Shopify - an expensive operating system

In our last week’s update, we sold our position in $SHOP to fund some of the other names. In this newsletter let’s dive into the details on why we like the company, and why it is very expensive even with great growth potentials.

In summary:

  • We think Shopify’s merchant solutions will outgrow its subscription solutions by 3x in next 5 years.

  • Within the merchant solutions, the fulfillment and installment segments are overlooked and will grow exponentially. The reach of the widest range of retailers will give Shopify unique advantages over other fulfillment and buy-now-pay-later products.

  • Shopify’s App Store has the lowest contribution to revenue, but is becoming its biggest moat. This (along with other core merchant solutions) will help them to become the future e-commerce operating system.

  • However Shopify’s valuation is so expensive and it requires very long term patience.

  • Readers familiar with $SHOP can jump into the valuation part: where we discuss our views and assumptions on each revenue segment.

Traffic Anxiety + Branding Anxiety => SHOP’s subscription model

Most e-commerce businesses are very much a traffic business. Cost of acquiring traffics becomes more and more expensive, due to:

  • Time and effort to build positive customer reviews.

  • Cost of bidding for higher ranks in searching algorithm.

  • Big platforms directly selling & competing.

A good case study would be looking at the most competitive e-commerce market -- China -- contrary to many people’s impression of Alibaba being the absolute dominator there.

Alibaba’s ebay equivalent, Taobao, has anecdotally over 10 million sellers in early 2021. Everyday there are over 1500 new third-party sellers opening new shops in Amazon, this number for Taobao is 30,000. 

This was once regarded as a market segment no one could ever challenge due its dominance in varieties (among many other reasons). But traffic acquisition cost increases as varieties increase. 

Pinduoduo ($PDD) was a bit of shock to even most Chinese consumers and investors how quickly it was able to open an impossible battle and be winning at a shocking scale. It has accumulated over 5.5 million sellers serving over 700 millions customers in a very short period. Its share price went from below $20 to over $180 in the last 18 months, reaching a USD 210 billion market cap vs. $BABA’s USD 700 billion. 

Yes it’s a story of product differentiation, business model innovation, and fulfilling the under-served lower-tier cities. But one key element that’s often overlooked is that $PDD wasn’t fighting the war in $BABA’s native battleground. It’s able to lower customer acquisition costs to its sellers, by providing a new, cheap, somewhat more transparent traffic channel.

This isn’t 100% comparable to Shopify’s case but the core paint point or the main reason for many sellers turning away from Taobao to Pinduoduo is somewhat similar -- the traffic anxieties. 

Dominant platforms like Taobao or Amazon controlling 100% of the traffic inevitably cuts into sellers’ profit margins if they ever want their products to be found within the first 3 pages of a search action, yet by the end of the day the traffic data is largely out of sights and useless in helping them improve their operation efficiency.

Building independent websites (different to Chinese sellers still choose to be third-party sellers but on different platforms) has been seen as a good way to try to solve such traffic anxiety in many other countries. Having the ownership of the traffic data and the ultimate flexibility to choose the customer acquisition channels will in turn help business operators better at customer service, stock controlling, and marketing budgeting.

When traffic anxiety meets branding anxiety, this solution looks even more appealing: in the creator economy, more individuals and businesses want to build their own brands.

“I buy this shirt from Amazon” is vastly different from “I buy this shirt from”. And I believe the creator economy will become much much bigger, enabling a huge creator-related e-commerce market. 

This how centralized e-commerce platform could possibly become abundant in future:

  • People buy necessities from farm-to-door or factory-to-door shops.

  • People buy semi-necessities from big brands directly, Apple, Tesla, Nike...etc

  • People buy non-necessities from creator-related e-commerce.

You no longer buy shoes by searching on Amazon or ebay. Instead you go on Tiktok to check what your favorite influencers are selling. Why not reward the people you like for Impulsive consumptions. This is not only a consumption habit change, but a change due to trust issues - when major media are losing credibilities, people turn to independent influencers for information because they are more trustful - and people buy stuff from the people they trust.

Inevitably small businesses come and go, arguably much more so in creator-related business. However, Ben Thompson has made an excellent point that,

This means they have to stand out not in a search result on, or simply offer the lowest price, but rather earn customers’ attention through differentiated product, social media advertising, etc. Many, to be sure, will fail at this: Shopify does not break out merchant churn specifically, but it is almost certainly extremely high.

