Shopify ($SHOP) -Time to check out or shop later ?

Table of Contents

1. Summary

2. Why is now the time to buy $SHOP?

3. SHOPIFY Q3CY24 Highlights:

4. Sales Growth

5. Gross Merchandise Value

6. Customer Acquisition Efficiency

7. Customer Retention

8. Gross Margin & Pricing Power

9. Operating Margin

10. Cash Is King

11. Balance Sheet Assessment

12. Final Thoughts

Summary

Originally created as an internal tool for a snowboarding company, Shopify (NYSE:SHOP) provides a software platform for building and operating e-commerce businesses.

• Total payment volume has soared over the last two years, showcasing high user engagement and robust platform activity

• Rapid sales cycles signal outstanding integration capabilities and capital efficiency

• Impressive net revenue retention rate shows its products play a critical role in customer workflows

Why is now the time to buy $SHOP?

Shopify is trading at $118.85 per share, or a 15.4x forward price-to-sales ratio. While the stock’s optically high multiple could cause short-term volatility, we think the valuation is reasonable given its quality characteristics.

Entry price may seem important in the moment, but our work shows that time and again, long-term market outperformance is determined by business quality rather than getting an absolute bargain on a stock.

SHOPIFY Q3CY24 Highlights:

• Revenue: $2.16 billion vs analyst estimates of $2.11 billion (26.1% year-on-year growth, 2.2% beat)

• Adjusted EPS: $0.36 vs analyst estimates of $0.27 (31.5% beat)

• Adjusted Operating Income: $402 million vs analyst estimates of $334.2 million (18.6% margin, 20.3% beat)

• Revenue Guidance for Q4 CY2024 is $2.19 billion at the midpoint, below analyst estimates of $2.63 billion

• Operating Margin: 13.1%, up from 7.1% in the same quarter last year

• Free Cash Flow Margin: 19.5%, up from 16.3% in the previous quarter

• Net Revenue Retention Rate: 118%, in line with the previous quarter

• Billings: $2.14 billion at quarter end, up 27% year on year

• Market Capitalization: $137.6 billion

Sales Growth

A company’s long-term performance is an indicator of its overall quality. While any business can experience short-term success, top-performing ones enjoy sustained growth for years. Luckily, Shopify’s sales grew at a solid 25% compounded annual growth rate over the last three years. Its growth surpassed the average software company and shows its offerings resonate with customers, a great starting point for our analysis.

This quarter, Shopify reported robust year-on-year revenue growth of 26.1%, and its $2.16 billion of revenue topped Wall Street estimates by 2.2%. Company management is currently guiding for a 1.9% year-on-year increase in sales next quarter.

Looking further ahead, sell-side analysts expect revenue to grow by 20.8% over the next 12 months, a deceleration versus the last three years. Still, this projection is commendable and implies the market sees success for its products and services.

Gross Merchandise Value

GMV, or gross merchandise value, is the total value of goods and services sold on Shopify’s platform. This is the number from which the company will ultimately collect fees (usually called a take rate), and the higher it is, the higher the switching costs, enabling Shopify to monetize in additional ways (like subscription revenue for services).

Shopify’s GMV punched in at $69.72 billion in Q3, and over the last four quarters, its growth was impressive as it averaged 23.1% year-on-year increases. This performance aligned with its total sales growth and shows the company is capturing significant demand. It also indicates that customers are highly active and engaged, giving Shopify more opportunities to upsell adjacent products such as loans and AI-driven inventory management software that are highly accretive to the bottom line.

Customer Acquisition Efficiency

The customer acquisition cost (CAC) payback period represents the months required to recover the cost of acquiring a new customer. Essentially, it’s the break-even point for sales and marketing investments. A shorter CAC payback period is ideal, as it implies better returns on investment and business scalability.

Shopify is extremely efficient at acquiring new customers, and its CAC payback period checked in at 6.8 months this quarter. The company’s performance indicates it has a highly differentiated product offering and a strong brand reputation. These dynamics give Shopify the freedom to invest in new product initiatives while maintaining optionality.

