The Biggest Risks With Shopify

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Shopify (NYSE: SHOP) has grown massively in the past few years, and many analysts think the company has barely scratched the surface of its total addressable market. But like any other company, there are some important risks that investors need to be aware of before buying in.

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In this Industry Focus: Tech segment, host Dylan Lewis is joined by analyst Michael Douglass and summer intern Ryan Reeves to explain the biggest risks facing Shopify today, and how much investors might want to worry about them going forward.

A full transcript follows the video.

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This video was recorded on July 21, 2017.

Dylan Lewis: For all that Shopify does have going for it, I think there are some risks that investors need to be aware of, particularly because it's a high-growth company, and it has just been running away with its valuation lately. Right now, it's currently trading around 20 times trailing sales, which is not cheap by any means, and I think that sets the company up for some hiccups if they're unable to deliver on any Wall Street's expectations.

Michael Douglass: Yeah, I came to the Fool in biotech, and even in biotech, 20 times sales is really expensive. You just don't see that kind of valuation often. But on the flip side, it's like, sure, that could cause some volatility, if they fail to deliver, God forbid the economy enters a recession, something like that. But at the same time, when you are addressing such a small percentage of your potential total addressable market, how much does valuation really matter when you're that small? You have this opportunity to grow to 10 times or far more your size. Twenty times sales doesn't sound so crazy, if you're able to actually execute.

Lewis: Yeah. I think the tough thing for investors with these types of businesses is, it's easy to fixate on valuation numbers, but the reality is, a $7 billion business versus a $9 billion business when the total addressable market is in tens of billions in revenue, it's kind of making a point out of nothing. It's almost silly to try and draw anything from it, because it's so inconsequential and the growth runway is so big. But it's worth noting.

Douglass: Yes. Investors beware. High-growth companies are incredibly volatile, and frankly, execution risk is a bigger concern. Procter & Gamble can afford to have some mess-ups before things get rough. Shopify is much smaller and has a much lower margin of safety.

Lewis: Yeah, and when you're working off a quarterly revenue base of just over $100 million, you're not Procter & Gamble. [laughs]

Douglass: Right. [laughs] Hint: you're not Procter & Gamble.

Lewis: I think some other things you need to keep in mind with this company are, there are other players in this space, maybe slightly less inclusive full systems, but there are other people trying to get at that addressable market that we talked about before.

Ryan Reeves: Exactly. You have BigCommerce. Similar to Shopify. You have Wix and Squarespace; they're more just building out websites. So Shopify, exactly how you said, they integrate everything, which is a huge advantage if you're a business owner. Just like you said, Michael, you just have the e-commerce portion completely taken off your plate, simple to set up. Squarespace and Wix and Weebly, other companies like this, they'll set up your website, but then you have to use other companies for inventory management or payments or something like that. But yeah, the barriers to entry aren't necessarily super high, with it being a software company. But yeah, there's some competition for sure.

Lewis: I think, to walk back some of those concerns, the switching costs are kind of high. There's going to be resistance to switching from your existing customer base. Those types of companies might impact future customer acquisition, but the people that use Shopify and love it, they're probably not going to switch just because there's another competitor out there.

Douglass: So long as the value proposition remains.

Lewis: Right, that's huge.

Douglass: If Shopify gets greedy and hikes prices too much, that's going to be a big problem. At certain point, it's like, yeah, this will be a pain in the butt, but it'll save us $50,000 a year; we're going to make the switch. But I think the fact that they're integrating all this together means that they should be able to bundle things for cheaper and get some economies of scale out of it. That's the hope. That would be my thesis around the company.

Dylan Lewis has no position in any stocks mentioned. Michael Douglass has no position in any stocks mentioned. Ryan Reeves owns shares of Shopify. The Motley Fool owns shares of and recommends Shopify. The Motley Fool has a disclosure policy.