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Shopify Stock Is Still Expensive

Bennett Raglin

Many investors have soured on Shopify (NYSE:SHOP) stock this year. In the same period when the NASDAQ fell 20%, SHOP fell 70%, testing investors’ patience. If you’d invested $10,000 in Shopify at the beginning of the year, you’d be all the way down to $3,000 today. You’d be down even more if you’d bought at the high, which occurred in late 2021.

In a recent article, I wrote that Shopify stock would be interesting at $500–$50 on an after-split basis. At the time, SHOP was still growing sales at 40% — the infamous fourth quarter earnings release hadn’t come out yet. Based on the growth rate at the time and the rate of deceleration from prior quarters, I thought the stock only had a bit further to fall before it became a buy.

Today I think differently. What changed my mind was the earnings releases the company put out this year. The first quarter released showed revenue growth cut in half, at 22%. The second quarter release showed still further deceleration.

At today’s prices, Shopify trades at 8.5 times sales and 5.3 times book value. These multiples are pretty high, even after the 70% crash. There was a time when Shopify consistently traded at 50 to 60 times sales while having negative cash flows. Today, the valuation is cheaper, but the growth is much lower too. In Shopify’s 50x sales days, it typically grew revenue by about 45% every quarter. In 2020, it got a big boost from COVID-19 lockdowns, and grew full-year sales by an astounding 86%. The pandemic-induced closure of retail stores was a huge catalyst for Shopify, but unfortunately it’s starting to look like the company just brought growth forward, instead of creating new demand. Taking this into account, I’d need to see a price of $20 or lower before I’d get interested in Shopify.

Why Shopify Crashed so Hard

To determine a good entry price for Shopify, we need to understand why its stock has fallen as far as it has. The market didn’t punish SHOP unjustly, but rationally responded to a slowing growth rate and a loss of profitability. This stock certainly isn’t worth anywhere near its all-time high price, and the company’s financial history demonstrates why that’s the case.

First, let’s look at Shopify’s results in 2019 and 2020 side by side:

2019

2020

Revenue

$1.5B

$2.9B

Net income

$-124M

$320M

Cash from operations (“CFO”)

$70M

$425M

Free cash flow (“FCF”)

$-70M

$269M

As you can see, there is tremendous growth in all of the metrics here. Net income swung from a loss to a profit while every other metric grew by triple-digit percentages. Naturally, SHOP was expensive when this growth was happening: a company with rapid growth will become progressively more valuable over time. There are limits to the value of even the fastest growing company, but with 86% growth in sales and 500% growth in cash flows, you can justify a mighty steep price tag.

Unfortunately, Shopify’s growth didn’t continue for long after 2020. It held up for most of 2021, but was gone by this year. To illustrate, here’s the most recent 2022 quarter compared to the same quarter in 2021:

Q2 2021

Q2 2022

Revenue

$1.11B

$1.29B

Net income

$879M

$-1.2B

CFO

$66M

$-124M

FCF

$108M

$-8.9M

As you can see, the revenue growth rate was much lower than in 2020, and the bottom line profits all swung to losses. Shopify’s 2022 earnings have been affected by an economic contraction (some would say recession), and the revenue pull-forward from 2020’s e-commerce boom. Its growth may accelerate when the economy begins growing again, but probably won’t re-take its previous rates (near 90% in the COVID-19 boom, about 45% in the years before that).

SHOP’s management has already said that future growth won’t be as good as in past years, and there are reasons to believe them. First, there’s the phenomenon of diminishing marginal returns: growth in general tends to diminish over time. Second, the COVID-19 era e-commerce surge did not create new demand out of nowhere, it came from a shift from brick and mortar to digital because of lockdowns. During the first wave of COVID lockdowns, non-essential stores were literally forced to close, so people had no choice but to shop online. Thus, e-commerce growth was “pulled forward,” in the sense that customers who might not have shopped online normally, had to do so in 2020. Today, lockdowns are mostly over, so some of that business is going back offline. Therefore, growth will be harder for Shopify going forward – at least until a catalyst occurs that creates genuinely new demand.

