Has Shopify Met Its Match With Adobe-Magento?

Shares of Shopify (NYSE: SHOP) slipped 4% on May 22 after cloud-services giant Adobe (NASDAQ: ADBE) agreed to buy its competitor Magento for $1.68 billion. Like Shopify, Magento is a "one-stop shop" that helps merchants digitize their businesses with websites, ads, payment services, analytics, logistics, and customer relationship-management channels.

Magento controlled 16% of the fragmented web-store market last year, according to a study by Magento industry partner Aheadworks. Shopify controlled 13% of the market, while industry leader WooCommerce held 18%. Other notable competitors included Oracle's ATG Commerce platform, which controlled 16% of the market, Demandware, which held 10%, and IBM's WebSphere, which held 7%.

The bears clearly believe that Adobe's takeover of Magento could significantly hurt Shopify and its other rivals. But are investors overreacting to the news? Let's dig deeper into this deal to find out.

Why Adobe bought Magento

Over the past few years, Adobe pivoted away from its core software products and diversified into the cloud-services market. It turned its flagship Photoshop software into a cloud-based service within its Creative Cloud and expanded its Experience Cloud, which focuses on enterprise software.

To build that business, Adobe acquired online marketing and analytics firm Omniture in 2009 to expand its digital advertising services. It subsequently bought video advertising platform Auditude for $120 million, online search and social ad campaign management platform Efficient Frontier Technology for undisclosed terms, and ad tech firm TubeMogul for $540 million.

Adobe can now bundle many of those services into Magento for its Experience Cloud customers. This could be bad news for Shopify, Oracle, and even Salesforce -- which competes against Adobe's Marketing Cloud in the cloud CRM (customer relationship management) market. Morgan Stanley analyst William Blair recently called the Adobe-Magento combination a "new long-term threat" to Shopify's growth.

Adobe's Digital Experience revenue rose 16% annually and accounted for 27% of its top line last quarter. However, that growth rate was slower than its core digital media segment's 28% growth, which was supported by its Creative Cloud products. The Magento acquisition could alter that balance in the near future.

Should Shopify investors worry?

Shopify has consistently posted high double-digit sales growth ever since its IPO in 2015. Its revenue rose 68% annually, to $214.3 million last quarter -- supported by 61% growth in subscriptions revenue, 75% growth in Merchant Solutions revenue, and a 64% jump in its gross merchandise volume (GMV), to $8 billion.

The company also reported robust growth at Shopify Capital, Shopify Shipping, and its premium package Shopify Plus -- indicating that it's successfully cross-selling products to its existing customers and expanding its ecosystem. Wall Street expects Shopify to post 51% sales growth for the full year.

However, Shopify only is profitable on a non-GAAP basis, which excludes stock-based compensation expenses and other one-time charges. On a GAAP basis, it reported a net loss of $15.9 million last quarter, which was wider that its loss of $13.6 million in the year-ago quarter.

Its cash and equivalents position grew from $938 million at the end of 2017 to $1.58 billion, but most of that gain (over $500 million) was attributed to its offering of Class A subordinate voting shares during the first quarter.

Simply put, Shopify isn't well-equipped to engage Adobe in a prolonged pricing war. However, Shopify weathered a similar threat before, when Amazon (NASDAQ: AMZN) launched its own "Webstore" service in 2010 to challenge Shopify. Amazon eventually killed the service in 2015 and integrated Shopify's features into its marketplace instead.

Investors also should recall that eBay (NASDAQ: EBAY) sold Magento, along with the rest of its enterprise unit, to a group of investment firms in 2015 at a steep loss. That sale indicates that Adobe could also struggle to integrate Magento into the rest of its cloud ecosystem.

The key takeaway

I like Shopify's business and think it still has great long-term growth potential. I'm not particularly worried about Adobe-Magento, since Shopify already faces tough competitors like Oracle and WooCommerce, but I'm concerned about its valuation.

Shopify trades at nearly 15 times this year's sales. Granted, Shopify is a high-growth company, but that lofty valuation makes it an easy target for short-sellers during news-driven sell-offs. Therefore, I'd steer clear of Shopify until its valuations cool down.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Adobe Systems, Amazon, Salesforce.com, and Shopify. The Motley Fool owns shares of Oracle. The Motley Fool is short shares of IBM and has the following options: short June 2018 $52 calls on Oracle and long January 2020 $30 calls on Oracle. The Motley Fool recommends eBay. The Motley Fool has a disclosure policy.