TIVP021: Shopify (SHOP): The Battle For The Future of E-Commerce w/ Shawn O’Malley & Daniel Mahncke

27:49What's your view on the modes of companies like Shopify and still being a value investor? Does it matter to you in any particular way? It's an interesting point to mention how quickly modes can change. Though in some cases with Adobe and Microsoft, we've seen these modes last for decades for software companies. And it's a dilemma that I think has really fragmented an entire generation of value investors. There are folks out there who have completely avoided companies like Meta, Microsoft, and Alphabet simply because they believe they can't understand them. Yet they have been the biggest drivers of the major stock indexes for 15 years.

28:28So that has been a costly omission. And there was this feeling that to invest in tech companies is almost to reject Buffett's success and presume yourself to be perhaps more capable of assessing business quality and moats than the Oracle of Omaha. I don't see it that way, but I think some people do. I've met those people and they try to focus on truly very simple businesses in the most literal sense, which is a great thing to do. And if we had really literally followed that thinking though, we also certainly wouldn't own Airbnb, Alphabet, Reddit, or Uber. So maybe we're biased because we've already committed the original sin of going into the tech world, you might say.

29:08But what I really would want to argue is that there are always shades of gray. And for starters, I try to learn from Buffett as much as possible. We shouldn't treat him as an infallible figure to blindly follow. I also learned from many other great investors, and maybe I'm naive, but I do buy into the belief that the best businesses of the 21st century are software companies. And I don't even know that Buffett would disagree with that. I'm not trying to play the exact same game that Warren Buffett has played throughout his career because, well, in part, we live in a different world. And I also can't invest the way Warren Buffett has because I'm not Warren.

29:45We all have to do what personally makes sense for ourselves. And what I do know is that Shopify will continue to be one of the primary winners of further e-commerce adoption in the coming years around the world. And that is compelling to me, or at least it catches my attention and makes me want to dive in further as we're doing today. And between the platform's ease of use, the large community of support experts, and this emerging developer ecosystem in the app store, the company has a number of advantages that I believe are combining together to form a very wide moat. And it's not a huge surprise that Morningstar has kind of validated that belief by also issuing a wide moat rating for Shopify.

30:26If Morningstar has your back, that's always a good sign. To me, the real story isn't whether Buffett missed tech. It's more so how the nature of moats has evolved. A lot of today's dominant tech companies like Amazon, Google, but also Adobe and perhaps also Shopify didn't look like they had doable moats or doable competitive advantages early on. They weren't capital intensive to start and this sort of vague term of innovation was always hanging over their head. But over time with scale, data and most importantly network effects, they've built economic fortresses that can last for decades and who knows for how long exactly.

31:08That's what makes tech so tricky. Without these scale advantages and the user lock-in, these businesses are vulnerable. But when those elements click into place, you suddenly have companies with modes that I would say rival or even surpass what we used to see in industrials or consumer goods that Buffett like to look at. But enough with all the problems and the difficulties of tech, how about you give us the bull case for Shopify? That's why we are here. The bull market is basically just that Shopify will continue to grow dramatically with its gross merchandise value booming as it onboards more businesses onto its platform.

31:47And with add-on features, the company will also increase its take rate over time by upselling merchants on more and more additional features. So more commerce is going to be going through Shopify and Shopify is finding clever ways to capture higher fees on that commerce and percentage terms. And so Shopify is just really attractive to small and medium sized businesses for the simplicity of it. At the same time, Shopify has proven that it can move upstream and appeal to larger enterprises too. And if that continues to be the case, that is very promising for the company because big enterprises are where the really juicy margins are.

32:27That's true. And also pretty straightforward. How about you give us the bear case then? Okay, yes, the bears would argue, and this is maybe more important to focus on, and they would argue rightfully so, that Shopify trades are some very lofty valuations. And even if the company does grow significantly, it may not be able to grow fast enough to justify current share prices. It's also very highly exposed to the economic cycle, such that a recession that causes a number of small businesses to go under could be very damaging to its top and bottom lines. And obviously, recession concerns are very popular right now as the market has moved dramatically from a greed cycle toward fear, or at least it has at the time of recording.

33:07For Shopify, in a recession, there'd be a two-pronged effect where not only would retail sales drop off that Shopify takes a small commission on with its take rate for merchant solutions. But also, as I just mentioned, companies might fail altogether and cancel their subscriptions, which would bite into that quarter of Shopify's revenue from subscriptions. This does sound like the potential setup of what could become a pretty significant hit. Not only would the fundamentals decline, but you also must factor in a pretty big multiple contraction. Just to give a perspective on how severe that impact could or might be, taking Shopify's current EV to EBIT of 110, where EV is the market cap plus debt minus cash, then when the market gets spooked by recession fears or something similar, perhaps tariffs, they might reduce the growth expectations for Shopify and only want to pay a multiple of 55, which would still be double of most magnificent seven companies.

34:14So even if Shopify's EBIT would be unchanged, its stock price would be cut in half. Now add to that an actual recession in which many small shops got a business and then you have declining profits and declining multiples, which is something like the perfect storm. This is the big problem of investing at high multiples. As long as the company grows, everything is fine, but one hiccup and it becomes so costly that it could take years to recover from that. You're doing a very good job of making the bear case for me, Daniel. There's no doubt about everything you just said being true. And I fully agree fast-growing companies that trade at high multiples of sales and earnings are the most likely to get hit the hardest by Mr.

