Chit Chat Stocks - Fundamental Analysis: Shopify (SHOP)

Episode Date: April 19, 2020

On this episode we discuss Shopify. Find out why Brett gave it a rating of 5 and Ryan a rating of 5.5.  Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome in. This is the Fundamental Analysis Show on Chit Chat Money. My name is Brett Schaefer and I'm here as always with Ryan Henderson and we're talking a maybe the hottest stock on the market right now. We followed the company for a few years here. It was actually one of our first Fundamental Analysis Shows that we did back in the day before we actually had all the formats going down. That was over a year ago, I think. but it is Shopify, the e-commerce platform for small business and large business merchants that

want to sell things online. So Ryan, do you want to get into what they do and then go over a little of the history of the Canadian company? Yeah. So you sort of touched on it there. Most people pretty much know what Shopify is, but I'll go ahead and go over it anyway. So they're a cloud-based e-commerce platform and they are an actual platform. Sometimes that's turned around, they are a platform and it's built for scalability in their words so if you want to sell clothes tools makeup whatever you want you name it you can quickly and easily make a shopify page or basically your own website and sell those goods so it's really kind of a simple to use e-commerce platform just like they say but shopify makes money in two ways so they have their merchant

solutions and subscriptions so subscriptions is pretty simple to understand based on the size your business or the or the accessibility of features that you want you would pick from three different monthly pricing plans so there's basic shopify i think that's like 29.99 a month shopify and advanced shopify and then there's even one for enterprise customers which is called shopify plus i want to say and so while most merchants subscribe to the basic uh basic shopify and shopify plans a majority of shopify's gross merchandise volume comes from those with the advanced shopify and shopify plus plan so it's their larger uh merchants make up most of their gross merchandise volume even though there are more people with these smaller uh pricing plans

there um and the subscription retention rate is also higher in merchants from those tiers so i mean if you think about it that's pretty logical that the people that make the most money are going to keep it um as people that go out of business but yeah that's kind of the subscription part of their top line there and then merchant solutions revenue comes in a variety of ways so they make money on payments processing fees from shopify payments uh they make money on transaction fees shopify shipping shopify capital referral fees from partners i'm not totally sure what that one was and then sales from their point of sales hardware solution they started introducing that for some of their merchants to have in-store shops as well.

Actually, these are all the merchant's costs other than their subscription. So basically anything that isn't subscription-related where Shopify makes money, that goes into merchant solutions. The history, Shopify was founded in 2004 by Toby Litke, Daniel Weinand, and Scott Lake. I think I'm getting all those right for once in my life.

And after trying to open an online store for snowboarding equipment, toby lookkey was upset that it was so hard to build an e-commerce store so he decided to become the platform instead where you can build it you know he saw the opportunity there and look he was always a computer programmer by trade so that probably helped the actual shopify platform was launched in 2006 and they've done tons of stuff since so i'm not going to get into all of it but shopify went public in may 2015 yeah they're actually a lot older than a lot of people probably think uh they're kind of booked into the new age uh silicon valley companies

even though they're not from silicon valley and they are actually older they're pre-grade financial crisis only by a few years there but yeah they get wrapped in with like twilio companies like that who were founded a little earlier but i'll get into the financials here they have a market cap of 66.7 billion dollars a ticker of shop which is shop and then a price of 590.39 and that is of we're recording on saturday but the last trading day was april 17th 2020 their ev to sales which is enterprise value divided by sales growth or sales is 40.8 and that is 40.8 so very very high they're one of the most richly valued companies on the market their margin adjusted price to sales is 164 which is one of the highest we've ever done again margin adjusted price to sales if you

listen you probably know what it is but it's more it's a sorry sales growth or no no wait i was getting too confident there it is price to sales divided by sales growth and gross margin trying to get all of the growth metrics in there for a company like this that isn't profitable or not historically profitable uh no dividend yield as you might expect and shares outstanding have actually gone up a significant amount every year meaning if you own shares they're getting diluted Stock-based compensation is at 10% of revenue, which is super high for a company of this size and scale. Negative net margins, as you expect, I already said that,

and they're basically break even on a free cash flow margin. They're probably getting a lot of that back from that stock-based compensation because that is not a cash expense. Sales and marketing is about 30% of revenue, which is not that great. It seems like it's a little on the high side, but it's not terrible. And then lastly, very strong working capital number, lots of cash on the balance sheet, and the net debt is at negative $2.5 billion.

