In the discussion below, we provide an overview of our thesis on Shopify and an update on the company’s most recent earnings. We continue to believe that our thesis remains in play and that Shopify will continue to take share in eCommerce, a massive, long-term secular trend. However, temporary trends such as tough comps and rising costs have introduced near term uncertainty that has momentarily pressured Shopify's valuation. If we decide to trim our position, expect us to reenter fully allocated by Q2.
Here are our recent write-ups on Shopify that outline our thesis in more detail:
Shopify Premium Analysis for 2021
Shopify Q3 Review and 2022 Outlook
Important to our thesis is Shopify’s ability to scale, now that the company has achieved product-market fit. There is no better stock to hold than those that are in this stage as risk is low compared to reward.
Here is what Beth said in the 2019 analysis:
“Shopify has made it clear they are in the product-market fit stage and will scale between 2021-2023, as referenced in a recent investor presentation. Product-market fit is an exploratory stage where profits are not prioritized. Once product-market fit is achieved, the growth trajectory can move very quickly […]
The reason to stay long on Shopify, is that industries get disrupted and e-commerce is overdue for disruption. Amazon’s pay structure is not fair to merchants at 26%. eBay is stagnant in revenue growth for nearly 10 years (fluctuating between $8B to $10B).
Shopify is already the third largest online retailer in the United States and is doing one thing very well that the others neglect: emphasizing the merchant (whereas Amazon’s focus is the customer). I believe this piece to the product-market fit will carry Shopify through the hurdles of taking market share from one of Wall Street’s favorite darlings (Amazon).”
Here is the chart Shopify’s management provided in 2019:
Sales have rapidly scaled since 2019. For instance, 2021 sales were up 192% relative to 2019 levels, nearly tripling in two years. This is above the 2Y growth rate in 2019, which increased 134% relative to 2017. The acceleration in the 2Y growth rate exemplifies Shopify’s product-market fit and its ability to scale.
While there is near-term uncertainty related to forward growth, rising costs, and supply chain issues, we believe that our long-term thesis remains in play: that Shopify will compete with Amazon in eCommerce.
As long-term investors in Shopify, we are prepared to weather the near-term volatility because we believe that the company will be a juggernaut in eCommerce, a $5.5 trillion global market in 2022, which is expected to grow to $7 trillion by 2025.
In the article below, I discuss the near-term uncertainty that may have spooked investors, and also revisit Shopify’s fundamental outlook. I also review the company’s financials and conclude with a discussion about the company’s valuation.
Near term uncertainty is only temporary
Shopify is heading into a quarter with the toughest comps in its history, and gave the market an opaque guide, creating uncertainty. Furthermore, expenses have been rising, and Shopify’s high-margin subscription business is expected to grow slower than its merchant solutions segment. This reduced EPS expectations, which has pressured the company’s valuation. Importantly, these trends are temporary, which we discuss in more detail below.
Shopify reported results that beat market expectations, as both Q4 sales and earnings beat estimates. However, the company once again provided a qualitative guide that did not quantify its top or bottom-line expectations. This is the second year in a row that Shopify provided only a qualitative guide, which has increased uncertainty around near-term growth. While investors likely understood Shopify’s rationale for the qualitative guide heading into 2021 given the unpredictable dynamics around COVID-19 and vaccine rates, the market’s sentiment towards this has changed and the company is being penalized for this uncertainty.
With Q2 2021 representing the toughest comps in Shopify’s history (Q1 2021 sales grew 110% YoY, a record high), investors may be concerned that near term growth will slow. Unfortunately, Shopify did little to ease these concerns with its opaque qualitative guide during the quarter. Specifically, Shopify disclosed that its 2022 outlook “anticipates revenue growth for the full year 2022 that is lower than the 57% revenue growth achieved in 2021, but still rapid and outpacing the growth of eCommerce”. The company added that growth will be lower in H1 but improve in Q4. This opaque, back-end weighted guide likely led institutions to step aside due to the uncertainty heading into tough comps.
Taking a step back from the opaque guide, the company is still forecasting growth, albeit below its 2021 (and 2020) growth rate. Furthermore, the company expects to outpace the overall growth in eCommerce, implying that the company still expects to capture market share.
