the-real-power-of-shopify-ditches-the-churn-argument

The Real Power Of Shopify Ditches The Churn Argument

Introduction

On April 30, 2019, Shopify (SHOP) announced its Q1 2019 earnings pre-market.

Shopify Shopify results Q1 2019 FY 2019 earnings

(Image Source)

The company is a serial over-deliverer, with positive earnings surprises in every quarter. You can see this on the chart provided by Zacks: every single arrow is green, indicating beats.

Shopify beats earnings Zacks

And yes, a new green arrow could be added to the graph: the company did it again, beating the expectations on all metrics. The non-GAAP EPS came in at $0.09, beating estimates by a whopping $0.14. Revenue in Q1 2019 was $320.48 million, up 49.5% YoY, also beating estimates, by $10.37 million.

The stock price shot up after the earnings:

ChartData by YCharts

And yes, there were many discussions again about the valuation of Shopify. These two comments on the article of my fellow Contributor Crispus Nyaga sum the two sides up:

In May 2017, I added Shopify as the first stock to my Potential Multibaggers - a series that still runs - and for a first pick, it couldn't have done better, since it has gone from a Potential Multibagger to a real multibagger in just two years:

ChartData by YCharts

I remember that Shopify was called a bubble stock too back then. And that is still the case.

In this article, I will give a closer look at the earnings and why the stock appears more expensive than it is. I also explain why the most-cited bear argument, churn really doesn't matter. The key? To make my own variation on that famous quote: it's the ecosystem, stupid! That is the real power of Shopify. But before we go into that, we start with a quick take on the Q1 2019 earnings.

Q1 2019 earnings: Great again

Shopify has had a huge run-up year to date:

ChartData by YCharts

The company announced its Q1 2019 earnings before the market opened on April 30, 2019. And again, as I have become accustomed to from Shopify, the results were great, blowing expectations out of the water. Revenue grew by 49.5% YoY to $320.48 million, a beat by $10.37 million. This was a great result, since bears had been pounding on the table for continuing slowdown of revenue growth.

The operating loss was just $1.4 million, versus the expected $13 million the company guided for at the low end. Non-GAAP earnings of $0.09 beat by a whopping $0.14 (the analysts' consensus was a loss of $0.05) and were up 125% YoY.

Shopify was able to grow both of its businesses: the subscription revenue and merchant solutions. The subscription revenue is what merchants pay to be able to use Shopify's platform in the form of a monthly fee, starting at $29 per month for a basic plan. Those subscriptions' revenue was up 40% YoY. The MRR (monthly recurring revenue) is up 36%. This is a very important business because the margins are extremely high. But the merchant business grew a lot more, and it is the future of Shopify. More about that later.

The real power of Shopify: The ecosystem

I see a lot of head-scratching when it comes to Shopify. A lot of investors don't seem to understand the story. Shopify is not just a platform. It has transformed into a whole ecosystem.

There are literally thousands of apps that can help you build out your Shopify store. 200 were added in Q1 2019 alone. Those apps really lift the Shopify experience. About a quarter of them are free, the rest are paying. They fall into several categories, of which the most popular are store design, sales and conversion, marketing, orders and shipping and customer support:

(Source: Indie Hackers, November 5, 2018)

On each sale of an app, Shopify takes a 20% or 30% cut (depending on the location). And the average prices are higher than you probably think:

(Source: Indie Hackers, November 5, 2018)

On the Q1 2019 earnings call, Harley Finkelstein, Shopify's COO, explained how fast this app store is developing:

It took us nine years to pay out the first $100 million to app developers and just 12 more months to double that number to $200 million paid out.

And that is just one part of merchant solutions. The whole system is growing like a weed. This is what Amy Shapiro, Shopify's CFO, had to say on the call about merchant solutions:

Merchant solutions revenue grew 58% over the same period in 2018 to $180 million. This growth was driven by GMV expansion which increased 50% year-over-year to $11.9 billion benefiting from our ongoing investments in international growth and Plus. Continued penetration of Shopify Payments, Shipping and Capital also contributed to merchant solutions revenue growth.

But she started with this statement:

Our stellar first quarter results reflect the diversity and strength of our growth drivers and the solid execution of our strategy.

