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Why You're Smart to Buy Shopify Inc. (US) -- Despite Citron's Report

By Brian Stoffel - Updated Oct 9, 2017 at 4:12PM

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Andrew Left is right about these things. Here's why they shouldn't matter to shareholders.

If you're a shareholder of Shopify (SHOP -10.57%), you're no doubt familiar with the story line right now. Infamous short-seller Andrew Left and his Citron Research released a scathing report on the company, sending shares down by as much as 20%.

Left's thesis is that the company employs a group of affiliates to sign people up with Shopify's e-commerce solutions. He documented how some of these affiliates have used questionable tactics in signing people up, including promises of being a millionaire.

Cartoon of individuals shaking hands at a table while passing money under the table

A version of what Andrew Left is alleging. Image source: Getty Images.

While my review of Left's claims show that he certainly has a point -- nefarious players have found and exploited a weakness in Shopify's affiliates program -- it shouldn't have a material impact on revenue growth at the company, and could actually strengthen the organization over the long run.

Reality check: Most small businesses go bust

But first, it's important to remember Shopify's mission -- "to make commerce better for everyone," especially small and medium-sized businesses. And as fellow Fool Keith Speights has pointed out, half of all small businesses will fail within five years, and two-thirds will be gone within a decade.

Many of the vendors that sign up with Shopify will fail over time. That's not the company's fault -- it's simply a characteristic of a healthy and functioning economy. For people who want to try their hand at the e-commerce game, there's little risk involved with signing up for Shopify's cheapest plan -- Shopify Lite, at $9 per month -- and seeing how it goes.

Most will fail. And that's OK.

Still, Shopify should be smarter

That's why it's disingenuous for Left to talk about traditional churn rates. Shopify has already demonstrated it has very high switching costs.

Still, Left pointed out a weakness in Shopify's recruitment efforts. The company will pay affiliates -- currently 13,000 strong -- up to $2,000 per referral. Knowing this, Left found some pretty blatant examples of affiliates publishing videos and sites making it sound easy to become a "Shopify millionaire."

A sign saying "Closing Down Sale"

Image source: Getty Images.

But one affiliate I talked to said it isn't that simple. While Left highlighted a $2,000 payout for referrals, that's only if the merchant signing up for Shopify goes on to be a very solid seller. Most referrals result in more modest payouts for affiliates.

Obviously, these less savory players are going straight for volume: If they can get thousands to sign up with Shopify, they can still make a bundle, even if referral fees are small, and the amount of money this generates for Shopify is negligible.

Why this shouldn't matter

Left spent a lot of time harping on the company's 500,000 merchants. There's no way, he said, that all will be around or contributing over the years.

He's right. And if you are investing in the company purely because of their merchant account growth, then perhaps it's time to reconsider your thesis. But for me and many other long-term investors, it really shouldn't matter. Here's why.

There are five tiers of Shopify annual subscriptions:

  • Shopify Lite: $108
  • Basic Shopify: $348
  • Shopify: $948
  • Advanced Shopify: $3,588
  • Shopify Plus: Starting at $24,000

Let's put this in perspective: Over the last twelve months, subscription services have brought in $241 million (47% of sales) and accounted for three-quarters of gross profit. According to the company, there are over 2,500 Shopify Plus accounts -- a figure that has grown by over 126% in the past year alone.

Over the next year, these accounts will contribute a minimum of $60 million to sales -- though that number could easily be as high as $100 million, given that the rates above are simply a starting place, and the roster of Shopify Plus accounts continues to grow.

Left also told us to assume that there were 20,000 Shopify Advanced customers signed on, though it's impossible to tell where he got that number from, or whether it's accurate. That being said, such a roster would contribute an additional $72 million in subscription sales.

Again, to put this in perspective: Shopify's 22,500 largest merchants -- less than 5% of all merchants -- will be contributing near half of all sales. The other 95% could be contributing the other half. In other words, even if affiliates are signing on merchants who have no business starting, the long-term effects for shareholders don't seem too extreme.

Those companies will fail. Again, that's OK. If you think that there won't be a slew of new entrepreneurs with new ideas to fill the slots, then you've missed most of the history of modern capitalism.

Steps I'd like to see, as a shareholder

Shopify already addressed some of these concerns with a posting on its website, saying, "We vigorously defend our business model and stand resolutely behind our mission and the success of our merchants." It also crucially pointed out that real things are being sold, saying that "stores using Shopify generated $10.7 billion in gross merchandise volume in the first half of 2017."

Beyond that, there are two more steps I'd like to see management take:

  1. A requirement for affiliates to state that they are compensated by Shopify for bringing them business, and a system in place to weed out the questionable players.
  2. A revenue retention metric. Note that this doesn't mean a standard "churn" rate; I'm really not concerned with the little players who dabble in e-commerce, then move along. Instead, I'm interested in how much the base of current merchants paid in subscriptions from one year to the next.

And so you know that these aren't empty words: Right now, Shopify makes up 3.7% of my real-life holdings. I'll be putting my money where my mouth is, and rounding it out to 4% of my holdings, once trading rules allow.

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