1 Number to Watch When Shopify Reports Earnings

By Frank DiPietro Markets Fool.com

Shopify Inc. (NYSE: SHOP) is scheduled to report quarterly earningsbefore the opening bell on Wednesday, Feb. 15. Here are some things for investors to watch and why monthly recurring revenue is the key metric to keep your eye on.

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Shopify's stock has been climbing higher over the past year based on lofty expectations from investors. Although the company has not yet turned a profit, a chart comparing the price-to-sales ratio and the stock price presents the picture of a high-flying stock with fantastic revenue growth:

SHOP data by YCharts.

Analyst estimates and company guidance

Shopify helps companies create internet-based, multichannel commerce platforms. The company's customer focus is small to medium-size businesses. It boasts more than 325,000 customers in 150 countries.

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Analysts on average are expecting the company to post 73% sales growth on a year-over-year basis in the fourth quarter, and they project a loss of $0.02 per share on $121.69 million in revenue.

The company itself issued guidance for a non-GAAP (adjusted) operating loss of $0.023 per share for the quarter on revenue of $121 million, both at the midpoint of the range. If the company hits its guidance, it will have 72.4% year-over-year revenue growth.

Metric Analyst Estimates Company Guidance
Revenue $121.69 million $120 million to $122 million
Non-GAAP EPS ($0.02) ($0.011) to ($0.035)

EPS = earnings per share. Data sources: Yahoo! Finance (analyst estimates), Shopify (company guidance).

How Shopify makes money

Shopify divides its revenue into two categories: subscription solutions and merchant solutions, which each accounted for about 50% of revenue in the quarter ended at the end of September.

The subscription solutions revenue is based on the monthly fee each merchant pays the company. This covers services associated with management of the customer's website and across channels that include web and mobile storefronts, social-media storefronts, and physical retail locations. These fees are extremely profitable, with a gross margin at the end of last quarter of 79%.

Shopify provides point-of-sales hardware for its customers. Image source: Shopify.

Merchant solutions revenue is correlated to the total gross merchandise volume generated by Shopify's merchant customers. Merchants pay Shopify for items such as payment processing, point-of-sale tools, and handling of shipping logistics based on a percentage of each sale. This category of revenue is much less profitable than subscription services, due to the costs associated with these activities. Last quarter, Shopify's merchant solutions had a 26% gross margin.

Shopify's dilemma

A company's value is eventually driven by the amount of profit it can generate. In the case of Shopify, that number is highly levered to the number of customers it serves. Each of these customers pays a monthly subscription fee, and the revenue generated has a very low direct cost associated with each dollar paid by the merchant to Shopify. The incremental dollars brought in by the ancillary merchant solutions business adds to the overall success of the company, but not necessarily the success of the stock.

For Shopify's share price to continue to soar higher, the company needs to convince the market that it can keep expanding its customer base. The dilemma it faces has little to do with its business model, and everything to do with its stock price and investors who are wary of falling profit margins.

If Shopify's customer expansion stalls as gross merchandise volume for its merchants keeps expanding, overall gross margin numbers will come down. It is not too hard to imagine that, in the current environment of consumers shopping more online, this scenario will play out. If it does, investors may begin to question the company's sky-high valuation in relation to its earnings power.

But the merchant solutions business, in addition to creating incremental profit, should be recognized for creating a retention factor among Shopify's clients.

Measuring subscription solutions growth

Shopify measures its subscription solutions growth via "monthly recurring revenue." This metric uses the number of merchants subscribing to Shopify at the end of each quarter, multiplied by the average monthly subscription fee. It is the number that will be the most telling in Shopify's earnings report, as it will give insight into growth in the number of merchants utilitizing Shopify's platform, along with any increase in subscription prices.

Shopify's monthly recurring revenue Image source: Shopify.

We'll know more on Wednesday

Keeping a long-term perspective is important when looking at quarterly results. At the end of Q3, Shopify's 325,000 active merchants were just a drop in the bucket, considering there are 10 million small and medium-size businesses in the geographic areas the company serves. This gives the company a long runway to work with.

When the company reports, if the market gets distracted by a robust holiday-sales-fueled merchant solutions number that causes a decline in gross margins, the share price may pull back. If that happens and the monthly recurring revenue still looks strong, it might be the ideal time for a Foolish investor to buy shares. Don't be distracted by the overall gross margin -- the monthly recurring revenue is the key metric to keep an eye on.

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Frank DiPietro owns shares of Shopify. The Motley Fool owns shares of and recommends Shopify. The Motley Fool has a disclosure policy.