My fellow Texans know that Cinco de Mayo is one of the best holidays of the year. And for many of my neighbors, it's as important as July 4th. Filled with dancing, laughter, and history -- raising a Topo Chico mineral water in the heat of May is a nice reprieve from the scorching Texas sun.
However, a much more serious event was hosted by our neighbors to the north on May 5. It was on that day when Ottawa-based Shopify (SHOP 0.19%) reported its first-quarter earnings. Shares were down nearly 20% in reaction the report, setting a bearish tone for the year as the young company weans off its pandemic-induced growth spurt and dives into the abyss of rising interest rates and a potential recession.
Here's a breakdown that will give you a glimpse into the bull case and bear case for Shopify so you can better understand what's pressuring the stock right now.
Image source: Getty Images.
The bear case
Shopify is a battleground stock for a reason. As compelling as the bull case is, there are also some powerful reasons to avoid investing in Shopify. In fact, even as Shopify stock fell between March 15 and April 14, the number of shares short increased from 3.51 million to 4.39 million. As of April 14, the short percentage of the float is 6.7%. For context, consider the short percentage of the float for Tesla, another battleground stock, is just 2.9%.
The company's growth depends on adding subscriptions, having existing users upgrade to a more expensive subscription, and supporting users' businesses so they adopt more merchant solutions. If there is a recession or an economic slowdown, that could mean fewer people launch new businesses or existing customers shut down and cancel their subscriptions. At the very least, it would probably mean most merchants on its platform are seeing little to no growth.
Another important bear argument is around competition. Shopify has grown to become the second most dominant e-commerce player behind Amazon. But new competition from Amazon or other companies with deep pockets could take a chunk out of Shopify's earnings or simply slow down its growth.
In the fintech industry, we're already seeing a similar theme play out. Big banks and brokerage firms were initially caught off guard by the success of companies like Robinhood and Square's parent company, Block. But now, many of them have added features that weaken the competitive edge newer fintech companies once had. The fear is the same thing could now happen in e-commerce, and that would impact Shopify.
And the best argument against an investment in Shopify is its valuation. Management doesn't expect its top-line growth to recover until the final months of 2022, and adjusted earnings plummeted to $0.20 per share in the first quarter, down from $2.01 per share in the same period last year.
In response to the latest results, shares have fallen another 18% as of this writing, stretching the stock's decline from its all-time high to nearly 78%. Even then, the stock remains expensive with a forward price-to-sales ratio above eight, and its forward price-to-earnings ratio is over 137.
The bull case
In hindsight, it's easy to argue Shopify had no business sporting a $200 billion market cap so early into its growth story. The good news is little has changed about the long-term investment thesis for Shopify. And when the investment thesis holds, but the stock price has fallen, that strengthens the bull case for the company.
At its core, Shopify's potential is beautifully simple. An investment in Shopify is an investment in small and medium-sized businesses -- and larger businesses to an extent too. But broadly speaking, it's an investment in creativity, imagination, and entrepreneurship. It has never been easier to start a business, and that's in part thanks to Shopify.
So while bears may argue the company could lose customers during a recession, it's also worth noting Shopify is likely one of the last expenses a business would cut, especially as e-commerce only becomes more prevalent. What's more, Shopify is sticky. This entrenched industry leader has integrated so many services and features into its easy-to-use platform that merchants would have a difficult time switching to competing offerings.
In this sense, Shopify doesn't face the same threats as, say, a fellow industry pioneer like Netflix, where a customer could get bored with its content and easily switch to a rival service. Shopify's customers are merchants, not consumers. While a service like Netflix is a discretionary expense, there's reason to argue Shopify is an enterprise staple -- like Adobe or Salesforce -- that thousands of business owners simply can't live without at this point.
Shopify stock deserved to fall because starting new businesses is harder during inflationary times and rising interest rates due to the increased cost of capital. And it's true the company's growth is going to slow as we're seeing now -- first-quarter revenue was up 22% year over year, compared to 110% in the prior-year period. But given the potential for Shopify and what it does -- its habit of innovating and trying new things -- it seems entirely possible the company will some day grow to be the size of an Adobe or Salesforce (in that $200 billion to $300 billion market cap range). And in a decade or more, it's not hard to imagine the company growing to a $500 billion-plus market cap.
E-commerce sales in 2021 accounted for just 13.2% of total sales in the U.S. And that was during the pandemic when e-commerce and Shopify saw booming business. Not every retail sale is headed online, but for those who believe e-commerce will continue to grow its share of retail, that means an expanding market opportunity for companies in the industry. In that light, Shopify stands to benefit in two ways -- by growing its share of e-commerce and as the e-commerce pie overall becomes larger.
High risk, high reward
Even after the latest sell-off, Shopify stock falls into the high risk, high reward category. The reality is we don't know how the company's growth will recover or when management will be able to rein back spending to fuel that growth.
For investors who have been waiting to buy the growth stock, now seems like as good a time as any to open a starter position. But for risk-averse investors who are wary of potential headwinds in the e-commerce industry, it's perfectly fine to take a wait-and-see approach too.