34:58Market's panic during a recession or even just a correction, the stock market. So it could get dramatically repriced from current levels. And I would say at the current valuation, it was probably more likely that that multiple goes down than up. And clearly, this is also not a healthcare company where you would expect them to be maybe entirely immune to a recession since people are always going to need medical services. When you have sales declines for a company with as much operating leverage as Shopify and as a company that is as closely tied to the global economy as Shopify is, that ripples down to have a reverse economies of scale effect that de-levers their business and could pretty swiftly wipe out their operating profits entirely in a worst case scenario.

35:44Very much a worst case scenario. I don't think recession would bring Shopify to its knees, but just from an investor's perspective, if you're looking at the company on a five-year horizon and two of those years end up in a recession, then the company might spend the next three years bouncing back from those setbacks, leaving you with no real return, no compounding in the meantime. You've treaded water for five years and the opportunity costs of that are very steep. I don't want to be too bearish and we are long-term investors. So let's take a look at the more positive side of what Shopify could achieve long-term.

36:20We also want companies that might not yet be cheap, but we could load up the truck when a scenario like recession actually happens. And as you mentioned, I wouldn't suspect Shopify to go to its knees even if a recession would actually appear. Now, to add Shopify to my shopping list in case there is a recession, I would need to better understand the stickiness of Shopify's products and how that forms, let's call it again, a mode around Shopify that they could use to bounce back when the economy would pick up again in a worst case scenario and continue to earn these excess returns on capital relative to their opportunity costs, which they have done in recent years, or at least in 2024, where they have generated attractive mid-teen returns on invested capital.

37:08So how does it look for Shopify and their competitive advantages? Switching costs are for sure one of the biggest factors in Shopify's moat. just intuitively if you are running your entire business through a single platform you're probably going to find it very difficult to switch away from it there's a lot of built-in inertia there and there's the risk that data gets lost along the way too which adds to the time cost of switching and the pressure of executing a switch well and all that combines together to discourage switching unless absolutely necessary. In some cases, it can take companies a full year to migrate away from Shopify to a competitor, which is something we talked about with our portfolio company, Adobe.

37:56And at worst, it would be a slow exodus over time that the company would be trying to aggressively counter, assuming that some competitor came on with a product that was maybe an order of magnitude better. I'd also add that a sort of secondary moat for Shopify are the network effects around its business. And a network effect, as most people probably know, means that a system becomes more valuable as more people use it. So Facebook is obviously a network effect. And in Shopify's case, their network effect comes from their app store that I've mentioned a few times. And they have more than 10 ,000 available apps there.

38:31And that is a big enough scale that, at least in my opinion, I think they should be able to continue attracting more developers who will make the company's software better, which then in turn attracts more merchants to use Shopify. And the apps really level up merchants' Shopify stores. And some of them are pretty cool. They can be as simple as just adding a countdown clock to a checkout page, which increases the pressure to make a purchase, to apps that will use AI to create and recommend product bundles based on what people have previously purchased or shown interest in. There's also a network effect around Shopify's referral program too.

39:11Tens of thousands of Shopify users have referred at least one other person to the platform. In exchange, Shopify pays a fee to anyone who makes a referral. It might be an expensive way to acquire customers, but it actually ends up working really well for them because the new referral customers tend to, on average, be higher quality users who stick with Shopify for longer and then generate higher gross merchandise volumes. Or at least that is what management has told us on earnings calls about the referral program. That's surprising. I think most referral programs are attracting lower quality members instead of higher quality ones.

39:46I've also seen some of the features of the apps that Shopify offers. And I think we've all seen that countdown way too many times in our online shopping experiences. And of course, isolated, those are pretty easy to copy and they are nothing special. But if you combine them, all these apps with the range of Shopify services and the sheer scale of the merchant network, that creates a difficult to copy ecosystem all in all. I've also heard Shopify venturing into the logistics business a couple of years ago. This has been a major differentiator for Amazon and their whole trajectory. And they spent billions of dollars to build out their fulfillment centers because Bezos knew convenience matters most.

40:35And fast delivery is the ultimate convenience if it comes to e-commerce. And it's not just Amazon. Alibaba chose a different path than Amazon, but also ended up running its own logistic company. And the same goes for MercadoLibre and Latin America and Coupang and South Korea. that you've covered as well. I haven't heard so much on that end from Shopify ever since. I think it has been three or four years ago. So how is that project going? Do they have this huge logistic empire? Or what happened to it? As you can imagine, the logistics end of things has been a big part of the story here. And at one point, Shopify's aim was to have its warehouse management software be able to provide package delivery in two days or less for more than 90 % of the US population.

41:23And to do that, they began to build out a network leveraging third-party partners with warehouses and sorting centers, freight handling, and also last mile delivery. And what I'm describing here is the backbone of the so-called Shopify fulfillment network, which was originally launched in 2019. The idea was for merchants to manage their fulfillment seamlessly through Shopify, whether that be with real-time inventory tracking or the handling of orders and returns. And as part of this fulfillment focus, Shopify acquired a company called Deliver, spelled with two R's, for$2.1 billion a few years ago.

