When Shopify (SHOP -1.20%) first introduced the Shopify Fulfillment Network (SFN) at a developers conference in 2019, Shopify's presentation made it seem like SFN had already created a powerful fulfillment solution for small and medium-sized (SMB) merchants. Yet some people still doubt whether SFN is even a viable business. Here are two reasons why SFN could continue to face difficulties moving forward in the fulfillment space.

Man delivering package.

Image source: Getty Images.

1. Fulfillment is harder than Shopify thought

Building an e-commerce fulfillment business from scratch is extremely difficult -- especially for Shopify, whose primary expertise is in software. 

Shopify initially thought it could use software and artificial intelligence to coordinate a network of third-party warehouse hubs and logistics providers. However, after three years of testing, Shopify discovered that it could not scale the business to achieve its profitability goals. Consequently, SFN switched its strategy and decided to run a majority of its warehouse hubs itself. Unfortunately, it is still unknown whether Shopify's new strategy will work.

Another unexpected challenge for SFN is developing in-house warehouse management software (WMS), which SFN needs in order to provide an extensive product selection and fast delivery at low costs. Despite Shopify's software expertise, its WMS software has been in development for the past 18 months, and it still could take many more years to become a good solution.

2. Competition from Amazon is fierce

Shopify only just started to lease and operate its warehouse network, while Amazon.com (AMZN -0.68%) currently operates 1,137 fulfillment centers, with plans to open 330 more -- a considerable advantage. Today, it is hard to see how SFN, which has yet to ramp up its two-day delivery service, can compete against Fulfillment by Amazon (FBA), especially considering that FBA already offers one-day service and is starting to offer same-day service in some locations.

In addition, Amazon has recently begun developing specific initiatives to compete against Shopify. According to Insider, Amazon formed a secret team in 2020 named Project Santos to target Shopify's business. One initiative that may have originated from Project Santos is Amazon's recently introduced Buy with Prime offering -- a fulfillment service that competes for the same SMB merchants as SFN. 

When Amazon approves a retailer for its Buy with Prime program, those retailers can place Buy with Prime checkout buttons next to eligible items on their websites. When an Amazon Prime member purchases any item using the Buy with Prime button, that item will be delivered by FBA for free within one to two days. Thus, Buy with Prime gives SMB merchants access to Amazon's 200 million Prime members outside of Amazon's main website -- which may be attractive to many Shopify merchants. 

Why Shopify Fulfillment Network can still succeed 

Despite SFN's slow start and significant competition from Amazon, SFN has several advantages.

First, Shopify acquired warehouse automation software and robotics specialist 6 River Systems in 2019 to help build an in-house WMS and other logistics capabilities. Additionally, Shopify can purchase any extra expertise that SFN needs. For example, Shopify is currently negotiating to acquire Deliverr, a start-up that provides merchants with logistics and fulfillment services.

Second, Shopify merchants view it as a trusted, neutral party. In contrast, FBA collects fulfillment data that many online retailers believe Amazon uses to compete against them. If enough retailers fear that using Buy with Prime could eventually damage their business, Buy with Prime might become an ineffective tool for Amazon to use against SFN.

Last, Shopify plans to eventually allow merchants to customize product packaging with the merchant's own branded material -- thereby enhancing a merchant's brand. In contrast, FBA ships merchant's packages with Amazon Prime boxes and labels -- diminishing a merchant's brand. One of the most significant negatives of FBA is that merchants can lose control of their brand.

Investor takeaways

Even though Shopify trades at a historically low 20 times trailing 12-month earnings as of this writing, there are reasons why the stock may not recover any time soon. First, since the economy started recovering from the pandemic, outsized e-commerce growth has been decelerating. For example, Shopify reported 2021 revenue growth of 57%,, a deceleration from its 87% revenue growth in 2020. In addition, Shopify expects revenue growth to slow even further in 2022 -- one of the primary reasons that Shopify's stock has dropped since the beginning of 2021.

Second, investors cannot see any near-term catalyst to reaccelerate revenue growth. Investors expected SFN to be a growth catalyst because of Shopify's history of quickly ramping up new services. However, investors have been disappointed by how long it has taken for SFN to get its operations up to speed. For example, Shopify only recently projected fulfillment volumes to scale toward the back of 2023 into 2024.

Third, Shopify management intends to spend aggressively throughout 2022. Shopify announced in February that SFN will require an increased investment of $1 billion in capital expenditures between 2022 and 2024. Investors in general are currently avoiding investing in companies increasing spending as rapidly as Shopify -- especially when the market has concerns over stagflation and recession.

While investing in Shopify is enticing at current valuations, you should be mindful of Shopify's strategy of investing large sums of money into SFN, an unproven business with uncertainty about its long-term future.