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Morningstar | Initiating on Narrow-Moat Shopify With a $150 FVE; We'd Consider Shopping for Shares on a Pullback

We are initiating coverage on e-commerce platform Shopify with a $150 per share fair value estimate, narrow economic moat rating, stable moat trend, and very high uncertainty rating. Our fair value estimate implies an enterprise value/sales ratio of 14 times.

Shopify is a multichannel e-commerce platform that allows businesses or merchants to set up online stores to sell products. Increasingly, Shopify’s services allow these merchants to sell their wares through multiple remunerative channels, such as marketplaces, like Amazon and eBay, or social media outlets, notably Facebook, Twitter, Instagram, and Pinterest. Merchants pay a monthly fee for Shopify's technology, with revenue reported in the firm’s subscription solutions segment. However, we view the firm's merchant solutions segment as the larger opportunity, whereby Shopify uses its scale to allow merchants to process payments through Shopify Payments or ship their products through Shopify Shipping and UPS, one of the firm’s logistics partners. Payments, Shipping, Shopify Capital (its merchant cash advance service), and POS, Shopify’s point-of-sales hardware, have yielded a merchant solutions business that is now larger than subscription solutions, even though many of these products were introduced in the last year or two. We believe that businesses built on Shopify’s platform, essentially run their business off of the Shopify ecosystem and we see the rapid succession of Shopify’s integrable solutions as supportive of a narrow economic moat.

The firm’s specialty is small and medium-size businesses, but Shopify Plus customers (essentially enterprise clients) composed 3,600 of Shopify’s 609,000 total merchants at the end of fiscal 2017. We expect Shopify to continue expanding in the enterprise market, particularly as these established clients can quickly launch direct-to-consumer operations without expanding their network engineer head count. However, we note seasoned enterprise software vendors operate or have entered the e-commerce solutions market, notably Salesforce and Adobe, creating barriers to robust expansion in the enterprise space.

In the long term, we see Shopify as a play on the growth in e-commerce and entrepreneurship trends. We think Shopify's mounting prospects will be driven by a growing base of merchants, an expanding enterprise footprint, launching offerings internationally, and continued implementation of additional merchant solutions services.

Shopify's growth rate has been nothing short of expeditious, with the firm posting a three-year historical CAGR of nearly 86%. We forecast the firm growing at a 36% CAGR over the next five years. We model the company surpassing $1 billion in revenue for fiscal 2018 and believe the firm could reasonably expand revenue to just under $6 billion by 2027. We see these assumptions as reasonable in the context of growing e-commerce demand and the erosion of brand equity in the legacy consumer space.

Shopify's gross margin profile is pivoting as its faster growth merchant solutions segment has overtaken the subscription services segment. Subscription services produced gross margins of nearly 80% in fiscal 2017, in line with what we expect from a software vendor, as the segment charges customers a monthly fee to merchants for utilizing the platform. Revenue for Shopify Payments, Shipping, and Capital is reported in the merchant solutions segment. We estimate Shopify Paymentsaccounted for nearly 94% of merchant solutions revenue in fiscal 2017. However, Payments carries lower gross margins as Shopify recognizes the Payments revenue, but Shopify then pays credit card interchange and network fees to Visa and Mastercard, as well as the firm’s processing partner Stripe. This meant that merchant solutions gross margins sat at 36% in fiscal 2017.

Overall, we expect merchant solutions (28% 10-year CAGR and 71% of total revenue by fiscal 2027) to outpace growth in Subscription Solutions (18.5% 10-year CAGR and 29% of total revenue by fiscal 2027) over the next decade. From a gross margin standpoint, we expect modest uplift in merchant solutions gross margins, as relatively higher margin offerings such as Shipping and Capital compose a great portion of the segment’s revenue and as total processed volume increases for the firm. As gross merchandise volume increases, Shopify can get better rates for Shopify Payments. We believe Shopify’s gross merchandise volume can reasonably exceed 75 million in 2020. We model merchant solutions gross margins expanding to 54% in fiscal 2027, with consolidated gross margins growing from 56.5% in fiscal 2017 to 62.5% in fiscal 2017. As Shopify’s platform expands, we model increasing operating leverage stemming from sales and marketing. We believe the firm will become GAAP profitable for the first time in fiscal 2021 and model operating margins expanding to 29% in fiscal 2027.