42:01But then in 2023, Shopify made a very dramatic pivot away from logistics and sold all of its logistics assets, including Deliver, to a company called Flexport. So that was a huge switch where they not only undid a major acquisition, but basically concluded altogether that order fulfillment was too messy and was distracting from their core mission of developing an e-commerce software ecosystem. And I mean, literally Shopify CEO called the logistics venture a side quest, which is a video game reference. And I think just trying to integrate deliver got way too complicated too quickly for them. That explains why I've never heard of the adventure again.

42:42And on the one hand, it's understandable because logistics is nothing you can do on the side. It's not a side quest, as you will probably know by now as well. And all the big e-commerce companies who succeeded in logistics made it a priority. And they were ready to invest huge sums of money into what is a capital-intensive business with very slim margins. You have to build warehouses, you hire huge delivery networks, you have to manage a fleet of trucks, deal with labor challenges, and just constantly invest in new technology to stay efficient and be on top of your game. And it only makes sense if you have an ecosystem in place that just benefits in its entirety from these investments.

43:26But honestly, I would have thought Shopify has that ecosystem in place. I mean, you elaborated on it quite a while today. They might have realized that this would have positioned them as a real competitor to Amazon. And that might have become just a very costly endeavor with a low probability of sustainable success. If you're looking for a red flag, or maybe just a reason to be a little less optimistic than the market is on Shopify, it is definitely fair to argue that this was a major blunder. Now, to their credit, they did backpedal as opposed to digging themselves into an even deeper hole, which some companies have done in similar circumstances.

44:05But still, it's not a great look and I don't want to make excuses for them. The Shopify fulfillment network is still a thing and it is a valuable offer to merchants, but it is all managed by Flexport now. Shopify kind of copped out and they burned a few billion dollars along the way by buying Deliver and then basically giving it to Flexport in exchange for what is now in hindsight a very small stake in Flexport and probably some operating agreements that tied them together for a few years. But around that time, they made this big switch from logistics, they also cut 20 % of their workforce and replaced most of their C-suite.

44:41So it was a time of big change at Shopify and Business Insider actually called it a midlife crisis, which is kind of funny, but I definitely don't think Shopify is halfway through its life. As Shopify's business boomed during the pandemic, though, I think it is safe to say they just got way too far ahead of themselves, which is a very common thing in 2021. I think we can all remember that this was a time of excess optimism, to put it mildly, across really the entire financial system and corporate world, at least across the US. But just on that midlife crisis point, the company really has changed a lot, as you can imagine when you have some rapid growth.

45:21For starters, Shopify used to literally have a go-kart track in its office space in Ottawa. And now you hear stories about the company and how it's been tied down by layers of middle management and bureaucracy, which were at least in part behind why they did some of these sweeping layoffs a few years ago. Seems like a natural and perhaps also a healthy development for a company like Shopify to not have a go-kart track in your office anymore. And although Shopify avoided competing with Amazon directly and logistics, there are obviously more similarities between these two companies or businesses than just that one part.

46:00A major one which is also a big part of Shopify's bull thesis is this idea of shared economies of scale. If I'm not mistaken the term was popularized by Nick Sleep in the value investing space and he used it to describe Amazon as one of the companies and then also Costco. The idea is that when a company gets bigger and more efficient, it doesn't keep all the benefits of that size and efficiency just to itself in the form of margins and profits. Instead, it passes some of these savings back to its customers. Amazon achieves this by leveraging its scale and ecosystem to reduce costs for services such as shipping, warehousing, and cloud computing by mostly spreading those fixed costs across an increasing number of sales.

46:54But instead of just keeping all the cost savings for themselves, they then choose to pass a lot of it, not everything, but a lot of it back to customers in the form of mostly lower prices, but also faster shipping and better selection. And Shopify does something similar, just from the merchant angle. As Shopify grows and signs up more merchants, It can negotiate better rates with partners or invest more in improving the platform. And instead of hoarding all those benefits, they pass a lot of it back to the merchants. Cheaper payment processing, better shipping options, and just a more powerful app, which makes it even more attractive to join Shopify as a merchant.

47:40It's hard not to say that there isn't some kind of competitive relationship between between Shopify and Amazon, even if they have also found ways to work together. After all, Amazon accounts for roughly 37 % of all e-commerce sales in the US. And those are just transactions that are occurring on their marketplace. Meanwhile, if you look at the transaction volume that goes through Shopify's merchants, their market share is something like 10 to 12 % of US e-commerce. So it is a distant second to Amazon. In 2022, Amazon expanded its ambitions beyond its own marketplace by announcing that it would extend some of its Prime membership offerings to merchants off of its platform by embedding their payment and fulfillment options onto third-party sites, which is what they call their buy with Prime initiative.

48:33Meaning merchants can store and ship products using Amazon regardless of whether their selling on Amazon's website. And that was a signpost moment where it became clear that Amazon actually wants to be the default fulfillment network for all of e-commerce, not just orders on their own marketplace. So on a company's website, they can show the Prime logo and offer Amazon's one and two day delivery options with checkout through Amazon Pay. And when you think about it, that is all a pretty incredible offering to merchants. Traditionally, Shopify has been all about giving power back to the individual merchant, helping them build their own brand, control their own store, and also the customer relationships.