Yeah, I think for Shopify, it'll be easy for that sales and marketing number to sort of decrease as a percentage of revenue. I'm sure it already is, but word of mouth will kind of be able to do the marketing for them as they continue to grow. But I'll get into the earnings. For 2019, they had $1.6 billion in revenue.

up 47% year over year. Their merchant solutions makes up 59% of the top line and their subscriptions makes up 41% of the top line. For reference, merchant solutions has gross margins of 37.5% and subscriptions has gross margins of 80%. Their overall gross margin when you combine those two is 55%. 2018, they had closer to 56%. And so for reference, merchant solutions and subscriptions, Those are kind of the two top line pillars. Merchant Solutions is growing faster. It is the lower margin offering that they have. And then subscriptions, the higher margin, it's becoming less of the top line as time goes on. And so that's why you're seeing the gross margins decline over time. Their gross merchandise volume was $61.1 billion in 2019, up 49% year-over-year. They had an operating loss of $141.1 million. $141.1 million operating margin was basically flat year-over-year,

so relatively steady there with their losses. And then net loss of $124.8 million. I think they had a tax benefit, and they have $2.46 billion in cash, cash equivalents, and marketable securities as of the year-end. okay let's get the second half of the show going here uh first up is digging trenches and that is the moat rating what do you think on this one ryan yeah so i think um originally it was probably it's probably developed over time so i'm gonna go with it uh two because it's a crowded space but they have built um so much functionality on top of their typical subscription that i think there

is some uh customer merchant dependency and switching costs are really high if i'm not mistaken so it kind of builds this mo especially for their enterprise or the larger customers because those are annual contracts and they're a little different than just monthly subscriptions yeah i'd say yeah i probably put it at 2.5 headed towards a three if they keep up this momentum i think it's lower for the enterprise players just because they probably have the ability to make a site on their own a lot more easier than someone that's just like a muffin shop that's just a small business but let's get to the next section here and that's further reading what are you looking at if you were interested in buying shares so um i do want to look at that

merchant dependency so if merchants are like especially the ones that are subscribing to the shopify advanced or advanced shopify or shop by plus if they are extremely dependent on that that's going to build that stronger mo and the part that really matters for them is their larger enterprise customers or merchants and just the larger businesses in general so if there's enough functionality where it makes it really hard for them to leave if switching costs are incredibly high even if i mean i don't know of any competitors that are as good as them as wix kind of does the same thing but not really yeah i mean square owns something i think square owns one of those platforms there's other competitors but shopify is the leader for sure um so basically how dependent

is the merchant on them can they switch if they want to and how difficult is that process okay yeah that's a good one uh mine is what's the relationship with their own app store so they have a third-party ecosystem uh you know do they work with developers or is it just enabling them to make money when people subscribe so like they have the shopify app store with like over a thousand apps i think and then uh if you are a merchant you can subscribe to these apps uh i want to know if like shopify itself works with these developers that makes these apps or if they're just taking a little bit of a take rate uh whenever someone you know like kind of like the apple store yeah definitely digging into that third-party api platform i think they launched that really

early on too so it's probably been uh been there for a long time definitely look into that um what do you have for future growth opportunities? I got Shopify payments. It is now in 15 countries and it enables merchants to manage financials within the Shopify dashboard instead of outsourcing it to someone like PayPal or Stripe. So trying to just go for, what is that would be? Horizontally integrating across all of e-commerce merchants needs, whatever you want to call it. I bet a lot of merchants like this. I think if I was running a store, I'd rather have it in-house within shopify just because you don't have to go through different sites there's probably not that it's probably not that great to connect with another website like if you're using paypal or anything

else maybe even quickbooks or something like that or i guess quickbooks doesn't process payments but yeah having it all in-house seems better and it seems like something that would keep the customers locked in that's going to be a good way for them to uh get more what would it be a higher arpu from their existing customers and also lock them in uh so they stay around longer yeah agreed I mean, that was probably one of mine. There were a lot of future growth opportunities here. And if you look at any of their earnings releases, they highlight all of their investments and stuff like that.

So it was pretty easy to, there were definitely a lot of options to choose from. I picked the fulfillment network. So a vast fulfillment network that operates really well, totally enhances the customer experience in terms of shipping speed, lower shipping costs. And well, I guess it does the same for the merchants as well, because it kind of speeds it up, but it really ends up helping the end customer. And in the fourth quarter, they acquired Six River Systems, which is a leading provider of collaborative warehouse solutions. And they made progress integrating it into the fulfillment network. Hopefully that acquisition will quickly

enable these customer benefits that I just talked about. I think the fulfillment network that's going to help long-term and it's really going to encourage more merchants to come to Shopify. And in the end it's helping customers so win win win in all scenarios yeah the and i think they're investing a few billion dollars into this which is quite a bit um and it's going to take them a while to do it but it should help if they can succeed trying to you know that's the big advantage that someone like amazon has and why you'd want to go with them for the free two day and possibly one day shipping i guess not right now but you know normal circumstances if shopify can replicate that for someone else maybe they'll think about going off of the amazon platform uh the last up

before our rating is highlights and lowlights you want to go first yeah so there's tons of highlights and just you know full disclosure i i do like this business i don't know anyone that like hates this business model because they've done an incredible job um a word that is thrown around a lot is optionality and they do have tons of it so they've um i mean you talked about it Shopify Payments, the Fulfillment Network. They're doing something with Shopify Studios. They can really go anywhere. Shopify Studios, I mean, what the hell is that?

