Shopify Inc. Report

We will not include the usual graph for Shopify since the company is not yet profitable on a GAAP basis. It is growing its revenues and revenues per share very rapidly as discussed in the report here.

This is our first and preliminary report on Shopify. It presents information and our thoughts but we are not yet able to rate it as Buy or Sell but can say it should be considered Speculative.

Shopify Inc. (SHOP, on Toronto and U.S.)
RESEARCH SUMMARY  
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold no shares
Based on financials from: Dec ’17 Y.E. + Q3 ’18
Last updated: January 12, 2019
Share Price At Date of Last Update:  $                            149.43
Currency: $ U.S.
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Speculative and not rated
SUMMARY AND RATING:  This report is our first and preliminary look at Shopify. This company has achieved huge growth in revenues. But because it is not yet reached the stage of profitability (partly or largely because it prefers to invest and spend and growth) it is very difficult know if the shares are under- or over-valued. The Value ratios would not a support a rating of Buy. Management quality appears to be excellent. The insider trading signal is considered negative but is not an important indicator. Executive compensation is generous but not of concern given the market value of the company. The outlook is for continued very strong growth. The economics of the business appear to be excellent with a high gross profit and probably an extremely “sticky” customer base. Given the quality of the company but considering that the value ratios do not seem attractive it is clear that this would be a Speculative investment. At this time we cannot rate it as a Buy or a Sell but will simply call it Speculative and have provided our description and thoughts about the company.
Long Term Value Creation: On an accounting basis Shopify has not yet created value. But on a market value basis it has clearly created he value for its earliest investors (prior to the IPO) and it has created good value for the IPO investors as well.
DESCRIPTION OF BUSINESS: Shopify describes it self as “the leading cloud-based, multi-channel commerce platform for small and medium-sized businesses”. “The company’s mission is to make commerce better for everyone”. Shopify enables businesses to set up online and provides the associated services and software. Shopify merchants are located world wide. At the end of 2017 56% were in the U.S., 8% in the U.K., 7% in Canada, 7% in Australia and 21% in the rest of the world. In the first nine months of 2018, 45% of Shopify’s revenue was collected from recurring monthly subscription fees. The remainder was collected mostly on the basis of the volume of sales that its merchants achieved and is also likely to be essentially a recurring revenue stream. Shopify’s annual revenues are U.S. $952 million as of September 2018 and are rising at about 50% annually.
ECONOMICS OF THE BUSINESS: Although it is not yet profitable on a GAAP basis, Shopify has very strong economics in that its gross profit level is about 55% and its customer base is likely to be extremely loyal due to the fact that Shopify’s software and services are at the very hart of its customer’s business.
RISKS: The company lists numerous risks. The share price is anticipating continued huge growth for the company and any failure to achieve rapid growth is a risk to the share price. Data breaches cyber attacks are likely an important risk.
INSIDER TRADING / INSIDER HOLDING: There has been insider selling which is to be expected. While not unexpected, we would still consider it to be a negative signal.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (at least a marginal pass because shopify’s software services are not that complex to understand and their customers will tend to be very sticky but the growth rate would be difficult to anticipate), has favorable long-term economics due to cost advantages or superior brand power (probably a passing grade given its gross profit margin of about 55% but tempered by the fact that it is not yet profitable on a GAAP basis), apparently able and trustworthy management (pass), a sensible price – below its intrinsic value (this is too hard to say at this time), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass, it has no debt), good recent profit history (fail on a GAAP basis) little chance of permanent loss of the investors capital (marginal pass at best given the high price to book ratio) a low level of maintenance type capital spending required to maintain existing operations excluding growth (marginal pass)
MOST RECENT EARNINGS AND SALES TREND: Revenues per share have been increasing at an annual rate of about 50% and that is despite a modest increase in the number of shares.
COMPARABLE STORE SALES  OR INDUSTRY SPECIFIC STATISTICS:
Earnings Growth Scenario and Justifiable P/E: Not applicable as the company is not yet profitable but it is clearly pricing in a very high rate of growth.
VALUE RATIOS: Shopify is not yet profitable on a GAAP basis and therefore important value ratios including return on equity and the P/E based on trailing earnings are not applicable. The price to book ratio of 9.5 is ostensibly very unattractively high and basically assumes that the company will ultimately achieve a very high return on equity. The 9.5 P/B ratio results in the $1.7 billion of equity trading at a value of $15.9 billion. That is a large premium. And if we remove the $1.6 billion in marketable securities and cash from both the book value and the market value we are left with a net of $264 million in business assets being valued at some $14.3 billion for a multiple of some 54 times book value! The P/E ratio based of analyst estimates of forward earnings is very high at 210. In the absence of earnings, if we look at the price to sales ratio it is unattractively very high at 16 times. It would be difficult not to conclude that the available value ratios would suggest that the stock is very much over-valued.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: Shopify
Currency: $ U.S.
Contact: 0
Web-site: 0
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $952.2
Latest four quarters annual earnings $ millions: $(66.0)
P/E ratio based on latest four quarters earnings: negative
Latest four quarters annual earnings, adjusted, $ millions: $(66.0)
BASIS OR SOURCE OF ADJUSTED EARNINGS:
Quality of Earnings Measurement and Persistence: The company is not yet profitable because it is spending heavily to drive growth.
P/E ratio based on latest four quarters earnings, adjusted negative
Latest fiscal year annual earnings: $(40.0)