49:22Amazon has been much more centralized. Sellers plug into Amazon's ecosystem, but it's Amazon's brand and customer base that really dominate the experiences. But lately, it feels like Amazon is trying to tweak that playbook a little, and you just mentioned it. They're starting to offer merchants more tools to build their own presence inside the Amazon ecosystem. So the lines between those two models is kind of blurry by now. And it raises a pretty interesting but also significant question about where Shopify fits into that shift in the next five to ten years. They have had opposite models in a way to compete for merchants' attentions, even if they're both sort of ultimately going after the same end customers.

50:07and with this buy with prime initiative that has been a big shift away from amazon's centralized marketplace focus to something very different potentially integrating amazon into any kind of e-commerce and making it more of a platform company for enabling e-commerce like shopify and from a different perspective a fulfillment first perspective but still and i'm sure you can imagine that this brushes up with shopify and with logistics they were very directly competing with Amazon. And as we know, Shopify sort of retreated from that area. Yet at the same time, Shopify CEO responded to this buy with Prime initiative by saying that they were thrilled by the news.

50:51Take that with a grain of salt. But he did suggest that they would integrate these features into Shopify, just as they've integrated features from companies like Meta, Google, and TikTok. And obviously they tried to play down how disruptive this could be for them. So it is true that Shopify integrates with many other platform companies and Shopify has been true to its word and made it possible for Shopify merchants to easily embed Amazon's buy with prime button onto their storefronts. And I think that really did mark a significant change in the competitive relationship between Amazon and Shopify.

51:30A Shopify merchant might want the independence and branding of their own site and the additional reach of Amazon's marketplace. And Shopify knows that. So on the one hand, Shopify offers a streamlined interface where you can easily take advantage of things like buy with Prime. And yet on the other hand, buy with Prime was arguably a warning shot from Amazon that they wanted a bigger piece of the e-commerce pie and shopify could either roll over and share more of the pie with them or engage in what would be a very difficult battle for them to win and at one point shopify did try to play the game of competing with amazon by blocking buy with prime but again they ultimately relented because in my opinion at least amazon is just such a giant force that you do not want to go against under this sort of peace treaty that Shopify and Amazon came to in 2023.

52:29The result is that a Shopify merchant can add a buy with prime button on their product page. And if a customer uses it, the checkout and fulfillment are handled by Amazon, while Shopify still records the order and data on the backend. So Shopify's condition for a truce was that merchants would still control 100 % of their customer and transaction data, even when Amazon is the one handling fulfillment. And I don't know if Amazon will eventually trample Shopify, but Amazon has certainly shaped what directions Shopify can go in and what it avoids doing. Looking at the history of Amazon and its relentless path of innovation and expansion, it would surprise me if they wouldn't try getting more market share eventually.

53:13And the fact that Shopify tried initially blocking Buy With Prime and then had to accept it isn't reassuring for Shopify shareholders either. It's another reason for Shopify to double down on their unique value proposition for merchants. And I don't know if you feel the same way, but we've seen logistics and now this Buy With Prime initiative. And it always feels like Shopify is only getting the second place when it comes to competing with Amazon. What would you say are the biggest differences between merchants who mostly use Amazon and those who rely on Shopify? Because that's probably where Shopify's advantage lies in, and we could better assess whether that's sustainable or not.

53:59So Shopify appeals to merchants who have their own distribution and want to control their branding by directing customers to their own website. as Shopify CEO has described it Amazon is trying to build an empire and we are trying to arm the rebels so there's that Star Wars reference again from the beginning of our episode today or any listeners who are wondering about the origins of that and maybe a merchant ranks highly in Google search for example and they have a large social media following or maybe they're well known in a local area they do a lot of paid marketing or just have a lot of organic web traffic for some reason Whatever it is, Shopify supports those merchants who are trying to sell on their own.

54:41They have their own customer flow, their own traffic. Whereas Amazon, of course, appeals to merchants who are trying to specifically rank for searches of certain items on Amazon's marketplace, which obviously comes with massive traffic, a massive number of visitors. And to a lesser extent, but so importantly, sellers on Amazon are also looking to take advantage of Amazon's fulfillment network and logistics, which we already know Shopify struggles with. And on top of that, Amazon also handles the customer service side of order management for merchants. So it's just simpler to sell through Amazon in many ways, but that comes at a higher cost in terms of both fees to Amazon and the loss of control over their customer experience and their branding, which is sort of more of a hidden trade-off, I would say.

55:32But I'm sure there are also many sellers who use both, like Shopify and Amazon, right? Totally, totally. Despite these differing visions of the future of e-commerce between Shopify and Amazon, and us framing it as this e-commerce war and the battle for it, there is definitely a good bit of overlap between merchants who take advantage of both platforms. It is obviously not an either or, and even less so after the rollout of the buy with prime button. So the way I would put it is that a company could be both an Amazon merchant and a Shopify merchant. But the reality is that a good chunk of merchants on Amazon really only sell on Amazon.

