Shopify: Platform Theory KPI’s, Moats, & Strategic Analysis

This is an analysis of Shopify’s (Ticker: SHOP) Key Performance Indicators (KPI’s) and an attempt to quantify aspects of Ben Thompson’s Platform Theory Framework to Shopify based on its public financial and operational metrics.

My goal is to understand Shopify’s underlying business fundamentals of providing a modern e-commerce shopping platform to small and medium businesses around the world; how the company is executing against its plan to cost effectively acquire, retain and monetize merchants on the platform; and what it is doing to build a competitive, enduring moat against larger, established players and potential new entrants like Amazon, Walmart, and Nordstrom.

Per Ben Thompson’s Platform Framework:

“…the primary function of a platform is provide a stage for the applications that users actually need to shine.” And “owning the customer relationship remains critical…How that ownership of the customer translates into an enduring moat, though, depends on the interaction of two distinct attributes: supplier differentiation and network effects.” (Thompson’s “Tech’s Two Philosophies” and “The Moat Map”)

In the case of Shopify, it is building a suite of applications so that 3rd Party DTC (Direct-to-Consumer) merchants (e.g. users) can, in turn, effectively sell products online to their end consumers. In effect, an OS for online commerce. Similar to the tactics of reference platforms and OS’s like Apple and Microsoft, signs of a vibrant and growing platform and ecosystem should emerge from the KPI’s.

If so, then Shopify’s continued share price increase will be supported as it should enjoy success for years to come as this fast-growing market continues to expand. If not, and potential warning signs begin to show themselves in the company strategy, then Shopify will not meet future revenue expectations and may be susceptible to industry consolidation.

The two key questions to answer as we apply the Theory to Shopify:

1. is the underlying business model working, and
2. is it building a moat fast enough, large enough, and cost effectively enough for it to sustain amidst complex industry forces and increased competition?

From a pure public company comps perspective, Shopify is expensive relative to its peers and other SaaS stocks. But I don’t know anything about how public companies are valued. What I do know about Shopify is four-fold:

1. Shopify is valued at a higher multiple than the any of its industry comps- traditionally 8x-10x revenue multiple- and its stock price growth has outpaced underlying revenue growth;
2. Shopify has raised more than $2B in the public markets since 2015 signaling that the company has an (expensive) plan of attack;
3. Shopify continues to aggressively invest in both market share and its platform capabilities and as a result will presumably lose money with no sign of profitability into the near future; and
4. Shopify sits at the nexus of retail, online commerce, DTC, SaaS, and dynamic omnichannel industry forces in which Amazon and traditional retailers like WalMart and Nordstrom similarly see opportunity.

What I find interesting about Shopify is that it uniquely combines the lessons of Ben Thompson’s Platform Theory, go-to-market activities of SaaS businesses, network effects, marketplaces and the fast-paced dynamics of large, growing categories that can be applied to companies of all sizes, stages, and industries.

Source: Ben Thompson https://stratechery.com/2018/techs-two-philosophies/

Shopify Business

Without question, Shopify’s stock performance is impressive. The stock is up over 600% since it went public in 2015 and over that time has far outpaced both Amazon and the e-commerce market as a whole. With a market cap of $20B, trading at 20x 2018 revenue, Shopify has been a Wall Street (and whatever is the Canadian Wall Street equivalent) darling.

Shopify Stock Performance

Per Shopify’s Annual Report, what the company provides is straightforward:

“Our mission is to make commerce better for everyone, and we believe we can help merchants of nearly all sizes, from aspirational entrepreneurs to large enterprises, and all retail verticals realize their potential at all stages of their business life cycle.”

And it is very good at what it does.

Revenue growth has been exceptional and consistent with other world-class platforms, crossing $1B in sales in 2018, up 423% since it went public in 2015. Though growth is slowing due to the unavoidable law of large numbers- 59% overall top-line growth in 2018 is phenomenal and world-class and speaks to the company’s demonstrable ability to focus and execute.

Shopify Annual Revenue and Growth 2012–2018

However…is Shopify simply riding the overall DTC/e-commerce wave and benefiting from being in the right place at the right time? According to the latest research, the e-commerce industry as a whole is indeed growing at a healthy clip- 23% in 2018 and 20%+ annual growth rates for the next several years. Compared to the company’s 59% growth, Shopify is clearly doing something different (and better) than the category itself.

E-commerce Industry Growth Rate 2014–2021

Total merchant Gross Merchandise Value (GMV)- the amount of product being sold across the Shopify platform- reached $41B in 2018; up over 400% from $7.7B in in GMV in 2015. As you can see, annual GMV growth has been 129%, 134%, 105%, 100%, 71%, and finally, 56% between 2013–2018, far outpacing the general commerce market.

