A few days ago, I read an excellent Fortune article on Shopify, the Canada-headquartered company that allows business owners to easily and quickly set up their digital e-commerce presence. It got me thinking about plenty of things on business and and investing.

 

My experience with choosing e-commerce platforms

I’ve known about Shopify for years, since at least late 2013. Back then, I was planning to set up a simple e-commerce store and was choosing between a number of platforms. These ranged from free ones like WordPress to paid platforms like Wix and of course, Shopify.

I actually quite liked Shopify as it seems fuss-free and powerful enough. What turned me off was the pricing. Well, at US$29 a month for the basic plan, it was not exactly unaffordable. But when I first started out, every cent counts. Besides, the margins of the products I was intendinf to sell were relatively lower and I guess it was just the penny pinching mindset that was part of the package as a value investor.

I ended up on the WordPress platform which is more robust than Wix or Shopify but requires a certain level of technical and programming expertise (of which I had very little of). Although I had to install it myself, the most crucial factor of deciding on WordPress was that it is largely free! Over the years, whenever I need technical expertise to upgrade or if the site breaks, I had to seek external help by turning to gig platforms like Fiver. For minor issues, Googling DIY solutions had been most useful. While the overall explicit costs from using WordPress were definitely lower, if I had known beforehand that I could have avoided all the headaches, struggle to learn how to use it, time spent to resolve issues, security fears, inability to utilise new functions due to obsolete underlying system, lost revenue when the site is down, minor errors faced by customers, I would probably have opted for Shopify instead.

Fast forward about 4 years later today in July 2017, Shopify is now a public company listed on the NASDAQ, with a stock price that’s climbed from US$17 to about US$89 since it’s listing in 2015.

Financials wise, Shopify remains unprofitable even though revenue has continued growing like a weed. In fact, it seems to be that the higher the revenue generated, the greater its losses. Cash flows from operations were barely breakeven and would have been negative without adding back stock-based compensation. The dismal quality of its financials stopped me from exploring further and from considering investing in Shopify. But the stock price keeps marching upwards. What is it that the market knows that I don’t? Could it just be a bunch of loonies pushing prices up? Turns out, the closer I read the article, the more I realised there could indeed be substance behind the skyrocketing stock price.

 

A tech startup’s snake oil – “We can be profitable if we want to”

It has been argued that Shopify can be profitable if it wants to. It just has to cut marketing costs. I viewed it with great scepticism. After all, all tech firms are saying exactly the same thing. There’s alot of Kool-aid being passed around and I thought this was one of it.

Well, it turned out there is truth in cutting down marketing expenses to gain profitability but it only applies to very specific business models. It only applies to businesses with strong recurring revenue, of which a complete reduction in marketing expenses would not lead to its existing customer base bailing out. Shopify’s business model is a prime example of this phenomenon. In my opinion, the function of its marketing costs is really to grow and acquire new customers rather than retaining existing customers.

The moment a customer signs up with Shopify, sets up shop and gets some revenue streaming in, you can be quite assured he will stay with Shopify for some time as long as his operations remain profitable. After learning how to use it and having invested effort into optimising his storefront and utilising value-adding third party plugins from riding on Shopify’s platform, he gets locked in to the system.

Contrast this with a fashion retail brand like Abercrombie & Fitch (“A&F”). Once a consumer purchases an item from A&F, that’s the end of the transaction. To induce the same consumer to spend at the store, he has to be convinced that down the road he will be perceived to be cool when people see him wearing a new piece of A&F apparel. That’s where marketing and advertising expenses come in for A&F – to not only attract new consumers but also retain existing ones.

**High switching costs**
The point on Shopify’s third party plugins is what makes the customer lock-in extra powerful. Over the years, Shopify has built an ecosystem of app creators not unlike Apple’s app store. Shopify is no longer just a web host and template provider. It is an ecosystem which app vendors can build onto Shopify’s underlying platform and integrate their functions with customers’ stores. As an example, Mailchimp, a highly popular marketing email automation tool layers onto Shopify’s platform, allowing store owners to automatically send emails to re-activate customers who have not made a purchase for 60 days by encouraging them to make a purchase, perhaps through discount codes. Customers pay a small fee to Mailchimp, but the returns can potentially be way more exponential. The more extra tools (plugins) customers use, the more app vendors Shopify sign up and the more innovative they are, the more locked in Shopify’s customers become. And of course, Shopify gets a cut of all those fees flowing through.

I’ve used the same web host, same WordPress platform, same domain name host for 4 years and I sure as hell am not uprooting from it, given all the hassle I’ll face if I do so.

