Shopify Deep Dive

Becoming an Expert on this Fascinating Disruptor.

Inception:

The year was 2006. A passionate coder by the name of Tobias Lütke wanted to find a new snowboard online. While sifting through options, frustration set in as a seamless ability to locate compelling products simply did not exist. Determined to fix this, Lütke embarked on a journey to build his own online snowboard shop.

Tobias Lütke

Some 17 years and $60+ billion in market cap later, that idea would blossom into the foundation of an online store builder for any merchant wanting to run a business. What started as a singular dedication to remove snowboard purchase friction has transformed into a core mission to tear down the barriers to entrepreneurship for businesses of all sizes.

Lütke set out to trail-blaze a means to “arm the rebels” with all needed commerce tools -- all under one roof, all with one interface and all hassle-free. This work gave way to the birth of what he hopes will be a “1,000-year company” and what he calls “the best idea he’ll ever have.” It gave way to Shopify.

Here, we will explore all there is to know about Shopify’s business model and investment case -- the good and the bad. After finishing this article, you will be an expert on the company and will be able to answer virtually any question thrown your way. More importantly, you’ll be able to assess new developments from an informed position. We’ve read every report, every earnings call, every transcript, every leadership interview and every single piece of relevant information that we could find. We’ve condensed it down into an intricately synopsized view of Shopify’s business, prospects and risks. This is a real deep dive. We hope you appreciate it as much as we enjoyed creating it and we encourage you to share it far and wide. Let’s begin.

Section 1 – The Basics

1a) Product Philosophy & General Differentiation

Shopify makes it easy for merchants -- large and small -- to thrive online with near-endless scalability. It provides the support, integrations, and ease of use to ensure businesses have access to any & all needed functions across their daily operations. These tools are readily available and deployable on the Shopify Admin for an overarching view of a business across all channels of selling. The Admin is the back-end that unites all disparate areas of business into a perfectly harmonized birds eye view of everything that matters to a merchant. This allows for more effective and contextualized decision making and enables those decisions to be pushed to all selling surfaces where a merchant presides. Importantly, decisions are easily synced with the front-end (what the consumer sees) in a way that always reflects their own brand.

Shopify’s general product categories are meant to remove pain points associated with enterprise maintenance and growth. The more headaches it solves, the more valuable it becomes. It obsesses over being a merchant’s “more important piece of software” by facilitating powerful ease of use. Specifically, its general product categories are split into two well-defined buckets: Subscription Solutions and Merchant Solutions.

It does serve many large enterprises, but the suite and mission were originally incubated for smaller merchants to offer them the same enterprise-level utility previously reserved for the behemoths. Shopify allows ALL merchants to enjoy these tools -- from single person start-ups to Fortune 100 brands.

Shopify’s unique value proposition comes from a few places. First, it boasts the scale-based benefits of selling through an aggregated marketplace while secondly granting complete authority over brand and data. Merchants enjoy a win-win not typically available: More demand and total control over customer relationships. No longer must a business choose between one or the other. Merchants get it all while enjoying several unique perks that Shopify’s economies of scale (10%+ share of U.S. e-commerce volume) allow. Why does this matter? Marketplaces routinely withhold consumer data and compete with successful products via white-labeled knockoffs. Shopify doesn’t and, in turn, avoids a real conflict of interest while building trust.

This concoction of perks is rare and means that businesses at all stages of maturity can grow with no limiting technological factors. The ensured scalability guarantees that merchants can handle holiday spikes and flash sales with confidence that soaring volume will not crash the site or foster latency. Competing web builders deal with frequent crashes which is actually a material source of lead generation for Shopify.

To test the resilience of its platform, Shopify runs constant 3rd party breach tests, bug bounty programs & vulnerability assessments. It seeks out holes and sluggishness in the infrastructure to proactively address. As latency and shopper conversion are directly correlated, this matters a lot.

Singular interoperability is another real selling point. Because all Shopify products tie perfectly back to a centralized Admin, the tools are cohesively amassing data to make all products work better together than they do in isolation. For a specific example, demand data can be used to more accurately guide inventory reordering and marketing investments. It calls this product silo unification its “Commerce Operating System.” This is how it accomplishes its mission to be the most important piece of merchant software. More relevant data means less guessing and more effective strategizing.

Furthermore, Shopify features a light-weight suite of Application Program Interfaces (APIs) providing seamless integrations between all Shopify apps as well as 3rd party apps (more later).

API Defined: APIs are the glue that tie together software-based utility by enabling broad use cases to be carried out by 1st and 3rd party developers. They provide the digital workspace and tooling for developers to create apps and experiences. As the name implies, APIs are an interface for programming applications. We realize that’s a circular definition, but we think it helps to view it in this light. APIs can also be considered blocks of code that enable software to perform various tasks. APIs act as the ‘language’ that empower developer access to data services, operating systems, and other applications to create an end product.

Shopify intentionally designed its business to ensure it only does better when its merchants sell more products. This selling translates into more gross merchandise value (GMV) on which Shopify commands a take rate. So? It is solely focused on helping merchants thrive and is fully aligned with their motivations. It has every incentive to make sure clients succeed. That’s why it never knocks off a product like Amazon or Costco and never opaquely siphons off needed customer insights for itself. There’s no reason for Shopify to do so which is the beauty of this model.

1b) Developer Partner Philosophy

The breadth and extensibility of the firm’s product suite relies on a vibrant community of developers motivated to build in Shopify’s Developer Environment. These partners round out Shopify’s offering with niche tools to ensure merchants can have whatever they want, however they want, and in a simplistic manner.

“Partners make Shopify better by extending our API functionality so merchants can customize stores to meet unique needs.” -- President Harley Finkelstein

In terms of what Shopify offers itself vs. what it uses developer partners for, there’s an easy rule of thumb. If the use case is needed by most merchants, Shopify will build it. Less commonly used software is usually delegated to partners. This delegation not only extends the tooling that Shopify can provide, but it also serves as a strong source of referral-based lead generation to reel in new merchants. Specifically, partners delivered roughly 40,000 new merchants to Shopify in both 2021 and 2020.

To help partners sell more through Shopify, the company debuted “Built for Shopify” in 2022. This program comes with a slew of new tools and authorizations to craft developer apps in ways that “look and perform like they’re natively part of the overall platform.”

It’s clear that Shopify fixates on being a rewarding place for these developers to work. Specifically, its partners make $7 in revenue per every $1 that Shopify collects. As of 2022, Shopify developers earned 1.5x more than Apple developers and 4x more than Google developers for the same amount of work.

Unsatisfied with this tangible edge, Shopify doubled down. In August 2021, it removed all revenue share for developer application and theme sales for their first $1 million in revenue. This figure resets annually and means that the vast majority of Shopify’s ecosystem partners pay nothing in app store fees. Quite the refreshing dichotomy vs. Apple and Google. As part of this news, Shopify lowered its take rate on revenue beyond the first million from 20% to 15%. The glass half full view of the change is that Shopify is deepening the value that it offers talented, scarce software engineers to augment the quality of its platform. It’s better incentivizing them to build integrations and use cases for its ecosystem vs. others. The glass half empty view is that this is a necessary move to better compete with other app stores to win developer time and attention. There’s likely truth to both arguments.

While Shopify readily caters to and supports its vibrant partner network, it can be a vicious competitor when need be. It demands elite product quality from 3rd parties and won’t settle for less. It has shown a willingness to cut ties with underperforming partners and to vertically integrate services that it thinks it can do better. For example, in the last few years, it ended its relationship with Kabbage to internalize more of its loan suite and moved on from Mailchimp as it realized it could deliver better ad return metrics to merchants on its own.

With all of this in mind, we can now discuss the two revenue buckets in detail: Subscription Solutions and Merchant Solutions.

Section 2 -- Subscription Solutions Revenue Bucket

2a) Subscription Solutions

Basics:

Shopify’s first revenue bucket -- called Subscription Solutions -- centers on website building. The core of the infrastructure was created through a popular open-source platform called Ruby on Rails. There are 4 established tiers ranging from $39 per month all the way up to $2,000 per month. “Basic” is the cheapest plan, followed by “Shopify”, “Advanced” and “Plus.” Very recently, it added a “Lite” plan as a bare-bones package for start-ups and a large enterprise tier called Commerce Components by Shopify (CCS) -- discussed later. In total, there are 4.25 million Shopify stores according to Builtwith and “millions of merchants” in 175 countries per Shopify’s most recent annual filing.

More expensive plans provide capacity for additional staff accounts, more trackable inventory locations, and heavier discounts on other products. For example, there’s a 2.9% + $.30 processing fee for basic plans with that take falling to 2.6% for the Shopify plan, 2.4% for the advanced plan and even more for Plus. Basic merchants also get up to 77% shipping label discounts while more premium tiers can tap into upwards of 88% discounts.

Subscription APIs to Build Merchant Stores & their Architecture:

This bucket creates value by allowing merchants to enjoy beautiful, unique online stores to easily sell direct to consumer (DTC). Facilitating this powerful granularity is a suite of Shopify APIs. These APIs are how developers customize merchant shops, how tedious integration work is sidestepped, how apps are built and how data is queried (or pulled) to populate sites with information. Simply put, APIs are an imperative vehicle used by developers to actually build on Shopify. Merchants see only the finished product, not the product creation process.

All of Shopify’s competition relies on these app programming interfaces to power functionality. It’s the sheer diversity of Shopify’s API use cases that create a point of differentiation. In total, the firm has a few dozen of them for inventory, webhooks and every other product that we’ll cover in this piece. Most notably, there are two core examples to call out for subscription solutions:

First is the Storefront API. This product allows developers to access and personalize store layouts for merchants. It facilitates custom checkout flows and so much more. If the Storefront API is the cause, delightful design and functionality is the merchant effect.

Importantly, Storefront API leans on Graph Query Language (“GraphQL”) to provide a real-time channel of data. This means stores are constantly fed a wealth of information to fill out product descriptions and glean actionable operational insights. Facebook created GraphQL specifically for mobile applications so that developers could precisely select ONLY the data they required. That rigor inherently diminishes cost and complexity and Shopify is taking advantage.

Apps cannot be effectively leveraged without scalable data querying. With no data, gorgeous Storefront API designs would be “just another pretty face” devoid of all needed details. Customization is peanut butter and data is jelly. Shopify’s integrations and APIS are the freshly baked bread bringing these two ingredients to life.

Shopify’s GraphQL-powered APIs like this one are often used alongside a JavaScript library called “React.” There are alternative libraries, but this is the most common here. In essence, React provides pre-built, recyclable interface features to expedite store design. It allows developers to customize without starting from scratch every single time.

The second subscription-focused API to highlight is the Admin API. Where the Storefront API powers front-end customization, the Admin API powers the back-end. It also plugs into React’s library, but doesn’t utilize it all that frequently as React is typically for front-end tailoring.

Like the Storefront API, the Admin API leans somewhat on GraphQL web building architecture. Differently from Storefront API, the Admin API heavily utilizes an alternative building approach called “RESTful API.” RESTful stands for Representational State Transfer. It allows for a different style of data querying via developers pre-setting parameters and protocols to populate an app.

Finally, unlike the Storefront API, the Admin API allows developers full ability to tweak and manipulate data. This means they must secure needed permissions from merchant clients before building on their behalf. The Storefront API doesn’t permit this as populated data can be read but not altered.

As an important aside, to make developer app and theme integration easier, Shopify offers an App Bridge API. This provides a simple process for developers to slickly embed their work into Shopify’s platform -- regardless of where that work was completed.

Online Store Building:

Shopify developers predominately author store themes through two template languages: Liquid and Hydrogen. There are many other languages that developers can utilize to build, but this encompasses Shopify’s main offering. Template languages are used to build store designs; APIs equip these designs with custom use cases and data. Both are vital.

There are a few template language hurdles: Merchants generally aren’t tech-savvy coders with bountiful software engineering experience or large rosters of internal builders. Secondly, developers are selling directly to these non-tech-savvy merchants through Shopify’s app store. This means easier app onboarding leads to more sales and more developer focus on building for Shopify.

To address this reality, Shopify debuted Online Store 2.0 in 2022. There are two main purposes behind this update. First was to trim latency-fostering redundant infrastructure and second was to remove the rest of the instances when merchants were required to code. Put differently, it was to make everything easier. So how does it work?

With Online Store 2.0, layouts are split into small app blocks which can now be dragged and dropped as if they were puzzle pieces. Vendors like SquareSpace and Wix have long offered this style of design which Shopify now does too. Under the old building model, this level of malleability was only available on welcome pages. Now it’s available throughout stores. This is one of the many ways Shopify is lowering the barrier to entrepreneurship by making store building as easy as playing with Legos. Less stressed merchants, and more successful Shopify developers. That’s online store 2.0.

