Over the past few quarters, Shopify's stock has been on a rollercoaster ride, with notable price volatility. However, the company's Q2 FY24 earnings report brought some much-needed optimism, as the stock surged over 22% on the day of the announcement last week. This rally was driven by the performance of Shopify's e-commerce business, which stood out in a challenging macroeconomic environment, whilst many competitors fell short. The market's initial reaction might have been driven by concerns about declining consumer demand and its potential impact on Shopify, leading to some of the stock's earlier declines. But with the latest surge, Shopify reports about 2% in YTD gains, albeit significantly underperforming the S&P500 which reports about 21% in YTD gains.
Shopify has solidified its position as a leading provider of e-commerce infrastructure, holding a 10% market share in the U.S. and 6% in Western Europe. The company is currently benefiting from multiple tailwinds, with consumer demand shifts being just one of them. If Shopify can achieve such robust earnings amidst economic headwinds, the potential for growth is even greater when the broader economy strengthens. The core growth drivers of Shopify's growth continue to remain intact, driven by both merchant expansion and increased buyer activity. With a promising revenue forecast for Q3 FY24, strong growth in gross merchandise volume (GMV), and improving free cash flow margins, Shopify's stock has continued its upward trajectory even weeks after its Q2 FY24 results. With these strong growth drivers, I believe that the stock remains attractively priced at current levels (refer to the valuation section below) and it appears that Shopify is evolving from a high-growth company into a more established, mature player in the e-commerce space.
Expanding the Ecosystem
As Shopify transitions from a high-growth company to a more mature and established player, it continues to expand its ecosystem as part of its growth strategy. This approach includes the consistent addition of new stores to its marketplace and offering merchants diversified sales channels, such as social media ecommerce. Unlike traditional online marketplaces like Amazon, eBay, or Etsy, Shopify allows merchants to create independent online shops, giving them full control over their brand and product sales. This unique model, combined with Shopify's robust financial position, allows the company to make substantial investments in growth initiatives aimed at global expansion—investments that smaller competitors like Squarespace or open-source platforms like WooCommerce may struggle to match.
The Untapped Potential in B2B
One of the key opportunities within Shopify's growth strategy is the B2B sector, which represents a substantial market. Traditional B2B order processing has substantial inefficiencies, making the prospect of online ordering for wholesale supplies, similar to how consumers order food through platforms like DoorDash, far more appealing. Reliability is essential for managing large orders, and although the shift to online B2B transactions will take time, Shopify already has a significant advantage. With a customer base of over 2 million merchants as of the end of 2021 (likely higher now), Shopify can leverage these existing relationships to drive growth in this area.
Shopify's B2B opportunities could add over $450 billion to its total addressable market (TAM), significantly expanding its reach beyond traditional e-commerce. Additionally, the company's merchant services are projected to add another $130+ billion in TAM. Although B2B is a relatively new initiative for Shopify, it is already gaining momentum, as evidenced by a 140% increase in B2B GMV. This growth illustrates the value Shopify offers to larger enterprises looking to streamline their ordering processes and capitalize on the shift to online transactions.
Shopify Plus: Driving Enterprise-Level Growth
Another important driver of Shopify's growth strategy is Shopify Plus, its premium subscription service tailored for larger merchants. Shopify Plus provides a combination of commerce management and payment processing tools designed to support multichannel platforms and cater to both B2B and direct-to-consumer (DTC) business models. Since its launch in 2017, Shopify Plus has consistently been a significant contributor to the company's financial performance, with approximately 28,000 Plus subscribers to date. Plus merchants have become increasingly vital to Shopify's revenue, accounting for 47% of the company's 2023 revenue, up from 31% in 2019, representing a compound annual growth rate (CAGR) of 61% over the period. This substantial growth outlines the value of Shopify Plus's comprehensive offerings and its strong appeal to enterprise-level merchants.
In February 2024, Shopify announced a price increase for Plus subscriptions. Existing customers could keep their current contract rate of $2,000 per month by committing to a three-year contract, while new customers are now charged $2,300 per month. Additionally, the company raised the online variable platform fee for customers on annual contracts. The timing of these renewals were expected to have a significant impact on Shopify's financials at the time of its inception. These impacts are already materializing as evident through Shopify's earnings beat in Q2 FY24, even amidst consumer demand weaknesses. Further, management has also reported a continued trend of enterprise migration, with the majority of Plus merchants opting for three-year contracts, which is likely to stabilize billing trends in the short term.
Strong Earnings Performance Amidst Consumer Demand Weaknesses
Despite concerns about weakening consumer demand, Shopify delivered robust Q2 FY24 results, significantly outperforming expectations. The company reported a YoY revenue increase of 21%, surpassing analyst estimates. Earnings also beat projections, with adjusted EPS coming in at $0.26 per share, exceeding consensus by $0.06 per share. A key highlight was the impressive 22% YoY surge in GMV to $67.2 billion, easily topping the consensus estimate of $65.7 billion.
