On its face, Shopify (NYSE:SHOP) stock looks like a bubble, or something close. Shopify stock has risen 190% in 2019 alone, adding almost $25 billion in market capitalization in the process. It trades at 373x 2020 consensus EPS and almost 20x next year’s average revenue estimate.
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In a market that — in tech in particular — looks dearly valued, SHOP stock seems like Exhibit A in the argument that U.S. equities have run too far. And yet those analysts — myself included — who have decried the stock’s valuation have at best missed out on profits and at worst been run over.
I wrote earlier this month that there was little reason to see the run ending any time soon. This is a momentum play, and that momentum remains intact. As I noted earlier this year, the company’s move into fulfillment opens up new opportunities for the company, and for Street growth models. At least one analyst already has jumped on board.
But those factors don’t necessarily answer the broader question here: is Shopify overvalued? To be honest, I still believe that it is, at least from a truly fundamental standpoint. This is a wonderful business, but there are worries about its resilience in a recession. And the valuation incorporates something close to perfection for years to come.
That said, it’s worth noting that there is a fundamental case here. This isn’t a pure bubble, like so many stocks were in the first dot-com era of the late 1990s. It’s hard to make the case that SHOP stock is cheap. But looking past the headlines, there is at least a way to justify the current valuation — and maybe even a bit more upside.
How Margin Expansion Can Boost SHOP Stock
Shopify’s earnings multiples admittedly look close to absurd, whether it’s the 370x+ forward P/E or a 2019 EV/EBITDA multiple likely in the 500x range.
But those multiples are impacted by the fact that Shopify’s margins are razor-thin right now. Adjusted operating income in 2018 was just 1% of revenue. In the first half of 2019, that figure has held, while improving from a negative 1% print the year before.
As those margins expand, earnings are going to grow exponentially even ignoring continued top-line improvements. Operating margins have expanded about 200 basis points (bps) in the first half; if the company repeats that performance in the second half, while posting its expected 43% year-over-year revenue growth, operating income should rise more than 400%.
It’s not as if Shopify is done with that expansion. Even assuming margins get to 3% this year, there’s still a nice path to over 10%. This is largely a subscription revenue business after all, even if gross profit on merchandise sales are much lower. Incremental margins (the profitability of added revenue dollars) should be quite high.
Meanwhile, Shopify still is investing in its business, with sales and marketing alone still about 30% of revenue. A more mature business can get that figure down dramatically. Revenue growth will boost gross margins and leverage G&A and R&D spend.
Consensus EPS for next year appears to imply a roughly 6% operating margin. Get that figure to 15% and double revenue — the latter of which Shopify should be able to do by 2023 — and P/E gets down to a more reasonable (if still very expensive) 70-80x.
That doesn’t mean SHOP stock is cheap. But we’ve seen SaaS plays like Salesforce.com (NYSE:CRM) trade at above 40x for years. Fulfillment profits should start arriving a few years from now. At the least, Shopify stock can go from being “absurd” to simply being expensive. That might be enough.
Comparing SHOP Stock to AMZN Stock
There’s another way to look at Shopify’s valuation that makes it seem at least potentially reasonable. According to estimates cited in Shopify’s most recent presentation, Amazon (NASDAQ:AMZN) has 47% share of U.S. eCommerce. Shopify has one-tenth that penetration, at 4.7%.
It’s too simplistic to argue that Shopify, then, should be worth roughly one-tenth of Amazon, or almost $90 billion. Amazon’s valuation, of course, includes Amazon Web Services, which one analyst believes could be worth $500 billion. Amazon’s greater scale should be more valuable. And, of course, Shopify’s market share doesn’t actually come from the company, but rather its merchants. Shopify gets only a portion of those revenues (which it refers to as GMV, or gross merchandise value) via subscription and payment fees.
That said, Amazon’s North American business likely is worth $500 billion or more. It, too, has a huge reseller business. And its profit margins in North America, about 5%,aren’t exactly enormous.
No. 2 on the list is eBay (NASDAQ:EBAY), at 6.3%. eBay is worth $35 billion. Given that Shopify almost certainly will pass that online reseller in the next few quarters, is there at least an argument that SHOP stock should be more valuable? And maybe much more valuable? The same is true of Square (NYSE:SQ), a semi-competitor which, even after a recent plunge, is valued at roughly $25 billion excluding cash.
Again, this is not to say that Shopify stock is cheap. It isn’t. I wouldn’t pay $370 a share for it. And if the entire market is overvalued, as many fear, these comparisons will break.
But here, too, there’s at least a way to see the valuation as something short of ridiculous. Right now, given the short-term enthusiasm behind Shopify stock, that too might be enough.
As of this writing, Vince Martin has no positions in any securities mentioned.
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