in predicting, in 2015, what we are currently facing.

Every investor is now rushing to try to understand how to handle this situation and its impact on their investments. Provided that many of the investors in the current market were not active investors during the last downturn of 2008, confusion is prevailing and over-reaction is the name of the game now.

Source: Wikipedia, as of 2020/03/09; Charts change regularly

This event that we are now facing is potentially the biggest health calamity that the human race has faced since the middle ages plague. This virus is very unique because:

• The death rate of this virus is currently (as of March 24th) at 14.22%. This is calculated by dividing the number of deaths (17,148) by the number of closed cases (120,543) as of 8:30 Eastern Time on March 24th as per Woldometer. To put this percentage in perspective, the CDC indicates that the regular flu that annually infects over 3M people in the US alone has a fatality rate of around 0.2%.
• The COVID-19 virus has two strains, the more aggressive of which is highly deadly as per Dr. John Campbell. Dr. Campbell’s video is a scientifically educational one that talks about the challenges of concurrently fighting two strains of the virus.
• The potential of mutation and evolution is quite high as per National Science Review published on Oxford University Press. Actually, some researchers are indicating that one of the two strains is already a mutation of the other; they are justifying that assertion by the fact that the death rate in China is lower than that in the rest of the world.
• COVID-19 is both airborne and surface-borne, and can spread from asymptomatic patients as per both the CDC and Jane Qiu of Nature Magazine. To put this in perspective, Ebola, one of the deadliest epidemics that ever faced humanity since the middle ages with a death rate of 50%, is transmitted among humans through close and direct physical contact with infected bodily fluids, the most infectious being blood, feces, vomit, breast milk, urine and semen according to the World Health Organization.

The above characteristics of the virus would cause an unprecedented economic impact on the world. I believe that ending up with a global recession is an under-estimation and expect that the next two quarters will experience a cumulative drop in GDP that would put last century’s Great Depression to shame.

In addition, I do not believe that the economic stimuli that governments around the world are adopting will be the permanent solution for this depression. The stimuli would help ease the pain for employed individuals and failed businesses, but the long-term ramifications would be seriously damaging to the world economy, and the recovery from this damage would not be fast. This may be the topic of another article that talks about the long-term economic impact of the economic stimuli on the world economy.

To summarize, this paper assumes that we are heading into the most serious global depression that the modern world economy has ever experienced.

What are the questions?

The answers to the following questions are mostly speculation based on many years of experience and extensive research. Only time will tell if the answers below are correct or not. Unless specified otherwise, the answers pertain to the next three reporting periods.

What do you expect will happen with Shopify's GMV and Merchant Solutions?

I expect that the GMV (Gross Merchandise Volume) for Shopify would decline considerably. The Shopify COVID-19 discussion board shows that most Shopify clients are seriously devastated as a result of the virus, and their sales are dropping anywhere from 25% to 100% (i.e. no sales). Of course, there is a small percentage of clients whose e-commerce business would thrive in this environment, and these are mostly brick-and-mortar stores. However, their number is very small compared to the overall number of Shopify clients.

In addition, Shopify is doing the right thing and is suspending stores that are price gouging during this pandemic. I think that this is the proper ethical and moral decision that Shopify management should have taken, and they certainly did.

My personal expectation is that the GMV for Shopify would drop by a minimum of 50% over the next two quarters. This would result in a significant drop in Merchant Solutions revenue. Please note that this variable component of Shopify Revenue constitutes over 60% of the total Shopify revenue.

Source: Michael Wiggins De Oliveira, Seeking Alpha

Would Shopify allow customers to pause their e-store for free?

Based on Shopify’s response to COVID-19, Shopify is not giving the option to pause the site for free to its clients. The option available for clients who are experiencing an abnormal decline in their sales is to drop their subscription level and/or to pause the e-commerce store on their subscription. This pausing of the e-commerce store would drop the monthly fees to instead of the minimum basic fee.

Source: Shopify Website as of 2020/03/23; Shopify has not yet updated its website to reflect the 90 days, and is not yet disclosing the option that customers have.