56:16And I don't know exactly why that is. It probably has something to do with the fact that these are just smaller brands, and it's just easier for them to focus on one outlet for distribution, especially one like Amazon, where they're offering to handle so much of it for you. And we've talked about the lines kind of blurring here between the advantages that Amazon can offer and the advantages that Shopify can offer. And I would say the lines have blurred even further because Shopify now has its shop app, which used to just be for order tracking, but now it has a marketplace shopping functionality too, where basically they have a platform where customers can scroll through and see what Shopify merchants are selling.

56:55It's essentially a really lightweight version of Amazon's main app. And I like the idea. I'm not super optimistic on it, but if they can get enough adoption for it to work as an alternative to Amazon's app, maybe that's promising. Honestly, I didn't even know customers could shop directly through Shopify in this way before I started researching the company. And it's actually funny, I have the Shop app on my phone, and I just never used it. So I didn't really even, I had the opportunity to know this, and I just never used it. So if that's telling at all about the awareness around this product and the likelihood of success for it, then that is maybe concerning.

57:38I mean, I don't have the app, but I've heard of Shopify's Shop app some years ago. So from what I know, Shopify didn't really nail the marketing since many users didn't know what shop is actually for. And probably you're one of those users, although you've downloaded the app. And without wanting to sound too negative, I feel like that's kind of my theme here. Although Shopify is a fantastic business model. I just don't see them winning a war with Amazon, no matter on what font they play it. And if you stack them side by side, Amazon's big advantages are pretty clear. They have built this huge fulfillment network.

58:15They have this marketplace with over 300 million active users to market and sell to. And it's a massive engine for driving sales. Shopify, on the other hand, gives brands something that Amazon can and doesn't want, actually, which is full control. And I would imagine that strong brands, especially the smaller local ones that you've also mentioned would prefer Shopify and continue to do so as growing your own brand on Amazon is just pretty difficult to do. But you've said that most brands on Shopify sell on Amazon as well. And that's kind of refuting my thesis. So I suppose only truly strong brands strive to establish this direct to consumer presence rather than selling on platforms like Amazon.

59:02The more replaceable the product is, the more likely you are to just go to Amazon, sell it, leveraging the ecosystem, and instead of running your own shop and having all those doubts and headaches that you have running your own shop. A key part of that is Amazon's advertising business that is not often talked about, but it's the third biggest after Google and Meta, and it's a huge pull for merchants since it lets you acquire customers within Amazon's ecosystem. Another way you could say all this, I think, at least in Shopify, favor is that they appeal to brands who truly want to quote unquote own their customer as opposed to renting customers through Amazon.

59:43And if you're going to argue that Shopify could win the war, the argument would really boil down to that. A large number of e-commerce brands want to own their customer. Amazon is excellent, though, for customer acquisition, but not necessarily loyalty to the merchant since the customers there are ultimately Amazon customers. Shopify enables more brand loyalty, but it does require merchants to have some skill in customer acquisition from different sources, which is why I say Shopify makes a lot of sense for brands that already have web traffic coming to them. And although you might not own the traffic coming to you on Amazon, because ultimately Amazon's algorithm is determining which brands get highlighted, as I've said, you can tap into their logistics network, which means independent sellers can ship products to Amazon warehouses and enable them to be listed on Amazon as either one or two day delivery.

1:00:39And doing that is just going to dramatically boost sales. That is quite literally hard to compete with as Shopify has found out the hard way. So I think that tells you about the different types of businesses the two platforms might attract. A city's most popular bakery might have a Shopify store for online orders. And because they're a localized business, they're not selling at all on Amazon. You're not selling cookies on Amazon. And as such, they don't necessarily need a fulfillment network because their business is geographically segmented to one area and is probably mostly in person. Meanwhile, a brand that's trying to sell something commoditized like low-end bike helmets, just to use that as an example, maybe they're trying to do so globally and they're sourcing from China.

1:01:29it's going to make a lot of sense for them to use Amazon because they don't really care about brand differentiation. And they just want to maybe take advantage of the best logistics available to them and get the most face time in front of the widest range of potential customers. And then in the middle, kind of straddling these two worlds, you might have some trendy, let's say, organic deodorant company. That sounds like something you'd see an ad for on Instagram. And they have their own website through Shopify, and they funnel people to it from either TikTok Docker, Instagram, and perhaps they also rank well on Amazon and they kind of leverage both and they might get 30 % of their sales from there too.

1:02:05So they use Amazon, but they're also not completely reliant on it. Like I said, they have social media traffic that's coming directly to their website too. And that maybe that's most of their business. And that's kind of what you might imagine when you think of a company that is using both Shopify and Amazon. And it's a stereotypical way to imagine the differences and what these merchants look like. But the point being there that there is some overlap, but also some discrepancies in the types of businesses that are maybe entirely Amazon-focused, partially Amazon-focused, or who just avoid Amazon altogether and don't get anything from it.

1:02:38And given all the fees that Amazon takes, it's almost certainly more profitable to have a sale come through a company's Shopify store than it is to go through Amazon. So there is an incentive that if you can get enough traffic to your website to try and sell there. But again, some brands are happy to make that exchange because they can tap in a much larger potential sales volume on Amazon, even if that comes at a higher cost. We've now talked a lot about Amazon and Shopify and how they fit into the picture. But when I think about Amazon's biggest competitor, at least in the US, I think Walmart comes to my mind first.

