Sept 12 2019 - Shopify: A Reality Check

Summary

Compared to other companies within its league, Shopify is clearly the most expensive, and its valuation cannot be justified using typical valuation methods.

This article provides a valuation spreadsheet and based on very optimistic estimates, Shopify should be valued at about 25% of its current valuation (as of September 1st, 2019).

Shopify is clearly a stock bubble that is bound to burst and drop significantly in price.

Shopify has already cleared the later stages of the “Mania Phase”, and we have either just entered the “Blowoff Phase” or on the edge of entering that phase.

What prompted writing this article?

Over the last few months, Shopify (SHOP) has been experiencing a meteoric rise that has not been seen since the late 1990s in the dot-com era. This price has been mostly supported by analysts who have been increasing their price target for the company stock price to very high levels.

In addition, for every article that was published about Shopify on Seeking Alpha or other sites during this rise, regardless of whether the article was positive or negative about Shopify, arguments sprouted about the justification of the company stock price growth.

I currently hold a short position on Shopify and the slew of positive comments about the company from both commentators and analysts alike made me doubt my position; I thus decided to go back to the drawing board, review my position, go back to the basics and conduct my own analysis on the company.

After I conducted my own analysis on the company fundamentals from both the growth and value perspectives, I decided to submit this analysis for publication.

Paper Thesis

This article starts by comparing Shopify’s value to similar companies within its own league in terms of capitalization, revenue, revenue growth, dividends and net income. In addition, the article also looks at different companies which readers can relate to. These companies fall into one of a two categories:

• Operate within the e-commerce industry
• Within a different industry and have a similar capitalization or revenue

The article next reviews what analysts are predicting for Shopify’s value, and what is driving the analysts to come up with their price targets.

After that the article presents a spreadsheet that contains a parametrized expected future revenue/expenses/income for Shopify; this spreadsheet is made available for downloading so that the readers can play with the parameters and come up with their own valuation.

The article then looks at the characteristics and history of stock and investment bubbles, and cross-references Shopify stock against these characteristics. The article concludes that Shopify stock price is a poster child bubble that is very highly over-priced, and that with very optimistic assumptions, its capitalization is expected to drop to about 25% of its current value.

How does Shopify’s price compare to other companies?

Personal Opinion: While some of the companies presented in this section are not direct competitors with Shopify, we have to remember that all public companies are competing for investors' money. So, whether they are in the same industry or not, all companies are indirectly competing with each other, and this is the reason that I am including these companies in this analysis. In addition, most of these companies are household names that readers may be able to relate to.

In this section, we will review a few Canadian companies that compare to Shopify in terms of capitalization, line of business (e-commerce or technology) or revenue, regardless of the industry they are in. The specific companies that we will look at are BCE (BCE), Canadian Tire (CTC.A), CIBC (CM) and Rogers Communications (RCI.B).

We will next review other SaaS or e-commerce companies (mostly US companies) that provide similar offerings, have similar capitalization or have comparable revenues. These companies are Adobe (ADBE), Amazon (AMZN), Alibaba (BABA), eBay (EBAY), Salesforce (CRM), Square (SQ), WiX (WIX) and Workday (WDAY).

Please note that because Shopify does not generate any net income, so we are not doing any significant comparisons related to net income.

BCE Inc. (BCE)

There are two reasons for comparing BCE to Shopify: First, its capitalization is very similar to Shopify and second, it can be construed as a technology company. The dollar figure revenue growth for BCE is almost twice that of Shopify’s total revenue and its capitalization is almost the same as that of Shopify but it is trading at a multiple of 2.41 times revenue versus 35 for Shopify.

Canadian Tire (OTC:CDNTF)

I included Canadian Tire here because it is investing heavily in e-commerce, and may be construed as a direct competitor to Shopify. Canadian Tire makes about ten times as much revenue as Shopify, its dollar revenue growth is twice that of Shopify, and is only 15% the capitalization of Shopify.

CIBC (CM)

CIBC was included here only because it is a Canadian company with a capitalization similar to that of Shopify. CIBC’s revenue is about 12 times the revenue of Shopify, its dollar revenue growth is higher than Shopify’s total revenue and its net income is 3.5 times as much as Shopify’s total revenue. CIBC has a capitalization lower than that of Shopify.

Rogers Communications (RCI)

Rogers was included here because it is a technology company that is within approximately the same range of capitalization (half Shopify’s capitalization). Rogers revenue is about 10 times Shopify’s revenue and its net income is 150% Shopify’s total revenue. Rogers dollar revenue growth is about twice Shopify’s revenue growth.