I do not expect that Shopify would provide a temporary freeze of the subscriber’s site even for a short period of time (e.g. two or three months). Clients have the option to freeze the e-commerce component of the store and reduce the subscription to , and this is what I expect clients will do. The reason why Shopify would not provide the option of freezing the account is two-fold: First, it would lose revenue, and second, the clients may not come back any time soon after they freeze their accounts.

Would the brick-and-mortar stores flood to Shopify?

With the closures and lock-downs happening, more brick-and-mortar stores will be flocking to create their stores online. The logistics would be quite challenging in terms of shipping the existing inventories to the customers, but eventually, the store owners would be nailing it. My expectation is that many of these stores will introduce "pick-up from store" delivery mechanisms, which would work well in the locations that are not locked down.

The total Shopify number of customers would thus increase at a rate higher than that of its competitors, primarily because Shopify provides one of the easiest and most comprehensive solutions for e-commerce stores. I would consider this change associated with brick-and-mortar stores as one of the key benefits of the COVID-19 pandemic for Shopify.

Would the number of clients/subscribers of Shopify increase or decrease?

With the massive layoffs that are now happening, I expect that new customers would be rushing to open their own businesses and thereby open their online stores with Shopify. At the same time, most existing clients will not quit and remain with Shopify. A major part of their fees is based on sales commissions and fees (a variable cost) which would drop with the decline of their sales. In addition, most of the clients that are suffering from the COVID-19 pandemic would choose to pause the e-commerce component of their existing stores (the per month option) rather than permanently closing their stores. Finally, Shopify has extended the free trial period from 14 days to 90 days, which would provide a further enticement for individuals to try opening their own stores. As a summary, I am expecting the number of Shopify subscribers to increase.

I am also expecting that the mix between these subscribers will change with many of the existing customers (maybe with the exception of Shopify Plus customers) downgrading to a lower tier. In addition, the free features that Shopify is now providing (e.g. gift cards) may provide a further incentive for customers to downgrade.

I don’t expect many of the Shopify Plus customers to downgrade to a lower tier. The Shopify Plus cost is mostly a variable cost which would automatically drop with the decline of sales and the fixed subscription cost is relatively low for these companies anyways.

Source: Compiled by author

If the number of subscribers increase, would the subscription revenue increase as well?

The potential increase in the number of subscribers would not necessarily translate to a higher subscription revenue, and the overall subscription revenue will most likely decline rather than increase. There are two reasons for this decline:

First, Shopify increased the period for the free trial from 14 days to 90 days. This means no revenue will come from the potential new clients until three months after starting to use Shopify. By that time, many of them would realize that competing with the big players is a futile exercise and may choose to quit the e-commerce business. In addition, some businesses may choose to close their existing stores and open new ones to capitalize on the 90-day free trial.

Second, many Shopify clients would downgrade the subscription level to a lower tier, which would reduce the overall subscription revenue.

Source: Thomas Smale, FE International, How to Sell a Shopify Business

The percentage decline in the subscription revenue, while potentially substantial, would be significantly less than the decline of the variable component of Shopify’s revenue (Merchant Solutions), which is mostly dependent on the GMV.

What will happen with Shopify’s bottom line?

A close study of Shopify’s income statement and its associated notes reveals that there are three major buckets of expenses: Labour cost (mostly spread across the different expense components), affiliate marketing costs (embedded in Sales and Marketing) and third party transfers (embedded in both Sales and Marketing, and G&A).

I do not expect Shopify to be conducting any massive layoffs for the foreseeable future. I would expect them though to stop the hiring process for the foreseeable future.

Shopify has a commitment to its partners for perpetual referral fees. While Shopify has the legal right to stop these fees, that would devastate Shopify’s affiliate marketing structure. Having said that, I expect that the affiliate marketing expense to be dropping marginally with the reduced subscription revenue. The above two components constitute the biggest components of Shopify’s expenses, and while they are expected to decline, the drop will not be significant.

The other big component of Shopify’s expenses is the pass-through funds (like credit card and third party fees). Shopify records its pass-through funds as expenses rather than a contra-revenue (the more conservative approach), and these variable expenses would significantly decline with the drop of its customer sales.

All the other fixed expenses (rent, hardware, hosting…) will generally remain as is, and their impact is minuscule anyways compared to the other big three expense buckets.