App Blocks Defined: Use cases that are portrayed within applications to augment customization and utility. They’re a force multiplier for developer efficiency by allowing them to build tools on top of pre-built code. App blocks are how merchants add custom perks like flash sales or rank shipping options by carbon footprint.

Merchants now create store layouts with a tool called Metafields. Metafields serve as no-code layers of more sophisticated customization. They allow for tweaking things like product and order flows at the company-specific attribute level. They enhance the amount and depth of data storage that can be enjoyed through the Admin. Effectively, Metafields make querying and customization easier and less intimidating for merchants. Shopify stakeholders use them to enhance the customer shopping experience or to better grasp back-office operations. Again… all no with no coding.

Previously, and still occasionally with Shopify’s competitors, data and apps had to be manually hardcoded into themes with clunky integrations. That headache is now completely gone. Finally, the upgrade came with a new Cart API which unlocks customization options like loyalty program on-boarding and upselling automation.

Online Store 2.0 includes a brand-new reference theme (bare bones theme applicable to most businesses) called Dawn. The theme loads 35% faster than its predecessor called Debut. Just a 10% improvement here fosters 7% higher merchant conversion (per Crazy Egg), so this advantage means 24.5% higher conversion. Think about how happy a merchant must be to convert 245 more shoppers per 1,000 into loyal customers. This matters… a lot.

QL Notebooks:

Fitting into this theme of approachable customization regardless of tech background is a GraphQL tool called QL Notebooks. Notebooks turns queried datasets into graphic key performance indicator (KPI) visualizations to make decisions more obvious. It’s easiest to think of this as a low-code, recommendation tool to hold a merchant’s hand while they glean insights from their operations. For example, a t-shirt vendor could use this to uncover high intent customer cohorts, return rates per size to tweak fit or even observe trends of other brands to know exactly what’s in vogue.

The powerful feature lets merchants emulate the work of large data science teams without having to hire and maintain the talent. QL Notebooks is a cost saver, another means of lowering the entrepreneurship barrier and makes technical processes extremely user-friendly. It frees businesses of all sizes to tap into more enterprise-level tools. For an idea of how needle-moving QL Notebooks is, Shopify Merchant Rumpl enjoyed +39% shopper conversion with it.

As another compelling Notebooks example, let’s consider Decathlon -- the largest sporting goods retailer in the world. Decathlon used QL Notebooks to fully automate data capturing and leveraging processes. In the past, the merchant’s developer teams tediously had to do all of this manually. With Notebooks, Decathlon can now see KPI trends in real-time to track performance in an automated fashion.

“Without using Notebooks, I would have done an extract in Google Sheets or Excel, maybe critiqued some pivot tables, and delivered it to leadership for comment. The problem with that is it's just one shot. It's out of date. That’s why we use Notebooks -- it’s specifically adapted to all of our data mining and storytelling needs as an e-commerce brand.” -- CTO of Decathlon Tony Leon

Liquid vs. Hydrogen Template Languages:

We briefly discussed how Shopify offers two template languages -- Liquid and Hydrogen -- to support developers. But what’s the difference and why are both needed?

Liquid is a Ruby on Rails-powered Shopify development format. It’s purpose-built to facilitate commerce design by intelligently surfacing assumptions and recommendations to expedite work. It also boasts a roster of templates to be utilized for faster app construction. It is the language and style of building that Shopify’s partners have used since the company’s inception. But now there’s a new option.

Hydrogen is Shopify’s newer developer kit used to power what’s called Headless Commerce. It’s built through Shopify’s acquired open-source web-development language called Remix rather than Ruby. It provides the same no-code customization as Liquid, but with a few key differences.

Headless Commerce (utilized through Hydrogen) Defined: Headless Commerce means the separation of the front-end (what consumers interact with) and the back-end (tools merchants use to manage operations).

Headless Commerce is how Shopify allows merchants with unique requirements to further customize without needing to build from scratch. It gives clients with more in-house developer resources the freedom to create what they want and how they want it. Notably, Hydrogen is one of the ways Shopify is securing larger merchants which routinely have more customization wants.

Headless Commerce development separation means expedited user experience (UX) customization. Why? Because the more configurable front-end does not need to wait for changes to be reflected in the back-end. Rather than waiting, Shopify uses the Storefront API as a bridge to communicate changes between ends to ensure they’re eventually accurately reflected. This allows interface and back-end developer teams to work in parallel without stepping on each other's toes.

The detachment allows for faster page loading since the front-end is not tied to the slower back-end’s bulkier processing requirements. This frees real-time front-end rendering as store edits take place -- something Shopify calls “progressive hydration.” Under this format, whenever a customer shopping on a Hydrogen-powered site activates a front-end touchpoint, the Storefront API sends that info to The Admin. This occurs without the customer seeing anything but a pretty user interface (UI).

The added layer of separation is used by merchants to power incremental store granularity. For some examples: Ilia uses Headless commerce through Hydrogen to perfectly match shopper skin tone with makeup shade. Using this style of build helped it lower site bounce rates by 10%. Bols used it to reduce disparate app integrations and workarounds that were slowing page load times. With it, those load times fell by 50%.

Allbirds launched with Headless on their mobile app in under 30 days. They were so pleased that they’re now embarking on a multi-year journey to move their entire software ecosystem to it. Patta & Tommy (Hilfiger) used it to add animation and HD video to their site with ultra-fast load times despite soaring bandwidth. It used Hydrogen to sidestep a tradeoff between more beautiful stores and lower latency to boost shopper conversion. In the right scenario, a Headless Hydrogen build can be an invaluable part of a merchant’s operations.

All Hydrogen stores run through Shopify’s back-end server called Oxygen.

Hydrogen Means Customization without Custom Builds:

Shopify has historically refused to custom build from square one for merchants. It routinely rejects these requests and forgoes the potential business. To the firm, custom build and maintenance revenue is not worth the time-consuming, expensive processes that coincide. It’s throwing good money after bad. Instead, the firm sees real-time configurability and speed to market as more valuable to merchants than full customization. This is why businesses frequently go with custom builds elsewhere before boomeranging back to Shopify. Leadership has even called custom builds a “death sentence” in the past where scale is nearly impossible.

That’s changing somewhat with Hydrogen. Effectively, this new framework brings Shopify much closer to emulating full customization in an economically rational manner. Hydrogen marries all of the tools and infrastructure that Shopify provides with more jurisdiction to tweak to exactly what a merchant requires. This is how merchants get the best of both worlds: scalability plus near-limitless flexibility.

Why Most Merchants Still Use Liquid:

This all sounds great, so why doesn’t every merchant build with Hydrogen? A few reasons. First, it’s more expensive. Most merchants do not have the customization needs or resources to justify going with Hydrogen. For them, Liquid works. Liquid is quicker to set up and, on Shopify, boasts more than enough adaptability for most merchants. Finally, Headless builds receive less support as they include external code not natively supported by Shopify’s architecture. Consequently, merchants are more on their own when building with Hydrogen.

2b) Powering Lower Total Cost of Ownership (TCO) -- With Concrete Examples:

Web-building is highly competitive. Shopify wins by creating more value while cutting total cost of ownership (TCO) and powering delightfully convenient shopper experiences. This source of differentiation is quite abstract, but fortunately there are many customer case studies to quantify this edge vs. competition:

2c) Catering to Larger Merchants

Shopify’s mission to “arm the rebels” explicitly implies its bread & butter niche of smaller merchants. Interestingly, it has positioned itself, especially over the last few years, to be a more legitimate and valuable large merchant vendor as well. Now, it’s arming the rebels AND the generals. By serving larger merchants, Shopify enjoys brisker revenue ramps, better retention (via typically longer-term subscription contracts), and more up-selling of ancillary products. This will be an increasingly important growth vector going forward. Hydrogen is a big piece of this niche extension, but there are a few other key developments to discuss.

Shopify Plus:

Shopify Plus is the enterprise level subscription package directed at larger merchants. There are nearly 30,000 Plus stores in circulation today per Builtwith. This package debuted in 2017, but really took off when Shopify accelerated investment dollars there in 2019 and went global in 2020. The original utility creator for Shopify Plus had been allowing all selling channels and geographies to be run through one singular Admin rather than individually.

If this sounds familiar, that’s because it should. Today, this perk is available for all Shopify subscription levels which follows a typical company pattern. It elects to siphon off material pieces of its suite for only Plus merchants to motivate upgrades. Over time, when these exclusive tools become more table stakes or expected throughout commerce, it opens the products to lower subscription tiers. Considering the roster of brands and celebrities like Tom Brady, The Kardashians, Wayne Gretzky and Derek Jeter using Plus, this approach is working:

“The cool kids all built successful direct to consumer (DTC) businesses on Shopify. Large retailers are now trying to look like the cool kids.” -- Chief Commercial Officer Loren Padelford

Plus merchants enjoy even cheaper access to card interchange fees and discounts across other products. Customers also enjoy higher transaction limits and more seamless onboarding. For example, Kraft Heinz stood up a brand-new online DTC store through Plus in just 7 days for its first foray into digital selling. With other vendors, estimated time to build was several months. Beyond the speed to market, discounts, and other perks, there are a few incremental services to highlight that deepen and cultivate Plus’s unique proposition.

Shopify Scripts is one of the main value creators exclusive to Plus merchants. Scripts elevates user experience (UX) customization on a deepen level via things like fulfillment ranking by fragility or setting discounts based on shopper frequency and bounce rate probability. Other useful examples include promotion offering on an individual shopper basis or separating customer segments by a certain variable to target advertisements. It’s not no-code but is relatively low code.

Shopify Flow, which was exclusive to Plus merchants until late last year, is a tool to seamlessly automate Scripts creation. Put simply, while Scripts is a tool to “build incremental back-end custom logic,” Flow is a close complement that frequently pulls from this logic to automate the workflows that it innately creates. All customizations are easily deployed (in a no-code manner) to stores via Metafields.

Below are merchant case studies concretely showing how these two products create value:

Beyond these tools, there are a few ancillary services Shopify offers that are only for this tier. Those include Shopify Markets Pro (its cross-border automation tool explained in detail later), the Notebooks product and Business to Business (B2B) selling.

An important way to gauge Plus traction is through Plus monthly recurring revenue (MRR) as a percent of total MRR. MRR is the most tightly correlated gauge of growth in value from its subscription revenue. It includes all subscription revenue minus theme and platform fees. Plus is a large and growing chunk of total MRR as Shopify sharpens the appeal. It has taken temporary hits via cheaper tier trials accelerating growth in other plans in relation to plus (see 2020). But the long-term trend is higher:

Commerce Components by Shopify (CCS):

Beyond Shopify Plus’s and Hydrogen’s abilities to offer more flexibility and tooling, Shopify has recently made it a point to become a better evolution partner for large merchants. What do we mean by this? In the past, it had required bigger brands with established tech stacks to effectively “rip and replace” existing infrastructure in favor of Shopify’s. Yes, it did offer abundant 3rd party integrations, but didn’t allow for much legacy custom software to be kept. That was partially resolved with Hydrogen, but there’s another key contributor to it embracing large client transitions at their own pace. This contributor is “Components by Shopify” (CCS). While Plus is for larger, more established merchants, CCS is for the largest and most established. It’s geared toward Global 2000 enterprises.

Announced in early 2023, this package enables clients to pick and choose pieces of Shopify’s store building infrastructure in a fully à la carte manner. This way, they can keep pieces of their legacy software while using seamless integrations to plug them into the Shopify tools they use. This is especially important to older, larger brands with ingrained standard operating procedures and a desire to not overhaul decades of comfortable workflows. They understandably want to keep their favorite bits and pieces to shrink the learning curve.

Shopify avoided these legacy integrations in the past due to fear of low performance and little flexibility for required updates. Now, it’s ready to permit them without sacrificing store functionality or quality. Hydrogen + CCS means merchants can select exactly what they want and emulate customization without requiring the intense work on Shopify’s end usually associated with custom builds. Hydrogen alone got them much closer to this; CCS gets them all the way.

The firm has always been a great à la carte vendor for smaller merchants, but not so much for larger merchants. Why? Larger merchants inherently use more products, require more customizing and more granular store design. This means they routinely rely on more API calls to power desired functionality than do smaller merchants.

API Call Defined: When one application or store front asks another application to use its software/product within its own.

Before CCS, all Shopify subscription plans, including Plus, had finitely capped API call limits. Those limits require merchants with the widest array of tooling needs to prioritize their most desired store traits. Now, CCS offers massive companies a Shopify plan with limitless API calls.