P/E ratio based on latest fiscal year earnings: negative
Fiscal earnings adjusted: $(40.0)
P/E ratio for fiscal earnings adjusted: negative
Latest four quarters profit as percent of sales -6.9%
Dividend Yield: 0.0%
Price / Sales Ratio 16.08
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         9.53
Balance Sheet: Shopify is valued for its potential earnings and not for its assets. Nevertheless, the composition of its balance sheet may be of interest. 72% of its assets consist of short-term marketable securities. A further 13% is cash. 2% is trade receivables, 5% is loans to merchants to finance their receivables, 1% is other current assets. 3% of assets is property and equipment which is mostly leasehold improvements but also computer equipment and furniture, 1% is intangible assets which is mostly software but also some purchased customer relationship value, and 1% of assets is purchased goodwill. These assets are financed as follows: 91% by shareholder equity, 6% by accounts payable, 2% by deferred revenue and 1% by lease incentives. With no debt and a huge amount of marketable securities this is an extremely strong balance sheet. Shopify has basically sold shares at high prices and built up a huge “war chest” presumably to fund growth.
Quality of Net Assets (Book Equity Value) Measurement: With the shares trading at over nine times book value, the value of the assets is not really relevant. However, the assets do have solid value in that they are mostly marketable securities. But the company is valued for its growth potential, not its tangible assets.
Number of Diluted common shares in millions:                                 106.6
Controlling Shareholder: The founder and CEO, Tobias Lutke, owns 36% of the voting power by owning 60% of the Class B multiple vote shares. A director owns 18% of the voting power by owning 30% of the multiple voting shares.
Market Equity Capitalization (Value) $ millions: $15,936.3
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 90.8%
Interest-bearing debt as a percentage of common equity 0%
Current assets / current liabilities: 11.8
Liquidity and capital structure: Shopify has extremely good liquidity and an extremely strong balance sheet as it has no debt and has 72% of its assets invested in short-term marketable securities and another 13% in cash.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: -5.0%
Latest fiscal year adjusted (if applicable) net income return on average equity: -5.7%
Adjusted (if applicable) latest four quarters return on market capitalization: -0.4%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
X years compounded growth in sales/share not available
Volatility of sales growth per share:  $                                  –  
X Years compounded growth in earnings/share not available
X years compounded growth in adjusted earnings per share not available
Volatility of earnings growth:  $                                  –  
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? 0.0
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: -5.7%
More conservative estimate of compounded growth in earnings per share over the forecast period: not available
More optimistic estimate of compounded growth in earnings per share over the forecast period: No prediction
OUTLOOK FOR BUSINESS: We would expect Shopify to continue to post excellent growth for the foreseeable future.
LONG TERM PREDICTABILITY: Shopify appears to have established a strong leading position in its market. We would expect its customers to be loyal due to the inconvenience of switching online sales platforms. Overall, we would expect Shopify to prosper over the years.
Estimated present value per share: Shopify is an early stage company and it is not possible to estimate what its future earnings per share will be and therefore we have no ability calculate any estimate of an intrinsic value per share.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry (Pass, as a large investment would be needed to enter this business). No issues with powerful suppliers (pass). No issues with dependence on powerful customers (pass), No potential for substitute products (pass) No tendency to compete ruinously on price (pass). Overall this industry appears to be very attractive for an established incumbent.
COMPETITIVE ADVANTAGE: Shopify may have a huge advantage as (we understand) the first large player in this market. Due to the way their service becomes the heart of their merchant customer’s businesses, it may be very difficult for competitors to lure customers away.
COMPETITIVE POSITION: We believe Shopify has a leading position in the market but we are not aware of its market share or the identity of its main competitors.
RECENT EVENTS:
ACCOUNTING AND DISCLOSURE ISSUES: No opinion
COMMON SHARE STRUCTURE USED: Unfortunately, Shopify has a dual share structure whereby it is controlled through multiple voting shares. The shares that that trade have only one tenth the voting power of each multiple voting share.
MANAGEMENT QUALITY: We would judge management quality to be extremely high. They have created a hugely valuable company in a short period of time and have continued to pursue huge growth. We believe they have also been very astute in selling shares to the public to raise a huge “war chest” of cash. The trade off between the amount of cash raised, and the strength and opportunities that the cash provides, and the level of dilution of the future expected profits was probably a very good trade-off.
Capital Allocation Skills: We would rate these skills highly. Management’s decision to invest in software and research to create and grow Shopify has been extremely beneficial. In addition their decisions at the time of the IPO and on subsequent occasions to issue shares and raise very substantial amounts of capital appear to have been very astute.
EXECUTIVE COMPENSATION: Compensation for the top 5 officers for 2017 was largely in the form of shares and options and ranged from $1.6 million to $8.2 million. This compensation is not a concern given the $16 billion market value of the company.
BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. The Board here has just six members. Most of the directors hold millions of dollars worth of shares and therefore we have owners in charge of the business. One director holds only options but these are likely worth over $1 million. One director holds only a modest amount of shares. Overall the Board may lack depth and independence.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, achieved earnings per share growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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