EMarketer expects global eCommerce sales to grow 13% YoY in 2022, down from the 17% growth rate in 2021 but only slightly below the 14% growth rate in 2019. More importantly, U.S retail eCommerce growth is expected to ramp in 2022 to 13% YoY growth, up from the 6% YoY growth in 2021 and above the 11% growth rate in 2019. The U.S. retail eCommerce market is Shopify’s biggest market.
Considering Shopify grew sales 47% YoY in 2019, the company’s 2022 growth rate may come in around that level (albeit slightly slower) if eCommerce growth is similar and Shopify continues to capture a similar level of eCommerce volume share.
Ultimately, capturing market share remains the most bullish aspect of Shopify’s story and management’s comments that they expect to outpace eCommerce growth is important to our long-term thesis.
Looking forward, the Street anticipates Q1 sales to grow 26% YoY to $1.24 billion. This would represent the slowest pace of YoY growth in at least the last five years, and is well below the five-year quarterly average of 66%.
In FY2022, sales are expected to grow 31% YoY to $6 billion, as sales are expected to ramp in the back half of the year. Assuming that U.S. retail eCommerce sales rise 13% YoY to ~$950 billion (as expected) and that sales as a percentage of GMV (excluding POS sales) remain constant YoY, the Street expects Shopify’s market share of U.S. retail eCommerce volumes to increase 170 bps YoY to 12%. This is equal to the 170 bps YoY expansion in its market share in 2021 but below its 270 bps expansion in 2020.
We think that the forward estimates may be conservative, and note that there is upside in its ability to capture market share, driven by the expansion of its fulfillment centers, key partnerships and investments in its growth.
In order for Shopify to continue to scale and take on Amazon, the company has ramped its investments in its fulfillment centers, with the goal of providing two-day shipping to 90% of the US population. However, this expansion will front-load costs and management stated that they do not expect to recognize the benefits of scale until ~2024.
Furthermore, management explained on the Q4 call that they expect 100% of their gross profit in 2022 to be reinvested into growth initiatives over the next few years, signaling that OpEx and CapEx will equal gross profit, which will limit earnings growth. Shopify also stated that it expects to hire more engineers than in 2021, “despite an exceptionally competitive market for top talent”. The expectations for a rise in expenses in the near term, during an inflationary environment, may have spooked investors during the quarter.
Moreover, management left analysts in the dark when questioned about the ROI and payback of its Shopify Fulfillment network (SFN) investments. Specifically, CFO Amy Shapiro responded to an analyst question about SFN payback by stating that “we're not going to get into the details of how we view payback ROI [for SFN]. But what we can assure you is, we've always been strong allocators of capital to the right opportunities to grow the various parts of the business at the right time, and this is no different”. As stated above, the market does not like uncertainty and the lack of commentary about the cadence of ROI on its SFN investments may have led some investors to step aside from Shopify in the near term, pressuring its valuation.
Despite the lack of commentary on the SFN ROI, we remain confident in management’s ability to deliver value to its merchants (and shareholders). In order to effectively compete with Amazon, Shopify needs to improve the convenience of shopping in its network, which starts with two-day delivery and its fulfillment network.
Furthermore, management has been prudent with their fulfillment network investments. In 2019, Shopify first announced its SFN, and in 2020 COO Harley Finklestein explained that the focus for SFN will be product market fit and added that “we want to ensure that the foundation of the fulfillment network is strong and the merchants’ experience is outstanding before we enter sort of the scale phase” (Q3 2020 call).
In the most recent Q4 call, CFO Shapiro added that Shopify is now entering the scale phase for the fulfillment center. She explained that “we are moving into a new phase in 2022 for building simple and fast fulfillment for our merchants. Over the next 3 years through 2024, our planned investments expand the merchant value proposition even more, including increasing 1-day delivery coverage in the U.S. and increasingly enhanced returns functionality. And we are planning to be able to handle progressively larger merchants with a broader set of needs as we build through 2024. When we launched Shopify Fulfillment Network in mid-2019, we said that we expected to spend $1 billion over 5 years. Through 2021, about halfway through the original asset-light plan, we spent $117 million, which includes funding cash operating losses and a small amount of CapEx.”.