Enterprise Resource Planning (ERP) Program:

In Q3 2020, Shopify announced its Enterprise Resource Planning (ERP) program. This endeavor gives merchants easy integration access to all their desired data sources. Whether it’s SAP, Microsoft, Salesforce, Oracle or others, the program creates a much broader virtual highway for merchants to access needed data to guide operational direction.

Simply put, while CCS unlocks more evolutionary flexibility, this unlocks additional data infrastructure integrations. The combination merges near-endless storefront tooling with omnipresent access to needed information to ensure merchants have everything they could possibly need on Shopify. Both make the company an easier partner to work with -- especially for larger merchants with richer, often siloed datasets.

Fragmented data is a cliché for the world’s largest consumer packaged goods (CPG) conglomerates. That’s why launches like this one have resulted in such rapid momentum with Unilever, Procter & Gamble, Nestle and others since 2020. It’s also proven to be quite valuable for other clients like Mattel and Hasbro considering the sheer volume of brands and businesses operating under one combined umbrella.

System Integrator (SI) Program:

Candidly put, large merchants are typically slow moving and resistant to change. That’s where its System Integrator (SI) program comes in. This program kicked off in 2019 -- right when CCS development initially began -- and involves partnerships with global consulting bellwethers like Deloitte, EY, KPMG, and Accenture. Massive brands utilize these iconic firms to manage major platform overhauls. Because Shopify hadn’t been working with them, hadn’t trained them on the product suite, and hadn’t incentivized their selling, the company missed out on big opportunities. Not anymore.

Shopify now educates and financially motivates these consulting firms to sell its tools to their clients. It trains the firms on how to expedite client on-boarding while making that process painless. For EY specifically, Shopify is training 500 of its employees to be dedicated sellers of its offering. Early on, this has already led to Shopify adding Audi and World Vision as new customers. Many more are expected to follow.

It’s one thing to be sold on modern commerce evolution by a somewhat quirky company like Shopify that loudly and proudly “arms the rebels.” It’s another thing to be sold on this transition by classic institutions. Shopify embraced this and created a go-to-market approach for CCS to find optimal traction. Referral networks of freelancers and developers work wonders for smaller merchants and even moderately sized Plus merchants. SIs are needed to land whales. Reflecting this change in philosophy, Shopify is finally participating in request for proposals (RFPs) which essentially let vendors audition for new business. It previously had refused to do this. All these new focus areas help explain why total Shopify Plus merchants have compounded at a rate of 37% over the last 3 years.

2d) Channel Ubiquity

The online store is by far Shopify’s largest channel for volume and revenue creation. More recently however, social, app-based, and physical channels have become more important. Being everywhere that a buyer could possibly shop is what makes a commerce operating system the most valuable to merchants. This complete availability means more successful clients with more volume and more Shopify success. So? Shopify obsesses over offering multi-channel ubiquity in a way that neatly ties back and integrates into the centralized Admin.

Social:

Shopify has strong partnerships with Meta’s Family of Apps (FOA) and Alphabet which both began in 2019. Today, merchants can sync their product catalogs from Shopify directly to Facebook, Instagram and Google Shopping. They can even build branded stores within FOA’s ecosystem to stand out in an increasingly competitive e-commerce world. Furthermore, Shopify’s accelerated consumer checkout (called Shop Pay) is available to merchants on these surfaces. Shop Pay provides fully in-line checkout (meaning within Meta’s or Google’s environments) rather than forcing consumers to bounce to Shopify and back. In-line always means higher conversion via less clicks and pages to checkout.

In Q2 2022, Shopify added a native product integration with Alphabet’s YouTube. This offers the ability to push product catalogs directly into YouTube Streams or its store tab and connects to Shop Pay just like Google Shopping does.

Most recently, Google and Shopify joined forces to “tackle search abandonment.” This type of issue is quite costly to merchants considering they’ve done the work to procure the search and the sale yet lose the revenue. So? Google’s discovery AI tools are now integrated into CCS stores. This partnership more intelligently displays search results by mining relevant Alphabet data to paint a more accurate picture of what the shopper is seeking. Rainbow Shops is among the first merchants to tap into the product which raised its search volume by 48%.

Shopify has a similar partnership with TikTok. It allows for the same product catalog syncing into TikTok’s Shopping Channel and an ability to create shop-able in-feed video ads amid the scrolling. Shopify just added native Pinterest and Twitter integrations -- although there’s no native checkout product on Twitter to date.

When looking across the web builder landscape, Wix is the only competitor boasting all of these native channel integrations. WooCommerce has Google and Meta natively, but not YouTube or TikTok. SquareSpace has all of them besides TikTok. BigCommerce has them all minus YouTube. When clients of competitors want channels without a direct integration, they must stitch together clunky, 3rd party, labor-intensive connections. This jeopardizes latency, accuracy and so conversion. It’s certainly doable, just less seamless and heavier weight than with Shopify.

Considering social commerce is expected to compound at a 26% growth rate through 2025, merchants can greatly benefit from more native and complete integrations here. And if they want all of them, they must go through Wix or Shopify. Perhaps that’s why social commerce GMV continues to grow at a triple digit clip for Shopify -- even as the base becomes a more material part of its overall business.

Marketplaces:

Marketplace integrations are a bit of a differentiator for Shopify. All web builders offer Amazon selling channels, but Shopify’s roster of marketplace integrations is uniquely broad and global. It showcases a tight channel integration with Walmart to allow merchants to place products directly on its marketplace. WooCommerce and BigCommerce have this. SquareSpace and Wix make merchants go through an external third-party integration to enjoy the perk.

Shopify uniquely offers native integrations with key Chinese marketplaces including JD.com and Alibaba as well as a barebones plugin to Mercadolibre in Latin America. For JD specifically, the relationship unlocks Chinese demand for Shopify’s merchants while allowing them to store goods in U.S.-based JD warehouses. With Alibaba, Shopify added Alipay as a payment option to support Chinese shopper conversion.

Dedicated Business to Business (B2B) & Wholesale Channel:

Not every merchant wants every transaction to be DTC. Profits and success can be reaped by large quantity sales to other enterprises -- even with discounting. This opportunity meshes perfectly into Shopify’s commerce transformation considering Gartner sees 80% of B2B transactions being digital by 2025. Knowing this, while Shopify predominantly operates on the DTC side of things, it has more recently added this means of selling to the fold.

Merchants frequently must force manual workarounds to patch together consumer-facing and enterprise-facing demand into one set of operational insights. Shopify fixed this. Its B2B offering -- with most of the tools only for Plus and CCS clients -- can be easily added to a merchant’s Admin to run it like any other channel. This means all lucrative B2B selling and inventory data is fed to the singular point of Admin analysis. Merchants can separate these channels if that better meets their needs, but most don’t want to.

No longer must merchants run each means of selling in parallel tech stacks. No longer must they maintain clunky, heavy integrations into antiquated vendors. Shopify provided the ibuprofen to solve this annoying headache so that merchants can easily activate and integrate the channel.

The tool features all basic B2B tools that merchants expect including: customer specific pricing, taxation, and payment terms as well as B2B-specific analytics reports. Beyond that, it offers (Metafield-powered) no-code site building customization to tweak themes and flows on a by-customer basis. This level of granularity ensures a merchant’s largest customers have excellent shopping experiences.

Finally, the B2B channel directly integrates with Shop Pay for single click checkout. Demandware competition cannot match this. All these tools helped Laird, which replaced BigCommerce with Shopify Plus, automate B2B and enjoy savings worth a few percent of overall EBIT. For this merchant, the tool “covered the cost of Shopify several times over.”

This is yet another way that Shopify is more effectively appealing to larger merchants. Global CPG giants virtually all have wholesale and B2B selling divisions making up large portions of their overall operations. This product was mainly built for them and other big potential customers.

The Shop App:

The company’s consumer-facing shopping app -- called Shop App -- is a rapidly growing commerce destination. As always with Shopify, it offers marketplace-like demand aggregation, but with full control over brand, data and the customer relationship. As this becomes more successful, Shopify enjoys another growingly important, low-friction DTC channel that it can offer while its competition can’t. And it’s clearing gaining rapid traction:

This traction means more complexity routed through the singular Shopify Admin which, in turn, deepens Shopify’s value proposition. So how does this app create consumer value and where is the traction coming from?

Shopify calls the tool a “mobile shopping companion” for consumers buying from all their favorite brands. Using a person’s purchase history data to season the app’s algorithms, Shopify offers product suggestions to make this channel uniquely powerful. So? Consumers enjoy a more personalized experience. As a result, merchants sell 17% more on average to Shop App users vs. other customers. A brand new ChatGPT integration in the search and discovery function could strengthen this edge more.

The app pulls from Shopify’s core competencies to create the most successful selling channel possible. Specifically, Shop Mini is its software development kit (SDK) allowing developers to take beautiful online store builds from other channels to use here. Upgrades like this have directly translated into 15% more product traffic for merchants. Shop App also features a native Shop Pay integration to offer fully in-line, single click checkout -- and so maximum conversion.

It plugs into Shopify Flow & Scripts to automate operational learnings and allows consumers to seamlessly track and edit orders with the “Arrive” function. Alone, this service has proven to juice reordering rates by 11%. All of this utility was tied into brand new customer accounts in February 2023 to allow shoppers to manage all activity from a singular place (just like merchants can). Merchants secure a better understanding of high intent buyers as they enter sites via the customer account’s “Sign in with Shop” identifier.

To make the selling channel even more powerful, Shopify added a loyalty program to the consumer app called Shop Cash. This is free for merchants to use; they only pay a success-based commission when new business is won from the program. Shoppers get 3% cash back (in Shop Cash) on all app purchases and even larger rewards if they leave product reviews. Specifically for a merchant like HydroMate, this has been the “best customer acquisition cost tool it could find” according to its co-founder. 43% of its entire new customer growth is now coming from Shop Cash.

Offline:

Finally, Shopify Point of Sale (POS) has become a paramount piece of this company. Much more later.

2e) Pricing Power

The clearest sign of a strong, defensible market position is pricing power. If you can hike pricing without significantly raising churn, that means merchants cannot find the same level of value elsewhere. That is pricing power. According to Shopify President Harley Finkelstein, there is “unequivocally room to increase prices and ample elasticity of demand.” He calls Shopify “intentionally the best deal in commerce” to make them tougher to compete with for other vendors.

Clear evidence of pricing power came in early 2023. Shopify hiked its Basic plan by 34% to $39 per month, its Shopify plan by 33% to $105 per month and its Shopify Advanced plan by 33% to $399 per month. It did not hike Plus or CCS prices in a move to motivate more merchant upgrades (and because CCS is brand new). These were the first hikes to the three packages in roughly a decade.

Shopify’s goal is to continue to add more incremental value than it charges for. This value-to-cost gap makes it inherently difficult to displace. Importantly, there has been “no pushback” from merchants on the price hikes according to Finkelstein -- pointing to this gap being maintained post-hike. The move leaves Shopify with an ideal choice: Either it can use the added high margin revenue to invest back into the business, or let it flow down the income statement to bolster profits. We see significantly more pricing wiggle room based on numerous total cost of ownership case studies and Finkelstein’s own words. The team is actively considering hiking more expensive subscription tiers, but has not made that final decision.

“In terms of pricing, our subscriptions are the best value out there.” -- President Harley Finkelstein

Section 3 -- Merchant Solutions

The Basics:

As briefly mentioned, merchant solutions are ancillary services offered on top of Shopify’s store building subscriptions. Virtually all revenue here is usage-based unlike with the subscription bucket.

Each merchant solution fixates on a large pain point not being effectively solved for businesses. The instruments consolidate disparate 3rd party offerings into the Admin to ameliorate and centralize decision making as well as lower TCO. The bucket is a major source of Shopify eclipsing a 10% share of U.S. e-commerce volume as of early 2022 with that share growing since then. It’s how Shopify makes itself uniquely valuable to merchants, how it motivates retention and how it can claim broader use cases stemming from its API suite vs. competitors: Each merchant solution is powered by a product-specific API. Without these incremental services, the firm would be just another web-builder with slightly better tooling and integrations. Merchant solutions distance Shopify from its competition.

Products from this bucket all leverage Shopify’s massive economies of scale to allow enterprise-level discounts to business of all sizes. Each solution shares utility and insight-rich data amongst each other to uplift the total value proposition. They all function in a better together manner. This aggregated demand works wonders in seasoning Shopify’s AI/ML algorithms to ensure merchants are as informed as possible.

Compared to subscription solutions, merchant solutions carry lower gross margins. Interestingly however, they also boast lower operating expense intensity which makes the EBIT margin profit similar. Still, as merchant solutions become a larger piece of overall sales, gross margin should continue to fall. This is a trade-off that Shopify is eagerly happy to make as an investment in growth, EBIT & retention.

