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Morningstar | Shopify: Helping Shoppers Shop (From Their Couch) Until They Drop; Shares Overvalued

We are transferring coverage of Shopify and maintaining our narrow moat and stable trend ratings. Our fair value estimate falls to $156 from $170. We see Shopify as an investment in the burgeoning e-commerce industry without being tied to any specific retailer. Shopify strives to be a one-stop shop for small retail businesses, especially those that are e-commerce primarily, only, or first. The company offers an e-commerce platform with a variety of related add-on functionality that ultimately converge into a turnkey solution for small and midsize businesses, or SMBs. Shopify’s rapid growth since its 2015 IPO underscores a nascent software niche that is rapidly growing and demonstrates a winning solution. We believe the company has established a narrow moat, as switching critical e-commerce platforms has financial and operational costs for an already resource-constrained SMB. We forecast robust top-line growth decelerating over the next decade but still clocking in the high teens compounded annually.

While we do not see a high degree of differentiation among the lower end of the market for core e-commerce platforms, Shopify has established itself as a leader in this niche. Ease of use, a large expert support community, and an emerging developer ecosystem combine to make Shopify’s platform attractive. Add-ons such as Payments, Shipping, and Capital allow for upsells and provide another growth lever for the company. The platform also offers an enterprise-grade solution, Shopify Plus, which allows online stores to remain on the platform as their needs become more advanced. We think at the higher end, the company will enjoy some success, but will face stiff competition from highly sophisticated and tightly integrated platforms from Salesforce.com and Adobe.

Our research suggests Shopify is the leading platform for SMBs, as supported by the largest number of merchants of any platform. More merchants and high attach rates from add-on features like Payments and Shipping should continue to drive strong revenue growth over the medium term. The company’s focus on using search engine optimization, topical blogs, and network referrals to attract SMB users suggest to us that there should be leverage in the sales and marketing line to help increase operating margins over time. We also think scale will help with margin expansion.

Our fair value estimate for Shopify is $156 per share, which implies a 2018 enterprise value/sales multiple of 10 times, adjusted price/earnings multiple of 232 times, and a 0% free cash flow yield.

Our forecast includes a continued shift to merchant solutions from subscriptions. We model total revenue growth of 41% in 2019, decelerating to 22% in 2023, representing a five-year compound annual growth rate of 29%. We see subscription revenue growing at a 26% CAGR, with merchant solutions growing at a 32% CAGR over that same period. In our view, revenue growth will be driven by new merchants on the platform, uptake of Shopify Pay, Shopify Shipping, and Shopify Capital, and growing gross merchandise value on the platform. We also assume the introduction of unspecified new merchant solutions over time, although we do not think this is a critical factor over the next several years. We believe the failure rate will remain high on the SMB side, but also that successful merchants will grow to become Shopify Plus enterprise customers.

We estimate the digital commerce platform market, broadly defined, was over $10 billion in 2018 and grew in the midteens. Shopify sizes the SMB total addressable market at $70 billion, which it arrives at by considering 47 million global retail businesses and the company’s own annual average revenue per user of approximately $1,500. Management is looking at retailers with 500 or fewer employees and specifically excludes early-stage entrepreneurs and enterprise customers. Either way, Shopify generated $465 million in subscription revenue in 2018, so penetration and market share are both low.

We anticipate that GAAP gross margins will rise from 56% in 2018 to 59% in 2023 driven mainly by improving scale in the merchant solutions segment. We think gross margins for larger software-as-a-service companies should ultimately be within 75% to 85%. That said, Payments within merchant solutions has a structurally lower gross margin. We model GAAP operating margins increasing from negative 9% in 2018 to 5% in 2023, driven by scale across all operating expenses, especially sales and marketing. The company does not offer long-term operating targets.