Are we on the precipice of a new bull market?
Stocks have soared to start 2023, reversing a lot of the painful losses for investors in 2021 and 2022. Growth stocks have especially rallied, with many stocks greatly outpacing the 15% gains for the S&P 500 index year to date (YTD). Shopify (SHOP -5.62%) is one of these growth companies.
Shares of the e-commerce software and payments platform have popped 85% YTD, with the stock now sporting a market cap of $83.5 billion. Since the company went public in 2015, shares are up 2,200%, making it one of the top-performing stocks worldwide over that time span, especially for large-cap companies.
With the stock up so much this year, should you sell your shares of Shopify and walk away? Or are there still more gains to be had in this growth compounder?
Growing faster than peers but without cost discipline
One thing all investors can agree on with Shopify is that it's growing quickly and gaining market share with its core e-commerce services. Last quarter, payment volume through its merchant customers grew 18% year over year in constant currency, which is much quicker than the 10% projected growth for the global e-commerce market this year.
Revenue is growing even quicker than payment volume, up 27% year over year to $1.5 billion in the first quarter. This is occurring as more merchants and customers are adopting Shopify's internal payment processor, which allows it to earn a sizable take rate on every transaction processed through its platform. In the first quarter, internal payments volume was 56% of total payments volume compared to 51% in 2022. If this trend continues, it will lead to Shopify's revenue growing quicker than its total payment volume, which is already outpacing the overall e-commerce market. This is a good recipe for durable double-digit revenue growth.
While revenue growth has been great, Shopify has shown a lack of efficiency with its cost structure. In the first quarter, the company posted an operating loss of $193 million -- or 13% of revenue -- compared to 8% of revenue a year ago. With the platform closing in on $6 billion in annual revenue, there is no excuse for Shopify to not generate any bottom-line profits. These losses will need to reverse in the next few years, especially if revenue continues to compound to even higher levels.
Data by YCharts.
Fumbling the logistics opportunity, competition with Amazon payments
Over the last few years, Shopify has talked a big vertical integration game about how it would start competing with Amazon in delivery and logistics for its merchants. It spent $2.1 billion acquiring start-up Deliverr and said it would invest billions of dollars into the Shopify Fulfillment Network.
But in 2023, after realizing Deliverr had negative gross margins and that it could not compete with the tens of billions in infrastructure spending from Amazon, UPS, and FedEx, Shopify did a complete U-turn and exited all of its logistics investments, including divesting its Deliverr acquisition to Flexport. The company not only wasted a ton of money trying to invest in logistics, but this exit now significantly shrinks Shopify's addressable market, a big selling point for growth investors interested in the stock.
This competition with Amazon may only get worse. Last year, the technology giant released a beta version of the "Buy With Prime" button, which allows merchants to process payments and shipping on their own third-party websites exactly as they would when selling on Amazon. Most of Shopify's revenue comes from its own payment processor, meaning its revenue will take a hit if any merchant customers start offering Buy With Prime. Since the payment buttons are all the same for the consumer, it is likely that many e-commerce shoppers would switch to the Amazon solution if it means the fastest shipping times.
The valuation doesn't make sense at these prices
Even with the looming risk from Amazon, Shopify shares have soared this year and now sport a steep valuation that makes the math for positive forward returns very difficult.
For one, even though it looks like a software company, Shopify's gross margins are much lower than you might think. As you can see from the above chart, the company only generated $2.8 billion in gross profit over the past 12 months compared to $5.9 billion in revenue, or a margin of 47%. A mature company run efficiently can generally convert around half of its gross profit into earnings. Since Shopify is an aggressive spender, let's say it will convert a bit less at maturity and hit 20% net profit margins.
If Shopify is able to fend off looming competition from companies like Amazon and keep growing revenue at 20% a year, it will hit $14.7 billion in revenue five years from now. With a 20% profit margin, that equates to $2.9 billion in earnings. Compared to its current market cap of $83.5 billion, that would be a forward price-to-earnings ratio (P/E) of 28.5 five years from now. This is higher than the market average today and requires Shopify to grow its revenue at a 20% annual rate for five straight years.
The math doesn't work for Shopify at these prices unless you believe the company will accelerate its growth rate or magically expand its profitability. Even though it means a tax hit if you've held for many years, now is looking like a good time to sell your shares of Shopify and redeploy the cash into cheaper stocks.