3a. Shopify’s Suite of Payment and Checkout Tools

Shopify Payments:

The payments landscape is important to understand in the context of this product. For the sake of making this deep dive shorter than 100 pages, we wanted to link to our previous explanation of the sector (in the context of Shopify specifically) rather than repeating it here. That explanation can be found here and clearly defines all terms used in this section.

---

Shopify payments is a native payment gateway for merchants and a processor via a Stripe partnership. While today Payments is a large profit contributor, this product was not initially launched in 2013 to make money. It was instead launched to eliminate merchant friction. Shopify had been sending merchants to alternative, 3rd party gateways, thus forgoing business and forcing use of fragmented vendors. This also meant losing direct access to merchant payment data which Shopify now uses to do things like offer cheaper access to growth capital. Remember, the overriding goal of Shopify’s product amalgamation is to create a frictionless, uniquely valuable one-stop shop for online commerce.

The product eliminates the need to maintain an external, clunky and unreliable gateway integration. It removes the headache associated with payment relationship upkeep by serving as as a cohesive layer on top of those value chain pieces. And while making things easier, it makes things more configurable too. Tools like its Payments and Checkout APIs are readily available for developers power, customize and automate on behalf of merchants. These products free merchants to offer and automate up-selling promotions, loyalty program on-boarding and omni-channel buy now, pay later (BNPL). Powerful and easy is a wonderful combination.

Shopify Payments painlessly connects to its internal checkout accelerator and gateway called Shop Pay. Simply put: Pay is consumer-facing and Payments is merchant-facing. Shop Pay uses Shopify Payments as the default processor and orchestrator to collect incremental fees.

The checkout accelerator is not the only consumer payment option on a merchant’s site -- and far from it. Part of the benefit of Shopify’s massive, diverse partner ecosystem is access to relevant 3rd party gateways and alternative payment methods (APMs) -- largely thanks to Stripe. This means other payment options like PayPal are available for merchants to integrate while local payment methods (LPMs) in key international markets are usable as well. With Shopify’s APIs, checkout integrations always emulate the native feel of merchant sites to keep the shopper experience consistent -- raising conversion further.

More access to the most relevant payment options means better shopper conversion, less baskets abandoned, and more revenue. To assist in international selling, multi-currency transactions are available to shoppers and merchants. This multi-currency perk was extended from Plus merchants only to all merchants in 2020.

Aside from more convenience and expedience, Payments offers the same control of checkout branding that Shopify demonstrates elsewhere. Interestingly, in response to popular demand, brand clients can now implement a “Powered by Shopify” label which has been shown to raise conversion due to Shopify’s growing clout. It’s up to them if they want their brand to be alone or joined by Shopify’s.

As briefly mentioned, Shopify Payments leans on a tight partnership with Stripe to power processing. It charges a typical merchant transaction fee of 2%-2.9% + $0.30 with volume discounts for Plus and CCS merchants. Shopify uses its aggregated demand to negotiate better interchange fees with 3rd party rails than could merchants on their own. Payments merchants also get free access to Shopify’s fraud protection program like many other competitors such as PayPal provide. This program has shown to lower loss and chargeback rates vs. both industry incumbents and next-generation competition.

Shop Pay:

Shop Pay (launched in 2017) is the firm’s internally developed checkout accelerator and gateway built right into Payments. It was among Shopify’s first consumer-facing initiatives and has been a big piece of “people realizing Shopify is behind their favorite brands” -- per President Harley Finkelstein.

The gateway functions like any other payment vault. It stores consumer card and shipping info to automatically populate upon password-less, single page verification. Considering forgotten passwords are by far the largest source of cart abandonment, this is a very meaningful feature.

Shop Pay’s checkout process is fully native to merchant stores and also the Shop App. This means as the merchant base and app traffic grow, the convenience associated with Pay merely builds as friction melts in ways that cannot be emulated by individual merchants. The overarching result of Shop Pay is consumers speeding through checkout in one click. PayPal and others are still working to get 100% of their merchants to two click, in-line checkout. Shopify is ahead here.

While gateways are similar among vendors in some ways, Shop Pay still stands out. As of 2023, the tool is 4x faster than the average competitor and converts at 1.72x the rate of competition. It has been the fastest to completion, highest converting checkout accelerator in the entire industry for the last two years. The accelerator is also now the top selected for Shopify consumers amid a sea of options. These leads enabled Pay to eclipse 100 million users in 2022 growing at a 2-year compounded annual rate (CAGR) of 41.4%.

“If consumers must fill out a form, we’ve lost them. Enabling Shop Pay made the most painful point of the customer experience delightful. Since it’s tied into the merchant ecosystem, even new customers can check out in one click.” -- KOTN Co-Founder Ben Sehl

Shop Pay would ideally want 100% of checkout share within Payments to juice revenue and profits, but that’s not realistic. What is realistic is being the most preferred provider while integrating with PayPal, Adyen and countless other gateways to power diverse consumer payment options. This ends up raising conversion and is a net positive to Shopify’s financials. More, relevant consumer choice is always a good thing at checkout.

In terms of what’s next for Shop Pay, the product is leading Shopify’s charge to open its product ecosystem to more external surfaces. It offers 2 click (soon 1 click) checkout on email, direct messaging, shoppable web links and social avenues. Pay can be added to all of these selling channels with the Shopify Wallet API.

Specifically on social, through partnerships with Meta and Google, Shop Pay is now available across those rapidly propagating commerce destinations. As part of this arrangement, through Stripe, Shopify Payments became the default processor for all transactions using Shop Pay. This is the first time Shop Pay is being offered outside of Shopify to compete with other checkout service providers more directly. According to leadership, investors should expect more of these relationships going forward. The firm wants to push its latency and speed advantages to more shopping surfaces to ensure merchants can enjoy Shopify-level conversion everywhere.

This goes back to doing whatever it can to juice merchant GMV so Shopify can make more money. Truly a win, win, win with Shopify, merchants and partners all benefitting. It’s still very early in the process of opening this up to large partner surfaces as seen below. The combination of Shop Pay’s better consumer experience paired with low merchant adoption today leaves a long runway. We expect traction to accelerate here.

To track the progress of payments suite adoption, investors can look at Gross Payment Volume (GPV) trends as a percent of overall GMV. The GPV proportion growing is direct evidence of outperforming traction here as payment-based volume makes up a larger portion of overall volume. This trend has been consistently higher over the last 4 years via Shop Pay share gains and growing cross-border volumes (which require merchants to have Shopify Payments). This pattern is fully expected to continue.

Installments:

Shopify hopped on the Buy Now, Pay Later (BNPL) bandwagon amid the COVID pandemic. Stimulus checks created a debit usage shock which contributed to the rapid proliferation of this new tool. Fortunately, Shopify went about this in a more asset-light way than did some others like Block (purchased Afterpay). Rather than making a massive M&A splash, Shopify partnered with Affirm to build out this offering. The two, following the signing of a multi-year exclusive agreement, rolled out the product in Q3 2020. Under the arrangement, Shopify uses Affirm’s software and gets a cut for procuring BNPL demand through Shop Pay and its network. Shopify also got equity compensation as part of the deal. As of Affirm’s most recent proxy statement, Shopify owned a total of 14.4% of Affirm’s total voting stock through warrants.

Shopify Installments has no late fees while competition like Afterpay does. The tool boasts no hidden costs, no interest payments and is the “most transparent BNPL product” according to leadership. For merchants, the added payment flexibility raises repeat buyer activity by 23% while powering higher conversion, better retention and a boost to AOV. The benefit is very similar to competing BNPL offerings. Merchants also get access to funds immediately to avoid any balance sheet or transaction risk -- just like with PayPal and many others. This offering became the top chosen BNPL provider for Shopify Merchants within 6 months of launch; it continues to take more market share into 2023 per leadership.

Shopify’s take rate and margin profile for BNPL transactions is better than the rest of checkout. This is partially because of added transaction complexity, but mainly due to how popular debit is as a means of payment for BNPL. Debit-funded transactions come with lower 3rd party interchange fees. This impact was most pronounced during the stimulus era. While the degree of this benefit has dampened since then, it remains in place to a lesser extent.

BNPL, in our opinion, does not work as a standalone product. It must be a tool in a toolkit rather than the entire suite. On its own, there’s nothing at all unique about the feature. There are no barriers to entry which is why PayPal has enjoyed such rapid traction and why Apple is now working on its own BNPL product. To be truly differentiated, BNPL must pull from relevant data sources to underwrite vs. new entrants more effectively. Shopify’s diverse product offering paired with its 10%+ U.S. e-commerce volume share delivers that prerequisite.

Shopify Point of Sale (POS):

Over the last few years, Shopify has aggressively ramped brick & mortar commerce efforts. As a company determined to be channel ubiquitous and agnostic for its merchants, physical shopping obviously is an important piece of the puzzle. Up until 2019, the firm had been using white-labeled hardware and what it called an “underwhelming” POS software package to integrate with external vendors. That changed in early 2020 when it launched its own, fully integrated hardware and software solution and established a dedicated POS sales team.

Why did it do this? Merchants were struggling to sync other hardware options into the Shopify Admin for a full, omni-channel view of operations. Furthermore, 3rd party vendors commonly forced manual delegation of employee tasks which slowed down decisions and product release cadence. These vendors also struggled with APM integrations and adding shopping formats like buy online, pick up in store. This all meant frustrating friction and poor physical conversion rates for Shopify merchants.

Shopify needed to move faster, be more organized, offer more customization and create better experiences than hardware partners were able to manifest. It needed to do this on its own. The pandemic-era launch of the integrated POS hardware and software subscription delivered these needed upgrades. It’s called Shopify POS Pro and is sold on a monthly subscription basis. POS Pro comes with the same QR code, tap to pay, swipe and chip functionality that has been commoditized in the space. So what’s unique about it? I’m glad you asked.

It removes offline integration headache to provide an end-to-end view of merchant channels through the centralized Admin -- for both digital and offline surfaces. This cohesion ensures that inventory data is complete with an easy ability to hide out of stock products in store and handle returns and refunds with ample scalability. That data, as always, is available to guide reordering, marketing, store expansion and more. The full integration also means extending Metafield-powered customization to physical checkout to bring offline store flexibility up to par with online. If a merchant wants rapid loyalty program onboarding, granular promotions or BNPL in brick and mortar settings, this means they can now have it.

Beyond these distinctions, merchants can use this software to organize pack-and-ship from in-store to leverage real-estate and raise revenue per square foot. And while tap to pay has become standard, Shopify does offer a slightly broader integration roster which includes ALL major digital wallets. It was also among the first to offer contactless pay through iPhone (thanks to Stripe).

The impact of these tools can be tracked by merchants with an intuitive smart grid to visualize graphic performance trends.

Imperatively, the new POS suite allowed Shopify to raise location limits from 50 to 1,000. That led to 35% of POS Pro sales in Q4 2022 coming from its larger merchants vs. just 14% year over year (YoY). Scale was a bottleneck for POS traction; that’s no longer the case as merchants embrace the service at a briskly accelerating pace.

While Shopify’s POS apparatus was once an afterthought, it has now morphed into a powerful top of funnel driver of merchant acquisition. How much of a driver? POS locations doubled in 2021 while continuing explosive growth into 2022 and 2023. Offline GMV for Shopify grew by 40% YoY in 2022 vs. 16% for the entire business. As a secondary benefit, this proliferation drives Shopify Payments volume as it is the default processor (thanks to Stripe) for Shopify POS transactions.

POS Go:

Late in 2022, Shopify announced POS Go. This is a large form factor update for merchants most reliant on mobility. While stationary POS systems work well for traditional physical store layouts, the same cannot be said for other formats like pop-up shops, music festivals, sports card shows and farmers markets. Stationary is not ideal in these settings. Even in clothing stores, it’s easy to see how taking checkout to a consumer while they try on a coat can cut line times and foster more convenient experiences.

POS Pro Hardware on the left, POS Go Hardware on the right.

The launch transformed the POS tablet into a case-like attachment for a smartphone. This minimizes hardware requirements for expanding to physical selling channels while maximizing mobility. It relieves yet another merchant headache: Now, waiters, artists and other service models can meet users wherever they are.

The lighter-weight hardware doesn’t sacrifice checkout customization or functionality as it offers direct plugins to the POS Pro subscription. There is no other product on the market with this level of merchant pliability paired with the diverse, extensive use cases of the integrated software. This is where Shopify most clearly separates itself from the pack; it’s how Desmond & Dempsey raised AOV by 11% and repeat customer rate by 49%.