1:03:16And so how do they factor into this picture? Are they having a connection to Shopify as well? What's the relationship there? It's funny because Walmart actually teamed up with Shopify to bring a curated set of, I believe, 1 ,200 Shopify merchants onto the Walmart marketplace back in 2020. And I guess this was sort of a mutually beneficial alliance. It gave Walmart's online marketplace a boost in assortment, helping it compete against Amazon and offered Shopify merchants a new sales channel too. And you might also say that it signaled that large retailers see Shopify's merchant base as an asset to tap into.

1:03:55And perhaps that the old adage, the enemy of my enemy is my friend, perhaps explains why Walmart and Shopify wanted to align together to take on Amazon. And how long that alliance can last is maybe another question. But to this day, Shopify merchants can still be integrated into Walmart's marketplace. and Shopify has made similar kinds of partnerships with Facebook and Google too, making it easy for merchants to promote their products in those places and make sales through Shopify. So it does kind of feel like these big tech companies are working together to take a bite out of the biggest of the big tech companies in the e-commerce world, which is Amazon.

1:04:36I mean, it kind of makes sense. Amazon is just so big and sort of a threat to all of them. Why not team up and not fight this war alone? But besides selling their logistics business, which has been because of Amazon, and responding to the competitive threats that come from them all the time during the pandemic era especially, I believe Shopify also did a share split back then, right? In 2022, Shopify did announce a 10 for 1 stock split, yes. and a stock split is an arbitrary thing that some people get excited about because it increases the number of shares you own but is not a dividend where you're actually getting paid something of value literally if you owned one share of shopify you were now given 10 so you didn't actually get wealthier you just got more shares while the stock price was proportionately repriced because everybody got more shares at the same time so it just became an order of magnitude cheaper As I said, it's a completely arbitrary thing, but it does basically make the stock more affordable, maybe to retail investors to purchase, which in the margins maybe creates more liquidity and draws more retail investors to buy shares in the company.

1:05:48These are not reasons why we invest in businesses, Daniel, but this is how some people think of it. And still, economically speaking, nothing has changed. But that is also not all that Shopify did. At that same time, Shopify also created a new non-transferable share class called the Foundershare that would be granted to Toby Lutka. And together with this existing ownership share would give him 40 % voting power over the company. So this is just really concentrated power in the CEO's hands. And we see this with a lot of these Silicon Valley companies, even though Shopify is actually not a Silicon Valley.

1:06:29I'm not sure what the Canadian equivalent is, but you get the idea. And again, like I said, he is really concentrating power such that any shareholder vote that goes through is going to have to go through him. He can almost single-handedly sway the outcome of any vote. And that creates a conflict of interest for shareholders. Fortunately, this voting power is voided. if Lutka no longer serves as the company's CEO, director, or consultant. So not transferred to the next CEO per se, but again, this just confirms that any bet on Shopify is really a bet on Toby Lutka. Sometimes having a founder concentrate power is great if they're brilliant and thoughtful, but it can also be a nightmare if they can't be deterred from making what ends up being a huge mistake.

1:07:21Mark Zuckerberg's metaverse comes to mind. there are a lot of things that can go wrong with this kind of concentrated power and not having an independent board but just one example is that the board is supposed to negotiate CEO compensation on behalf of shareholders the CEO isn't abusing shareholders to enrich themselves and if the board isn't independent because they're all selected by the CEO who has all the voting power well you can see the conflict of interest so it is no coincidence that on top of already owning 6 % of Shopify, Toby Lutke managed to secure a nine-figure compensation package for himself last year too.

1:08:01I must say this doesn't look too good. I don't know enough about Lutke personally to have a strong opinion on whether I like him having that much voting power or not. On the one hand, no one understands a company better than its founder, especially a company as mission-driven as Shopify is. But on the other hand, there are a lot of examples where founders were amazing at building something from nothing, but maybe not the best people for scaling it from a hundred billion dollar company to a trillion dollar one. When you've got a dual share class structure with concentrated executive power and a board that isn't fully independent anymore, it can create blind spots.

1:08:42Even for the greatest founders, you mentioned Mark Zuckerberg, who is without any doubt one of the greatest founders on Wall Street and even he makes mistakes that are costly and cost billions and perhaps even tens of billions. If things start going sideways there aren't many natural checks and balances to course correct. It's not a huge problem when everything is going well but if strategy or execution starts slipping it can get messy really fast. In the end it can go both ways and it's one of those situations where only hindsight will tell us whether this was a good move for the company or not perhaps it's best if we just avoid the guessing game and come to the fundamentals of the company so how about you walk us through your valuation process for Shopify there's no doubt that this is a terrific business for all the bare cases and concerns we've raised objectively this is a terrific business and having the work done on the best businesses can really pay off handsomely as you know if we get the chance in a bear market to initiate a position already having that work done is just a big advantage and that is kind of what i hope to accomplish with shopify because i already knew up front it was richly valued so i didn't think that we were going to be adding it today but with that said for my model i focused firstly on estimating the amount of gross merchandise value that I think can occur through Shopify's merchants based on historical growth rates and some of the initiatives I know they're working on.

