As the market hits new all-time highs, driven largely by outsized gains in “Magnificent Seven” stocks, investors may want to turn their attention to smaller companies that are still performing well.
For example, Shopify (SHOP 3.24%)THE popular e-commerce platform, skyrockets. Its shares have soared 146% since the start of 2023 (as of February 7). After a difficult 2022, investors seem to be in love with growth technology stocks Again.
But if you're considering adding Shopify to your portfolio now in hopes of riding its momentum for solid returns, you should first weigh the bullish and bearish arguments in favor of the company.
Bulls have reason to be excited
Shopify offers services like website hosting, payment processing, and marketing solutions, among others, that make it incredibly easy for anyone to establish an e-commerce presence, start selling products, and manage your business. The company benefits from the continued growth of the online sales channel compared to physical purchases.
Its growth has been truly spectacular. Shopify's third-quarter revenue of $1.7 billion was 530% higher than the same period five years ago. And its gross merchandise volume increased from $10 billion to $56.2 billion over the same period. As the company pursues a total addressable market it sees as being worth $849 billion, management is aiming for much greater expansion in the coming years.
The services offered by Shopify have made it the leading e-commerce platform in the United States, with a market share of 28%. It's easy to see why, from a merchant's perspective, Shopify would be a mission-critical infrastructure provider. And the switching costs – in time, money and effort – for its customers to migrate to a competing platform give it a key competitive advantage. Once a business owner becomes comfortable using Shopify's subscriptions and add-on features, they are unlikely to switch providers unless they are prepared to put up with the disruption to their operations that such a transition would entail.
Shopify was able to monetize all activity on its platform at higher rates over time. Its so-called “attachment rate” stood at 3.05% in the third quarter, compared to 2.96% in the year-ago period. This may not seem like a huge difference, but when looking at tens of billions of dollars of gross merchandise volume, small fractions of a percent can add up. Attachment rate has trended upward over the past few years, indicating not only the value Shopify's customers perceive, but also its ability to profit from it.
Convincing arguments for the bears
Although Shopify is making progress in attracting enterprise customers, its services remain a popular choice for small businesses and entrepreneurs. This gives the company increased sensitivity to macroeconomic conditions. Small businesses have a 45% failure rate within the first five years. As a company that provides services to them, Shopify would also be negatively affected by an economic downturn which would have a greater impact on these customers.
It is still possible that the United States will enter a recession in the near future, especially if inverted yield curve turns out to be a warning sign of what will happen. If this scenario plays out, it would be reasonable to believe that Shopify would experience much slower growth.
To its credit, Shopify reported positive net income in the first and third quarters of 2023. While some might applaud this news, believing it to be a positive sign for what's to come, it would be better if Investors are tempering their expectations.
Shopify posted a monster net loss of $3.5 billion in 2022. Additionally, the company aggressively cut costs across the board and also sold off its logistics segment. These may only have a one-off impact. Until the company can report consistent profits over several years, there is financial risk.
Although the stock is 50% below its all-time high, it doesn't look cheap today, trading at a price-sales ratio multiple of 16.5. This is expensive, even for a top-flight software company. And this reflects the fact that optimism surrounding the company has increased rapidly, leaving no safety margin for potential new investors.
Shopify is a good company with impressive growth potential, but I'm not comfortable with its current valuation. And because of this important factor, I'm going to forgo buying its shares for now.
Neil Patel and his clients have no position in any of the stocks mentioned. The Motley Fool posts and recommends Shopify. The Motley Fool has a disclosure policy.