That, though, is the point.

Unlike Walmart, currently weighing whether to spend additional billions after the billions it has already spent trying to attack Amazon head-on, with a binary outcome of success or failure, Shopify is massively diversified. That is the beauty of being a platform: you succeed (or fail) in the aggregate.

To that end, I would argue that for Shopify a high churn rate is just as much a positive signal as it is a negative one: the easier it is to start an ecommerce business on the platform, the more failures there will be. And, at the same time, the greater likelihood there will be of capturing and supporting successes.

Operation anxiety + cash flow anxiety => the great bundling

Shopify’s subscription model is easy and straightforward. It is their merchant solution that’s much more interesting and truly has the potential to become their own version of AWS.

The future of e-commerce is nothing but bundling. Imagine this: a good online store operator is a master of bundling & managing different digital functions: 

Building store design and landing page;

Buying social networks traffic;

Handling payments that connect to the accounting system;

Ordering customised goods from manufacturers and monitoring them real time;

Tracking warehouse and logistics in the same inventory system;

Getting customer feedback and bots will create required actions into to-do lists;

Asking for emergency lending or loans for expansion, and get approved instantly based on your business data;


Now you may have a different preference for landing page design, which social network you want to use, the accounting software, the CRM software, a different delivering partner for a new city … don’t worry, there would be an app for your every unique need.

Furthermore the availability of API of all these functions would mean this isn’t only a solution for SMB, but can be one for large companies with many customisation demands.

Now name a company who has the best chance to provide all above in one platform and offer smooth experience. 

Yes the ecosystem and the API platform will be the biggest moat of Shopify. As they accumulate more bundlings and partners, the moat gets bigger.

Valuation: bright future vs. expensive today

Let’s waste no time to put Shopify’s bright future into numbers. We will dive into each of its revenue segments, explain our view and the according assumptions.

Shopify separates their revenue into Subscription Solutions Merchant Solutions for good reason. One is a function of # of merchants, one is a function of GMV. 

Please note the work of valuation is to get approximately right rather than precisely wrong.

Subscription Solution:

Non-plus merchants are typical small business customers. They essentially will see higher growth, higher churn rate (based on our view that more people will join the creator economy and operate e-commerce business)  and lower revenue per customer.

Plus merchants are bigger spenders, and we see them have slightly higher increments in total subscription spending. 

At this stage, we think the revenue per merchant est. 2025 ($670 per year for small business; $40k per year for large business) seems reasonable for a stable long term estimation, i.e. material increase over those numbers would be considered more difficult.

The total number of merchants (close to 2.5million in 2025) will also see Shopify take a reasonable chunk of total global online sellers, as current total numbers of US online shops are estimated between 7-8 millions.

Merchant Solution - GMV estimation

Before we dive into merchant solutions, let’s make assumptions of total GMV. Based on current GMV per merchant, we assume a 8% annual growth for small business, and a 10% annual growth of large business over next five year.

As of 2020 US total e-commerce GMV is around 860 billion, up more than 40% from previous year. We agree the quicker online adoption is here to stay.  A year-5 366 billion from Shopify merchants globally is a reasonable target, but also requires great execution of the company.

Merchant Solution - payment

We believe payments is an extremely competitive market. Not only payment functions are being commoditized (meaning many players are providing very similar functions and user experiences), central banks’ digital currency could also be a huge threat as we’ve seen in China.

We think it’s sensible to assume a lower take-rate for both non-plus and plus payment solutions. 

Furthermore within non-plus merchants, due to high competition, we estimate that the percentage of clients using the default shopify payments will decrease over time. Currently ~80% of Non-plus clients use Shopify payments, we give it an annual decrease rate of 3%.

It is, however, the opposite case for Plus merchants, mainly due to their better bargaining power. The ability to negotiate lower charges and the convenience of staying within the ecosystem will mean a higher % of plus-members using Shopify payments. Currently ~20% of Plus clients use Shopify payments, we give it an annual increment of 10%.

Overall this will continue to be the strongest contributor to Shopify total revenue.

Merchant Solution - Capital

This is essentially the cash advance service. 

Similar to small business lending, this area has huge growth potential due to a structural reason: this particular segment is under-serviced because big banks are not making enough margin vs. the human capital cost and high credit risks they need to take. Such mismatch of supply & demand precisely creates opportunities for many new entrants. 