Company	Symbol	Market Cap	Revenue	Revenue Multiple	Revenue Growth	Net Income	Number ofEmployees
BCE	BCE	56.72	23.5	2.41	0.7	2.9	51,000
Canadian Tire	CTC.A	7.83	14.1	0.55	0.8	0.8	58,000
CIBC	CM	45.88	17.8	2.58	1.5	5.3	40,000
Rogers	RCI.B	26.41	14.1	1.87	0.7	2.1	26,000
Shopify	SHOP	51.45	1.46	35.00	0.4	Negative	4,000

** Capitalization as of September 1st, 2019; Revenue and Income are for the 2018 fiscal year.** Symbols are the Toronto Stock Exchange symbols** All figures except for revenue multiple and number of employees are in Canadian Dollars (Billions)

Adobe (ADBE)

Adobe was included here because it owns Magento, one of the direct competitors of Shopify. Adobe is arguably a fairly expensive company with 3.5 times the capitalization of Shopify. However, its dollar revenue growth is 50% higher than the total revenue of Shopify and its net income is more than twice Shopify’s total revenue.

Alibaba (BABA)

Alibaba currently has the highest net income worldwide in the e-commerce industry, even higher than that of Amazon. Its capitalization is about half that of Amazon and about 12 times the capitalization of Shopify. The revenue growth of BABA is over 17 times the total revenue of Shopify and its net income is about 11 times the total revenue of Shopify.

Amazon (AMZN)

Some analysts consider Amazon one of the key Shopify competitors. Although Amazon has 128 times the revenue of Shopify and its dollar revenue growth is 88 times the dollar revenue growth of Shopify, it only has 22 times the market capitalization. I recently published an article in Seeking Alpha about the relationships between Amazon and Shopify: “Amazon And Shopify: 'Coopetition' mAt Its Best”, which you might like to review to have a better understanding of the relationships between Amazon and Shopify.

eBay (EBAY)

Shopify recently surpassed the market capitalization of eBay, and they are still in the same capitalization range. This is despite the fact that the revenue of eBay is 34 times that of Shopify, that eBay’s net income is more than twice Shopify’s total revenue and eBay's revenue growth is larger than Shopify’s total revenue.

Salesforce (CRM)

Salesforce can be arguably coined as the world’s SaaS leader, and this is why it is included here. Its capitalization is just 3.5 times that of Shopify, although it is a profitable company with revenue equal to 13 times that of Shopify's and its dollar revenue growth is higher than Shopify’s total revenue.

Square (SQ)

After acquiring Weebly, Square became a direct competitor of Shopify. Its capitalization is about half of Shopify’s capitalization. Square has 3.5 time the revenue of Shopify and its revenue growth is over 50% of Shopify’s total revenue.

WiX (WIX)

Some may argue that WiX as the biggest potential competitor of Shopify. While WiX has significantly more customers than Shopify, it is mostly used as a web site builder rather than an e-commerce platform, despite its abilities to provide this functionality. The target market that WiX has for its e-commerce abilities is not for drop shippers like Shopify but rather manufacturers and service providers. This is a much more sustainable market and as a result, its churn would be much smaller for WiX. WiX has about half Shopify’s revenue but its capitalization is less than 20% of Shopify’s capitalization. Over a year ago, I published an article that compares Shopify with WiX: “Shopify And Wix.com - Where Are They Going?”, and many of the comparison points are still valid now.

Workday (WDAY)

This is a very fast-growing SaaS company; that is, while not a direct competitor, it is in the same industry sector as Shopify. The company has a capitalization of 75% that of Shopify with almost twice the revenue, and Workday’s revenue growth is over 50% of Shopify’s total revenue.

Company	Symbol	Market Cap	Revenue	Revenue Multiple	Revenue Growth	Net Income	Number ofEmployees
Adobe	ADBE	138.11	9.0	15.35	1.7	2.6	21,000
AliBaba	BABA	460.02	56.2	8.18	19.0	12.0	102,000
Amazon	AMZN	878.65	141.4	6.21	35.3	10.1	648,000
eBay	EBAY	33.79	37.5	0.90	1.2	2.5	14,000
Salesforce	CRM	136.00	14.7	9.25	1.5	0.01	35,000
Square	SQ	21.19	3.9	5.43	0.7	Negative	2,000
WiX	WIX	6.99	0.6	11.65	0.2	Negative	1,800
Workday	WDAY	28.72	2.1	13.68	0.6	Negative	10,500
Shopify	SHOP	38.67	1.1	35.15	0.4	Negative	4,000

** Capitalization as of September 1st, 2019; Revenue and Income are for the 2018 fiscal year.** Above figures except for revenue multiple are in US Dollars (Billions)

Based on the above analysis, Shopify is insanely expensive compared to the other companies that are compared against. The comparison shows that many companies have a lower capitalization than Shopify while their last year revenue growth is higher than Shopify’s total revenue. Yes, you read it correctly: I am comparing the revenue growth against Shopify’s total revenue.