The Subscription Solutions segment, which represents the recurring revenue portion of Shopify's business, showed a notable 27% YoY revenue increase. This growth was primarily driven by an increase in the number of merchants and recent price increases in subscription plans. Additionally, Monthly Recurring Revenue (MRR) rose by 25% YoY to $169 million, beating consensus estimates by $10 million. A key driver here was the 30% YoY global increase in merchants, which is exactly what investors want to see. Shopify Plus, the company's premium offering, contributed $52 million to MRR, making up 31% of the total. It's worth noting that many Plus merchants committed to three-year contracts at 2023 rates despite the price increases, which outlines the value and stickiness of Shopify's SaaS solutions. I'm particularly positive about this segment's future, as the company has shown the ability to drive revenue growth through strategic price increases, which we saw pay off last year with accelerated top-line growth.
Expense Management and Margin Expansion
Shopify has also made significant strides in managing its operating expenses, which have decreased substantially from their peak levels, falling to approximately $800 million in late 2023. This improvement in cost management is particularly impressive given the challenging macroeconomic environment outlined by high inflation, rising labor costs—especially for skilled workers like software engineers—and increased energy costs. In Q2 FY24, Shopify's gross profit increased by 25% YoY, reaching $1 billion, resulting in a gross margin of 51.1%, up from 49.3% in the same period last year. While part of this margin expansion was driven by the divestiture of Deliverr, Shopify's logistics business, the shift in pricing plans also played a significant role. Lower operating expenses further contributed to this margin improvement. These developments have positioned Shopify well to continue its focus on profitability, even in a challenging economic landscape.
Strong Free Cash Flow and a Healthy Balance Sheet
One of the most positive developments of Shopify's financial performance is its robust free cash flow (FCF) generation. In Q2 FY24, Shopify reported FCF of $333 million, representing a YoY growth rate of 243%. The company's FCF margin expanded by an impressive 10 percentage points to 16%. Given the company's seasonal fluctuations, I forecast an average FCF margin of around 15% for the year. This strong FCF performance not only highlights Shopify's ability to generate cash but also outlines the potential for shareholder returns through stock buybacks in the future. Shopify's financial health is further outlined by its solid balance sheet, which includes $4.1 billion in net cash. This strong financial position equips Shopify with the flexibility to invest in growth initiatives and explore opportunities for strategic expansion. Looking ahead, I anticipate further improvement in gross margins, likely by 0.5% in the near term. I also expect FCF margins to remain around 18% in Q3 FY24 and stay in the double digits for the remainder of the year. As the benefits of recent price increases continue to materialize, I believe this positive trend will persist over the long term, driving sustainable growth and profitability for Shopify.
Valuation Thoughts
Shopify's 5-year historical average P/S ratio has hovered around 27x. Currently, the stock is trading significantly below this average, which, in my view, represents a compelling opportunity given the current tailwinds propelling the business. The notable increase in the number of merchants, strategic price adjustments, and the trend of consumers trading down to more affordable options offered by Shopify merchants all indicate that growth prospects may now be even more robust than in the past. Consequently, I believe Shopify should command a valuation multiple closer to its historical average. Currently, Shopify trades at a forward P/E of 13x. With the strong tailwinds I've mentioned, I expect this multiple to expand into the 18x to 20x range. If we consider the lower bound of this range, a forward P/E of 18x would imply an intrinsic value of around $110 per share, which would offer approximately 40% upside from current levels. This upside is quite appealing, especially considering that Shopify is transitioning into a more mature company.
Even if multiple expansion does not materialize, there's still a strong case for Shopify's current valuation. The stock's forward P/E of 78x is justified by its projected EPS growth rate of 45%. If Shopify's stock price increases in line with its earnings, this would translate to a 45% annual increase over the next three years, effectively tripling the stock's value and sustaining the current P/E ratio of around 78x.
Source: Alpha Spread
To further quantify this, using a discounted cash flow (DCF) model with a 17% revenue CAGR over the next 5 years (in line with Wall Street forecasts), a terminal growth rate of 5%, and a discount rate of 8%, we still achieve a margin of safety of about 23%. This cushion adds another layer of confidence in potential stock appreciation. Although Shopify's current price might not scream "buy," the growth opportunities in the e-commerce sector are substantial. The long-term potential, particularly within Shopify's merchant solutions segment, is quite compelling, and the company's consistent sales growth supports this narrative.
Conclusion
In conclusion, Shopify's ability to deliver impressive earnings growth amid a challenging macro economic environment outlines its resilience and strong market position. With strategic growth initiatives like expanding its ecosystem, growing its B2B presence, and improving its premium Shopify Plus offering, the company is well-positioned to seize future growth opportunities. While the stock's valuation may not offer a deep discount, it remains attractive given the company's solid fundamentals, robust free cash flow, and potential for further expansion. As Shopify continues to mature and evolve, it presents a balanced investment proposition for investors looking for both growth and stability in the e-commerce space.