And indeed, Shopify is diversifying away from a platform to a whole ecosystem in which a merchant has all the solutions he or she can dream of. If you are not convinced that there is a huge opportunity in this area, just look at the growth rates. Again, Amy Shapiro on the Q1 2019 earnings call:

$4.9 billion of GMV was processed on Shopify Payments in Q1, an increase of 65% versus the comparable quarter last year.

Shopify's COO, Harley Finkelstein, added:

On a personal note, it took me less than 20 seconds to buy my latest pair of Allbirds using Shopify Pay from initial landing on their store to receiving a confirmation of a completed checkout. It is by far the best and fastest checkout I've ever experienced.

Shopify Shipping could offer lower prices in Q1, which boosted its use, of course, and Shopify Capital reached a milestone: $500 million in accumulative loans have been granted to merchants now. Shopify Capital is a new system, and I think it is very promising. Unlike for a traditional banking loan, for Shopify Capital you don't have to pay monthly installments. You pay a percentage of your store’s future daily sales until you have paid off the total amount that you have received from Shopify. Your risk level is calculated to grant the loan.

All of these merchant solutions have huge growth left. They all contribute to the ecosystem that the company is building. Too many investors still think that Shopify is only about subscription, and that is the reason it keeps talking about churn. I think that discussion is outdated by the constant innovations that Shopify keeps adding to the ecosystem.

And the pace of innovation isn't slowing down. Besides the software, the Shopify Shipping, Shopify Payments, Shopify Studios and Shopify Capital, the Canadian company also added point-of-sale hardware to better support its merchants.

(Shopify's Tap & Chip reader)

Shopify has seen what Amazon (AMZN) has seen too. The future of retail is not purely online e-commerce, it is multichannel. That is one of the reasons that Amazon has bought Whole Foods.

Since traditional retail is not going anywhere soon, but is rather becoming a sort of central hub for the multi-platform selling strategy, the company introduced the Shopify Tap & Chip Reader at the end of 2018. The Shopify reader accepts contactless "tap" payments (for example, Apple Pay or Google Pay) and chip credit cards.

While that may be the most visible new feature for customers, for merchants there have been introduced a wide range of new features over the last years: new multi-location inventory features (Shopify Locations), Shopify Returns and Exchanges (which deals with cheap returns and exchanges of products bought at a Shopify POS), Store Switcher (to handle multiple stores easier), Shopify Flow (an integration tool to connect apps and automate repetitive tasks), Fraud Protect, a tipping feature, new marketing capabilities, a retargeting tool, iPad stands etc. Shopify keeps rolling out new solutions for merchants at an unseen pace.

All of these solutions tie the merchants to Shopify's ecosystem, and they strengthen one another. And exactly that is the power that the company has. I think that in the future there will only be three big platforms for independent sellers, apart from niches such as Etsy's (ETSY). The other two will be Adobe's Magento (ADBE) and Square (SQ), which is building out its merchant solutions at a very high pace too, apart from Shopify. Of those three, I would argue that Shopify clearly has the lead in terms of the ecosystem at this moment. You also see that Square and Shopify start to come closer to each other: Shopify with its reader, Square with its acquisition of Weebly. I am a proud shareholder of both, since I think the market opportunity is more than big enough to make both very big. Square has been a recent pick in the Potential Multibaggers series too.

There is no doubt that Shopify is on a winning streak in the scaling game. Once a customer is into the Shopify environment, the upscaling cycle can take place, although you don't want to do that too bluntly. You have to look at Customer Lifetime Value, or CLV. Once somebody deserves money with Shopify, he or she will be open to upgrade to a more expensive product and earn even more or have more services. And that is the reason why the whole discussion about "churn" (the number of clients that leave because they have an unsuccessful shop) is futile.

The churn fixation

The high growth of all of Shopify's metrics burns bears and their "churn" refrain. To make it clear: Shopify doesn't make churn figures publicly, but there is a lot of chitchat about churn. A lot of Shopify bears claim that the number of merchants that give up prematurely is a huge problem for Shopify. I don't think it is a problem at all.

Suppose you have 10 merchants and you can only keep 5, but those 5 do not only stay very loyal clients but buy upscale after upscale and they make more and more money, of which you can take a share, can you explain the problem exactly? The ones that fall out of the boat are the ones you don't want, since they are not monetizable. It is as if the weeding of the garden is done automatically. Who wouldn't want that?