Competition

Another reason why Shopify may not grow as quickly in the future as in the past is because competition is growing. Shopify sells a platform for managing online stores and payments. It doesn’t have a consumer-facing platform like Amazon (AMZN) that benefits from network effects, so it’s vulnerable to competition from other businesses that do the same thing. Some businesses that offer at least some of the same features as Shopify include:

  • Wix (WIX)

  • Squarespace (SQSP)

  • Magento

  • WooCommerce

  • Ecwid

If any of these companies can beat Shopify on features, marketing, or pricing, they could conceivably take away its market share. A business could stop using Shopify and get all of its customers back on another platform. This is in contrast to Amazon, where if you leave the platform, you lose access to Amazon’s user base and ad network. Right now, Shopify is the market leader in e-commerce platforms, with about four times the market share of the second place offering, Magento. That’s a solid market position, but Shopify doesn’t really have built-in structural advantages like Amazon does. It has to stay ahead on features, marketing or pricing, otherwise competitors will inevitably catch up.

Valuation

Having looked at Shopify’s future growth prospects, we can get to the meat of this analysis:

Valuation.

At today’s prices, Shopify trades at 10.3 times sales, 5.9 times book value, and 413 times CFO. It has a reasonably high revenue growth rate, so the multiples should come down if the stock price doesn’t change. Still, they’ll be on the high side even if they’re cut in half.

What kind of multiple should Shopify trade at? We can’t do a discounted cash flow analysis on the stock, as its latest quarter’s free cash flow is negative. However, we can compare Shopify’s multiples to those of other stocks with similar growth rates. Some stocks with growth in the same range as Shopify’s include:

Based on comparable companies’ multiples, SHOP is still overvalued. Not only are these stocks cheaper than SHOP, they’re also much more profitable. When you compare Shopify to a universe of tech stocks with similar growth, it looks more expensive than it should be. Now, I’m not going to say that the giants listed above are exactly Shopify’s “peers”: for one thing, they are much larger companies. However, a company being small doesn’t mean it’s guaranteed to have enormous growth. Given the competition and other issues it faces, Shopify should not be expected to grow any more than the larger companies in the tech sector.

Where should Shopify trade at today?

The four companies I used as benchmarks suggest that Shopify should be cheaper than it is now. However, a few of them imply more downside than I think SHOP actually has. I wouldn’t use Microsoft or Adobe’s CFO multiples as guides; Shopify is in the process of laying off 10% of its workers, so the cash flow multiple should improve. I also wouldn’t use Amazon’s sales multiple because that company has notoriously thin margins. It’s the most similar to Shopify operationally, but its cost structure is very unusual, featuring enormous amounts of spending on fulfilment centers.

I think Alphabet’s sales multiple could tell us where Shopify should fall to. That company’s operations are very different from Shopify’s, but its gross margin is nearly identical. GOOG trades at 5.7 times sales. Shopify’s growth rate is slightly faster than Alphabet’s, so let’s say it should come down to 6 times sales. In that case, it has to fall to $23.88. At that price, we would be able to say that Shopify had lost all traces of its 2021 bubble valuation and was basically being priced like a normal company.

Risks and Challenges

As we’ve seen, Shopify is valued more richly than other tech stocks with similar growth rates. Based on those companies’ valuations, SHOP needs to come down to something like $20 to $25. That’s significant downside, but I’m rating SHOP a ‘hold’ rather than a sell, mainly because there are reasons to think Shopify’s trajectory could improve.

Growth acceleration is a major risk to those who choose to short Shopify. We are currently in the midst of an economic contraction; if the economy starts growing again (in real terms), then consumers will start spending more money online. If that happens, then Shopify’s growth could accelerate. Currently, Shopify’s growth is no better than that of mature tech giants, but it’s small enough that it could theoretically ramp up its growth. SHOP isn’t anywhere near reaching its total addressable market, so it could return to its previous growth rates in a future period of economic expansion. I don’t think SHOP is getting back to 86% growth anytime soon, but 25% seems doable in a stronger economy.

The risk to longs is that the current trajectory continues. In 2021, SHOP grew sales at 57%. In 2022 so far, it has grown at 18.5%. Growth is down by about two-thirds. If this pattern continues into 2023, we’ll be seeing 6.2% growth soon enough. At that growth rate, Shopify is not worth even $20. Unlike GOOG, SHOP does not have consistent profits. There are no positive cash flows that could be used to pay dividends; therefore, without growth, the company is not worth anything.

Does this mean that everybody who invests in SHOP will get burned? Hardly. The company’s free cash flow loss was only $-8.9 million last quarter; the recent layoff could be enough to make it profitable again. If the cost cutting pays off and growth remains at today’s rate, then Shopify is worth something. Personally, I’d be comfortable investing at about $20.

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