Looking forward, Shopify will ramp CapEx related to Shopify Fulfillment Network, with $1 billion in capex over 2023 and 2024 for self operated warehouses. While the rise in capex transitions Shopify from a mostly asset-light business model to a moderately more capital intensive one, the costs have been well telegraphed to the market since 2019.
Furthermore, the investments in SFN should help improve Shopify’s ability to capture market share, potentially providing upside to future growth estimates.
We suspect that Shopify has been punished by the market due to its opaque guide and expectations of rising costs in an inflationary environment. However, we note that Shopify is expected to continue to capture market share in a massive $5 trillion global eCommerce market, and has a long runway of growth ahead of it. We believe that these are just temporary issues and that Shopify has proven it has product market fit. Forward estimates appear conservative and there is upside to growth expectations, considering Shopify’s commitment to improving its merchant network.
Another potential driver of topline growth will be the global expansion of Shopify’s reach. Shopify has partnered with JD.com, which allows its merchants to reach Chinese shoppers. The partnership with JD.com opens up the opportunity to expand into the biggest e-commerce market in the world. China has a population of 1.4 billion and 52% of all retail sales in China in 2021 were transacted on eCommerce platforms.
Notably, we had stated in our 2021 analysis that partnerships like these are key for Shopify to take market share from Amazon when we cited international growth as a key strategy: “Globally, Shopify has a better chance of penetrating various regions as the merchants (and lack of walled garden) localizes the content and offerings. There is also stigmatism towards Big Tech globally and Shopify works quietly in the background while letting the merchants remain in the spotlight. This will be popular globally […] we see global as an important piece to our thesis as merchants who want to reach global audiences will likely choose Shopify over Amazon. We think this is an important competitive edge.”
According to Shopify President Harley Finkelstein, “China's eCommerce market is estimated to be worth $3.3 trillion by 2025. That is 5x larger than the U.S. market. This channel integration opens up the China market to our merchants who can now reach JD's 550 million active users … This integration removes barriers to one of the most important e-commerce markets and is a major step in solving cross-border commerce for our merchants”
According to the press release, Shopify merchants in the US will be able to begin selling in China in three to four weeks, well below the 12 months typically required for foreign brands to begin selling in China.
The JD.com partnership follows numerous other partnerships, such as Alipay, social media companies such as TikTok, Facebook and Spotify and CTV leader Roku. In this way, Shopify is using Amazon’s weakness against company, which is that it’s too large and too dominant to make an attractive partner. Amazon also competes with many of these platforms in various ways due to its broad reach, while Shopify has instead focused on partnering with other platforms and is intently focused on eCommerce.
These partnerships represent a value-add for merchants and prospective merchants, giving Shopify an advantage over competitors. At this point, an entrepreneur looking to sell products online is likely to choose Shopify for the reach the company offers, as well as the tools Shopify is frequently releasing (such as SFN, Shop Pay, etc).
We also believe this adds to the flood gates of distribution plus more strength on being omnichannel. We wrote about this here.
While there may be near term headwinds from an uncertain guide, rising costs from SFN and supply chain issues, we believe that Shopify’s product market fit in a massive market and its relatively low penetration rate position the company to outperform in the long run. In the next section, I discuss the company’s most recent results and its valuation.
Shopify’s Q4 results and valuation
In 2021, Shopify’s growth remained strong, driven by the 46% YoY growth in Gross Merchandise Volume (GMV). GMV is an indicator of the success of Shopify’s merchants and the overall strength of its platform, and Shopify’s sales are directionally correlated with growth in GMV. Shopify is also a platform with high margins, however margins were a bit thin in this earnings report as the company has ramped investments in the near term to sustain its growth. Importantly, we believe that these headwinds are only temporary and that Shopify’s margins will improve as the company continues to scale its platform. Furthermore, due to Shopify’s product strength, we believe that GMV growth will continue to be robust going forward. I discuss this below.
Shopify’s Q4 sales beat estimates by 3% and increased 41% YoY to $1.4 billion, after increasing 94% YoY in the year-ago quarter. Q4 Sales were driven by merchant sales, which increased 47% YoY to $1 billion. Q4 GMV increased 31% YoY to $54 billion and was $175 billion for the year, up 47% YoY from $120 billion in 2020. As mentioned above, Shopify has captured about 10% of U.S. eCommerce retail sale volumes and has leverage to continue to capture more share as it scales.
