Shopify (SHOP 1.11%) just announced its earnings for the first quarter of 2023, and it probably represented a turning point. In the report, the company announced its exit from the fulfillment business, selling most of its logistics business to supply chain management company Flexport.
Even though Shopify will hold a stake in Flexport and make it the preferred logistics partner, the news profoundly changed the investment thesis for the software-as-a-service (SaaS) stock. Investors reacted by taking the stock 24% higher in the following trading session.
Still, many shareholders (including myself) felt the fulfillment business strengthened Shopify in the long run. Hence, the question for shareholders is whether the exit from logistics will help the company longer term.
How Shopify's investment thesis has improved
The most obvious improvement may come from the Q1 financials and future quarters. The $1.5 billion in quarterly revenue increased 25% versus year-ago levels. Amid that growth, Shopify faced rising operating expenses, especially with a 51% increase in research and development costs.
However, Shopify turned in a surprise profit, thanks to $269 million in unrealized gains. It earned $68 million in net income during the quarter, up from a $1.5 billion loss in the year-ago quarter. And for the remainder of 2023, Shopify forecast a revenue growth rate similar to Q1.
Also, during the bear market, investors ran away from stocks that reported one quarter after another of continuing losses. During that time, Shopify's profits gave way to losses as it invested more heavily in fulfillment. That change may have worsened the bear market sell-off in recent quarters, which led to a stock decline as high as 87% from peak to trough.
Today, despite an overall negative performance over the last three years, Shopify stock is up about 170% from its October 2022 low. Additionally, now that it's selling its logistics business (or at least most of it), the reduced operating expenses increase the likelihood that it can stay profitable or at least return to sustained profitability more quickly.
Investors should remember that fulfillment is a capital-intensive, low-margin business. With Shopify now exiting that business, it can focus more heavily on its core competencies in the software realm, selling services that typically deliver higher margins.
Why the sale could hurt Shopify
Nonetheless, the move could reduce Shopify's competitive advantage long term. Indeed, its merchant functions, such as Shopify Payments, Shopify Capital, and Shopify Plus, offer services that are not provided by most of its peers.
However, numerous companies provide e-commerce platforms, and most of Shopify's subscription and merchant solutions revolve around software. In that respect, competitors theoretically have an opening to copy most of its offerings.
With a fulfillment arm, it transcended the software business, going into an area its peers couldn't or wouldn't enter. That gave Shopify a competitive advantage, making it more likely that an online seller who needed or would need fulfillment services in the future would choose Shopify. Fulfillment can also give it a level of control over the selling process more comparable to that of Amazon.
But with the exit from that business, Shopify loses a key competitive advantage over Wix, one of its primary competitors. In 2022, Wix partnered with Amazon for fulfillment services, probably to compete against Shopify's fulfillment network. Although Shopify will maintain a portion of the company it has sold, one has to assume that Shopify is, at best, on equal footing with Wix in this area.
Did Shopify make the right call?
Given the current circumstances, Shopify probably made the right decision by getting out of the fulfillment business. By selling this logistics arm, a high-cost, low-profit business is off its balance sheet.
While that may seem like a loss in terms of competitive advantage, quarterly and annual filings don't typically reflect the internal costs of operating such a business, and one cannot deny that the once-profitable company returned to losses to invest in logistics. The return to losses probably contributed to its stock-price decline. Hence, Shopify may well have made the right move when weighing the costs against the benefits.
Moreover, Shopify will still offer more services than most competitors, maintaining a significant competitive advantage with its software-related solutions alone. Considering the company's success, investors were probably right to turn more bullish on Shopify.
