When I think about the future of retail I see Amazon. They will lead mass-retail for the foreseeable future. They dominate our phones, tablets, and voice-enabled devices when we want to find something that everyone wants. Amazon Go and Whole Foods will revolutionize how people buy products and food in-real-life. Most of these products are commodities. There is a race to the bottom in the types of products that Amazon really specializes in, in terms of price, and Amazon has invested billions of dollars in retained earnings to build the best supply chain in the world. But they have a weakness, mostly because their scale is so large that they need to create multi-billion dollar businesses to make their investments worthwhile.
That weakness is the niche retail startup. Enter Shopify...
Shopify: The King of the Retail E-Commerce Niche
The niche retail startup has a lot of options in terms of creating a new web storefront. Wordpress, Magento, Reaction, and Fulfillment by Amazon all compete for e-commerce noobs and professionals to get physical products to their customers. The problem these services have is the relatively high cost of entry and exit. Most of the reason is because us software engineers cost so damn much. Setting up a storefront with any of these services will typically cost $2,000 minimum for a simple site and $10,000 - $100,000 for something highly customized. Most of that is software engineering labor cost!
Shopify has effectively killed the market for expensive customizations with a simple SaaS model based on low monthly pricing and highly effective integrations for payments, fulfillment, and marketing. Shopify has turned the $2k upfront cost into $29 and the $100k upfront cost for complex systems to $1k per month. Automation is making e-commerce software consultants and specialists almost irrelevant at those prices. It's clear what the value proposition is to retailers.
Shopify is a Low Cost, High Quality Tool to Prove a Retail Product's Viability in the Market
Having used Shopify, I can attest that it is ridiculously easy and fast to get a shop up and running and even have sales in the same day. It may not be the prettiest site at first, but for $29, it is an incredibly effective tool to de-risk a retail product, get a baseline cost of customer acquistion, and fully determine whether it is possible to set up a sales funnel in a very short amount of time.
Valuation
For growth oriented stocks, I am a fan of The Rule of 40 which was popularized by Brad Feld and explained in further detail by Dave Kellogg. Most investors use the Rule of 40 as a tool to determine whether a company is balancing growth with profitability effectively. Companies with a higher number have a combination of higher profitability and/or growth while companies with a lower number have lower profitability and growth. Higher numbers should generally correlate with more effective and valuable business models. I'll call these "40 Plusers". They are either so damn good at getting new business that they can fund their losses with expansion or they are so damn profitable that they don't need to grow that much any more to be valuable.
The Profitability Side
Warren Buffet is a master of the latter category. He buys on the value of future profits balanced with stable predictable growth. He buys at discounts so cheap, that it is almost impossible for him to lose money. He buys when everyone is selling. A colleague that I admire, is following in his footsteps and I respect his ability to risk his own capital while providing funds to run his own private equity fund in his own way. For those, that don't know who Brent Beshore is, he's an incredible capital allocator, and great guy in general. He knows business and he knows investing beyond his years. Read his annual letters. They are incredible and they will give you his down-to-earth, midwestern perspective on growing a business for the long-haul.
The Growth Side
A fast growing company is often frustrating to talking heads and finance columnists. You'll often hear things like "Amazon hasn't turned a full year profit! Why do people keep investing!" Concepts like the Rule of 40 help to explain exactly why. Amazon is balancing growth with profitability. Most importantly, their incremental cost of a dollar of revenue, is much less than a dollar, much to the chagrin of the talking heads. Amazon invests heavily into automating their value streams, to the point where bricks and mortar competition are having headaches trying to keep up (Walmart!).
What's SHOP worth?
I'll go into a bit more detail on my estimates of value in further posts, but the basis of it lies in the Kellogg article posted above. The research in that suggests that ~50% of the variance in value of growth SaaS companies can be explained by the rule of 40. The trick is finding what explains most of the rest of that remaining 50%!
So without further ado, here's what my research supports as of 1/22/2018! Shopify is worth about $129 given its recent growth rates and profitability. Today it trades at $119, a discount of about 8%. It has recently traded as low as $90 following a news report of unethical marketing practices. This would have been a deep discount and provided a high margin of safety to establish a position.
For those that are technical analysis inclined, Shopify had an incredible run up last year and is currently "basing" in a cup pattern and rebounded strongly off of it's 200 day moving average at the beginning of December. If history is any guide, Shopify will test its highs in the 120s, then move lower into a "handle" as part of the classic Cup and Handle pattern. At this point it may move higher in a breakout as it faces less selling resistance from technically minded sellers.
Risks
Shopify doesn't come without risks. While it does have an incredible growth rate, SHOP's lofty revenue multiple is driven mostly by hopes that it can sustain that growth rate for a while. Retail is a big market, so it's entirely possible that SHOP will continue this rate for the next 2-3 years. The inevitable slowdown will eventually occur though, and the revenue multiple will eventually compress to AMZN's more predictable 3.5X revenue. Also, SHOP's marketing practices may come under scrutiny from regulators. I doubt it, given that AMZN has similar affiliate practices.
Disclaimer
I own Shopify stock.