Although I’m not on Shopify, if I am and they take care of all my traffic load, security matters, create value for me with additional functionalities to bring in more sales and better track inventory, etc, you can rest assure I’ll stick with Shopify for a long long time.

In short, I believe the marketing expenses are truly and largely for growth purposes. Customers who sign up and gets the first dollar of revenue rolling in likely stays for a long time. In other words, these customers have long lifetime values. On the topic of lifetime value, it is also important that it drags on as long as possible. As an example, say dating apps like Tinder, there is a natural attrition when a user enters into a serious relationship with a new partner. In most cases, he or she is not likely to utilise it again during the relationship until a breakup occurs. They may never use it again if the parties get married. Each iteration of marketing and advertising efforts serves to retain a certain customer count and the business is left running on a treadmill. In fact, the irony is that the better the dating app is at matching, the faster users drop off from the platform. Qualitatively, Shopify undoubtedly has a better business model and greater staying power from these perspectives.

The other consideration of the switching costs or likelihood of customers being retained on Shopify or any other platform would be the repercussions if they stopped using it. If Shopify customers want to move their sites elsewhere and recreate the previous site experience which their users are used to, to an extent, they may be able to export or recreate certain segments of their site but overall, the effort will likely be Herculean, if not a total nightmare especially for customers without the technical expertise.

Financials and valuation

Financials wise, revenue and gross profit grew almost 90% and 85% respectively between FY2015 and FY2016. Revenue was US$389m and gross profit was US$209m in FY2016. Losses widened from US$19m in FY2015 to US$35m in FY2016.

Sales and marketing expenses were US$129m in FY2016 and makes up the largest part of operating expenses of US$247m. This will not be a direct and most accurate comparison but if we take a peek at Verisign’s sales and marketing expenses, it makes up about 8% of revenue as compared to Shopify’s 33%. Verisign holds the monopoly to the .com and .net top level domain, has a quality of customer retention that is probably among the strongest I know and has a very slow and steady revenue growth pace. At 8% of revenue in sale and marketing expenses, I would think it probably is a good floor reference. Assuming Shopify requires a normalised equivalent of 10% to achieve a slow steady rate growth, that would translate to US$39m in sales and marketing expenses. R&D for Verisign makes up about 6% of revenue. Verisign, as the .com and .net monopoly hardly needs R&D so it probably is a lowball percentage. Shopify definitely needs a much higher percentage and this is arbitrary but I believe 10%, which is double that of Verisign’s should be fair for Shopify to achieve a slow steady rate growth. That translates to US$39m in R&D expenses for Shopify.

Assuming minimum sales and marketing expenses of US$39m and R&D of US$39m, would give us US$88m in normalised operating profit. There will probably be quite alot of NOLs for claims given the accounting losses Shopify made over the years. This would mean that Shopify may not need to pay taxes on incoming profits for some time. Assuming Shopify incurs effective Canadian tax rate of about 26%, it would generate about US$65m in normalised net profit or a net profit margin of about 17%. Not so unprofitable now eh?

This is where things take a much more arbitrary turn. Shopify had been growing at crazy rates and has near-guaranteed growth in the future given the secular trend of rising e-commerce volume. By exactly how much, it’s hard to tell but I do think 30% compounded over the next 3 years isn’t out of the question since the existing infrastructure has been built out and the incremental cost of a new customer who signs on isn’t that high. In fact, 30% CAGR over 3 years is probably conservative. I would slap on a 25 times EV multiple as a reasonable exit multiple down the road to pay for such a high quality, strong moat and high growth business.

Assuming earnings for the next 3 years grow at the 30% CAGR, at the end of year 3, earnings will be US$143m. At 25x exit multiple, That comes up to an EV of US$3,575m. To get the equity value, I’ll also add back 75% (arbitrary again – I assume the company needs about 25% for working capital) of net cash (US$296m) as at 31 Mar 17, and we get an equity value of about US$3,871m.

This is way below Shopify’s current market cap of US$7,800m and I could be too conservative about Shopify’s prospects in terms of financial projections. Sometimes, one does need to take a leap of faith to invest in compounder businesses with a wide moat. However, I am still pretty much a value and numbers driven investor as opposed to a story driven investor. As such, I find it hard to jump in with both feet into an investment with too high a valuation.

 

Conclusion

Ultimately, I may not be buying Shopify anytime soon. Nevertheless, I thought this was a great exercise to pen my thoughts down and build a framework to uncover potential investment gems with similar high quality moats and earnings that are obscured by expenses largely relating growth.

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