Market-beating stocks sometimes do so quietly, as is the case with stock-image company Shutterstock (SSTK -0.05%). It may only be outperforming the S&P 500 by a slim margin, but as of this writing, it's up about 196% since its initial public offering (IPO) in 2012, compared to a return of 179% for the market.
Many investors believe that images created by artificial intelligence (AI) pose a material threat to the long-term viability of Shutterstock's business. And that may actually be true, but the company seems to be making the smartest play it can, given the cards it's been dealt: embrace AI-generated content.
Shutterstock's bread and butter
Shutterstock is the kind of business I love: a marketplace selling third-party stuff. What's great about these businesses is they can enjoy very high profit margins, because they're not producing or sourcing the product but providing the marketplace where buyers and sellers connect.
And indeed, Shutterstock is a high-margin business. Its gross margin is consistently over 60%. And its operating margin has been over 10% in recent years, which is fairly consistent with its historical norms when zooming out far enough, as the chart below shows.
Data by YCharts.
In my opinion, marketplace businesses earn enviable margins, because they first must overcome one major challenge: getting the flywheel spinning. Naturally, sellers only want to go to where the buyers are. And buyers only want to shop where they have the most options. It's a chicken-and-the-egg scenario in that it's hard to attract one group without already having the other.
In the third quarter of 2022, Shutterstock reported 607,000 subscribers to its various content-licensing platforms. Thanks to acquisitions, this is much higher than the 368,000 subscribers it had at the end of the previous quarter, but subscribers were steadily growing before those acquisitions as well.
Moreover, Shutterstock ended the quarter with over 424 million images available for download, up 9% year over year. And its video-footage collection was up 17%.
In short, the company looks like it has the spinning flywheel that all marketplaces need, which is good. However, AI-generated content threatens to disrupt the entire business.
How Shutterstock is embracing AI (and why)
AI is front-and-center on investors' minds because of OpenAI's ChatGPT. The text-generation application is a viral sensation on social media. But beyond the buzz, the underlying tech is impressive enough to attract the attention of Microsoft, with the tech giant investing $10 billion in OpenAI.
Besides just text, AI-generated images are going viral as well, including images generated by OpenAI's Dall-E application. In theory, it may be quicker and cheaper to generate an image with AI than to go to Shutterstock to license one, which is what investors are getting worried about.
However, people often forget that AI works by ingesting large datasets. Therefore, when it comes to AI-generated images, where does the data come from in the first place? And therein lies a rising controversy.
There's currently a class action lawsuit against Microsoft, OpenAI, and other AI companies. Basically, the argument is that AI uses real images to create its art-generation models. In other words, artists are unwillingly supplying the data that's training their AI competition.
Legally, I don't have any clue where this could go. But practically, I imagine that AI-generated art is here to stay, for better or for worse. And that's why Shutterstock is smart to embrace the change in a way that benefits its community of artists. Remember: It can't afford to lose this crucial side of the flywheel.
Shutterstock also needs to offer AI-generated art to buyers or risk losing them.
In October, Shutterstock signed a deal with OpenAI. OpenAI licenses images from Shutterstock to train its Dall-E application. With its new deal, Shutterstock buyers can come to the platform and generate AI art. But the artists contributing the data to the AI models still get compensated. This puts Shutterstock on the right side of the rising controversy, in my opinion.
There's much more that would need to be considered to build an investment thesis for Shutterstock stock. Therefore, I would recommend digging more into the company before buying.
However, shares of Shutterstock will likely fall long term if its business model gets completely disrupted by AI. That said, the company appears to be making the best moves it can to get ahead of the curve, which should be encouraging for shareholders.