Source: YCharts

Because of the expected significant drop in Merchant Solutions (over 50%) combined with the drop in the subscriber revenue resulting from customers downgrading their subscription tiers, I am expecting the net income to dive into the red at an unprecedented rate. How much will it actually be in the next few quarters is anyone’s guess.

How would Shopify benefit from the growth of e-commerce resulting from the COVID-19 pandemic?

With the lock-downs happening all over the world combined with the massive layoffs, people will have more time on their hand and will be forced to do as much as possible of their shopping on-line. This will result in a fundamental structural change in the e-commerce business. The hallmarks of this change can be summarized in the following structural changes:

1. Customers will be doing more shopping online, and the GMV for the global e-commerce business will increase.
2. The sale of discretionary products will decline significantly and may even come to a halt as layoffs increase and sources of income get curtailed; this is the normal trend in any recession. In general, essential products have a lower margin compared to discretionary products; in other words, the GMV increase would not necessarily translate to an increase in the bottom line.
3. Customers will have more time on their hand and with financial pressures they will start to search for the least expensive products to buy. This will result in a serious price war where the smaller companies would have no chance of winning against the giant e-commerce retailers. In other words, impulsive buying of discretionary products will disappear, and customers will be wiser and slower in making their buying decisions. I strongly believe that this is an attitude adjustment that is expected to continue after the COVID-19 is defeated.
4. The delivery and return policies will be rendered as one of the most important factors in the buying process.

The above structural changes would be devastating for most Shopify store owners; most of the products sold on Shopify stores are discretionary and are sold based on impulsive buying. Actually looking at Shopify’s Market your business page would reveal that most of the techniques that are suggested to focus on how to get the customers to buy without researching other competitors, aka, impulsive buying.

Source: eMarketer, Global Ecommerce 2019

The growth that is expected in e-commerce will mostly be for essential products rather than discretionary products. Some Shopify sites would benefit from that, however, this will be short-lived as essential products are mostly commodities (e.g. groceries and toilet paper). With commodities, prices and speed of delivery are the main factors in the purchasing decision, and with the ease of search for the different availability and prices, larger retailers, that have large economies of scale and efficient operations, will always win.

Small e-commerce stores are well-known for their poor return policies and drop-shippers are known for their slow delivery. The return policies and the delivery times are not expected to be any better with the disruption in the supply chain resulting from the COVID-19 pandemic, especially for smaller businesses. This would result in pushing the customers away from these small e-commerce sites into larger e-commerce sites like Amazon (NASDAQ:AMZN), Walmart (NYSE:WMT) and Alibaba (NYSE:BABA).

Unfortunately, for Shopify, their focus is small businesses (Shopify’s main page states that its mission is “Empowering independent business owners everywhere”), which would be suffering under COVID-19 with the price wars and the behavioural changes for the buyers. In other words, I do not believe that Shopify would benefit from the structural change that is happening in the e-commerce landscape as a result of the COVID-19 pandemic.

What will happen with Shopify Capital?

I have always maintained that Shopify Capital is another form of a pay-day loan structure that charges an enormous amount of interest. A high interest usually comes with a significant risk, and I do not believe that this is the case for Shopify. Here is the definition of the business from Shopify’s annual report.

The Company also earns revenue from Shopify Capital, a merchant cash advance (MCA) and loan program for eligible merchants. The Company evaluates identified underwriting criteria such as, but not limited to, historical sales data prior to purchasing the eligible merchant's future receivables, or making a loan, to help ensure collectibility. Under Shopify Capital, the Company purchases a designated amount of future receivables at a discount or makes a loan, and the merchant remits a fixed percentage of their daily sales to the Company, until the outstanding balance has been fully remitted. For Shopify Capital MCA's, the Company applies a percentage of the remittances collected against the merchant's receivable balance, and a percentage, which is related to the discount, as merchant solutions revenue. For Shopify Capital loans, because there is a fixed maximum repayment term, the Company calculates an effective interest rate based on the merchant's expected future payment volume to determine how much of a merchant's repayment to recognize as revenue and how much to apply against the merchant's receivable balance.

Source: Shopify’s annual report

The financial services industry all over the world is suffering as a result of the COVID-19 pandemic. The primary reason for this distress is the massive increase in the bad debt and loan default allowances. And, for financial institutions, we are not talking about loans that are guaranteed by future business (like Shopify Capital), but rather talking mostly about loans that have real estate and personal guarantees as collateral.

