As the market hits fresh all-time highs, primarily due to the outsized gains of the "Magnificent Seven" stocks, investors might want to turn their attention to less-prominent businesses that are still performing well.
For example, Shopify (SHOP 1.11%), the popular e-commerce platform, is skyrocketing. Its shares have soared 146% since the start of 2023 (as of Feb. 7). In the wake of a rough 2022, investors appear to be in love with growth tech stocks again.
But if you're thinking about adding Shopify to your portfolio now in hopes of riding its momentum to strong returns, you should first weigh both the bull and bear arguments for the company.
The bulls have a lot to be excited about
Shopify offers services such as website hosting, payment processing, and marketing solutions, among many others, that make it incredibly easy for anyone to set up an e-commerce presence, start selling products, and manage their business. The company benefits from the ongoing rise of the online sales channel versus brick-and-mortar shopping.
Its growth has been truly spectacular. Shopify's revenue of $1.7 billion in the third quarter was 530% higher than in the same period five years ago. And its gross merchandise volume jumped from $10 billion to $56.2 billion over the same time frame. With the company pursuing a total addressable market that it sees as worth $849 billion, management has its sights set on much more expansion in the years ahead.
The services that Shopify offers have cemented it as the top e-commerce platform in the U.S., with a 28% market share. It's easy to see why from a merchant's perspective, Shopify would be a mission-critical infrastructure provider. And the switching costs -- in time, money, and effort -- for its clients to move to a rival platform give it a key competitive advantage. Once a business owner gets familiar with how to use Shopify's subscriptions and add-on features, they are unlikely to change to another provider -- unless they are willing to endure the disruptions to their operations that such a transition would bring.
Shopify has been able to monetize all the activity on its platform at higher rates over time. Its so-called "attach rate" came in at 3.05% in Q3, up from 2.96% in the prior-year period. That may not seem like a huge difference, but when we're looking at tens of billions of dollars in gross merchandise volume, small fractions of a percent can add up. The attach rate has trended upward over the past few years, indicating not only the value that Shopify customers perceive that it provides, but its ability to make money from this.
Compelling arguments for the bears
Although Shopify is making progress at attracting enterprise clients, its services are still a popular choice for small businesses and entrepreneurs. This gives the company a heightened sensitivity to macroeconomic conditions. Small businesses have a failure rate of 45% within the first five years. As a company that provides services to them, Shopify would also be negatively impacted by a downturn that took a greater toll on those clients.
There's still a possibility that the U.S. will enter a recession in the near future, especially if the inverted yield curve proves to be a harbinger of what's to come. If that scenario comes to pass, it would be reasonable to believe that Shopify would register much slower growth.
To its credit, Shopify reported positive net income in the first and third quarters of 2023. While some might cheer that news, believing it's a positive sign for what's to come, it would be best for investors to temper their expectations.
Shopify posted a monster net loss of $3.5 billion in 2022. Furthermore, it has been cutting costs aggressively across the board, and also sold off its logistics segment. These might only have one-time impacts. Until the business can report consistent profits for multiple years, there is financial risk.
Despite the stock being 50% below its all-time high, it doesn't look cheap today, trading at a price-to-sales multiple of 16.5. That's expensive even for a high-flying software enterprise. And it's a reflection of the fact that the optimism surrounding the company has increased rapidly, leaving no margin of safety for prospective new investors.
Shopify is a good business with impressive growth potential, but I'm not comfortable with its current valuation. And because of that important factor, I'll pass on buying its stock right now.
