At this point, it's no secret: E-commerce platform company Shopify (SHOP -1.94%) wants to go toe-to-toe with top competitor Amazon. And to do this, it needs to enhance its shipping capabilities. So on one hand, it's obvious why Shopify is investing tons of money in logistics.
On the other hand, logistics for shipping and fulfillment is believed to be a low-margin opportunity -- precisely what companies should avoid. But for Shopify, investing in its logistics infrastructure is more than just competing with Amazon. And it has higher potential than what first meets the eye, as we'll see.
Is this a good idea?
For proof that it's going all-in on logistics, look no further than Shopify's $2.1 billion acquisition of Deliverr last year. That's a lot of money to drop on what many analysts label as a low-margin opportunity.
According to The Boston Consulting Group (BCG), growing into a low-margin business could be the wrong approach for Shopify. In 2006, BCG published a paper explaining how growth affects top stocks. Its conclusion was that growth is extremely important for market-beating stocks. But not all growth companies provide good returns for shareholders.
BCG had several explanations for the laggards, including one that caught my eye for this conversation. BCG wrote, "In other cases, companies experienced strong growth through acquisitions, but this growth was not profitable."
Translation: Investors shouldn't look for growth at all costs because the quality of the growth matters. Growth that comes at too high of an acquisition price or that impairs profit margins should be avoided. As Warren Buffett wrote in his 1992 letter to Berkshire Hathaway shareholders: "It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain."
It's fair to wonder if Shopify has pursued low-quality growth. As the chart below shows, the company's gross-profit margin has steadily declined as revenue has skyrocketed, which is what BCG and Buffett warn of.
SHOP gross profit margin (quarterly) data by YCharts.
Why Shopify is doing this
Management believes two key things that could turn this entire conversation about logistics on its head. First, it believes logistics can be approached in a higher-margin way. Second, it believes having impressive logistic capabilities can drive growth in its higher-margin business segments. And these two assumptions -- if true -- could make all the difference for shareholders.
To the first point, we should acknowledge how big a challenge it is to offer fast shipping to anywhere for the thousands of merchants using Shopify's platform. Geographically positioning product supply with anticipated demand takes insight and skill. And if an e-commerce company gets it wrong, it could result in dust-collecting inventory and underutilized warehouse space.
Shopify is approaching logistics with an asset-light model. The company operates more-expensive central locations, which it calls "hubs." But then it outsources logistics to third-party warehouse "spokes" from there, hopefully taking a lower-margin business off its plate.
Shopify's acquisition of Deliverr takes its asset-light logistics ambitions to the next level. Think of Deliverr as being like Uber or Airbnb -- a software platform that connects customer demand with third-party logistic providers. It's an acquisition that augments what Shopify was already doing.
Therefore, it might be premature to label Shopify's logistics business as low margin. Moreover, if the company gets logistics right, it could be a revenue driver in higher-margin categories.
At the Morgan Stanley Technology Media and Telecom conference earlier this month, management pointed out that Shopify and Deliverr have few customers in common today. Looking at past products like payments and tax services, Shopify's customers have adopted new solutions in a hurry. And it hopes that will happen again here once management is ready to roll out Deliverr's services to all of Shopify's merchants.
And Shopify's customers might be particularly interested in adopting its logistics services compared to past new services. Management noted that a fully integrated Deliverr will allow the company to offer Shop Promise to all merchants -- a badge that gives customers the guaranteed fast shipping they've come to expect from Amazon.
Consumers appear to be more willing to buy from a Shopify merchant when the Shop Promise badge is present; management has noted a 25% increase in sales conversions. This massive increase will likely motivate merchants to adopt Shopify's logistics services, which will bump up the company's revenue from its logistics segment. But if it truly unlocks greater sales volume, that will boost revenue for Shopify's other services as well.
In conclusion, Shopify's asset-light approach to logistics could preserve profits without sacrificing the competitiveness of its services. And offering this to its merchants could drive growth in sales volume. Therefore, this could be a far greater opportunity than Shopify is getting credit for, and there's good reason for cautious optimism from shareholders.