Subscription sales increased 26% YoY to $351 million during the quarter, which was the slowest rate of growth in the last five-years. The deacceleration in subscription sales was driven in part by a change in accounting treatment as app and theme sales recognition were changed from being recognized on a gross basis to a net basis, which lowered Q4 subscription sales by ~2%. Subscription sales were also impacted by a tough comparable base period, as subscription sales accelerated to 53% YoY growth in Q4 2020. Monthly recurring revenue grew 23% YoY to $102 million, representing a CAGR of 41% since Q4 2016 and highlighting the long-term strength in Shopify’s subscription sales.
Gross margin declined 140 bps YoY to 50%, which was below the five-year average of 55% and was driven by the outsized growth in merchant solutions, which is lower margin. On a segment basis, subscription gross margin declined 32 bps YoY to 78% and Merchant solution gross margin fell 16 bps YoY to 41%.
Operating margin was 1%, marking the 7th consecutive quarter of positive operating profits while adjusted operating income was $130 million in Q4, down from the $200 million in the year-ago quarter. Management explained during the Q4 call that the decline in profitability was driven by an acceleration in investments and hiring trends. Non-GAAP EPS was $1.36, down YoY from $1.58 but bested estimates by 4%.
The balance sheet remains in good shape with over $8 billion in cash and $1 billion in long-term debt as of December 2021. Merchant advances increased from $244 million in Q4 2020 to $471 million in Q4 2021. These advances help merchants scale, but also introduce risks of impairment.
While there are risks with these advancements, impairments have been low to date and Shopify has advanced over $3 billion since 2016. This program illustrates Shopify’s commitments to merchants, helping them scale and compete with larger brands. Shopify also introduced an ERP program in 2021 to help high-volume merchants further scale their operations. Shopify’s focus on the merchant is different than Amazon’s approach of being focused on the customer. We believe that this differentiated focus helps Shopify compete with Amazon and allows the company to expand globally while operating largely in the background.
As mentioned above, management provided an opaque guide and stated that sales will continue to grow rapidly in 2022, but will be below the 57% YoY growth rate in 2021. Merchant Solutions revenue is expected to grow twice as fast as Subscription sales driven by a higher attach rate as merchants use more of Shopify’s solutions, such as SFN and new features such as Shopify Markets. Management also explained that a change in its revenue share agreement on the first $1 million in app and theme sales will be a headwind to H1 subscription sales.
For the year, FY2022 sales are expected to rise 31% YoY to $6 billion, which we estimate implies a 170 bps expansion in its U.S. eCommerce retail market share. However, there is upside to estimates with the company’s buildout of SFN, its global partnerships and investments in growth initiatives which should help the company continue to capture more market share.
Shopify currently trades at a 17x P/S ratio, which is 32% below its five-year median of 25x and 59% below its three-year median of 42x. Looking forward, Shopify trades 14x 2022 sales, which appears cheap for a company that has averaged 66% topline growth for 20 quarters and has 50%+ gross margins. Relative to other cloud platforms, Shopify appears to trade in-line with peers. For example, HubSpot and Shopify both trade at a 14x forward P/S multiple and grew sales 40%+ YoY, while Adobe trades at a 12x forward P/S multiple but is growing at half the rate as Shopify.
Notably, Shopify is a cloud platform with high margins, so the company has been awarded a premium multiple by the market. We believe that Shopify has clearly demonstrated its product-market fit, and is best positioned to compete with Amazon in the long run, which warrants a premium valuation in our opinion.
Moreover, Shopify’s total market cap is $85 billion, and it operates in a massive $5 trillion eCommerce market. Shopify has captured just 10% of the U.S retail eCommerce market, with plans to continue to expand globally, highlighting the long runway in front of the company.
Moreover, management’s decision to reinvest all of its gross profit back into the business over the next few years is a sign that the company also believes that there is a large opportunity in front of it. As Shopify continues to scale, it has numerous levers to pull to ramp sales and earnings growth in the future. While there may be near term uncertainty embedded in Shopify’s valuation, we expect the company to continue to outperform in the long-run and capture market share. As a result, expect us to remain allocated in Shopify through the volatility.