One industry that experienced more pronounced growth during the height of the COVID-19 Pandemic is e-commerce. While Amazon represents the 800-pound gorilla in the space, other players such as Etsy and Shopify (SHOP 4.59%) have proven to be formidable challengers.
Shopify in particular is a company that I believe has more uphill challenges to conquer. When it comes to the company specifically, consider the fact that it spent billions acquiring assets to build out its logistics infrastructure, only to divest it after roughly one year of integration efforts.
Furthermore, from a more macro perspective, the Federal Reserve has consistently raised interest rates over the last year or so and has alluded that more rate hikes could be on the horizon. For this reason, it is legitimate for investors to be concerned about the overall strength of consumer-discretionary spending.
Unlike Amazon's well-diversified business, Shopify does not have a ton of wiggle room to pivot should its core e-commerce business begin to stall. Yet despite its exposure to the broader economic climate, as well as the challenges management must navigate when it comes to its core operation, the stock is up 55% so far in 2023.
In this article, I will assess the state of Shopify's business and benchmark the company against other e-commerce companies to determine whether the stock looks attractive at its current trading levels.
A hard look at the business
Shopify has done a pretty solid job of building an end-to-end commerce solution for online merchants. If you've ever purchased something on Meta or Instagram, then there is a good chance you've checked out via Shopify. Anecdotally speaking, I will admit that I find Shopify's user interface and features to be extremely convenient.
For example, having my credit card information and address saved is a nice bonus when checking out. But having the ability to split the payments into installments and have discounts automatically applied provides an extra layer of flexibility and comfort. Yet despite the ease of the platform and my personal feelings about it, it's Shopify's financial results which raise some concerns.
For the quarter ended June 30, Shopify increased total revenue by 31% year over year to $1.7 billion. While the Merchant Solutions business grew 35% year over year to $1.3 billion, the company showcased some impressive pricing power in its Subscription Solutions segment. In Q2, Subscription Services increased 21% year over year, largely due to the addition of more merchants using the product suite as well as price increases for existing customers.
Where things can get a little cloudy is when investors look at Shopify's operating losses. Despite the impressive top-line growth, Shopify booked a net loss of $1.3 billion. However, investors should understand that Shopify incurred $1.7 billion of non-recurring charges in the form of severance, stock-based compensation, and an impairment related to the divestiture of the logistics business.
For this reason, it is likely a good idea to move beyond the income statement and take a look at Shopify's free cash flow.
Image source: Getty Images.
The valuation is hard to justify
SHOP Free Cash Flow (Quarterly) data by YCharts.
When it comes to valuation, there are a multitude of different approaches investors can take. The first set of charts above highlight two important metrics: free cash flow and diluted earnings per share (EPS). Both of these figures are illustrated over a three-year period. Investors can see that when benchmarked against its cohorts, Shopify's free-cash-flow generation is significantly more volatile. Stated differently, Wix and Squarespace both have relatively steady free-cash-flow profiles, while Shopify and Etsy are less consistent.
On top of that, Shopify's EPS is the only negative figure in the chart for Q2 earnings. Granted, as I pointed out above, the company did include $1.7 billion of non-recurring charges during Q2 related to the logistics business. And while this contributed to the hefty operating losses for the quarter, I see a larger issue. For a company as diversified as Shopify, it's a little underwhelming to see such muted EPS growth over the highlighted multiyear time horizon.
It's the next pair of graphs, below, which really seem to disconnect valuation from the fundamentals.
SHOP Market Cap data by YCharts.
These two graphs showcase market capitalization and price-to-sales (P/S) multiples. The primary takeaway here is fairly obvious: Shopify's market cap is roughly $69 billion, well above its peers. Moreover, its P/S ratio is more than double its next-closest comparable company.
Given the company's operational challenges, coupled with an inconsistent cash flow and profitability profile, it's easy for some investors to become a little skittish. Furthermore, after assessing several valuation metrics for others in the competitive landscape and seeing just how much of a premium Shopify trades for relative to its peers, buying the stock right now becomes harder to justify. While I believe that Shopify can evolve into a market leader in the long term, I personally need to see far more progress before buying the stock.