Oh, and just for the record, I think the churn is actually a lot less than 5 out of 10. I think 2 or 3 out of 10 will be closer to the real number. But my point is: it's not the number of customers that counts, it's the money that they bring in. Just look at the names that were added to Shopify Plus in the first quarter of this year alone:

Shopify Plus brands that launched this quarter included fashion labels such as; Betsey Johnson, Levi's and Hudson Jeans; celebrity brands like, Reese Witherspoon's, Draper James brand; the toy company Hasbro; publishing house, HarperCollins; personal transportation company, Segway; and even more brand-specific shops from consumer packaged-goods companies like Johnson & Johnson and Procter & Gamble.



- COO Harley Finkelstein on the Q1 2019 earnings call

I think it is time for bears to ditch the churn argument. It has been proven wrong again and again. The discussion between bears and bull often turns around Shopify's churn, but I think this is a really sterile discussion. It is the money that is brought in by those who don't leave that counts, not the academic discussion about churn. Churn numbers are very important for businesses that don't offer extra products to existing clients. Clearly, that is not Shopify.

The important role of management

What is often overlooked by investors is that management is a force that is extremely important in any company. And I think that it is not stressed enough in analysis of stocks. A visionary CEO, like Mark Zuckerberg, Steve Jobs, Jeff Bezos, Howard Schultz and many others, is an element that you cannot put into numbers but that is so important in investing.

Shopify has got a great management team. There is, of course, the visionary leader Tobi Lütke, who founded Shopify because he was not satisfied with the existing solutions. He wanted to sell his snowboards online and developed a solution which he thought was better than the existing ones. And Lütke is a great leader, both hyper-focused and laidback at the same time. You should hear him talking about gathering money from venture capitalists riding his bike from one posh VC office to the next on The Tim Ferriss Show.

Tim Ferriss Shopify Tobi Lutke CEO

(Source)

In the podcast, you get to hear Lütke when he is at ease. After all, he is still the nerdy programmer who is rather shy and was more or less forced to become the CEO of his own company. But he has known Ferriss for quite a few years, and here he is less shy because of that. Recommendable!

For most companies, a visionary CEO is enough to have great success. But often, there is a second person. Steve Jobs had Steve Wozniak and later Tim Cooke, Mark Zuckerberg has Sheryl Sandberg, Warren Buffett has Charlie Munger. In Shopify, Lütke has his COO, Harley Finkelstein.

(Shopify COO Harley Finkelstein, Source)

He is an entrepreneur and lawyer. He's Canadian, and at 17 founded his first company - a T-shirt company - while he was at university. But he himself talks about DJing as his first streak of entrepreneurship.

First he got a degree in economics, and then went on to study for his MBA and Juris Doctor. He had worked for a law firm for one year when he met Tobi Lütke in 2009, and soon joined Shopify as its Chief Platform Officer. Since January 2016, he has been the COO of Shopify. He is also on the Board of Directors of the Canadian television channel CBC, after he was one of the Dragons in Dragon's Den, the Canadian version of Shark Tank.

Unlike Tobi Lütke, who is shy of nature, Finkelstein is a more outgoing speaker. If you want to see him in action, I would advise you to take a look at this interview.

I think Finkelstein a great complimentary force for Lütke. Their personalities differ enough to have a broader perspective and to get Shopify where it wants to be. It is no coincidence that Finkelstein, and not Lütke, does most of the conference calls. Only if there is a technical question or something about the future of Shopify, Lütke joins in.

In April 2018, Amy Shapero became Shopify's Chief Financial Officer. Before Shopify, she already had ample experience as CFO in several other companies. I really like women in top management functions, and particularly as CFOs. In general, women are a little bit less risk-prone than men, a bit more cautious, and I think that is mostly a very good thing, especially when finances are in the picture.

The most important thing is that management has instilled a clear purpose instilled in the company. The mission was spoken out by CFO Amy Shapero on the Q1 2019 earnings call:

Inspiring entrepreneurship, removing barriers to commerce and helping merchants thrive in a competitive environment are core to our merchant first philosophy

Purpose-driven companies always outperform, in my experience.

Is Shopify overvalued?