As a result, we should expect that Shopify Capital's business would be devastated. However, Shopify management was astute in insuring (part of) the Shopify Capital business. I am impressed by this action and consider it as a remarkable positive action from the Shopify management team:

The Company has mitigated some of the risks associated with Shopify Capital by entering into an agreement with a third party to insure some of the merchant cash advances offered by Shopify Capital.

Source: Shopify’s annual report

Shopify did not disclose how much of the Shopify Capital loans were insured, and their disclosure indicates that only part of the loans are insured.

Shopify indicated that they are planning to increase the loans for Shopify Capital by 0M in their COVID-19 response letter and that they are working with governments to make the capital offerings available in other countries. It is not very clear what they are planning to do regarding insuring these additional loans but I am fairly certain that the insurance carrier would increase the premium for insuring these new loans quite substantially.

My expectation is that the impact of Shopify Capital on the company’s bottom line would be negative as a result of increasing the bad debt allowance, and that the insurance that Shopify bought will help weather this impact. Having said that, I believe that this additional expense will pale compared to the deterioration in the Merchant Solutions revenue.

Do you expect any government involvement related to Shopify?

Shopify has a very strong relationship with the Canadian political leadership. The head office is in Ottawa and Tobi Lütke seems to have a strong relation with the Canadian Prime Minister, Justin Trudeau. In addition, Shopify is considered one of the technology flagship companies of Canada. Based on this, Shopify is in a good position to get some sort of support from the Canadian government.

Source: Prime Minister Justin Trudeau participates in an armchair discussion with Shopify CEO Tobias Lütke in Toronto on Tuesday, May 8, 2018. THE CANADIAN PRESS/Nathan Denette

Chris MacDonald recently published a report on The Motley Fool indicating that “Should Shopify begin to see serious declines in the company’s stock price, I would not be surprised to see the government offer a major helping hand.”

While an interesting concept, I think that the support from the government will be limited to providing funds to Shopify to distribute to its small business clients via Shopify Capital. I do not personally expect this to happen soon, but if/when it does, it would have a minimal impact on Shopify’s bottom line.

Where is the Shopify stock price bottom, and will it recover?

This is a question that is almost impossible to answer, and any answer will be mostly speculative. I am presenting my personal opinion here, and am trying my best to justify it.

For the short term (next two quarters), Shopify’s top and bottom lines will drop at an unprecedented rate. I expect the stock price will continue dropping quite substantially as a result of that, and the main decline in the stock prices would coincide with the quarterly announcements.

On the long term, after the COVID-19 is defeated, the position of Shopify will depend on one key factor, which is whether the structural changes in the customer behaviour will persist or not. If the customers remain vigilant in their online purchasing habits, it would spell trouble to most Shopify site owners who rely on impulsive buying of discretionary products. By association, the persistent change in behaviour would spell trouble to the Shopify stock price.

If the customer behaviour returns to what it was before COVID-19, I would expect Shopify's growth to continue until the behavioural change eventually happens.

Conclusions And Summary

The COVID-19 pandemic will impact all industries without exception either positively or negatively. Despite the hopes of some analysts, I believe that the world is currently facing a global depression, and we have not yet experienced the second leg of the virus falling. Most businesses in the world will be negatively impacted with the exception of a few limited number of industries.

One of the industries that will be positively impacted is e-commerce. While Shopify is in this industry, it may not experience the same positive impact that the big giants (e.g. Amazon, Walmart and Alibaba) are expected to receive. The primary reason that Shopify would not benefit and would rather suffer is simply because most of its clients are relying on impulsive buying of discretionary products, and these sales practices and products do not sell well (if at all) during a recession, let alone a global depression.

Reviewing the Shopify bulletin boards shows the extremely high level of suffering that the Shopify retailers are experiencing as a result of the drop in their sales. Shopify responded in an impressive way to its customers providing them with additional free services and extending the trial period from 14 to 90 days. I don’t believe there is anything else that can be done at this stage by Shopify for its customers, and they just have to try to ride the wave instead of fighting it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am planning to short Shopify again before its next release.