As an important technical aside, the POS suite is built on React’s mobile development framework. This means a seamless ability to build cross-channel apps on both iOS and Android with pre-existing templates to expedite development. Shopify had been running redundant teams in parallel for both operating systems, so this change made its POS division more profitable and efficient. Finally, like CCS, the new hardware comes with uncapped API calls to cater impactfully to the largest of physical retailers with more customization potential.

3c. Shopify’s Merchant-Facing Financial Services

Shopify Balance:

Announced in 2020, Shopify Balance is a banking product that caters to smaller businesses and entrepreneurs. As Shopify is not a chartered bank, it offers this through a partnership with WebBank. The purpose of Balance, like every other merchant solution, is to lower the barriers to entrepreneurship and remove unnecessary pain points within operations. Simply put, it equips merchants of all sizes with financial service affordability and access that had been reserved for the largest enterprises. The service was born from Shopify’s opinion that banking products did not cater effectively to smaller merchants. Incredibly, pre Balance, most of its customers had been using their own personal accounts to route business transactions. Shopify Balance fixes this.

The offering multiplies financial service use cases from the Admin. With it, merchants can pay bills, create expense reports and maintain business accounts. The accounts entail zero fees, no overdraft penalties, free ATM withdrawals and no balance minimums. They also allow merchants to enjoy immediate access to funds. That’s key when considering time-consuming bank alternatives routinely take up to 4 days. Time is money. Most recently, the tool added tax management products to handle cross-channel compliance from the Admin.

Balance comes with a physical card built on Visa’s rail with 2% cash-back on business purchases and 10% cash-back when hiring from Shopify’s partner marketplace. Thanks to the firm’s breadth and depth of products and data, it can offer Balance users uniquely inexpensive access to shipping labels, loans, marketing placements etc.

Balance took just a few months to reach “hundreds of thousands of merchant users.” That’s the perk of the trust Shopify has built over the last 20 years: The right to offer more products.

Shopify Capital:

Shopify Capital is a product designed to give merchants more affordable access to loans. Like Balance, this product goes through bank partners like WebBank, but also uses Celtic Bank to provide some of the credit. Shopify assumes all the balance sheet risk by immediately repurchasing these originations.

That makes it reliant on “rent-a-charter” legislation which allows non-banks to assume some charter perks by going through partners to originate. That legislation has been affirmed and reaffirmed by congress multiple times in the last few years, but politics are never predictable and this issue could always resurface.

With Shopify Capital, the company can tap into all internal demand data to paint an accurate picture of a merchant’s ability to repay credit advances. This inherently sharpens underwriting vs. standalone originators, lowers its apples-to-apples loss rates and streamlines the application process (don’t need to ask for paperwork if you already have the information). The precision allows Shopify to offer cheaper access to credit than a merchant can typically get elsewhere.

The firm is happy to offer this affordability considering Capital merchants retain at a higher clip and consume more merchant solutions vs. non-users. The issued loans also feed merchant growth opportunities with that incremental GMV benefit eventually accruing to Shopify. For example, Fable used this product to triple YoY sales when it ran out of inventory and couldn’t find other affordable funding. Win, win.

There are two formats that the firm uses for Shopify Capital. The first is called Merchant Cash Advances which functions similarly to competing PayPal and Block products. Here, merchants agree to remit a percent of future revenue to pay back loans. Under this arrangement, Shopify is effectively buying rights to receivables. The other format is Shopify Capital Loans which is a straight loan with a more traditional interest & principal repayment period.

Shopify originated over $4.3 billion in credit through this offering in 2022 vs. $3 billion YoY. Its origination volume has compounded at 70% over the last 3 years and 91% over the last 5.

3d. Shopify Fulfillment Network (SFN)

Purpose:

Among Shopify’s newest, highest upside Merchant Solutions is the Shopify Fulfillment Network (SFN). Merchants routinely work with 10+ freight vendors to service fulfillment with more partners utilized to execute a shipment. This leads to uncertain delivery windows and incomplete inventory data which eventually raises working capital costs and fosters delays.

To solve this discombobulated process, SFN glues siloed supply chain pieces together. In doing so, it vastly enhances communication, organization and value-creating efficiency. It’s imperative to note: The purpose of this product is NOT to build a logistics footprint to rival giants like Amazon. Instead, it uses existing partner capacity and its software (called Fulfillment Management Software (FMS)) to unite fulfillment in a software heavy, asset-light manner. The effect is faster, cheaper fulfillment which fosters higher conversion and more GMV funneling through Shopify’s ecosystem.

Like all of its merchant solutions, SFN works to eliminate a merchant headache. For this specific offering, that headache elixir is a full-service means to move goods “from port to porch.” Its aim is to make sure merchants don’t need to manage logistics, but instead can focus on growth. No longer must businesses endure a frustrating maze of legacy vendors to painstakingly stitch together a supply chain.

Timeline to Scale:

SFN was first announced in 2019 when management gave us a 5-year timeline to scale and an estimated total cost of $1 billion. The initial focus was understandably on creating product-market fit. Originally, it was for North American merchants shipping 10-1000 orders per day with goods “smaller than a microwave.”

During this period, SFN added partnerships with affiliate nodes (warehouses) and other players, built supply chain integrations and fortified/operationalized its software. It took a slow, calculated approach to wrapping up this phase as it was keenly focused on elite merchant service. It was only willing to go as fast as it could while maintaining satisfactory performance levels. Key issues such as annoying merchant onboarding friction also needed to be solved before the company shifted to a focus on ramping scale.

While it secured product market fit, Shopify built a small fulfillment center in Ottawa for R&D purposes to test logistics workflows and to perfect its software. It also leased a larger fulfillment center in Atlanta to assist in its capacity needs. This combination of moves led to a sharp operating expense (OpEx) ramp without much revenue to offset losses. So? SFN, especially early on, has been a large drag to overall company margins. Leadership has temporarily assuaged concern by setting expectations of positive contribution profit by the end of 2023 -- and ramping profits thereafter.

A profit inflection will require a large volume ramp to extract more value from the large fixed cost base. We’ll see if it executes on this objective in the next 9 months, but management fully expects it to eventually be a profit driver on its own. They’re constantly asked that question by analysts and give the same answer each time.

As we moved further into 2022, SFN gradually began opening up for broader availability in the U.S. Initial signs of a needed volume ramp began popping up at this time. As this ramp occurred, so did a shift in leadership’s supply chain philosophy. It originally hoped to rely almost entirely on partners for physical capacity. The company soon realized that it needed to partially manage distribution center capacity internally to control costs and service quality. At this time, it embarked on consolidating its partner infrastructure into larger centers to boost efficiency. The company still planned to partner with spokes, hubs, sort centers and couriers, just not entirely.

This shift in philosophy was announced alongside updated cost plans for building out SFN. The $1 billion previously earmarked was boosted to $1.4 billion in capital expenditures with another $600 million in OpEx for $2 billion total. Leadership assured us that this elevated spend would lead to stronger long-term return on investment.

This confidence is being driven by Shopify recently reaching 2-day or less affordable delivery for 70% of all orders vs. 2% in 2020. And not coincidentally, surveyed merchant satisfaction tripled over this same period. Additional evidence of fulfillment traction came in Q3 2022: The Atlanta Facility 10xed volume throughput YoY, merchants using 1+ SFN service rose 80% QoQ and FMS order handling spiked 450% YoY. Leadership initially told us these signs would begin to pop up throughout 2021. It took them a bit longer than expected, but it’s good to see the results.

Notably, Shopify’s decision to self-operate more of its capacity is over a year old. And today, Atlanta still remains its only self-leased fulfillment center. I’d be interested to see if the updated spend plans are a bit more than it actually needs.

Its acquisition of Deliverr (explained below) is allowing it to rethink its build vs. partner approach. In March 2023, new CFO Jeff Hoffmeister all but told us that expense guidance would meaningfully fall once it wrapped up Deliverr integration. According to him, Shopify can stick to “1 to 2 hubs” and “clone the functionality of the Atlanta hub” for its partner warehouses in both urban centers and remote locations thanks to its improving software. This would be excellent news and marks leadership effectively resetting expectations so that future surprise is to the upside.

“We can do SFN in a much more thoughtful way than we were before.” -- CFO Jeff Hoffmeister March 2023

Where SFN Helps Step 1 -- Origin Port Service:

So what does SFN do for merchants?

The full-service product begins creating value for merchants with (typically) international manufacturers. SFN handles the invoice and documentation to ensure goods clear customs upon arrival to the states. While it doesn’t handle picking and packing at international origin ports, it does organize transportation capacity and allows merchants to pick from a wide array of these options. This process can be fully automated if a merchant wants it to be.

Through a key partnership with Flexport, SFN enables merchants to reserve space in pre-booked containers to accept service at a smaller pallet level vs. needing to do so at the container level. This can be done through the Flexport app which is directly integrated into SFN. Why does this matter? For the vast majority of Shopify’s merchants, full container capacity is rarely needed; smaller pallets loaded into containers are almost always sufficient. Furthermore, most carriers and origin ports have massive minimum order thresholds to clear before a merchant can even utilize the service. This creates cost and flexibility headaches that SFN solves.

The added flexibility lowers merchant origin port fees by allowing them to tap into SFN’s aggregated network. Rather than meeting minimums on their own, merchants can order exactly what they need and simply join other SFN merchants to access service. No longer are they forced to reserve excess capacity and pay the coinciding cost. This is yet another economy of scale-based advantage that Shopify passes on to its merchants. Specifically, this feature lowers service cost from origin ports to hubs by 50% while cutting cost per pallet well below industry averages.

Combining Marketplace & White-Label Advantages:

This leads us to a brief, yet important point. SFN, like many pieces of Shopify, merges fulfillment and white-labeled perks. Merchants tap into the combined scale to enjoy fulfillment at rates cheaper than they can otherwise access. And? They keep full ownership of customer relationships, branding and data.

With SFN, the merchant is always front & center with branded shipping boxes able to be designed without coding. Lucrative consumer data is also openly plugged into the rest of operations. That data can be used to guide more accurate product ordering, precise customer segmentation for marketing campaigns etc. Again, that’s the power of consolidating all pieces of operations into one commerce operating system. The possibilities of value from the sum of Shopify’s products working better together vs. in isolation are bountiful.

Where SFN Helps Step 2 -- Hubs, Spokes, Destination Ports & Cross-Docking:

Shopify merchant goods are usually sent from origin ports to hub ports to subsequently be directed to a destination port spoke. Sometimes goods go directly from hub to destination, but that’s rare.

Within this piece of end-to-end fulfillment, Shopify provides savings in two areas. First, all of its incremental demand allows warehouse partners, which routinely have empty space, to utilize more of their capacity, more consistently. This makes them more efficient and more profitable with less deadweight loss. Happier warehouse partners enable the second bucket of savings: They’re happy to let SFN merchants enjoy 6 months of free storage, zero upfront costs and a single charge for all service. The transparent approach to pricing stands in direct contrast to alternatives.

Upon arrival at a hub, goods are either stored within the warehouse for later fulfillment or immediately go through a process called “cross-docking”. If it’s stored, it’s eventually cross-docked before moving closer to the final destination. Cross-docking is the process of unloading container goods, inspecting them and immediately re-loading them into another means of transportation to be sent to a local fulfillment center or the final destination. Cross-docking cuts down storage time and costs while expediting deliveries and is how Shopify reached 2-day or less fulfillment for most of North America.

The firm initially tried to build out this capability internally, but last year decided to buy a company called Deliverr to help. It paid a hefty price tag of $2.1 billion (80% stock & $420 million in cash). We viewed the move as leadership admitting they needed some assistance to ensure effective scaling and optimal delivery windows. Deliverr added several partnerships (including Amazon), 400 talented employees and a software-based shot in the arm to re-accelerate SFN’s timeline. And again, it’s how Shopify has been able to re-think expense and self-operated capacity needs for building out SFN. Deliverr owns no warehouse space and conducts operations solely through partners. Talk about asset-light.

While Deliverr augments and upgrades nearly all aspects of FMS, it really shines within the cross-docking process. Deliverr facilitates unloading, inspection, re-loading and freight forwarder coordination on behalf of merchants. It can execute this while comparing service bids throughout a good’s movement to combine optimal pricing with optimal timing. Deliverr blazes a tight line of communication between carriers and ports more effectively than Shopify could on its own. Leadership readily admits to this.

“The team from Deliverr helped us accelerate our asset-light thinking around SFN.” -- CFO Jeff Hoffmeister March 2023

Closely related to this cross-docking strength is Deliverr’s demand forecasting algorithm. This forecasting is what allows SFN to know where to place what goods and how to route them in real-time with near 100% accuracy. That’s another vital piece of condensing delivery times. Moreover, the inventory orchestration excellence means lower working capital needs and healthier cash flow conversion. If we know exactly where to send our inventory, we can send less of it to fewer distribution centers in a more meticulous manner. This is called inventory balancing. Deliverr has better algorithms, Shopify has more data. Together, 1 + 1 = 3.

