Shopify (NYSE:SHOP) reported slowing growth and rising expenses. As of late, the market tends to penalize companies that report slowing growth and declining margins and Shopify has not been spared. However, with Shopify’s stock in the gutter, is now a good time to buy the company? The answer is that it depends on your time horizon. The long-term story is intact but there are also opportunity costs to holding a stock that must be considered.
By now, we all know that macro conditions are affecting most consumer-facing businesses. In addition to macro, Shopify faces high investment costs for the Shopify Fulfillment Network (SFN) coupled with the unknowns around the company’s growth rate now that the economy is reopened. Essentially, it’s hard to model this because the return on the investments made in SFN will not appear until H2 2023 or early 2024. This presents a predicament for Shopify’s stock if the market is uncertain of how SFN will perform.
What could overcome these headwinds would be Shopify’s strength in merchant software solutions including an omnichannel approach and the company’s social commerce inroads. Because Shopify offers an omnichannel strategy through point-of-sale (POS) and various products, the company may be able to regain the Street’s confidence even while e-commerce continues to soften.
Notably, one more headwind that Shopify will have over the next three months is the company’s pattern to not provide guidance. This may have worked well when the ecommerce sector was on fire, but investors need more to go off of with macro putting pressure on the consumer-facing companies. This lack of visibility may work against the company while others are striving to reiterate full year guidance and discuss more granularly their current revenue growth.
Shopify’s Q1 2022 results
In the most recent quarter, Shopify’s growth slowed as GMV increased just 16% YoY, nearly half the 31% YoY growth rate the company reported in the prior quarter. Total sales increased 22% YoY to $1.2 billion, which was the slowest rate of growth since Shopify went public.
The company stated the lower revenue was due to Omicron easing and inflation pushing consumers towards discount retailers in Q1. Long-term, management believes despite the macro backdrop that “e-commerce will continue to penetrate commerce overall”- a $6 trillion market.
Subscription sales increased just 8% YoY to $345 million while Merchant services increased 29% YoY to $859 million. Management noted that a change in how they share revenue impacted subscription sales, without this subscription sales would have been up 15% YoY.
The tough macro environment flowed down to gross margin, which declined 354 bps YoY to 53%. Shopify also guided that Merchant sales would grow 2x as fast as Subscription sales in 2022, which is likely pressuring Shopify’s valuation. This is because Merchant sales are lower margin and implies further margin compression.
Also pressuring gross margin were investments in Shopify Fulfillment Network, which are expected to pressure earnings for the next couple of years. During the Q1 2022 call, management stated that “the expectation [for SFN] is that scale will still be towards the back half of 2023 and into 2024, and we’ve always said that’s where the unit economics really start to shift to favorable. So, we fully expect the volumes to continue to increase into that timeframe.”
In other words, there will be a delay until Shopify’s income statement reflects the benefits of scaling up its fulfillment network. In the meantime, the optics of slowing growth and rising expenses are temporarily pressuring Shopify’s multiple. However, these investments are necessary to support long-term growth and Shopify’s multiple will likely improve as the benefits of scale are reflected in earnings.
Adjusted operating income declined YoY from $210 million to $32 million. The decline was driven by a ramp in R&D and sales and marketing expenses, coupled with the investments being made in SFN outlined above. Shopify also reported a large $1.6 billion unrealized loss during the quarter related to its investments in Affirm and Global-E, which have seen their equity values more than halve since last year. The rapid decline in Shopify’s equity investments has also likely impacted by the company’s valuation due to a lower sum-of-the-parts valuation.
Nevertheless, last year Shopify had reported over $1 billion in equity gains from the aforementioned investments, and excluding the impact from equity investments, adjusted earnings per share were $0.20, which missed estimates of $0.65. As mentioned above, margins and earnings were impacted by numerous short-term trends.
Shopify also announced the acquisition of Deliverr for $2 billion during the quarter. Even though it makes sense to add logistics software, the timing of this announcement was not great given Shopify’s low top line growth and weakness in the margins. Analysts have to digest that Shopify is spending another $2 billion on Shopify Fulfillment Network, while it was previously stated the company would spend $1 billion per year until 2024. It’s possible that we have not seen the end to the investment that will be required.
Deliverr is an asset-lite business that brings logistics and inventory management capabilities to Shopify. CFO Shapero explained that Deliverr accelerates fulfillment volumes, which will help accelerate the development of SFN.
Yet, the $2 billion acquisition adds to the total cost of SFN and management noted that the acquisition will be dilutive to earnings in the near term. In the current market, where investors want profits today, this commentary likely hit Shopify’s valuation. Importantly, margins will improve as the company scales, highlighting how this is yet another one-time concern impacting Shopify’s valuation.
As a tech investor, I like it when tech companies re-invest for growth. However, the timing of when return on the investment will begin to appear could cause Wall Street to grow impatient. This year, the investment will be $3 billion if you factor the original statement of $1 billion per year plus the $2 billion Deliverr acquisition.
Amazon Could Become A Partner
Shopify management shrugged off concerns that Amazon was a competitor and reframed the company as a partner. Here is what was discussed on the earnings call:
“So we are actually thrilled with Amazon making a decision to take the amazing infrastructure that they’ve built because they have a second to none infrastructure and want to share this broadly with small merchants across the Internet. And so we are happy to integrate this into Shopify, just in the same way how we integrated what – the infrastructure that Meta built, the infrastructure that Google built and the infrastructure that TikTok built and so on.”
Speaking of Meta, Google and TikTok, Shopify’s social commerce revenue was up 4X year-over-year – and this was despite direct response and smaller businesses being the hardest hit from Apple’s IDFA changes. I believe the growth in social commerce is key to Shopify re-accelerating revenue.
Shopify recently reported slowing growth, rising expenses and shrinking margins. Which is exactly why Shopify could very well be trading at its low as all negativity is probably priced in. The real question is whether Shopify can bounce back as quickly as peers with management teams who are providing more visibility? We won’t know for another three months how Shopify weathered Q2. Tech investors should always have a long-term horizon or the gains will not outweigh the losses, that is a fact, because timing is nearly impossible given the volatility in this sector. If you don’t have a long-term horizon, you’ll end up selling at the low. While many are panicked over losses right now, the more common problem that tech investors face is closing winners too soon. I believe Shopify was quite clear on the horizon required for Shopify investors to see a meaningful return, which will be around the time Shopify Fulfillment Network begins to scale in 2023/2024.
At my firm, we manage allocations very closely for long-term high conviction plays. We prefer to rotate our higher allocations into stocks that have strong relative strength and fundamental strength today. At the same time, we believe in putting high conviction plays that are struggling, like SHOP, on the back burner at a very low allocation until we start seeing signs of a breakout move. We believe that finding the right combination between being nimble and conservative in position sizing while at the same time remaining invested in a great long-term story is the key to successful tech investing. Shopify may need more time, and for that reason it will remain as a low allocation in our portfolio, but we do believe the company has the right ingredients and warrants being in a top-5 position once the moving pieces come together.
Financial Analyst Bradley Cipriano, CFA, CPA at I/O Fund, contributed to this analysis.