Shopify Annual Merchant GMV 2012–2018

So…then is Shopify a proxy for the broader DTC commerce trend of selling anything and everything in-a-box- or as a subscription? Again, the answer seems to be “no.” Indeed, company and GMV growth ran largely in lock step up until 2017, when, for the first time in Shopify’s history, the growth curves crossed and the company’s own revenues outpaced that of the GMV of its merchants. In 2018, the company outpaced revenue growth again in 2018- achieving the above-referenced 59% growth to the partners’ 56% expansion.

Shopify Annual Revenue Growth Outpacing Platform GMV

So Shopify is executing on its Platform better than the industry as a whole. How? Back to Platform Theory- let’s look to see how and if Shopify is building great applications, establishing supplier differentiation and creating network effects. If so, we should see an increase in product innovation, more applications, more and larger DTC brands, and a robust partner ecosystem that would increase the value of being on the platform.

And, in turn, is Shopify’s strengthening platform being reflected in the KPI’s in terms of:

• merchants selling more products and staying on the platform longer before either folding or graduating onto more established enterprise-grade systems (such as Magento),
• company building more applications and layering on additional revenue opportunities to accommodate successful merchants as they scale, and
• increasing commissions on GMV.

Platform KPI #1: Increasing Per Merchant GMV and Keeping Enterprise Sellers

The average Gross Merchandise Value (GMV) per merchants has doubled from 2014 to 2018- from $25,862 to $50,121 last year. These are still very much small businesses.

Shopify Increasing Per Merchant GMV

Shopify’s goal is to continue to build out a platform that combines “…an ease of use with enterprise-level functionality allows merchants to start with a Shopify store and grow with our platform to almost any size….Shopify Plus is also designed for larger merchants not already on Shopify who want to migrate from their expensive and complex legacy solutions and get more functionality.”

The best example of Shopfiy’s ability to keep larger merchants on its platform as they scale is Kylie Cosmetics. Kylie Cosmetics’ revenue climbed 9% last year to an estimated $360 million. Not only has Kylie scaled revenue, but it also entered into a multi-channel partnership with retailer Ulta, launched pop-up stores, sold via Snapchat and Instagram- showing off Shopify’s investment in more sophisticated applications. You can check out more on the story here.

Shopify’s goal is to acquire SMB e-retailers as the de facto platform of choice to start selling online, that Shopify is continually investing in applications to keep those hard-to-acquire customers longer and selling more.

Platform KPI #2: Increasing Per Merchant Revenue

As merchants sell more, Shopify is able to better monetize those merchants- generating $1,300 per merchant in 2018, nearly double it’s take from the $725 in 2014.

Shopify Increasing Revenue Per Merchant

How Shopify is increasing revenue is critical. It is a delicate balance in that the company business model has to be aligned with the goal of merchants to sell more product. By increasing merchant GMV- through a variety of applications- Shopify is in a strong position to earn more revenue share. Another way of saying this, does customer engagement increase the longer merchants remain on the platform? Beginning in 2017, the answer appears to be “yes.” The company’s investments in R&D coupled with the global e-commerce Direct-to-Consumer (DTC) trend appear to be healthy tailwinds.

Shopify Increasing Take Rate

Potential Moat Warning Sign #1: Decreasing New Merchant Acquisition

Customer acquisition is a critical success factor for any business- in particular for a company like Shopify that caters to startups and small direct-to-consumer (DTC) brands.

Shopify Crossed 800,000 Platform Sellers

As of the end of 2018, there are 820,000 total merchants on the Shopify platform. However, 2018 was the first year in its history that Shopify net new merchants (ie, the number of new customers it acquired) decreased from 231,500 new sellers in 2017 to 211,000 merchants in 2018. That said, as you can clearly see, Shopify is enjoying the compounding effect of its previously acquired cohorts- and thus is able to spend more than it did previously to acquire additional merchant customers.

Shopify Decelerating New Merchant Acquisition

Potential Moat Warning Sign #2: Increasing Customer Acquisition Costs

And that is exactly what is happening as the amount that Shopify is paying to acquire new customers increased 70% from $975 in 2017 to $1,660 in 2018. This is one of the main areas where Shopify is using its freshly raised capital- and pricing smaller, potentially competitive platforms out of the market. And the reason it can do this is because it believes once a merchant begins to sell on the platform that there are enough applications, services, and network effects to create lock in. Shopify is a net buyer of as many new merchants as it can get onto the platform- even while that annual number is becoming saturated.

Shopify Customer Acquisition Costs Are Rising

Potential Moat Warning Sign #3: Longer Acquisition Payback Period

Shopify’s new Merchant Services revenue streams are still in their relative infancy and coupled with increasing acquisition costs, it is taking longer to break even on merchants.

Shopify Acquisition Costs Now Outpacing Merchant Revenue

Platform Theory Moat 101: R&D, Network Effects

As Ben Thompson has written extensively and Jeff Jordan and Ryan Caldbeck discussed on a recent a16Z Podcast, the requirement to create a healthy platform is to continuously and vigorously invest in supplier differentiation, new applications (ie, new layers to the cake), and network effects.