Shopify by leveraging their great data advantage can serve this demand very well. We assume cash advance volume will increase from 1% to 3% (out of total GMV) and the take-rate will vary from 10% to a lower 8% over the years.

Furthemore, we believe Shopify can not only directly provide cash, but also offer pure data service (by analysing merchants’ data and providing decision-making insights) to allow other capital lenders to step in the space, earning safer & higher profitable fees.

We assume an aggressive cash advance usage (but a lower take-rate due to competition) out of total GMV and a potential data related revenue in a few years’ time.

Merchant Solution - Shipping

Shipping is another highly commoditized segment. But due to universal low margin, not many competitors are able to win Shopify’s customers over the convenience of using integrated services. We assume a constant 40% usage rate and use consensus data from various banks for the average number of shipping orders per year. A slightly lower shipping take-rate is assumed from 2024 considering competitions.

Merchant Solution - Fulfillment

This is a very attractive service to small to medium businesses as it solves some of their major operational headaches. But fulfilment can be vastly different for different types of retailers, and requires time to build trust. We give a lower usage rate initially, but a higher growth rate to reflect our view: the company needs time to develop a better product/experience over time to grab more clients. Once it has enough clients using it, the flywheel of more & better data will greatly improve user experience, build enormous advantages over competitors, and eventually allow Shopify to charge much higher margin. However given big risk of execution, we assume a relatively low 10% take rate to start with.

Merchant Solution - Installments

This is a super interesting area.

This is basically the buy-now-pay-later solution provided by Shopify to its merchants. It is yet another highly competitive area where we see commoditizing is coming. Unless one player is able to provide an exclusive network of participating retailers, there’s no clear moat any one competitor can build over others as they all provide very similar user experiences. 

But it is precisely where Shopify may be able to build a huge advantage over its competitors, by leveraging its enormous reach to so many retailers. Just imagine a separate Shopify Buy-now-pay-later app where you can search all its merchants’ eligible items.

This is one area we see HUGE growth even beyond 2025, and contributing much much more revenue to other components. 

We assume an aggressive growth but eventually lower take-rate to reflect both Shopify’s unique advantage and the competitive environment.

Merchant Solution - Balance

This product includes business banking and some early access to the merchant's earnings. But it is an internal competition to some of its App Developers’ solutions, and to some extent its own cash advance solution. As a low margin business, we think this will remain a small part of total revenue.

Merchant Solution - App Store

87% of Shopify clients use their partners’ app. We believe this is Shopify’s biggest moat going forward, just as what the iOS app store means for Apple. The variety of Apps and the difficult to build an API platform will fence off most competitors wanting to enter into this area. This will contribute greatly to make Shopify to become the operating system of future e-commerce. 

Unfortunately in the foreseeable future, it is unlikely to contribute much revenue - but this is good news: a small extra cost for the average merchant but many more functions to lock them in -- as an outcome a very high switching cost to other platforms.

Now let’s look at them together

As we believe Shopify will pretty much follow Amazon’s path to invest most of their cash flow to build out more functions, it is less useful to do margin analysis for the near term. Let’s simply look at its future total revenues and implied Price-to-Sales ratios.

As we see from the table, subscription solutions will contribute less than 25% of future total revenue, while merchant solution revenue will grow exponentially along with the growth of GMV. 

However even with the relatively aggressive assumption of growth in most of its revenue segments, Shopify is priced at a very expensive level. 

Its 2025 revenue to its current market cap translates into a future implied Price-to-Sales ratio of 13.7. This is what basically Paypal and Square are priced at their 2020 revenues. Its P/S ratio ranges from 30-45 over the next 3 years assuming no change in its current share price — an extremely high level even compares to some of most expensive SaaS businesses.

Even though we believe its Fulfillment and Installment can continue to generate very high growth beyond 2025, it will require near perfect execution and may face some regulatory risks.

Its App Store, in our view, is the biggest X-factor that could turn Shopify into a future operating system of e-commerce and become its own version of AWS. Nonetheless, cloud computing is a much more general purpose product that has much larger TAMs. The App store (even fulfillment & installment to some extent) might not be contributing much revenue in near future and indicates a somewhat big opportunity cost by allocating money to $SHOP vs. other growth names.

We do believe $SHOP has great growth potential, and looks very similar to $AMZN many years ago. But holding this investment requires very long term patience. We are neutral on $SHOP, and suggest core positions for long term investors, but no position for short term / momentum traders.

Leave a comment