Customer Retention

One of the best parts about the software-as-a-service business model (and a reason why they trade at high valuation multiples) is that customers typically spend more on a company’s products and services over time.

Shopify’s net revenue retention rate, a key performance metric measuring how much money existing customers from a year ago are spending today, was 119% in Q3. This means Shopify would’ve grown its revenue by 18.9% even if it didn’t win any new customers over the last 12 months.

Shopify has a good net retention rate, proving that customers are satisfied with its software and getting more value from it over time, which is always great to see.

Gross Margin & Pricing Power

For software companies like Shopify, gross profit tells us how much money remains after paying for the base cost of products and services (typically servers, licenses, and certain personnel). These costs are usually low as a percentage of revenue, explaining why software is more competitive than other industries.

Shopify’s gross margin is substantially worse than most other software businesses, signaling it has relatively high infrastructure costs compared to an asset-lite business like ServiceNow. As you can see below, it averaged a 50.9% gross margin over the last year. Said differently, Shopify had to pay a chunky $49.07 to its service providers for every $100 in revenue.

This quarter, Shopify’s gross profit margin was 51.7%, which is in line with the same quarter last year. Zooming out, Shopify’s full-year margin has been trending up over the past 12 months, increasing by 2 percentage points. If this move continues, it could suggest better unit economics due to more leverage from its growing sales on the fixed portion of its cost of goods sold (such as servers).

Operating Margin

Shopify has been an optimally-run company over the last year. It was one of the more profitable businesses in the software sector, boasting an average operating margin of 10.9%. This result was particularly impressive because of its low gross margin, which is mostly a factor of what it sells and takes huge shifts to move meaningfully. Companies have more control over their operating margins, and it’s a show of well-managed operations if they’re high when gross margins are low.

Looking at the trend in its profitability, Shopify’s operating margin rose by 39.5 percentage points over the last year, as its sales growth gave it immense operating leverage.

This quarter, Shopify generated an operating profit margin of 13.1%, up 6 percentage points year on year. The increase was solid, and since its operating margin rose more than its gross margin, we can infer it was recently more efficient with expenses such as marketing, R&D, and administrative overhead.

Cash Is King

Although earnings are undoubtedly valuable for assessing company performance, we believe cash is king because you can’t use accounting profits to pay the bills.

Shopify has shown impressive cash profitability, driven by its cost-effective customer acquisition strategy that gives it the option to invest in new products and services rather than sales and marketing. The company’s free cash flow margin averaged 17.4% over the last year, better than the broader software sector.

Shopify’s free cash flow clocked in at $421 million in Q3, equivalent to a 19.5% margin. This result was good as its margin was 3.4 percentage points higher than in the same quarter last year. Its cash profitability was also above its one-year level, and we hope the company can build on this trend.

Over the next year, analysts predict Shopify’s cash conversion will slightly fall. Their consensus estimates imply its free cash flow margin of 17.4% for the last 12 months will decrease to 16.1%.

Balance Sheet Assessment

Businesses that maintain a cash surplus face reduced bankruptcy risk.

Shopify is a profitable, well-capitalized company with $4.90 billion of cash and $1.14 billion of debt on its balance sheet. This $3.75 billion net cash position is 2.7% of its market cap and gives it the freedom to borrow money, return capital to shareholders, or invest in growth initiatives. Leverage is not an issue here.

Final Thoughts

The latest quarterly earnings matters, sure, but we actually think longer-term fundamentals and valuation matter more. Investors should consider all these pieces before deciding whether or not to invest in Shopify.

Shopify is a high-quality business worth owning. For starters, its revenue growth has been solid over the last three years. And while its gross margins show its business model is much less lucrative than the best software businesses, its efficient customer acquisition hints at the potential for solid profitability. On top of that, Shopify’s operating margin expansion shows Shopify has become more efficient at building and selling its software.

Shopify’s price-to-sales ratio based on the next 12 months is 15.4x. This valuation may appear high at first glance, but the multiple is deserved because Shopify’s fundamentals really stand out. We think the stock is attractive here.