I don't know how it'll work out, but I mean, they're kind of adopting that Amazon model of try random crap. And if it starts to work, continue with it. So, and I'm not opposed to that, especially if I'm a shareholder. They've also created that certain dependence thanks to the functionality

and they have exceptional management. I really like Toby Lutke. Low lights is that they have slowly shifted to a lower margin business model. And it was the right thing to do because you can't be stuck and be one dimensional with the subscriptions because, I mean, how do you grow that?

You increase prices. That's going to deter a lot of merchants. So you have to add on these merchant solutions as a part of that revenue. And they did, I think, seven years ago or something like that. um but in the process they've lowered the margins because it is significantly lower margin and the stock okay i'm going to get right this is kind of into my rating but the stock multiple

should come down as the margins come down even though it's the right thing to do for the business the revenue and the top line will continue to grow it their capacity to make money on that is is decreasing so the the logically the the multiple should come down um is the right thing we've seen the opposite happening wow right and uh is it the right thing to do for the business yes like i said management doesn't have control over their stock um and honestly the stock-based compensation is probably a good idea with the valuation that they have right now um so they've done a tremendous job but uh i guess that kind of tailors into my rating but i'll let you get your highlights and lowlights first. Yeah, I'll keep it simple. It's a fantastic business,

recurring revenue business model that locks into customers with gigantic lifetime values. We're talking millions and millions of dollars of lifetime value for Shopify, at least for their larger customers. Lowlights for me though, share dilution is quite high. 10% is way too high for someone that's this mature of a business. I think they should have better cashflow numbers right now it's it's not great especially with that sbc number as that high how is that the stock-based compensation or the share dilution is a good idea at these prices i mean shouldn't it's still so high as a percentage of revenue i don't know yeah but i mean as management wouldn't you want to utilize your share price and that multiple um to be able to attract and pay employees

yeah i mean it's a good idea to get employees but that's kind of locking people in where are you gonna have to dilute shares forever um and i mean maybe you could do an equity offering but either way if you're holding shares here and the only way that shopify can get the engineers they need to separate themselves is to dilute shares by 10 every year you have to take that into account when you're valuing the company okay continue sorry uh last one i just saw the shopify studios thing i think that's like not to get pessimistic but that's just a giant waste of money um i don't know what they're doing there i think it's i think it's a total waste um yeah and i guess time will tell on that um we can just get into the rating then uh i'm gonna assume yours is a

little low at prices right now so what do you have uh yeah it's gonna be low i mean it's it's been on my watch list for a long time i did own shares i think i sold a year ago when i was at like two something, uh, which is a lot lower than what it is right now. So I guess that is a mistake on my part, but I still think the valuation is just getting out of hand. Uh, we were talking about some numbers before here. Their sales multiple has never been this high, even with revenue decelerating, uh, revenue growth decelerating, uh, their margins are decreasing. So I'd give it like a five flat. I mean, it's going to be on my watch list just because the business is so great but the valuation there's rarely does a business ever deserve a valuation

of a price sales above 20 uh and this one's above 40 so i i just don't enterprise i don't think they deserve it um yeah agreed and uh the margin part for me it looks like it would have it did exactly the invert inverse of what i was expecting so you talked about it we took we're both talking about before the show and i don't know if you have the data points on there but it was like the sales multiple has been like 7 8 13 20 uh yeah i can i can get i can bring it up for real quick uh 2015 they had a price of sales of 7.75 and then the next year uh price to sales of 9.24 then 15 then 13 then 28 um it's you know it's really high yeah and so it's it's grown as margins have compressed and so that doesn't necessarily make sense to me um i do love the business but the

right now if i was a shareholder i would be hedging i think i would just sell um or trim at least because i mean look everyone to their own um there's taxes and stuff like that but do you believe that it truly can have outperforming truly can outperform the market over the next five years i think you're just fooling yourself and well so and i guess the bull case is that it at the current business with its current business model it it's it probably can't grow as much but they're going to evolve and change over time and i think the bull case is set in the management and the optionality i know people throw that word around all the time but you know when you first bought Amazon, you didn't think AWS was going to be the largest component of it, that kind of thing.

True, true. Yeah, I think the management should get a bump for their track record. I don't think it should be this high though. Yeah, I'm going to go 5.5. I would hedge if I had shares and at the right price, I would totally buy this. I love the business, but this is not the right price. Yeah, I think if shares got cut in half, I'd consider it. I think it'd have to go down by like 60, 70% for me to consider it too. I do like the business. I just think the valuation is just insane as I've said like five times, but that's going to do it for this episode, guys. Thank you for listening. Make sure to follow us as always on Twitter at Chit Chat Money. And then do you want to, again, get the email out there, Ryan?

Chit Chat Money podcast at gmail.com. Yeah. So that one, you can email us any questions or suggestions for shows to do. Remember, We are not financial advisors. Anything we say on this show is not formal advice or recommendation. Thank you for listening. We'll see you guys next time. Thank you. Smarter.