Shopify: A Growth Story That Needs A Shift In Course (NYSE:SHOP)

As one of the highest growth names in the large-cap application software space, Shopify Inc. (NYSE:SHOP) stock has enjoyed a major tailwind on its back since November of last year.

As the term premium collapsed following the quarterly refunding announcement by the U.S. Treasury, almost all growth names skyrocketed. That is why, share prices of Shopify, Intuit (INTU), Salesforce (CRM), Block (SQ) and many others exhibit such a similar pattern since 1st of November of last year.

In spite of the short-term risks for growth stocks more broadly, Shopify investors’ strong attachment to the company’s spectacular revenue growth rate seems to have made the topic of profitability and return on capital largely irrelevant.

But as the market makes new all-time highs and optimism that the currently supportive monetary environment would continue indefinitely, investors should ask the hard questions about achieving high GAAP profitability going forward.

A major warning sign also came from the most recent quarterly results when Shopify reported results that were largely in line with expectations, but the stock fell roughly 13% on the day following the release.

No Problems On The Surface

In spite of the negative stock price reaction following the Q4 2023 earnings release, Shopify’s total revenue grew 26% over the past year and analysts are expecting growth to remain above 20% over the coming year.

Management’s guidance for the next quarter was also quite optimistic, with revenue growth anticipated to be in the mid-to-high twenties and margins expected to improve.

When compared to other large cap companies in the Software and Cloud space, Shopify is expected to be the company with the highest revenue growth rate over the coming year. As a matter of fact, SHOP’s forward revenue growth rate is more than twice the average of the extended peer group below.

Not only is top line growth rate among the highest in the industry, but the big selling point for Shopify is the company’s broad ecosystem which aims to improve the company’s recurring revenue and reduce attrition rates.

With monthly recurring revenue increasing at a 30% on an annual basis for the past 5-year period, it appears that Shopify’s strategy to improve the stickiness of the business is working.

As exciting as all that sounds, achieving high revenue growth rate is not the only thing that matters for investors and the share price reaction following the latest earnings release was a warning sign.

Failing To Achieve Profitability

With the pressure rising on Spotify to improve its bottom line results, it appears that the stock is in for a difficult 2024.

In recent years, Shopify has significantly improved its ability to extract more revenue from merchants as the gradual increase in the company’s attach rate shows.

This, however, did not translate into higher gross margin for the company. Quite the opposite, gross margin figure of SHOP actually fell from 55% in FY 2019 to below 50% in 2023.

The share of fixed costs to revenue fell over the same period as economies of scale were materialized. Nevertheless, Shopify remains barely profitable on a net income basis (see below). The last two quarters of 2023 gave investors some hope that GAAP profitability is achievable, but it appears that momentum has faded away during Q4 of 2023.

As a matter of fact, most of the uplift in the net income figure over the last two reported quarters (marked in green on the graph above) was caused by other income, which contains items such as interest income, net realized/unrealized gains on equity and other investments.

Even though SHOP was able to quadruple the size of its revenue since FY 2019, the business is barely able to achieve operating profitability and the last quarter has put an end to an encouraging short-term momentum in GAAP operating income.

Pressure Is Building Up

In recent years we have seen more large cap software businesses prioritizing profitability over revenue growth at any cost. The most recent example has been Salesforce, which similarly to SHOP experienced a sharp fall in its share price in 2022. The recent pivot in CRM’s strategy, however, has been a great success for shareholder returns and has made the stock a great turnaround story.

Similarly to CRM, Shopify is now beginning to feel the pressure to improve its profitability as top line growth rate is bound to slow down as the business expands.

Although, SHOP is still smaller than CRM by a factor of 4 in terms of total revenue, the latter has done a great job at expanding its service offering and creating a unique service ecosystem that is targeting a wide range of large to mid-sized enterprises across the globe. Shopify has been following a similar strategy at expanding tits total addressable market in recent years, but I remain skeptical that it could replicate CRM’s success when it comes to scale.

Moreover, when compared to SHOP, Salesforce is strategically positioned in higher margin areas of the software application business where its pricing power is much higher than that of Shopify. This results in Salesforce having much higher gross margin, which in turn allows the company to achieve much higher profitability on an operating and net income basis.

As I mentioned above, tor the time being Shopify’s high valuation is supported by its industry-leading expected revenue growth and this creates significant risk of a multiple contraction should growth slows down even slightly.

What we could also notice from the graph above, is that companies like Microsoft (MSFT), Intuit (INTU) and Adobe (ADBE) are priced at similar sales multiples to that of Shopify, even though these three companies are expected to grow at rates below 15%. The difference in profitability profiles of these companies, however, is quite large, which gives us an indication of the level of profitability that Shopify would need to achieve in the coming years.

Lastly, as growth rates in the cloud and software sector are coming down from their post-pandemic highs, operating margins are becoming more important for valuations within the industry.

When substituting the forward revenue growth rate with operating margins and plotting these against Price/Sales multiples we could easily conclude that there isn’t a strong relationship (at least not as strong as we had on the graph above).

However, this is due to the two outliers from the group above – Shopify and Workday (WDAY) – another company that is facing significant risks going forward. Once we exclude these two stocks from our sample size, we could see that the market now puts more weight on profitability than it does on growth as far as differences in valuation multiples are concerned.

For the time being, Shopify’s smaller size and expectations that the company would be able to sustain this high growth rate beyond 2024 is giving investors hope that the company would have enough time to expand its business into higher margin areas of the market. However, the share price reaction following Q4 2023 results was a major warning sign. Moreover, given Shopify’s current gross margin relative to other companies in the software application space, the odds are increasingly stacked against the company’s current premium valuation.

Investor Takeaway

Contrary to other stocks in the software sector, Shopify Inc. stock has failed to return to its 2021 highs, and the recent rally was largely caused by outside factors that have little to do with the business itself. More importantly, it appears that investors are losing patience with the company’s efforts to improve its profitability profile and this is a major risk for shareholders going forward. Unless we see a major shift in Shopify’s strategy over the coming year, Shopify Inc. stock is likely to underperform its peers in 2024 and beyond.