Shopify has smartly focused on building out both its partner and developer network as a way to accomplish its two main KPI’s of acquisition and platform retention/engagement. On one hand, it now has 18,000 partners referring new merchants- this is cheap customer acquisition that helps Shopify keep as wide a top-of-funnel as possible.

On the other, it also now has 2,500 developers building applications for the Shopify platform- that simultaneously increase the platform’s capabilities but also provide Shopify with a traditional App-store monetization engine where it enjoys margin share. The larger the surface area of partners, developers, and customers, the more each constituent is incented to invest in Shopify’s platform- establishing an attractive flywheel that is difficult to replicate.

Second, Shopify is allocating their resources- it is now spending close to $400 every year on new capabilities for those merchants who remain with them. And this is up nearly 40% from when Shopify went public in 2015.

Shopify Heavy Investment in Platform Capabilities

Online commerce is hard- and is getting more complicated.

“Amazon has reshaped consumer expectations by delivering seamless shopping experiences, fast shipping and free returns.” .

As new shopping channels emerge (such as social), new consumer platforms mature (such as mobile), and new payments become mainstream (such as Stripe, Apple Pay), Shopify has to continually be ahead of the curve and invest in applications and capabilities that represent the best-of-breed modern shopping platform capabilities. Just as Ben has pointed out that Netflix can afford to outspend any other Aggregator on original content- as it can amortize those costs across a larger installed base- Shopify needs to do the same. And it is an expensive proposition.

Platform Moat Pricing Power?

As Shopify itself explains, “While our platform can scale to meet the needs of large merchants, we focus on selling to small and medium-sized businesses (“SMBs”) and entrepreneurs. The large majority of our merchants are on subscription plans that cost less than $50 per month, which is in line with our focus of providing cost-effective solutions for early stage businesses.”

This means that Shopify has to develop other- more lucrative- revenue streams from the Platform.

Shopify Changing Revenue Mix- Sales, Marketing & Financial Solutions

Finally, as you can see in the above chart, the results of this platform investment has contributed to the new revenue mix that Shopify can enjoy from now and into the future. The business model has become less reliant on the small and commoditized aspects of the platform- website hosting, storefront designs, etc- and more on participating from each transaction that flows through its ecosystem.

As Shopify itself admits, “SMBs, which comprise the majority of merchants using our platform, may be quite sensitive to price increases or prices offered by competitors. As a result, in the future we may be required to reduce our prices, which could adversely affect our revenue, gross profit, profitability, financial position and cash flows.” 2018 Annual Report (pg. 44)

It is not inconceivable to see a future whereby Shopify gives away the core platform features for free or near-free in exchange for transaction fees and other, more strategic (and lucrative) merchant marketing and financial services. Especially as their more successful merchants hit the “glass ceiling” and need more sophisticated multi-channel applications, including wholesale.

“While traditional brands like Coach and Michael Kors tighten up inventory buys and reduce wholesale accounts in order to focus on direct sales, DTC brands born online are hitting a glass ceiling as the cost of online advertising and customer acquisition continues to climb. In search of new growth opportunities, these brands have already moved into direct physical retail stores and expanded into more product categories, leaving one retail stone unturned: wholesale.”

Shopify’s Platform Moat

Will Shopify be able to create a moat in the ultra-competitive world of online commerce? Can it survive an attack from Amazon, who is already working with 3rd party resellers? Can it keep building enterprise-like features fast enough in order to cater to its most successful and fastest-growing merchants and prevent them from jumping ship to “Magic Quadrant” legacy SaaS providers such as Magento, SAP, Oracle, and Salesforce? There is no reason it can’t- other “bottoms-up” SaaS businesses, like Dropbox, have successfully made the move upmarket.

In September, 2018, Amazon announced the launch of Storefronts- its new product offering aimed at selling products from some “20,000 SMB” merchants. Per Amazon’s stated vision “to be earth’s most customer centric company; to build a place where people can come to find and discover anything they might want to buy online”- this move makes sense.

As Jeff Jordan and Ryan Caldbeck discussed in depth in the above-mentioned recent podcast “Who’s Down With CPG, DTC?”, Amazon wants to be the front-door online (and offline destination)- the Everything Store. However, this is not what small and emerging brands- Shopify’s customers- want. The very purpose of DTC is to own and control the end-to-end user experience and customer journey. They are purposefully building their own brands, going around Amazon, selling through other channels, and owning that DTC relationship.

To quote Ben Thompson, for “Amazon… brands are much less important than they are in a world of limited shelf space, and few people even realize they are buying from the 3rd party merchants that make up over half of Amazon’s sales. (The Moat Map, 5/15/18 Newsletter)