How Shopify Inc. Makes Most of Its Money

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Investors in Shopify (NYSE: SHOP) have seen their stock double in 2017 alone and triple in two short years on the public market. That's an undeniably awesome return on your investment, but how does Shopify earn its keep?

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Let's take a deeper look at what Shopify does for a living.

Cloud-based retail tools

Shopify founder and CEO Tobi Lutke wanted to start a snowboarding equipment business back in 2004, but found it difficult to equip his shopping site with the existing range of e-commerce tools. A programmer by trade, he wrote his own online ordering, checkout, and inventory management software instead -- and the seeds of Shopify had been sown.

On Shopify's investor relations site, you'll find this simple mission statement: "Shopify is exactly this: the only platform you need to build your empire."

So the company's software and products are designed to run a small to medium-sized e-commerce business as efficiently as possible.

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In many ways, Shopify is a head-to-head rival of Square (NYSE: SQ). Both companies offer credit card processing tools and services, e-commerce backends, and pre-packaged shopping site designs, all aimed mainly at small to medium-sized businesses. Square attacked these markets from the perspective of a payments processor, while Shopify entered the ring from the software-focused corner.

But they are most certainly in the same arena now.

By the numbers

Shopify breaks down its incoming revenue into two buckets. Subscription solutions account for recurring service and license fees that its customers pay for the use of Shopify's cloud computing tools. The merchant solutions division is made up of mainly payment processing fees with a smaller contribution from transaction fees, shipping services, and the sale of Shopify-powered credit card readers. Every time you buy something from a Shopify-powered online shopping site, a few percent of that transaction's total value falls into Spotify's coffers under the merchant solutions banner.

Here's how the two categories break down in terms of money-making muscle:

Revenue Type

Q2 2017 Revenue

Q2 2017 Gross Profit

Q2 2017 Sales Growth (YOY)

Subscription solutions

$72 million

$58 million

64%

Merchant solutions

$80 million

$29 million

86%

Merchant solutions brings in more revenue and is growing faster, and that's exactly how Shopify's management likes it. The company is explicitly working to expand its merchant programs, and merchant solutions sales are expected to make up a larger portion of total revenue in the future.

Profit margin is currently a bit on the low side in that revenue category, but things are changing. In the second quarter of 2016, merchant solutions kept just 30% of its incoming sales as gross profits. Fast-forward to the same quarter in 2017, and the margin has widened to 36%. Economies of scale make a big difference here, and the early going is more expensive due to the costs of setting new customers up with the hardware required for on-site credit card processing. To push the segment along a bit faster, the company recently introduced the first Shopify-designed credit card reader, having relied on off-the-shelf solutions for the last three years.

So the company records roughly half of its sales under payment processing today, and the other half comes from businesses paying their monthly dues to access Shopify's many services. Over time, payment processing will become the bigger story -- and a more profitable one, as well. Moreover, the new Shopify Plus program offers additional services for larger clients. The company is learning new tricks from the first contracts in that category, as each new enterprise customer is likely to ask for its own custom features that later can be folded into the basic Shopify toolkit.

It's an interesting business with a bright future, but it's hard to pin a correct market value on Shopify today. The company is unprofitable in every way, leaving investors waiting for sustainable earnings and positive cash flow. The same is true for Square, and the two companies are destined for increasingly direct competition in the coming years. Comparing one against the other will always be a useful exercise.

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Anders Bylund has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Shopify. The Motley Fool owns shares of Square. The Motley Fool has a disclosure policy.