Shopify (SHOP 3.62%) stock took a dive after its latest earnings report. Shares closed down 7% as investors became worried about future growth and a potential stock offering of up to $5 billion. This pullback gave bears an opportunity to gloat:
$SHOP Q2 earnings again show that there is no operating leverage in the model. Every single cost line (Sales&Marketing, R&D, G&A) growing faster than its Gross Margin. When will investors start to care?— Jan Barta (@absurdtrader) July 31, 2018
$SHOP-Oh, look, how shocking.... another mixed shelf (and forthcoming offering). They have 1B of assets and (almost) no debt. Complete scumbags. Canadian companies shouldn't be allowed to be listed on US exchanges. https://t.co/IkWX9XgAuZ
— Jin SEO (@JTSEO9) July 31, 2018
However, Shopify's numbers topped estimates: Revenue jumped 62% to $245 million, well ahead of expectations at $234.6 million, while the company posted an adjusted profit per share of $0.02 on the bottom line, up from a penny per-share profit a year ago and better than estimates of a -$0.03 per-share loss.
Still, the company only modestly raised full-year revenue guidance, which may have prompted the sell-off, especially as the stock carries a sky-high valuation and had gained as much as 70% year-to-date before the recent sell-off. In fact, that price tag is a big reason for the bearish sentiment: Shopify currently trades at a price-to-sales ratio of 19, with essentially no profits. Let's take a look at that argument, and the other popular bear angles.
1. The valuation question
Indeed, Shopify stock carries a high price tag, but its growth record explains why. The company has grown 62% or more every quarter in its publicly traded history, and is projecting 51% revenue growth this year. The company has historically provided conservative guidance, so it's likely that it will even beat that forecast, especially as revenue has grown 65% through the first half of the year.
But the company's future opportunity may be the best argument for its high valuation. As the leading cloud-based, multi-channel platform for online merchants, Shopify sits at the intersection of two of the biggest growth markets in business -- cloud computing and e-commerce.
According to its prospectus, the company sees a global market of 46 million online businesses, nearly 100 times what it serves today. Products like Shopify Plus also show the power and scalability of Shopify's software, as merchants can upgrade to the more expensive Plus as they get bigger. And in fact, that's just what they've been doing: Shopify Plus contributed $8.1 million in monthly recurring revenue, or 23% of MRR, compared to 18% a year ago. Converting current subscribers to Shopify Plus may be the best and most efficient way for Shopify to grow, as it shows it's delivering results for its merchants. Monthly recurring revenue is also high-margin revenue, as it comes from subscribers the company has already acquired.
Alongside valuation, profitability is another concern that bears bring up regularly. Indeed, Shopify has never reported a GAAP profit, and for the full year expects an adjusted operating profit of just 0 to $5 million. Though that may seem like a deficiency in the company's model, it's likely because management is prioritizing growth over profits: The company spends more than a third of its revenue on sales and marketing, as well as a significant portion on research and development, a strategy that seems designed to grab as much market share as possible while the industry is rapidly expanding.
As the company matures, I'd expect it to focus more on profitability. As for the model itself, there seems little reason to worry about its profit potential. Cloud businesses like Amazon's often make bumper profits, and the subscription model also tends to work well once a large subscriber base has been accumulated. And Shopify already has more than 600,000 subscribers.
3. Are the merchant numbers really inflated?
In a screed published last October, Citron Research claimed that Shopify's merchant numbers were inflated. Citron's Andrew Left argued that Shopify only had about 2,500 Plus subscribers and 20,000 Advanced ones, and said the majority of the company's merchants had essentially been conned into joining the service with get-rich-quick ads. He likened the service to multi-level marketing companies like Herbalife that have come under scrutiny by the Federal Trade Commission, and insisted that many of Shopify's advertising practices, like attracting merchants with dreams of becoming millionaires and encouraging them to quit their jobs, were illegal.
There may be some truth to what Left is arguing; Shopify does not disclose churn, so we don't how many merchants leave the platform every year. But his underlying suggestion that the company is fradulent seems ridiculous. It's clear that Shopify provides a valuable service to thousands of large and small businesses, including global companies like Nestle, Red Bull, and Unilever.
Also, those skeptical that a company like Shopify would be able to find 600,000 merchants should be aware that there are 27.9 million small businesses in the U.S. alone according to the Small Business Administration. Not all of them sell on the internet, of course, but many do, especially with the growing popularity of online shopping.
The stock is up about 50% since Left first made his short pitch, and Shopify's growth remains strong, as well as its conversion of customers to Plus. It seems like the market has rejected his argument for the time being.
Shopify stock has lost 20% over the last few days, causing some doubts about its future, but such volatility is normal for a high-priced growth stock. Meanwhile, the company remains on track with strong growth and a promising long-term opportunity. Profitability should eventually come as the market matures, and Left's concerns seem exaggerated.
The stock still looks like a winner.