Looking at Shopify’s number of employees compared to the other e-commerce companies like Alibaba, Amazon and the likes, we can easily make an assessment that it is a very small company. If the company were generating a large net income, that would be ok, and it would position the company for high growth. However, for Shopify to grow, it would need to increase its number of employees; because Shopify generates no net income, growing its number of employees may have a negative effect on the company’s cash flow.

So, why am I providing this comparison here?

Investors need to make a choice about how to invest their hard-earned cash, and have to conduct their thorough analysis related to where to put their money. This above comparison provides a few alternatives for other companies that are growing at a relatively fast rate, with a dollar growth much higher than that of Shopify and are valued at a lower price. This is not a recommendation for buying the other companies but rather a pointer for readers to investigate these companies, conduct their own analysis and decide whether they should invest in Shopify or any of these other companies.

Some investors invested early in Shopify, recouped their original investments, and their Shopify investments are strictly composed of their Shopify profits; these investors need to remember that in investments there is no “house money”, even if your assets are locked into an escrow account. It is “your money”; if you keep it invested in a particular stock because you already recouped the original investment of this stock as it rose multiple folds without proper justification, then gambling on the roulette may be no different. In other words, these investors need to make a decision whether to keep Shopify or to sell it assuming that it is a brand-new investment that they are starting today, otherwise, they would be simply gambling.

What assumptions can be taken to reach the analysts price targets?

Analysts who are coming up with the price targets described in the next section (average of approximately 0) are relying on some assumptions that are sometimes believable and sometimes unreasonable. This section will list and analyze these assumptions. Now, whether these assumptions are valid or not is a decision that the readers have to make. So, here are a few assumptions that analysts tend to make to reach the price targets described in the next section.

(1) Shopify will maintain its technological lead in the e-commerce market

Shopify currently has a distinct technological advantage over its competitors in terms of ease-of-use, customer service, rich features and full integration of e-commerce functionality. While some may argue that Magento is more flexible and has more third-party tools available with it and is accordingly more flexible, and that WiX has an easier user interface, I personally believe that Shopify currently has a clear technological lead when taking the combined aspects listed above. However, as we have learned over the years, a technological lead cannot be construed as a moat against competitor’s attacks especially when the competitors are larger companies, and should be heavily discounted in the company valuation.

(2) Number of Shopify stores will continue growing

Analysts base their valuation on at least a linear growth of Shopify’s stores (e.g. Baird boosts SHOP target on merchant growth). I am personally very uncomfortable with this assumption and believe that eventually, the number of Shopify stores will start declining. The number of Shopify stores is over 800,000 stores, the vast majority of them are drop shipping stores that are aggressively competing with each other in addition to competing with the giant e-commerce companies. Despite the assertions of Shopify’s CEO Tobi Lutke about drop shipping (which coincidentally contradicts the assertions of his COO and CFO about fulfillment and warehousing), I personally believe that the drop shipping business is a doomed business and that eventually the number of Shopify stores will start to decline. There are simply not enough products in the world to support 800,000 stores, the vast majority of which are operating in a drop shipping model. In addition, the whole e-commerce business is expected to be dominated by a few giant competitors. I tried to explain this point in details in my earlier 2 articles that I published about a year ago: “Shopify: Will It Be A Winner Or A Loser Because Of E-Commerce Growth?” and “Shopify's 600,000 Online Merchants: Too Many For Our Planet”.

Tobi Lutke’s response to a question related to his opinion about drop shipping during the February 2018 conference call. Source: Seeking Alpha Transcripts

(3) Shopify will maintain its multi-channel listing lead in the e-commerce market

Currently Shopify has the ability to list the merchandise of its merchants in different venues like Amazon, Walmart, Etsy and the like. In addition, Shopify allows its clients to place their advertisements in different places like Facebook, Google, Instagram and the likes. While some people argue that BigCommerce has better multi-channel capabilities, I personally believe that Shopify has a distinct leading advantage in this area. The multi-channel capabilities for Shopify makes its product sticky; that is, it would be difficult for customers to switch from Shopify to another customer. However, the Shopify business is built on replenishing its very high percentage of departing clients with new clients, and the stickiness cannot apply to new clients. I have done some calculations and found that Shopify’s churn rate is over 50%, and I invite you to download the spreadsheet and play with the assumptions to come up with your own estimate of Shopify’s churn rate.