“Shopify merchants using Deliverr made it obvious to us how far ahead of everyone it was with inventory balancing & demand forecasting.” -- President Harley Finkelstein

But wait, there’s more! As another Deliverr benefit, it freed SFN to add full-service returns to round out its end-to-end fulfillment expertise. Shopify’s “Shop Now” tool even automates the re-targeting of customers returning goods with product recommendations to recover some of the lost revenue. Considering 20%+ of all e-commerce orders end up being returned, this matters a lot.

Where SFN Helps Step 3 -- Expedient, Affordable Delivery:

Deliverr’s expertise, precision, and expedience bolsters SFN’s delivery utility. First, it allows SFN to outbound ship goods from ports at the individual parcel level rather than at the pallet level. Flexport meant in-bounding at the pallet not container level; Deliverr means out-bounding at the parcel not pallet level. Both allow merchants to access logistics services in a more exact manner without elevated costs.

Deliverr’s operational synergies allowed Shopify to debut “Shop Promise” last year. This is a badge displayed on Shopify-powered sites that guarantees delivery in 1-2 days. It has shown to boost merchant conversion by up to 25% out of the gate. Today, 67% of SFN merchants have access to this. Remember at the beginning of this section when we discussed SFN’s main goal of improving fulfillment to raise buyer confidence? Well… this conversion boost shows that it is working.

It’s not just painless customer service for merchants, it’s cheaper shipping rates too. Shopify used its scale to secure SFN partnerships with key couriers like DHL, UPS and FedEx to offer access to discounted shipping labels. This is a perk it borrows from Shopify Shipping.

Easy-to-Use App:

All of these fulfillment services are available within an omni-channel SFN app and integrated into the singular Shopify Admin. That reality allows Shopify to run retail inventory replenishment for physical merchants and to accurately automate hiding in-store product availability on online pages. The app comes with authority delegation to compartmentalize responsibilities within teams as well as real-time updates to track fulfillment performance. Merchants can also use it to edit orders, prioritize shipments and tap into new local fulfillment partnerships to cut costs further. From this single tool, merchants can seamlessly push goods from port to porch. Fulfillment friction: Gone.

6 River Systems:

6 River Systems (6RS) was Shopify’s other acquisition (announced in 2019) in the fulfillment space. While Deliverr augmented SFN’s existing product offering, 6RS added entirely new capabilities within warehouse task management. It provided an ability to streamline warehouse operations and workflows for its own fulfillment capacity and for partners. Shopify describes 6RS as the “muscle” of the fulfillment system while SFN plus FMS is the brain. It bought 6RS for its cutting-edge warehouse robotics hardware to boost picking and workload efficiency. Specifically, implementation of this hardware leads to throughput gains of 2x while enhancing safety levels and productivity per worker. This helped 6RS win 2 Red Dot Awards for outstanding design.

So how does it work? The robot is called Chuck. Chuck constantly travels throughout designated warehouse sections to be given a task -- usually assigned by a warehouse worker from their phone. Task delegation, guided by the Chucks, is based on shortest time to task completion as well as most pressing needs. Once given the task, Chuck travels to the assigned zone and finds the involved employee to tell them where to find goods.

Source: Tech Crunch

These goods are loaded into the Chuck which will go to a packing station once full. This assisted picking and packing is the source of the throughput gains. Established warehouses do not need to overhaul layout or procedures to onboard Chucks. The product can easily map and work within existing layouts for wildly easy implementation. Beyond Chuck, 6RS also features “The Bridge.” This is an API tool that establishes a connection between FMS and physical warehouses for better, more complete operational oversight.

By 2020, 6RS was integrated into SFN and its network and by 2022 it was assisting 100% of all SFN orders at participating partner nodes.

Shopify Shipping:

Before SFN, the firm debuted Shopify Shipping in 2015. This tool is for merchants not wanting to outsource the entire fulfillment process. It’s a more bare-bones offering where merchants can relish in Shopify’s demand aggregation to purchase discounted shipping labels right from the Admin. These can be easily printed for fulfillment at any local courier office. Merchants can customize rates by region and product as well as track fulfillment performance. This gained a lot of traction over the years to reach usage by 52% of merchants at the end of 2020. Shopify subsequently stopped updating this metric in 2021 other than to say adoption keeps rising.

3e. Shopify’s Cross-Border Commerce Offering

Shopify Markets:

Shopify markets is the company’s response to the globalization of commerce. 28% of Shopify merchant traffic is international; Shopify Markets is how the firm ensures those experiences are seamless to optimize conversion. Importantly, this is not replacing Global-E -- one of Shopify’s equity investments. Global-E provides more full-service outsourcing of cross-border business for the occasional merchant with uniquely complex needs. This is more of a cookie-cutter, generalized tool that works for most merchants.

The product allows businesses to easily expand to 14 countries to open configurable and localized storefronts. Merchants can turn on selling in these markets with one click of a button and tap into several localization tools which are absolutely crucial to their success. Specifically, effective localization has shown to raise international conversion by a whopping 40%. Shopify’s Translate and Adapt app allows for automated conversion to popular languages to make securing this conversion edge seamless. Obviously, a German buyer shopping in German rather than English inherently makes the process more familiar.

Beyond translation of store content, Shopify tweaks tax inclusion by market to add it into final prices where that’s expected (like in Europe and APAC). It allows for granular product availability on a per country basis, offers localized domains and makes duty and tariff compliance straightforward. Shopify Payments customers also enjoy discounted access to Markets for another example of “better together” products. The tool frees merchants to accept sales in 130 currencies and guides the FX conversion. Additionally, through key partnerships with Stripe and others, it can offer all of the most popular LPMs in each of these 14 markets.

All of this incremental complexity is condensed, aggregated and seamlessly displayed on the Admin. Whether it’s more channels, products or geographies, Shopify lets merchants visualize overarching operational health from this single source. It doesn’t get easier than that which is likely why Markets needed only 3 months to pass 100,000 merchants. More headaches, gone.

Shopify’s margin profile here is better than for domestic sales. It gets its typical transaction take rate, enjoys an added FX conversion fee and fetches a commerce compliance fee for handling duties and regulatory items. It does not charge for access to this product as a subscription like many others do. It charges for it based solely on usage to further align its success with merchants. More recently, Shopify deepened its channel partnerships with Meta and Google to enable this cross-border selling in 14 markets through their platforms as well.

Shopify Markets Pro:

Shopify Markets Pro is a more full-service version of Shopify Markets for Plus merchants. Global-E’s software is an important piece of this. While Markets lets merchants sell with a local feel in 14 countries, Pro does so in 150. It fully guarantees FX-conversion to eliminate that financial risk, handles translation and automates duty and tariff compliance to make “going global the default.” Merchants can add beautifully localized storefronts in these countries with one single click like with Markets. Businesses get access to full fraud protection on all cross-border transactions as well as deeper fulfillment discounts thanks to Shopify’s DHL partnership.

For an example of how impactful this tool is, Lounge Underwear was able to expand into 8 markets while lowering customer acquisition cost (CAC) by 59%. Entering more speculative geographies does not usually coincide with falling CAC. It does here.

3f. Shopify’s Expanding Suite of Advertising Tools

Apple’s cross-app data sharing restrictions along with Google’s 3rd party cookies degradation left advertisers with less ability to target high intent buyers. Since the news was publicized, Shopify has been more keenly focused on filling this void. Its data treasure chest and cross-channel omnipresence provides a great opportunity to match merchants with customers in a more efficient, profitable way. So? It built tools to take advantage.

Like other merchant solutions, the advertising tools are to help solve another merchant pain point: Affordable customer identification with open, honest campaign reporting (cough, cough Google). Lower CAC, better reporting and more sales all mean happier merchants and a more successful Shopify.

It kicked this product suite off with a native chat function in Q3 2019 to catalyze real-time communication, deepen customer relationships and add high value up-selling opportunities. This comes with a tool called Shopify Ping that merchants can use to track employee service levels. More importantly today, there are 3 main advertising-based products to discuss: Shopify Email, Audiences and Collabs.

Shopify Email:

Shopify Email is an email marketing tool with campaigns designed directly in the Admin. Merchants are allowed 10,000 free monthly emails and then are charged $1 per 1,000 above that level. The solution was mainly built to raise the number of up-selling touch-points that a merchant has with buyers. These touch-points include welcome emails, post purchase offers as well as abandoned cart win back campaigns. Because 80% of Shopify merchant EBIT comes from repeat buyers, these interactions are make or break for business success.

The ad utensil pulls from valuable customer context to segment and target in a fully automated fashion. Shopify’s insights direct the creation of these segments to allow merchants to objectively identify high value customers -- rather than guessing. According to leadership, this delivers consistent return on ad spend (ROAS) and conversion advantages vs. alternative marketing avenues. It meshes well with a current Shopify goal to build buyer relationships along with other initiatives like Shop App and Shop Promise.

Email was upgraded in 2022 to ease data querying with plug-ins to Shopify’s API suite to ensure simple access. The revamped feature boasts more granular customer segmentation with new sorting categories like last purchase date and total spend. These segments are automatically updated as customers qualify or do not qualify for the prerequisites. This added sophistication importantly frees merchants to fully control ad frequency per shopper. No more annoyed buyers being inundated with the same message over and over again. This utility helped True Vintage raise repeat buyer rates by 3% and Boie double its conversion rate from previously abandoned carts.

Influencer Marketing -- Shopify Collabs, LinkPop & Dovetale:

As a company originally born to arm the proverbial rebels, influencers are a wonderfully intuitive extension of this niche. Grandview Research sees influencer marketing rapidly compounding at 33% through 2030 to reach a $143 billion market opportunity. Shopify, through decades of building entrepreneurial trust, has an obvious right to play here.

Shopify Collabs allows merchant to sift through influencer lists and reach out to those most closely connected to their brands. Not only does this further lower the barrier to identifying profitable revenue, but it also supports influencers. Just 4% of these creators are full time, and we can personally say that finding mutually beneficial sponsorships amid a sea of noise is the main reason why. This attempts to create a better means of matching.

The service blazes a connection between merchants and a large influencer network to sell goods in an affiliate-style arrangement. This means merchants only pay for access when an influencer actually procures a sale. This allowed Duradry to lower CAC by 29% after it switched from WooCommerce to Shopify.

Collabs customers often lean on two other Shopify marketing products: LinkPop and Dovetale (acquired in April 2022). LinkPop is a tool allowing merchants to display shoppable, beautifully embedded links on social channels where these influencers preside. This is another reason why close partnerships with Google and Meta are so vital. These links integrate with Shop Pay to enable single click checkout from the influencer’s page -- combining more selling surfaces with frictionless transactions. Considering shoppable links convert buyers at 2x the rate of less functional links, this is meaningful.

Dovetale is more specific to Instagram. It allows merchants to communicate with influencer fans who have expressed interest in their products. This, as always, is done through the centralized Shopify Admin.

Shopify Audiences:

Shopify Audiences is the firm’s newest ad product launched in 2022 for Plus merchants. This is its most formal push into advertising and the piece that we are personally most excited about. How does it work?

Through a few clicks, using all of its aggregated data and models, Shopify populates a list of a merchant’s highest value buyers. These lists can then be exported to any desired ad network to be used for campaigns. Virtually all walled gardens and open internet targeting channels are available through it. Merchants can easily split test customer segmentation to further focus on what works best and use a Shopify Functions integration to automate all of this campaign building. Audiences relies on Shopify’s data scale and targeting algorithms. The latter is an abstract value proposition to say the least, but these case studies are quite concrete:

And again, Apple and Google identification restrictions make this product and its targeting capabilities all the more valuable. Cookies degradation and the new Identifier for Advertisers (IDFA) initiatives have had zero impact on Audiences’s efficacy -- and have actually accelerated demand.

Section 4 -- Growth Levers

a) The Obvious Items

The wonderful part of Shopify’s business is how much low hanging fruit there is left to gobble down in its core markets. DTC and e-commerce structural tailwinds have plenty of room to blow, and Shopify will surely benefit.

Its main growth opportunity is to keep doing exactly what it’s doing: More store customization, offline growth, persistent removal of checkout friction, perfecting fulfillment, more integrations, channel additions like B2B and new merchant solutions like Audiences.

It separates these core aims into 4 different buckets:

• “Building buyer relationships” with more consumer touch-points like Shop App and the Powered by Shopify label.

• Going global. This includes Shopify Markets and Market Pro as well as product localization (covered below).

