Shopify Has Gotten Ridiculous
I sent out this tweet Friday morning: “$SHOP now with an EV/sales of 36, meaning like 5 years of 50% growth is already priced in. Why would anyone hold shares here?”
$SHOP now with an EV/sales of 36, meaning like 5 years of 50% growth is already priced in. Why would anyone hold shares here? https://t.co/QRFEV8BGfP — Brett Schafer (@CCM_Brett) April 17, 2020
I expected some interesting responses, both bullish and bearish, to this question. What I did not expect was an onslaught of bulls fervently defending Shopify at a sales ratio above 40 (where it finished trading on Friday, April 17th). Here are some of the reasons they put:
Multi-decade time horizon
Let your winners run
Sure…I guess all those points are true? Shopify the business will benefit from most of these things (multi-decade and ‘let your winners run’ I don’t subscribe to). But what does that have to do with Shopify the stock? From my point of view, the only reason to own a stock is if you believe it has a strong chance of outperforming the market over the next five years. Nothing else matters when evaluating a company.
Shopify is not set-up to do that. For the rest of this post, I’m going to go in-depth on why, even though Shopify is a great business, it will underperform the market over the next five years.
The Addressable Market Isn’t Infinite
U.S. e-commerce was estimated to be $602 billion in 2019. This is a gigantic and growing market, mainly dominated by Amazon. But Shopify is nipping at its heels.
Check-out this chart from Shopify’s recent investor presentation. It’s hard to see in the photo, but the company now makes up 5.9% of U.S. retail eCommerce, compared to Amazon’s 37.3%. This gap should close over time.
The problem is, Shopify doesn’t bring in revenue on e-commerce sales. Merchants pay them a take rate on the sales they bring in, which drastically reduces Shopify’s overall revenue potential. In 2019, the company’s take rate was 2.58% (calculated by taking revenue divided by GMV).
If in a few years U.S. e-commerce sales reach $1 trillion, Shopify captures 15% of the market, and their take rate is 3% (three really, really optimistic scenarios), revenue in their largest market will be $4.5 billion. Shopify’s market cap is $66.7 billion.
There’s a lot of talk about Shopify getting a boost from stay-at-home orders and the pandemic. CNBC, Bloomberg, and Fox Business have started a narrative that e-commerce is going to crush it this year, giving Shopify a lot of sentiment momentum.
E-commerce is definitely getting a boost in 2020. But we are in a recession, with 15% of the United States unemployed. This is not a recipe for the consumer economy exploding in growth. In fact, it probably means a giant contraction.
Amazon will likely do well, as will Wal-Mart and Target, because they are the main seller of consumer essentials. Shopify, on the other hand, is the leader in consumer discretionary items. Don’t believe me? Take a look at this list of the 37 biggest brands on Shopify. You buy toilet paper on Amazon. Shopify powers makeup, toys, and sunglasses.
Shopify also powers a ton of omnichannel “craft” and “knick-knack” stores. What if 30% of these side-hustles and small-businesses go bankrupt? What multiple will the stock get if they lose 15% of their current revenue this year? I don’t think it would be 40-times sales.
Valuation, Valuation, Valuation
The most absurd part of Shopify is valuation. Like I mentioned above, it has an EV/sales of 40.8. Facebook, Google, Adobe, Microsoft (except at maybe the height of the dotcom bubble), Netflix, Mastercard, and Visa have never traded at a sales ratio above 21. These are some of the most profitable companies, with some of the largest addressable markets, of all time! And you’re telling me Shopify should be valued twice that?
Valuation matters. I don’t care if you have a multi-decade time horizon, or if a company has “optionality.” The price a company is trading at matters and always will.
Margins and Slowing Growth
Maybe, just maybe, you could convince me a stock with an EV/sales of 40 was fairly priced if it was growing sales 100% or more and had 80% gross margins, like Zoom Video. But Shopify has neither of those things.
In fact, Shopify’s revenue growth is slowing with declining gross margins (a proxy for long-term potential net/cash flow margins).
Here is a chart of their revenue/revenue growth going back to 2015:
This is impressive, no doubt. Going from $200 million to over $1.5 billion in annual sales shows Shopify is a dynamite company. But look at that sales growth number. It has gone from 90% in 2016 all the way down to 47% in 2019. Original guidance for 2020 (which has now been taken down) called for further deceleration.
Gross margins should head in the same direction. Merchant Solutions, Shopify’s fastest segment with the largest market opportunity, has lower gross margins than its traditional subscription offerings. GM should head down to 50% over the next five years, which decreases the company’s net margin/CF margin potential.
Let’s do a quick, optimistic scenario for Shopify. Say, over the next five years, sales grow on average by 40% annually, GM goes to 50%, and cash flow margins go up to 20%. 2025 sales would be $8.49 billion, with $1.7 billion in cash flow (assume operating, because I doubt they could get 20% FCF margins with all the investments they are making). Based on today’s enterprise value, Shopify would be valued at 38 times its 2025 cash flow numbers.
And that just doesn’t make sense to me.