(4) Shopify will reduce the cost of customer acquisition

Currently the vast majority of the cost of customer acquisition is the money that is paid to Shopify partners (approximately, 0M annually as per the DIGIDAY article). The 0M are paid (usually in perpetuity) to partners who refer clients, who write blogs about Shopify, who provide training programs, and practically, anyone who promotes Shopify to its customers and investors. Some people may even take this partnership program as an outsourcing of the sales and marketing functions for the company. Shopify can easily drop this amount quite significantly (their partner program agreement allows them to do that); the challenge would be that without the partner network, the rate of loss of clients would exceed the rate of acquisition of new clients and this can be devastating for the Shopify stock price and its growth story.

Personal Opinion: I believe that this partner program is a brilliant approach from Shopify management to replenish lost clients from its relatively high natural churn. I do not anticipate Shopify abandoning this program any time soon, but rather, I would expect them to continue enhancing and nourishing it.

(5) The Shopify fulfillment business will be self-funding

When Shopify announced its last financial statements, management indicated that they are starting a fulfillment line of business to service the needs of its clients. The company management later indicated that the fulfillment program will be self-funding. Despite an expert assessment of the massive capital requirements for fulfillment systems, most analysts take the management assessments at face value and take this fulfillment “no additional capital” assumption into consideration when conducting their valuations.

Personal Opinion based on 2019/09/09 Shopify Announcement: Based on the latest acquisition of Shopify buying 6 River Systems for 0M, with a potential of M in revenue annually and a very small net income, I have come to the conclusion that the fulfillment business will not be self-funding and that Shopify management have an awkward interpretation of what “self-funding” means.

(6) Shopify will generate billions of dollars in fulfillment revenue

Some analysts are assuming that Shopify fulfillment business will contribute B in six years to Shopify’s total revenue (e.g. Shopify +1.5% on Street-high target). Given that the total revenue of Shopify now is .1B, and assuming a 35% growth in annual revenue, the total Shopify revenue would be B in six years. This means that these analysts are assuming that Shopify’s fulfillment revenue will be equal to the all the other revenue from Shopify within six years. While possible, the likelihood of this happening is very remote because the vast majority of Shopify customers are drop shippers who do not need fulfillment, but then again, miracles do happen.

(7) The profit margin for Shopify’s fulfillment business will be 30%

Shopify management indicated various times that the profit margin for the fulfillment business will be 30%. The average successful fulfillment business margin in general is 3%. Despite this order of magnitude discrepancy, some analysts take the 30% margin into consideration when coming up with the Shopify valuations. This SA article casts some doubts on Shopify’s fulfillment expansion plans: Shopify's Expansion Plan Is Questionable, and presents the reasons for its doubts in a professional and comprehensive manner.

(8) No new competition will enter into this market and existing competition will not change

Currently, Shopify is leading the e-commerce third-party provider market together with WooCommerce and Magento. Analysts are assuming that most of the growth of the e-commerce market will be going to Shopify and that new Shopify clients will continue flocking to them from the other competitors in big numbers.

Market Ahare of Top e-commerce providers. Source: Coudways

(9) The Shopify Capital business will continue growing

Shopify Capital may arguably be considered the most profitable business line of Shopify. Through Shopify Capital, the merchants securitize their receivables by giving away 10% of the future receivables. Given that the inventory turnover for retailers on average is over 13 times annually, then we are talking about an annualized return interest rate of over 130% on these loans. Please note that the turnover for e-commerce companies is usually much higher than 13 times annually because of the relatively smaller need to carry inventory. This means that the interest rates that Shopify charges for their loans is arguably higher than 130% annually. This is not much different from pay-day loan companies and/or loan sharks. Analysts are expecting this business to continue growing.

Personal Opinion: I personally believe that the growth of the Shopify Capital business implies that Shopify is adding more low-quality merchants who do not understand the sizable amount of interest that they pay on the loans.

(10) The Shopify subscription revenue will not drop and will increase

Analysts are expecting that the growth rate of the subscription solutions fees that Shopify receives will continue at its current rate of 35%. This is happening despite the declining trend as shown in the next chart. The margin on the subscription services is significantly higher than that of the merchant solutions, and a high growth in this area may result in abnormally high valuations.

Source: The Street

(11) The drop shipping business will continue to thrive

Shopify’s vast majority of clients are drop shippers, and as a result, the growth of drop shipping is integral to the growth of Shopify. Many analysts are assuming that drop shipping is here to stay and its growth will not abate. This is despite the fact that interest in drop shipping has been constant, and even declining over the past 2 years as shown in the following 5-year chart.