• “First sale to full scale” or ensuring merchants can grow endlessly on the platform without ever having to leave. Tools like B2B selling and Shopify Capital are big parts of this.

• Perfecting SFN.

It does not need to reinvent the wheel to find near-term or long-term growth. It merely needs to keep driving its operations forward and to keep taking more market share. Still, with its team determined to build a “1,000-year company,” status quo is far from the only growth area of focus -- it’s just the most obvious. Here are the other compelling growth levers not yet discussed:

b) Product Localization

Going global is a key piece of Shopify’s future growth. It created all of these products and established a massive roster of developer partners and integrations. It’s now time to extend all of this unique utility across the globe. It was investing here in 2018-2019, but narrowed its focus to less speculative, developed international markets starting in late 2021. This is when international progress really started to build:

The Admin has been translated into 20 languages. More recently, it debuted local currency subscription pricing to better match buying power of each individual country. This juiced international growth mightily in 2022 and paved the way for nearly 50% of all Shopify merchants presiding outside of North America. International merchants more routinely lean on cross-border selling which is a material boon to Shopify’s overall transaction margins. And generally speaking, international clients consume more merchant solutions on average than do domestic customers.

For merchant solutions, localization is a bit more complex. Payments requires extensive LPM integrations, SFN demands deep courier partnerships and Shopify Capital needs global banking partners. All of these associations must also comply with dynamic rules and regulations in each country. That’s the only way it can offer its full product suite across the globe. Luckily, Shopify has been hard at work on this for years.

Its integrated POS tool is now available in 14 countries vs. just a handful at the start of 2021. Shopify Payments is available in 17 countries with its consumer-facing Shop App localized in all 17 of those markets. Finally, Shopify shipping is available in 5 nations. The firm is actually ready to launch many of these products in more markets today. It’s just waiting for a friendlier macro and cost of capital environment to do so. We support this.

Global expansion is a relatively easy, lower risk, asset-light means of chasing growth. The infrastructure has already been established. This is a matter of picking up those capabilities, tweaking them for specific markets, jump-starting brand awareness and enjoying growth. Localization of existing tools is cheaper than building brand new tools. Competition does exist in all of these markets, but the landscape is more favorable everywhere else (besides maybe China) than in the U.S. -- where Shopify has already established a prominent position.

c) Brand Building

As a company supporting businesses from the background, Shopify’s unaided brand awareness is low. In the U.S., it sat at 2% as of early 2022. That percentage is lower everywhere else besides Canada, but rose to 4% as of 2023 with a U.S. campaign.

There’s still a massive runway for boosting this number and bringing Shopify to the forefront of more minds. That’s why you’ve likely begun to see more Shopify TV advertisements in the U.S. The Shop App and perks like Shop Promise do help with this awareness, but there’s really no substitute for targeted marketing dollars. It will spend those dollars going forward with a strict target of positive ROAS within 6 months.

d) Speculative Opportunities

Shopify has always obsessed over “setting the innovation curve.” While it has offered Tap-to-Pay on iPhone for over a year, competition like Wix is only now adding this to the fold. It was the first to offer native embedding of videos and augmented reality (AR) tools. The AR-based features helped Allbirds and Rebecca Minkoff raise buyer conversion by 100% and 65% respectively. Shopify was first to offer many of the selling channel partnerships we’ve already covered.

These products and integrations all require constant updates as commerce evolves -- meaning first to market is an edge. If there’s a new channel or feature relevant to commerce, Shopify is usually among the first to offer it. Simply put, a future growth opportunity is continuing that trend. Whether it’s adding new selling vectors proliferating from Internet of Things (IoT) or elsewhere, it will obsess over being the fastest to innovate. That also means it embraces “bubblicious” trends like NFTs and Canadian Cannabis while showing a willingness to take chances when others won’t. Sometimes that means looking brilliant. Sometimes, like in the case of NFTs, it means looking somewhat silly.

Their willingness to swing and miss and rack up at-bats until they find what works is why they set the innovation curve. It’s something that we passionately support.

Section 5 -- Risks

5a. SFN Traction

Some of you may hear that SFN offers “2-day shipping” and rightfully think “well what about Amazon’s 1 day shipping?” Amazon is the largest threat to SFN’s proliferation and SFN is an important part of the Shopify investment case. In the past, Shopify had been able to differentiate vs. Amazon by granting merchants that sought after control over branding and customer data. The edge, however, recently became less pronounced with Amazon’s new Buy with Prime (BwP) tool.

Buy with Prime allows merchants to borrow Amazon’s incredible logistics network to offer white-labeled, prime-level service directly on their own sites. This means access to Amazon’s shipping windows which are objectively better than what Shopify can provide today. Shopify leadership has repeatedly taken the position that BwP is good news for its merchants’ ability to sell more with that benefit ultimately accruing to Shopify. We agree and disagree.

The GMV boost is certainly valid and, considering how massive fulfillment is as a space, this will not be remotely close to a winner take all outcome. But if SFN wants to be a material contributor to long term profits, this added, ultra-formidable competition makes margin preservation more difficult.

The product differentiation is not entirely gone. BwP forces merchants to list products directly on the Amazon Marketplace if they’d like to tap into the white-label service. Many merchants are unwilling to do so given countless examples of Amazon white-labeling successful products to sell on their own. BwP also doesn’t provide the level of personalized branding that SFN guarantees. Furthermore, other perks like free storage for 6 months aren’t available and checkout is not fully in-line. Instead, it requires going through Amazon and back to a merchant’s site which lowers conversion and complicates data sharing. Finally, one could argue that SFN will be a lower cost provider vs. BwP. We know that sounds crazy, but Amazon built out its capacity alone. It established a gigantic, singular network of logistics. Shopify, on the other hand, is going about this from a partner-heavy angle. So? Shopify feeding its partner network SFN’s volume doesn’t really require much incremental capacity. It just uses capacity already in place in a more efficient manner.

Perhaps most interestingly, Shopify’s 2-day promise appears to be enough for consumers for now. It produces an added 25% boost to conversion while BwP is delivering the exact same lift according to Amazon’s last earnings report. Consumers care a lot more about guaranteed delivery windows that come “soon enough” vs. a package getting to them in 24 hours vs. 36. This is especially true for non-perishable goods like Shopify merchants usually sell. That bodes well for SFN as it will obviously take time to emulate Amazon’s delivery windows.

Today, Shopify and Amazon are actively working on integrating the products. The two partner in other areas while Amazon even uses Shopify’s subscriptions for Ring, Whole Foods and Washington Post. Still, it’s unclear if Amazon will be willing to play ball and work together here within its core competency. For now, there’s no update. Shopify has also taken aim at BwP by warning merchants about Amazon using external code that isn’t properly protected in transactions. That does not inspire confidence in a future integration.

5b. Pandemic

The Sugar High:

For a company that directly benefits from e-commerce proliferation, the pandemic was very positive for Shopify. Social distancing paired with stimulus checks created the perfect storm for discretionary online shopping demand. Shopify was a key beneficiary of that boost -- and it fully took advantage.

In a matter of weeks following the initial outbreak, it added gift cards and tipping. The firm debuted easier store building which led to sub-3-day storefront creation skyrocketing 85% from March-April 2020. Shopify extended its 14-day standard free trial to 90 days and paused expansion into speculative international markets to solely focus on shipping mission critical products. As part of this, it expanded Shopify Capital in the U.K. and Canada in just weeks to provide desperately needed liquidity to more customers. It also revamped curbside pickup with 63% of its physical merchants adopting it by Q3 2020 vs. 2% as of February 2020.

Shopify became a merchant lifeline amid their time of pressing need. Specifically, it allowed 94% of lost offline revenue to be replaced with online sales. Wow. It obviously benefited too as its 3-year revenue CAGR accelerated from 53% in 2020 to 57% as of 2022 -- on a far larger base.

It wasn’t just a demand tailwind, but a boon to margins too. Stimulus skewed payment method preference towards debit. Again, debit means lower 3rd party interchange fees, fewer mouths to feed and better Shopify Payments margins. Shopify’s growth also shifted to smaller companies where transaction volume per client is lower -- and so its take rate is higher. This all has since normalized.

Shopify also built reserves for its credit issuance at the beginning of the pandemic in anticipation of loss rates spiking with layoffs. Stimulus and payment holidays meant these losses never came to fruition. So? It was able to release the reserves which technically count towards positive net income. Loss rates have since normalized.

Finally, equity investments in Affirm and Global-E exploded in value which propped up the company’s GAAP net income from 2020-2021. To Shopify’s credit, it milked this tailwind for all it was worth. Candidly however, it got too excited in extrapolating pandemic-era trends to be more permanent than they’ve proven to be.

Post-Pandemic Hangover -- Macro Tailwinds Turn to Headwinds:

Leadership -- like many other teams -- thought the e-commerce pull-forward was sustainable. It assumed e-commerce adoption as a percent of total commerce would return to its normalized growth rate without giving up any gains. That didn’t happen.

Brick and mortar shopping came back with a vengeance, and Shopify’s offline business was not large enough to counteract the coinciding online weakness. Its merchant solutions revenue abruptly slowed as merchants sold less and tightened their belts. All of the margin tailwinds it enjoyed during the pandemic vanished and made YoY profit growth turn negative in 2022. Soaring inflation, diminishing consumer confidence and rising yields all weighed heavily on discretionary spend and Shopify’s business. Smaller businesses still make up the largest chunk of its base, and these merchants fail more frequently amid putrid macro than do Fortune 2000 brands. The strengthening dollar has also been a pain in the neck here. Its expenses are incurred in Canadian dollars, which actually means a rising dollar helps its margins a bit. However, the main impact is less revenue since it switched to local currency pricing to better match buying power of international markets.

To make matters more difficult in 2022, it was comping vs. a period before it lowered its partner take rate. This all led to MRR growth slowing from ~30% to under 10% in Q3 2022. Growth has since accelerated in Q4 2022.

All of this culminated in Shopify firing 10% of its staff and vastly slowing hiring activity. It was caught with its pants down and took its medicine by streamlining the bloated cost base. There will be more economic and geopolitical challenges for companies to navigate; this team’s track record is not perfect in maneuvering chaos. Few are, but it’s still worth noting.

5c. More on Competition

Shopify tries to do pretty much everything in the world of omni-channel commerce. Considering that, it competes with essentially everyone in the space. It does have key partnerships with central players like PayPal and Adyen, but those relationships are a complicated mixture of friendly and competitive.

Let’s start with PayPal. Shopify and PayPal are both big players in payments and checkout. PayPal is integrated into Shopify Payments and makes up roughly 25% of its checkout share. When a merchant’s customer selects PayPal, PayPal is the processor and gets that fee; Shopify Payments serves only as the gateway by passing needed info to it to complete the transaction. While this is a collaborative relationship, it’s still somewhat contentious. Why? Shopify ideally would have all Payments customers choosing Shop Pay to diminish 3rd party take rates and to prop up its own transaction margin. Every basis point matters here, but it offers PayPal because it knows many customers prefer that option and would churn if it wasn’t there.

Interestingly, PayPal’s white-labeled Stripe competitor (called Braintree) recently won Shopify Payments business in France, but Stripe enjoys the majority of the back-end processing business elsewhere. We’d love to see Braintree replace Stripe in every Shopify market to allow these two checkout giants to align interests further.

Shopify and Adyen have a somewhat friendly relationship as Adyen doesn’t have its own checkout button to promote. While Stripe powers a large chunk of Shopify’s global LPM integrations, Adyen helps a bit too. Specifically, it allows Shopify to offer “iDEAL” in the Netherlands, “Bancontact” in Belgium and “SOFORT” in Germany to enhance the convenience of stores in those markets.

Broadly speaking, Shopify competes with countless other web builders. All of them offer tooling for crafting pretty stores and boast unique pros. For example, WooCommerce is free and features seamless commerce plug-ins to WordPress -- making it difficult to compete with for merchants wanting to use that. Wix also has a free plan that works for a lot of small businesses. Shopify must continue to stand out from the pack in two ways. First, the aforementioned channel partnerships must allow its subscribers to sell natively on all surfaces. Secondly, its merchant solutions must continue to gain traction, offer clear differentiation and motivate higher subscription retention. Simply put, it must provide more value than merchants can find elsewhere.

In our view, no other web builder offers capital, banking, marketing, inventory management, marketing tools and cross-border capabilities under one roof. Candidly, none really come close without forcing merchants to stitch together heavy 3rd party integrations. Wix, Woo and SquareSpace are all great options for more bare-bones, simplistic stores -- but not so much for more complex, intricate functionality and design. That could always change. Shopify also competes with more legacy demandware vendors like Magento and Hybris, but has been taking share from both for years.