1:10:13And then from there, I try to estimate the take rate for Shopify as a percentage of all those merchandise sales, which I do think can continue to grow a bit modestly over time as Shopify continues to scale its merchant solutions offerings and add more features that can be monetized beyond simply just the subscription fees that users pay. So with that, I, am able to estimate a revenue CAGR of about 20 % by 2029, which is fast growth, but it doesn't take one too long after first studying Shopify to see how massive their market opportunity is and how much of it remains untapped. And through that lens, and based on their track record, 20 % a year is honestly conservative relative to even what many analysts on Wall Street think the company could do.

1:10:59And from there, with that said, I tried to make some estimates about what operating margins could look like for them. And I've got margins expanding by a few percentage points as I continue to realize the benefit of a kind of scale as a software company. And then with all that, and there's a lot of digging through financial statements and dirty work like that, but I won't drag you through right now. I get a model of the company's operating profits mapped out over the next five years. And with that model of operating profits, which we normally treat as a sort of ballpark way to put some numbers around all of the qualitative considerations we discussed today and in this episode, I'm guessing you try to narrow in on an exit multiple.

1:11:44Can you maybe just walk us through how you think about that, where Shopify should be valued in 2029? You beat me to the punchline, but as you said, the next step is this sort of trying to account for a realistic exit multiple that I think the company could be sold for in a few years. Whenever you're buying into a company, you need to think about your exit strategy. What would the valuation look like down the road? And as they continue to grow, I do think the exit multiple should probably be relatively higher than the market average, even still by 2029. We also are going to want to account for it to decrease a bit as the company continues to mature.

1:12:28And if we look at the NASDAQ 100 index of big tech companies, that index has grown its earnings per share at about 11 % per year over the last five years. And the enterprise value to operating earnings ratio for the broader large cap tech sector is about 25 times. So you're paying 25 times operating earnings for a share of the company. And when we think about Shopify growing its operating profits per share by well more than twice that in the coming years, it's no surprise that Shopify looks expensive at around 50 times operating earnings. And we also know that the company will likely still command a premium valuation over its peers by 2029, even if it does come down a bit, because we know that Shopify is probably still going to be growing faster than the market averages and the markets like to pay up for growth.

1:13:19So in my model, I have them trading at around 30 times operating earnings as sort of the average point in a range of what I think are maybe plausible exit multiples. And like I said, 30 times operating earnings for a company that might still be growing one and a half times as fast as the NASDAQ 100 is not that crazy. So there's really to be more aggressive. But with all these assumptions, I get an intrinsic value per share of about$53, which I calculated as a price we'd need to hit for me to feel very confident about being able to earn a double-digit annual return on average going forward without relying on exorbitantly high valuation multiples, which is just never guaranteed.

1:14:01I do see Shopify as being very richly, richly priced, given that the stock is currently trading about$40, call it$45 per share, higher than my buy price target where in my defense, I'm still forecasting 20 % plus annual revenue growth and an exit multiple of 30 times operating earnings, which I don't think anybody could accuse me of being conservative. And that would still leave Shopify actually trading at a premium to Amazon's current valuation of 29 times operating earnings. And I know I'm throwing a lot of numbers around, which can be hard to follow. If you're watching this, you'll be able to see some of the numbers I've been talking about in screenshots from my valuation model.

1:14:46But for those interested in the modeling stuff, that is a quick rundown of how I'm thinking about things with the point being that Shopify is a really great company. And it's no surprise that the market recognizes this, not maybe a bit too much. And for anyone who wants to download my model on Shopify, and just for context, we talk about our models every week on the show. And if you wanted to actually see it, you need to go to our newsletter. So we have a newsletter linked to in the show notes below in the description for this episode. If you just click it and then you read through the Shopify newsletter for this week, at the bottom, you should find a link to the valuation model.

1:15:27I like that you resisted the temptation to just pluck in numbers that would justify Shopify's current price. It's not easy to resist. You have a great company that's already proven it can grow at rates beyond 20%, but it's no small company anymore. It's a lot harder to grow from 100 billion to 500 billion than it is to go from a billion to 5 billion. And just for perspective, at your assumed 20 % annual growth rate, Shopify would keep doubling its revenues roughly every three and a half years. That's incredibly fast growth already. So the fact that even this growth rate would suggest Shopify is trading at almost double its fair value, says a lot about the market's expectations for Shopify.

1:16:13And this ties into a bigger point about paying up for growth. Investors are willing to do it because true compounders, businesses that can sustain high returns over a long period, are kind of the dream of every investor. Compounding without any turnover, the difficulty of finding new great opportunities each year, which is just not easy to do. But the key is figuring out what growth has already baked into the current price and what's realistic going forward. If you look at frameworks like the Graham and Dart PE matrix, it basically shows that the higher the expected growth, the more you can justify paying a higher multiple.

1:16:53But only up to a certain point. At some level, no matter how great the company is, and Shopify is a great company, the opportunity costs get too high compared to safer alternatives. So it's not just about whether Shopify can grow. It's about whether the growth you are paying for today actually leaves enough margin of error. But you understand the company much better than I do. So I'm curious to first hear your take on the valuation and adding it to our intrinsic value portfolio. And then I will have some closing thoughts. Yeah, it's funny because I'm the one pitching Shopify, but I want to emphasize I'm pitching Shopify generally and not at today's current prices, which I think we both see as not being all that attractive.

