Forget the Rest of the E-Commerce Upstarts: Shopify Stock Is Still the Top Dog

Don't let the lower-margin merchant solutions segment fool you!

Brian Stoffel
Brian Stoffel
Feb 16, 2019 at 8:47PM
Technology and Telecom

When it comes to e-commerce, Amazon.com is clearly the king of the mountain. This article isn't seeking to dispute that -- indeed, Amazon accounts for nearly 20% of my family's real-life investments. But beyond Amazon, when we look at the sea of companies looking to capitalize on the massive e-commerce opportunity, none is better-positioned than Shopify (NYSE:SHOP).

This week the company came out with earnings that Wall Street largely yawned at. In some corners, skeptics are starting to question the company's growth. This is especially true of lower-margin merchant services -- which don't benefit from the powerful software-as-a-service (SaaS) business model.

I'm not buying into that argument though. Here's why I think Shopify is the best up-and-coming e-commerce play for individual investors.

Man's hand touching graph showing a chart doubling

Image source: Getty Images.

Subscription revenue is still very strong

There are two parts to Shopify's business. The first is subscription revenue. If someone wants an online presence for their business, they can pay as little as $9 per month to set up shop. If this business grows, it will likely stick with Shopify and upgrade to a pricier plan since all of its data are on Shopify's platform and it would be a pain to switch.

While the up-front costs with building Shopify's platform are high, it costs next to nothing to rent it out to businesses via the cloud, which is essentially what the SaaS model is all about. Because of that, Shopify gets to keep almost 80% of subscription revenue as gross profit. 

With the number of merchants on Shopify surging 35% year-over-year to 820,000 in the most recent quarter -- and the number of high-tier Shopify Plus partners growing over 45% to 5,300 -- it's easy to see why the company has experienced results like this:

revenue and gross profit from subscriptions at Shopify

Data source: SEC filings. Chart by author.

This is what investors like to see. Shopify can add customers for very little cost, and collect more and more money as merchants sign on.

Merchant solutions was a no-brainer

Unlike for its subscriptions, there's no monthly fee that Shopify collects for its merchant solutions business. Instead, it offers merchants tools they can use to grease the wheels of their operation.

Shopify Payments accounted for roughly three-quarters of merchant solutions revenue in 2018. This is Shopify offering up an easy way for merchants to get customers to pay for goods they buy online. Because Shopify is simply providing a solution that relies mostly on banks and credit card companies, most of the money does not stay with Shopify; it goes to those institutions. In the merchant solutions segment, Shopify keeps less than 40% of the money as gross profit.

Check out the latest Shopify earnings call transcript.

That said, in the United States, Canada, Australia, and the U.K., over 80% of merchants using Shopify use Shopify Payments. Because the volume of stuff sold on Shopify has increased so much -- gross merchandise volume grew 56% last year to $41 billion -- revenue from merchant solutions has grown even faster.

Chart of revenue and gross profit from Shopify's merchant solutions segment over time

Data source: SEC filings. Chart by author.

And here's something just as important: The amount of money Shopify gets to keep from each transaction in gross profit has increased over time -- from 28% in 2015 to 38% last year. 

But many still bemoan the growth of merchant solutions, saying the fast revenue growth masks the fact that margins are much lower. That's a fair point. But it's still a no-brainer for Shopify to pursue. I can't imagine a company executive saying:

Well, we could just plug in a payment app and collect fees on everything bought on our platform. That would bring in millions of dollars we wouldn't otherwise have. And we almost don't have to lift a finger to do it. But some might complain that it's low-margin -- so let's not do it.

The fault, then, is in how results are interpreted by investors, not necessarily in anything Shopify is doing.

But don't miss this key feature

Here's what I think many are missing. Gross profit is not where the story ends. Shopify still has to spend millions of dollars on sales and marketing, as well as on research and development. 

Almost none of this money is spent on merchant solutions. Why? Because sales and marketing teams primarily work to get merchants in the Shopify ecosystem via subscriptions. Once they are signed on, it's almost a default to use Shopify Payments.

And while some R&D money is spent on merchant solutions, most is not. It's just like the hypothetical quote above: Shopify barely needs to lift a finger to plug in a payment option and collect fees on it.

Of course, the hope is that, as the platform matures, a smaller portion of sales will have to go to subscription marketing and R&D. But for the time being, most of that revenue is eaten up by such expenses. 

What does that look like? While I cannot say what percentage exactly is devoted to subscription services, the comparison of spending on sales and marketing and research and development to subscription gross profit looks like this (after backing out stock-based compensation):

Chart showing subscription gross profit versus spending on sales and marketing and research and development.

Data source: SEC filings. Chart by author.

I'll break this down into plain English: While subscriptions appear to have great margins, Shopify is spending so much on new products and new customers that it's still losing money on them. 

That makes money coming in from merchant solutions look far more appetizing...for the time being.

Putting it all together

If you stopped reading right now, you might think I was arguing Shopify is a bad investment. After all, it's spending more than it takes in on its banner service.

But here's the thing: Shopify has demonstrated its growth potential (remember those 820,000 merchants?). It's spending that money to draw merchants in and keep them there. Eventually -- years from now -- it will spend far less on sales, and modestly less on R&D. When that happens, profits will soar.

And evidence points to successful merchants staying with the company. While no figures were offered for 2018, monthly billing retention rates have always been above 100%. Merchants who stay in business stay with Shopify.

There are already 2,500 apps available on Shopify's app store -- most created by third parties. For the most part, these apps can't be bought anywhere else. The number will surely grow thanks to the network effects at play. 

That's why I believe Shopify is still one of the best e-commerce plays around. I have no problem with the company occupying 6% of my real-life holdings -- and I think you should have no problem buying shares for your own portfolio as well.