A lot of investors seem to have difficulties with the company's valuation. I have argued before (when the price was $141) that it was not overvalued. If you look at the classic ratios, you cannot justify Shopify's stock price, of course. $261.51 (at the moment of writing, before the markets open on, Thursday, May 9): a negative P/E, a forward P/E of 310 and a P/S of 26.5. Now, I won't argue that the company is not fully valued now, unlike just half a year ago.

But let's look at it from another point of view, from the perspective that Shopify has become a mature company. This may take a decade, and maybe more, since the company plows back all the money it earns back into the business to continue the ultra-high growth. But I always invest for the very long term, so I don't mind.

At this moment, Shopify projects revenue of around $1.5 billion for this fiscal year. Mostly Shopify beats expectations, but let's just take that $1.5 billion. There are 108.99 million shares outstanding. That is a revenue of $13.76 per share.

The gross profit margins are around 55%. Once the company becomes mature, net profit margins will rise too. Bigger SaaS companies like Adobe and Intuit (INTU) have net profit margins of 20-30%. Suppose Shopify would have a net profit margin of 25% now. 25% of $13.76 equals EPS of $3.44. That would give Shopify a virtual P/E ratio of 74. High, but don't forget that the company is expected to grow at 40-45% next year too. When I wrote my Shopify valuation guide, that kind of "virtual P/E" was around 40. That was a "virtual PEG" of just 1. Now it is closer to 2, which means more growth has been priced into the stock. A bit expensive, but not as crazily overvalued as some investors believe. And yes, I know, there are a lot of assumptions here (whether Shopify will get to a 25% net margin, for example), but it makes more sense than judging such an ultra-growth stock by its (forward) P/E ratio.

Put it in another light: e-commerce. The TAM (total addressable market) is expected to be $4,878 billion in 2021.

(Source: Statista)

I believe that more and more of what is now FBA (Fulfillment by Amazon) will go to Shopify (and other independent platforms). Amazon (AMZN) uses the data of its users to compete against them and sell products itself if they do well.

Suppose you create a new product - something that is not earth-moving, but new nonetheless. Let's say a new design for baby potties. The process of creating this is often quite expensive, complicated and time-consuming. You have to find a manufacturer, make dummies, organize the production line, pay for marketing, travel, etc.

After the whole process, you start selling on Amazon (FBA). And yes, your product sells like hotcakes. Amazon sees that, and before you can say FBA, the company starts selling its own product - not similar enough to your product to sue the company, but similar enough for people to buy it. And it undercuts your price by 25% or so. If it is not Amazon itself, it will be someone else. And what do people do when they come to Amazon? They select to display the items from cheapest to more expensive. Your precious product? Forget your margins.

Now, don't get me wrong. I am not an Amazon hater. To the contrary. Just as so many people, I enjoy its services and am Prime member, I have had a subscription for Audible for quite a while now (and am enjoying it!) and I am a stockholder of that great company. But from the point of view of an entrepreneur, I know which platform to choose. I think there is still an enormous margin of growth for Shopify.

Internationally, the company is really only starting and has a lot of ground it can still cover. Six new languages were added in Q1 2019, including simplified Chinese and Dutch. CFO Amy Shapero said that Shopify is still in learning mode for international locations, having only started a year ago. But already more than 100,000 merchants use the platform in another language, including Chinese brands to sell internationally. To put that into perspective: that is on a total of 800,000. As a funny aside: Tobi Lütke now uses Shopify in German, sending notes to the team every now and then if some translation is not 100% natural native German. That is involvement!

Conclusion

Shopify has delivered another whopping quarter and keeps adding more and more brands and merchants, both big and small. Shopify Plus keeps expanding. But the most important element of Shopify is the sum of its parts. The ecosystem that the company is building out more and more is unmatched, and it is the real power of Shopify. While it is fully valued after the recent run-up, I don't think it is as crazily valued as some seem to think. You just have to look at the situation of every company in detail and not apply metrics blindly for all stocks. For long-term investors, Shopify remains one of the best holdings to set and forget.

If you have enjoyed this article and would like to read more articles from a long-term perspective and updates about Shopify, please hit the "Follow" button next to my name.

In the meantime, keep growing!

Disclosure: I am/we are long SHOP, SQ, AMZN. 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.