1:17:41It's a company I know I want to buy at a better price, though. And I get the whole argument that if a business is great and grows fast enough over a long time period, it really won't matter if you overpaid a bit. but in this case i can't even in good conscience put numbers into my model that spit out the current share price it just feels too optimistic and maybe it wouldn't feel that way if i had a deeper understanding of e-commerce i just don't have a ton of insight into that world and certainly not enough to be comfortable underwriting the necessary growth to justify shopify's current share price as is implied by maybe a reverse tcf that you might do on shopify to look at what the market kind of expects.

1:18:22In my bull case, I could maybe imagine the company growing at 30 % a year for five years and trading at an exit multiple of 33 times operating profits in 2020. And still, my price target for the company would come a few dollars short of current prices. So like I said, even me trying to intentionally be as bullish as possible, I can't quite recreate the market's bullishness on this company. And 30 % revenue growth per year is more than what most analysts I'm projecting. So this isn't just bullish, but this is like super bullish. And as I said, through that lens, the stock still does not look cheaply priced.

1:18:58So Shopify is an excellent business with so much potential, which is why the market pays a massive premium for it at around 54 times last year's earnings and 67 times free cash flows, which are numbers that make me blush. But and so I just can in good faith suggest that we add it. If you told me in five years that Shopify did actually grow 30 % a year. I would not be surprised. But it's another discussion to have that as your baseline outlook for a company, which is what is implied at current prices. And I just can't get comfortable with that. It's safe to say that it's never a good sign that your best case scenario ends up below the current market price.

1:19:39It's a prime example for a company that is priced for perfection. And that going into an environment that seems more uncertain than at any point since COVID, you had all the tariffs. Many economists actually expect to have a recession in the US. And we talked about how that would impact Shopify's business. So this just wouldn't be the time for me to buy a company like Shopify, which is priced for perfection. and to say nothing either of the elephant in the room though i guess maybe not an elephant in the room because we talked about it so much but the competitive concerns with amazon and in short i think shopify and amazon really are vying in different ways for the future of e-commerce and what scares me is that amazon might have some aces up its sleeve that it could pull out to damage shopify further if push really came to shove and one of those which we've already seen being the buy with prime initiative.

1:20:33If Amazon was not in the picture and it was this open landscape for Shopify to conquer, I could definitely get behind the company at these prices. But Amazon just adds a layer of competitive uncertainty on top of the tariffs and economic concerns. That's just really make me hesitate about some of the more optimistic projections of what Shopify can accomplish. so i am recommending we hold off on shopify ironically as the person who's pitching it but if we get a price south of maybe 60 per share which would be a considerable discount from where the market is currently trading it wouldn't be an unprecedented sell-off for companies with a stock as volatile as shopify's but it would have to take something like that like a 30 percent or more sell off maybe even a 40 percent sell off for me to really seriously revisit the decision to add shopify to the portfolio the value investor in me wants a 40 percent sell off i mean the good news is that shopify has been incredibly volatile so there is a pretty good chance that at some point we will see those prices again and the good news is that after today's deep dive i think you gave such a good idea of how Shopify operates as a business and how secure it is from a long-term perspective.

1:21:56So perhaps there is a recession coming and the stock price would drop dramatically. And I think both of us would have enough conviction now to probably use that stock price drop to establish a position. But buying a company as richly priced as Shopify and seeing all those looming risks, mostly Amazon in the long term and short term, perhaps some macro concerns. It just doesn't feel like the right time to add Shopify to our portfolio. So it's a hot rating for me as well. Okay, well, we're in agreement. Maybe just to wrap things up today, I'll give us a quote to reflect on. And then Daniel, if you just want to quickly give us a few hints on what company you'll be pitching next week, that'd be great.

1:22:38So here goes the quote from Amazon's Jeff Bezos, who says, if you are competitor focused, you have to wait until there is a competitor doing something. Being customer focused allows you to be more pioneering. With Shopify, you could say they're merchant focused and that has taken them a long way too. So Daniel, how about you tell us about your company for next week? I've given these hints some thoughts and it was not easy since I felt that all of them make it too easy. Perhaps I'm on the other side now, which is too difficult to figure them out. If so, I'll apologize in advance, but here we go.

1:23:16So the first one is that just like Shopify, my next company wanted to expand its business. And to do that, it tried launching a hotel booking platform, but it shut it down within a year. So there's a close resemblance to the logistic business of Shopify. The second hint would be that while the company is by no means an M &A business, it did make some acquisitions. and one of them was a small internet movie database in the late 90s. And then last but not least, it has been a pioneer in its space and it inspired similar businesses on pretty much all major continents and big countries. So I think that's where I will leave it.

1:23:57Some people might be surprised when they see the company, but those are my hints. Okay, those are some very thoughtful hints, Daniel. Thank you. I don't know if I have an answer for you. I'm not sure I have a guess. But if anyone in the audience does, they can always leave a comment and let us know what they think it is. And with that, I hope to see you all back here next week for another company breakdown in valuation and then decision on whether to add this mystery company to our intrinsic value portfolio. We'll see you all then.

1:24:36Thank you.