The bull market is back, and so is pandemic favorite Shopify (SHOP 1.11%). After posting robust growth and showing strong operating leverage in the third quarter, the e-commerce platform gained more than 30% in the last five trading days and is closing in on a market cap of $80 billion. Year to date, the stock is up 78%.
However, that doesn't necessarily mean you missed the boat on this fast-growing company. Shopify is still down by 63% from the all-time high it set in 2021, which could indicate there is still more room to run here. Or, it could just be an example of how egregious stock valuations got during the first couple of years of the COVID-19 pandemic.
Getting more efficient, but still growing
Shopify's Q3 earnings were strong across the board. As the software backbone for many online sellers, Shopify grows along with the overall e-commerce sector. It makes money through its core software subscriptions, by processing payments, and by selling add-on services to its merchant customers.
In the quarter, Shopify's revenue grew 25% year over year to $1.7 billion. Factor out last year's revenue from its logistics and delivery services business -- which the company divested itself of earlier this year -- and the growth rate was an even more impressive 30%.
Shopify sold the delivery services business to Flexport in a pivot to refocus solely on the digital world, providing software services to online merchants. This is already showing up in the company's profit margins. In the quarter, Shopify's gross margin was 52.6% compared to 48.5% in 2022.
Lastly, it is important to discuss the efficiencies Shopify is obtaining in its operating expenses. Research, marketing, and general overhead costs all declined in Q3 compared to 2022, which is highly impressive in light of that 30% adjusted revenue growth.
Many investors had been worried that Shopify had a bloated cost structure and wouldn't be able to grow while also generating a profit. The third-quarter results showed these concerns are likely misguided.
And finally, Shopify generated $122 million in operating income in Q3, up from an operating loss of $346 million in the prior-year period. Not bad.
How big can this business get?
Shopify proved it can generate a profit, so that shouldn't be a concern for investors going forward. The next thing to contemplate is how big this business can get.
While Shopify talks about all its software services, the majority of its revenue comes from its payment business, aptly named Shopify Payments.
Last quarter, its gross payments volume -- meaning the total value of payments processed on its platform -- grew to $32.8 billion. In 2022, its gross payments volume was just over $100 billion, and it should come close to $150 billion in 2023.
This gives the company a sizable portion of the e-commerce market. Excluding China, the e-commerce market is approximately $1.5 trillion worldwide. So outside of China, it looks like Shopify Payments is processing around 10% of e-commerce transactions. If you exclude Amazon's sizable market share, these numbers look even more impressive. Outside of the vertically integrated retailers like Amazon, Walmart, and Target, Shopify is the dominant payment processor for e-commerce merchants.
But there is another side to this coin. With a market share that is already so large, Shopify will likely not see the same market share gains as it has in the past. I would bet it can grow slightly faster than the overall e-commerce industry over the next five years, which itself is expected to grow payment volume by 10% through 2028. Its days of 25% growth are close to over, though.
SHOP Gross Profit (TTM) data by YCharts.
Does the stock price make sense?
A dominant company inflecting toward profitability and poised to grow its revenue at 10% or higher usually indicates a buying opportunity. But with Shopify, if you run the numbers, all this and more seems to be priced into the stock right now.
Over the last 12 months, Shopify has generated $3.25 billion in gross profit. Let's estimate that it can double that over the next five years to $6.5 billion and through solid operating leverage can eventually convert half of its gross profit to net income, which makes sense given the operating leverage inherent in a software business model. That would bring its net income to $3.25 billion.
Today, Shopify has a market cap of $80 billion. On a five-year forward net income of $3.25 billion, that would give the stock a price-to-earnings (P/E) ratio of 25, which is around what the average stock trades on its trailing earnings. That's a lot of growth already priced into Shopify's stock.
Unless you are confident the company can keep growing revenue at 25% a year, forward returns for the stock don't look great from a market cap of $80 billion.
