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Shopify Inc. (Q4/19) (Update)

Initiating Coverage, Shopify, The Privatized Grand Bazaar - Target Price: US$599.28; Recommendation: BUY; Risk: High

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(all currencies are in US$ unless otherwise noted)

EventShopify Inc. (“SHOP” or “Shopify”) reported Q4/19 results on Feb 12, 2019. The following is an initiating report by Modelyze Investments on SHOP.

Highlight: Shopify is in the high growth stage of its corporate life cycle and has not failed to impress in Q4/19 given its creative business model. Total revenue grew by 47% relative to Q4/18 due to a continuous 32% increase in MRR and 47% increase in GMV relative to Q4/18. Gross profit was up 42%. For the first time Shopify reported a positive net income of $0.77 million. Shopify closed the acquisition of 6 Rivers System, Inc. and continued expansion and integration of Shopify Fulfillment Network. It launched Shopify Email, an email marketing tool for merchants to manage and build customer relationships and Shopify Shipping adoption by merchants continued to climb. The company ended the quarter with significant liquidity of $2.46 billion of cash and marketable securities providing for financial flexibility and further expansions. The company continued global expansion by launching 13 different native language capabilities bringing the total languages available to 20, launched Shopify Payments in four additional countries expanding to 15 countries in total, started selling in multiple currencies and by 2019FYE 29% of the merchants were based outside the core geographies compared with 24% in the largely non English speaking markets in 2018. Shopify is committed to make commerce better for everyone with incremental investments in Shopify Fulfillment Network, 6 River Systems, Shopify Plus, Shopify Platform, Shopify Brand and international expansions in 2020.

Financial Analysis: Modelyze Investments considered numerous financial and operating metrics to determine the earning quality, cash flow quality, balance sheet strength, operating efficiency and valuation risk of Shopify. Though operating cash flow (“CFO”) to net income over the last five years has been volatile ranging from -636% in 2017Q4 to 41% in 2019Q3, there are no signs of earning manipulation and earing quality is high. The company only carries debt in the form of office leases and have C$8,000 undrawn credit facility. As management is compensated through stock-based compensation (SBC), SBC add back is the main contributor to positive operating cash flows. Cash flow return on invested capital (“CFROI”) are volatile ranging from -15% to 30% though this is not concerning as the company has mainly financed operations through equity financing and managing marketable securities efficiently; hence, cash flow quality is strong. The company has a history of negative operating income due to increased Sales & Marketing, R&D and G&A expenses which comprises 58% of revenue as of 2019Q4. Operating and net margins have been consistently negative but improving over time. As a result, operating efficiency is quite weak. Shopify holds significant cash balance equating to roughly 5% of business value on its books in the form of cash or marketable securities as of 2019FYE, it pays no dividends, it has current ratios ranging from 2.8 x in 2015Q1 to 15.4 x in 2018Q4 and  has been managing working capital efficiently by extending payables and collecting receivables fast.  Consequently, Shopify has a strong balance sheet. Shopify is trading at the 92nd percentile of North American technology firms given its last twelve-month P/S of 32.5 x as of Feb 13th, 2020. Valuation risk is considered high.

Management and Governance: Overall, 5 out of 6 board members are independent, executive chairman of the board, Tobias Lutke, is a non-independent member who is also the founder and CEO of the firm. Tobi holds 66.27% of Class B multiple voting shares and John Philips holds the rest with the two controlling the firm holding roughly 54% of Shopify voting control. All other members of the management team and board hold less than 0.051% of the voting rights distinctively. All members of Audit, Governance and Compensation Committee are independent. The company has two classes of shares: Class A subordinate voting shares and Class B multiple voting shares and there are no preferred shares issued. The company has a capacity for unlimited number of Class A, Class B and preferred shares issuance. Shopify is controlled by the founder and insiders holding 53.28% of the voting rights; institutional investors hold 30.42% of voting power and public 16.30%. In many technology companies founder CEOs hang on as large stockholders; founders think like shareholders rather than managers with their decisions benefiting the public in the long term. Overall Modelyze Investments ranks corporate governance at Shopify fair. In order to measure the historical performance of the stock and the management team, Modelyze Investments derived SHOP’s Jensen’s alpha over the last 5 years given its monthly prices. Modelyze Investments believes the management team has been doing a good job at creating value for shareholders and selecting projects with returns above stock’s current return on equity.

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Valuation: Shopify is a unique company operating in the rapidly evolving e-commerce market. The outlook and extensive growth prospect of this industry given the fast-paced introduction of disruptive technologies is unpredictable. The uniqueness of Shopify business model and the uncertainty of cashflow growth make intrinsic valuation and pricing of Shopify a challenge. The two segments contributing to the top line are Subscription Solutions and Merchant Solutions with Subscription Solutions having a much higher margin than the latter. The number of merchants and subscribers on the platform is the main driver of revenues as Subscription Solutions revenue is a function of monthly recurring revenue (“MRR”) and the number of merchants; Merchant Solutions revenue is a function of GMV with GMV directly correlated with the number of merchants. The average GMV per merchant in 2019Q4 was $19,336. Consequently, the growth of this value during the high growth forecast period as well as the number of merchants up until 2030 when the company reaches a mature steady state will determine the top line. Overall Merchant Solutions revenue has been a much larger contributor to the revenues and Modelyze Investments expects this business segment to contribute roughly 77% of the revenues by 2030. Despite the high growth stage of Shopify corporate life cycle, Shopify has been able to manage operating expenses such as R&D, Sales and Marketing and G&A reasonably and Modelyze Investments expects this trend to continue with gross margins at those of Information Services industry average of 55.53%. Current Shopify share price is justified at roughly 84.5 million users by 2030. The sensitivity analysis of the share price relative to the number of merchants by 2030 and the quarterly growth rate of GMV/Merchant with a cost of capital 7.37% is conducted in the full report. Like many young technology companies, Shopify compensates its managers, directors and employees with equity options. Modelyze Investments applied Black Scholes valuation approach to value these options and decreased equity values accordingly. A detailed study of price to sales ratios of technology companies in North America given proxies for survival and growth such as revenues and cash as a percentage of revenue was also conducted. A comparison of predicted price to sales (“P/S”) ratios with respect to the actuals shows Shopify to be significantly overvalued relative to peers in the market; however, the pricing approach is deemed to be less reliable due to Shopify’s unique business model and the disruptive nature of e-commerce market. 

Risk to Target Price: Investors in SHOP face market, credit and company specific risks. Risks associated with investments in Shopify include but not limited to technological risks, single source supplier risk, seasonality of merchant sales, Shopify Capital and credit risk of merchants, exchange rate fluctuations, macroeconomic risks, reliance on search engines and social networking sites, strategic relationships with third parties, a severely competitive, fragmented market, limited experience in pricing, sensitivity of SMB’s to price increase, taxation in foreign jurisdictions and expiration of loss carry forward, political risks in regions where internet is shut off without notice for long periods of time, acquisition and integration risks, security and liability risks with respect to external app providers in the ecosystems, unregulated ever changing technology markets and a history of losses. Rapid growth and the diversity of merchants and services rendered on the other hand have masked seasonal trends at Shopify.

Conclusion: Modelyze Investments believes as a high growth technology company, SHOP has a powerful business model with significant expansion opportunities into new markets and potential for merchant acquisition. With a first mover advantage, the company has been growing organically and through acquisitions. Management have been managing operating assets efficiently and maximized shareholder value. Modelyze Investments assigns a BUY recommendation with a HIGH risk rating at a target price of US$599.28 and annualized return to target of 59%.

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