Source: Google Trends

(12) Customers will switch into buying from small stores through impulsive ads rather than from large e-commerce companies

Supported by assertions from Shopify management, analysts have been assuming that the e-commerce market will transform into buying mostly from smaller e-commerce firms instead of larger e-commerce companies. Such a transformation would be very beneficial for Shopify as, according to Shopify’s COO, its focus is on smaller companies.

Personal Opinion: So far, I have not seen a valid justification for the above assumption. I personally believe that the opposite will happen and the transformation will happen on the opposite side: customers will stop buying from smaller stores based on impulsive ads, and will opt to buy from larger e-commerce firms whenever there is an opportunity to avoid buying from smaller firms. I expect this to start happening aggressively with the next downturn in the economy.

Does the argument for Shopify pricing make sense?

This article asserts that the assumptions made by the analysts are questionable, and as a result, their price targets of an average of CAD6 (US0) and an average rating of 3.68 as shown in the graph below cannot be justified. The readers need to make an assessment of whether these assumptions are justifiable or not according to their own analysis. Based on this assessment, they can determine whether they should invest in Shopify based on the price targets of these analysts or not.

Source: Analyst Sell Side Rating, Seeking Alpha

Personal Opinion: I personally believe that the assumptions in the previous section are mostly unjustifiable, and that the price targets that the sell side Shopify analysts are coming up with are grossly inflated.

Based on my experience, once the stock price misses any of the analyst estimates, analysts will start publishing new reports that have lower price targets and the stock price would start its decline. As of today, I am not familiar with any company that has never missed analyst estimates, and the decline in Shopify will start aggressively when this happens. When Shopify will miss analyst estimates is practically anybody’s guess.

What should Shopify’s valuation be?

I tried to come up with the most justifiable optimistic assumptions related to Shopify and created a simplified spreadsheet to come up with what the valuation of the company should be. The calculations that I have performed are based on the discounted net income for the company. I started by looking at the discounted cash flow, but it resulted in an abnormally low valuation, so I decided to use the discounted net income instead. So, here are the assumptions that I made:

• Current Revenues is M: This is an optimistic number as Shopify’s last year revenue was only .1M.
• Current Expenses are M: This is also an optimistic number as Shopify’s management provided a guidance of a loss rather than a break even.
• The discount (hurdle) rate for the calculations is 15%: This is another very optimistic number. For a company with the risk profile of Shopify, the discount rate would normally be higher.
• The revenue growth rate will continue in perpetuity and will be 10% after 10 years until the “end of time”: This is another optimistic assumption. Having a 10% growth rate in perpetuity is very rare, but then again, I am trying to be overly optimistic here.
• The expense growth will continue declining to reach a level of 5% after ten years and in perpetuity: Based on Shopify’s business model, and their need to replenish their churn, their expenses will most likely continue to grow at the same growth rate as the revenue.
• The net income will continue growing beyond the 10th year at a rate of 5%: This is more of a simplification of the calculation beyond 10 years, and it is conforming to the standards for calculating the terminal value. A 5% perpetual growth in the net income is a very optimistic estimate.

The above assumptions give rise to the following chart that shows how the revenues will be growing above the expenses to reach a net income of B in 10 years.

Source: Compiled by the author

As per the attached spreadsheet, the above assumptions result in a valuation of approximately CADB (versus the current CADB+ as of the time of writing this article). I invite readers to download the spreadsheet, and play with the parameters in it to come up with a valuation that makes sense to them.

So, is Shopify a bubble then?

According to the Smart Market Data article of 2014, there are 8 key characteristics of a bubble. This section will look at each of the 8 characteristics and assess whether it applies to Shopify or not.

(1) This-time-is-different mentality: Many Shopify long investors are indicating that Shopify is different from all the other competitors and that they have a management team that will always perform to perfection and is not subject to making any mistakes. When comparing Shopify to other companies that experienced the same growth rate as Shopify and eventually collapsed (e.g. Nortel and Blackberry at the end of the last century), these investors indicate literally that “this time is different”.

(2) Financial risk has been underwritten by the authorities: Because of the relationship that Shopify’s CEO has with the Canadian political circles (for example, Tobi Lutke is currently considered one of Justin Trudeau’s technology advisors and Trudeau spoke at the annual Shopify conference (UNITE) of 2018), long investors of Shopify do not expect any actions from the Canadian government that may negatively impact the operations of Shopify. In addition, Shopify’s head office is in Ottawa, the centre of the political arena in Canada which would put it in an ideal position for lobbying government officials and bureaucrats.

(3) Easy money: Almost every investor of Shopify has been raving about how easy it was fo