Should Investors Be Concerned About Shopify's Slowing Growth?

Shopify's (SHOP 4.90%) stock rallied about 150% over the past 12 months as the e-commerce services company dazzled investors with its double-digit sales growth. However, shares recently dipped after the organization posted slowing sales growth and a surprise loss in the third quarter.

Its revenue rose 45% year over year to $390.6 million, which beat estimates by $7 million but marked its slowest growth rate since its IPO in 2015. On the bottom line, Shopify posted a non-GAAP (generally accepted accounting principles) net loss of $33.6 million, or $0.29 per share, compared to a profit of $5.8 million, or $0.05 per share, a year earlier.

Analysts had expected a profit of $0.11 per share. The company mainly attributed the loss to a one-time tax provision of about $48 million related to its overseas expansion. On a GAAP basis, which includes stock-based compensation expenses and other charges, its net loss widened from $23.2 million to $72.8 million, or $0.64 per share. Should investors be concerned about Shopify's slowdown and wobbly bottom-line growth?

Image source: Getty Images.

The key numbers

Shopify's wide range of e-commerce tools, including digital storefronts, marketing services, payment tools, and other services, helps merchants quickly digitize their businesses. Here's how its two core businesses (merchant and subscription solutions) fared during the third quarter.

Source: Shopify Q3 earnings report.

The company's growth in merchant solutions was driven by a 48% increase in its GMV (gross merchandise volume), or the value of all goods sold across its merchants' platforms. It noted that a growing percentage of its total GMV now comes from higher-growth international markets, and it now serves over a million merchants worldwide.

Subscription solutions revenue growth was driven by the Shopify Plus platform (for higher volume merchants) and a growing number of apps in its app store. Its MRR (monthly recurring revenue) grew 34% year over year to $37.9 million, and Shopify Plus accounted for 27% of that total, up from 24% a year earlier.

Shopify's ecosystem continues to expand with newer features like its payments platform Shopify Pay, a point-of-sale card reader, a wholesale channel for buyers, bulk label printing services, APIs (application programming interfaces) and augmented reality features for mobile apps, and cash advances to merchants via Shopify Capital. It also recently acquired fulfillment automation start-up 6 River Systems to bolster its logistics services.

Image source: Getty Images.

Shopify expects its revenue to rise 37%-40% annually during the fourth quarter, and it expects full-year revenue to grow 44%-45%. Those growth rates look solid, but analysts expect the company's growth to decelerate to 36% next year as it faces tougher annual comparisons and competition from rival platforms like Adobe's (ADBE 1.29%) Magento.

Stable margins and rebounding earnings growth

Shopify reported an adjusted operating margin of 3% during the quarter, which marked an improvement from its negative operating margin of 1% a year earlier. It attributed the improvement to a better mix of higher-margin products and lower marketing expenses.

It expects that trend to continue into the end of the year, with an adjusted operating margin of about 3% (at the midpoint) for the fourth quarter. On a GAAP basis, which bears a significant impact from the 6 River Systems acquisition, Shopify anticipates an operating loss of $47 million-$57 million -- compared to a loss of $9.5 million a year earlier.

Shopify didn't provide exact guidance for its full-year adjusted earnings, but analysts anticipate a 50% drop this year followed by nearly five-fold growth next year. They also expect its annual earnings to improve at an average rate of 57% over the next five years.

Those estimates suggest that Shopify will leverage its first-mover's advantage in the e-commerce services market to expand its portfolio of services, enter more international markets, and counter aggressive rivals like Adobe -- which can bundle Shopify-like services with its other cloud services -- as it protects its long-term margins.

But the stock could be too expensive

Shopify's revenue growth is decelerating, but it's still remarkable for a 15-year-old company. As for the organization's bottom line, the growth of its higher-margin services and tighter cost controls should eventually stabilize earnings growth.

However, Shopify's biggest weakness is still its valuation. It trades at nearly 350 times forward earnings and over 17 times next year's sales, which suggests that the stock is priced to perfection.

By comparison, Adobe trades at less than 30 times forward earnings and roughly ten times next year's sales. Analysts expect Adobe's revenue and earnings to rise 18% and 24%, respectively, next year -- which makes it a less volatile play on the cloud-based e-commerce, marketing, and creative software markets.

In short, Shopify's business is still rock-solid, but its stock looks dangerously speculative. Investors shouldn't fret too much about its mixed third-quarter numbers, but they should only nibble at the stock at these frothy levels.