As of now, Shopify has a platform share lead of the largest million e-commerce sites with far more room to run:

Source: Builtwith

Key Market Share Stats per Builtwith:

• Shopify’s 26% share of the top million global sites was under 20% as of 2020. It’s taking a larger piece of the pie.

• Shopify’s e-commerce platform share in the United States sits at a leading 25%. This is just above Wix at 24% (has a lot more small merchants and nearly double the total storefronts because of that). Woo is at 18% with SquareSpace at 11%.

• Shopify has just over 10% share of all global stores. This is 4th with WooCommerce leading at over 38%. Because Woo is free to use, it has a large share of the smallest merchants around the World.

In point of sale, there’s fierce competition from Block, PayPal’s Zettle, Clover and many others. In advertising, it competes with every other vendor on delivering superior ROAS. It competes with loan originators and banks across its financial service suite. Wherever you look, there are several, deep pocketed vendors vying to grab Shopify’s market share. That’s what happens when the opportunity is this large. It must continue to hold its own. We’ll see if it does.

5d. Margins

It’s uniquely difficult to forecast a long term free cash flow margin for Shopify. Yes, there are great public comps for the web building bucket, but not for web building paired with all of its merchant solutions. It’s somewhat of a guessing game to project revenue share for each of these products down the road.

Merchant solutions have and will continue to provide greater share of Shopify’s overall revenue. This has been a clear gross margin headwind and should continue to be while SFN is fortified. The impact on margin lines further down the income statement is less pronounced as the merchant solutions are less OpEx intensive than its subscriptions. There are less maintenance fees and less external marketing costs. For that reason, we've been told repeatedly to expect merchant solution offerings at mature scale to carry a similar operating margin profile to subscription solutions.

We think that’s overly optimistic, even if SFN takes a software-first, asset-light approach. We do not believe its run rate EBIT and cash flow margin will rise to the level of a software firm like Salesforce at 25%+. We’re also confident that its overall margins will greatly surpass a courier like FedEx at roughly 5%. Even SFN on its own should be higher margin than the physical courier via less infrastructure and fixed costs. Shopify’s run rate margin will likely be between the two and closer to Salesforce’s. Still, there’s risk in educated guessing -- especially given the fluctuating exogenous factors over the last 3 years and lack of perfect public comps.

The risk is that overall margins are closer to FedEx’s than Salesforce’s. In that scenario, this investment, as spelled out in the modeling section, will not work at today’s multiples. Alpha here is extremely sensitive to the margin profile at maturity. That profile is less certain than the other important variable of revenue compounding. Future margin expansion is never a certainty as new entrants flock to its various businesses.

Section 6 -- The Team, Ownership & Incentives

6a) The Team

Founder/CEO Tobias Lütke:

The company is led by founder/CEO Tobias Lütke. This has essentially been his entire career outside of a few early developer roles and re-writing code for fun as a kid. We love nerds. His resume is Shopify and helping to establish Ruby on Rails as a frequently used development platform. He sports a decent Glassdoor approval rating of 71% while 75% of his employees are motivated to “go above and beyond what they would in the same role elsewhere.” Always take these internal surveys with a grain of salt. What’s much more legitimate is the fabulously successful company he built over nearly 2 decades. He constantly calls Shopify his “best idea” and the company he wants to lead for the long haul.

If you aren’t a fan of Tobi, you may want to look elsewhere as he is not going anywhere. Last year, shareholders approved the creation of a new share class. This class, called a founder share, locks in his control of the company. This is discussed in detail in the ownership and incentive sections.

Shopify President Harley Finkelstein:

Harley Finkelstein is the President of Shopify. He focuses on the business side of things and has been the key driver of Shopify’s transition to serving larger merchants. Like Tobi, Shopify is the majority of his resume. Out of school, Harley briefly worked for a law firm before soon meeting Tobi. The two hit it off and Harley even became one of the first merchants on Shopify. He was initially the Chief Platform Officer, then the COO, and is now the President. He’s been with the company for 13 years.

CFO Jeff Hoffmeister:

Jeff Hoffmeister is Shopify’s new CFO. While Harley and Tobi are both big picture, charismatic leaders, Hoffmeister is the ideal Yin to that Yang. His career has been wonderfully boring and impressive. He spent 22 years climbing the Morgan Stanley ladder to Head of Americas Tech Banking. During his time there, he actually was part of underwriting Shopify’s IPO which gives him a uniquely familiar perspective on the company.

We view Jeff as the perfect hire. He will take a “more balanced approach to growth vs. profit” compared to the old CFO’s “invest all gross profit” philosophy. And we support that. For this reason, we view Shopify in a similar light to Uber or Airbnb in 2020: A company with obvious potential to cut low hanging costs to bolster margins faster than any analysts are currently modeling. Jeff is the person to pull this off. He has already convinced the team to reduce SFN CapEx and, thanks to his 22 years following public firms, has a keen idea of what investors wants from a CFO: Under-promise, over-deliver. He effectively executed this in his first quarter while the old executive struggled to consistently do so. It looks like 2023 will be more of the same:

“The Q1 2023 guide was mindful of the environment we’re in… I would say explicitly, we’re not seeing what caused us to be cautious on the overall economy [play out] in our business. Our business is doing very well. The guide was out of an abundance of caution as it relates to some of the news out there.” -- CFO Jeff Hoffmeister in March 2023

COO Kaz Nejatian:

The most underrated piece of the team is newly appointed COO Kaz Nejatian. Kaz worked for Meta until 2019 where he served as a lead product manager. He then moved to Shopify as the VP of Shopify Money before being promoted to VP of Merchant Solutions in 2020. Most recently, he was named COO in 2022. His first task as COO was to consolidate selling and marketing teams to ensure merchants were always being presented with the “right product at the right time.” Strong merchant solution and total attach rate trends are direct evidence that he’s achieving this.

Merchant Solutions Attach Rate = Merchant Solutions Revenue / GMV; Total Attach Rate = Revenue / GMV

There has been a lot of upper management turnover in the last two years. A dozen senior leaders have quit or been replaced with more seasoned talent to usher in the next era of Shopify’s growth. It’s important to us that these four executives stay with the team for a long chunk of time. We want the leadership turnover to slow and think it will.

Board of Director Highlights:

• Colleen Johnston -- retired CFO of Toronto-Dominion Bank & previously CFO of Scotia Capital.

• Fidji Simo -- CEO of Instacart and previously VP and Head of Facebook App.

6b) Capital Allocation

Shopify is not in a position to be buying back shares or paying a dividend. It is too deeply entrenched in growth mode and early on its journey to be siphoning off productive investment dollars for these purposes.

Tobi and the team are fully against “acquiring revenue.” Their M&A goal is to accelerate product development when doing so through acquisitions is faster and cheaper than building internally. This is what M&A is supposed to look like.

In terms of previous acquisitions outside of those already covered, Shopify has made the following moves:

6c) Ownership & Executive Incentives

Ownership:

Shopify has 3 share classes. First is its Class A common equity which entitles holders to one vote per share. It also has a share Class B which is owned by early investors and Tobias Lütke. Each Class B share gets 10 proxy votes. Class B can be converted to Class A with the holder losing the equivalent of 9 votes but gaining access to liquid markets for sale. These shares were granted, like is the case with a growing number of public firms, to maintain founder team control as Class A shares were sold to public investors.

In aggregate, Tobi owns all of his voting power in Class B Shares representing 33.8% of the company’s outstanding votes. Klister Credit Corp also owns all of their voting power in Class B shares representing 16.1% of total votes. Klister is an investment fund operated by John Phillips that invested in Shopify in 2009 and assumed a board seat in 2010. Combined, these two entities own 49.9% of voting power with the other 9 directors and executives owning very little Class B equity.

The third class is the aforementioned, non-transferable founder share. This unique share class, issued in 2022, all but guarantees Tobi 40% voting power when combined with the rest of his equity. As long as he stays with the firm (at least as a board member) and refrains from liquidating more than 80% of his total current holdings, he will get that 40%. This was a move to counteract mounting fears of unwanted takeover bids from large caps and private equity (PE) firms. It was also somewhat due to stock compensation and M&A pushing the team’s combined voting power down near the 50% benchmark by February 2022.

Under its previous format, the 2-class structure would terminate if Class B represented under 5% of all total shares -- called a Dilution Sunset Clause. As of the latest proxy, Class B shares represented 9.4% of the total float with that set to fall further via Deliverr-related dilution and more stock compensation. The 9.4% was rapidly falling towards 5% and this was leadership’s answer for ensuring continued control. Regardless of why this happened, if Tobi isn’t as capable as we think he is, the investment case could likely falter. This is his show.

To note, Tobi wanted the 40% voting power guarantee to be 49.9% and this was the compromise with Shopify’s board. Obviously, Tobi came to these negotiations from a point of power due to his dominant stake and board-crafting power.

Most minority shareholders did not want this to pass at the firm’s 2022 proxy vote. Tobi’s and Klister’s votes pushed it through. Somewhat controversially, Klister Capital was able to vote as a disinterested party (with its large class B stake) despite this clause allowing it to sell shares more freely without ceding its control.

Finally, institutions own about 66% of the Class A float. Over the last twelve months, there has been a near even split of reduced and increased positions as well as new and exited positions. Unsurprisingly, Baillie Gifford, Morgan Stanley, Vanguard and T Rowe Price represent the largest bellwether holders. Combined, the 4 entities own about 15% of Shopify’s overall Class A shares. Remember, this represents very little voting power as Class B holders enjoy the lion’s share of that perk.

Executive Compensation and Incentives:

Shopify’s proxy statement defines its executive compensation philosophy as follows:

“Compensation is designed to attract, maintain & motivate highly talented executives. We believe compensation should be structured to ensure a significant portion of the comp opportunity is at risk and related to factors that influence shareholder value.” -- Most Recent Proxy Filing

Board member Gail Goodman leads the compensation committee while Robert Ashe and John Phillips (from Klister) are each members as well. Shopify consults with Compensia, a disassociated consulting firm, to revisit compensation structure on an annual basis.

The various pieces of Shopify’s compensation are standard. First, there’s an annual base salary aspect. Lütke has deferred all of his cash compensation since 2020 in a signal of confidence to shareholders to assume all of his pay in equity. Cash Compensation by key executive as of the most recent proxy statement is as follows:

• Tobias Lütke made $1.

• President Harley Finkelstein made $473,000.

• Old CFO Amy Shapero made $600,000.

• Old CTO Allen Leinwand made $600,000.

• Old COO Toby Shannan made $512,000.

Equity is unsurprisingly the other piece of compensation. Importantly, 100% of it was paid in longer term options to align executive interests with longer term shareholder value creation. Grants are made in preferred, restricted and deferred share units. Shopify avoids all annual and shorter-term incentives. 33% of this compensation vests annually following the issuance for 3 years.

The value of this compensation is based on class A share price 5 days before the grant goes live. For this reason, equity packages paid out at prices much higher than where Shopify sits today makes dilution intensity look more bloated than it actually is. Some of the compensation included in the total number comes with share price strikes that will never hit, yet it’s still incorporated. For this reason, share count growth is the most important dilution gauge as that’s the true cost of compensation.

Executives can choose to take their equity awards in stock or options. Lütke takes it all in options and was paid the equivalent of $20 million as of the most recent proxy vs. $15 million in the prior year. He has a total of $47 million in unexercised, in the money options that will expire between 2029 and 2031. He also had a massive $127 million chunk expire in-the-money in 2021. Finkelstein takes his equity compensation in half stock and half options. He was paid $6.6 million total as of the last proxy vs. $5 million YoY. He has $100 million in options expiring from 2027 to 2031 and had a $37 million chunk vest in 2021.

Equity compensation here is understandably viewed as aggressive by the investment community. It is, we think, a material part of the firm’s shares falling out of favor in addition to worsening macro and SFN concerns. Selfishly, this is what enabled us to start a position.

Equity programs are reviewed quarterly, but we find the lack of formal financial targets to hit for bonuses to be annoyingly vague. The board -- which includes Harley and Tobi -- has the power to design these compensation plans based on habitual reviews of performance. There are no concrete free cash flow, revenue or share price targets to hit which we’d like to be added for full shareholder transparency.

Section 7 -- Financials

In this section, we’ll walk through the pieces of Shopify’s financial statements. Importantly, we’ll do so within the context of pandemic-related tailwinds and headwinds that have made its YoY comps anything but apples to apples.

7a) Demand -- This Section will Frequently Reference the Tables Below

Yellow highlight depicts quarters enjoying the largest pandemic boost

Q2 2020 - Q2 2021:

As seen from the demand charts, the most noticeable, pandemic-related acceleration of Shopify’s business was from Q2 2020 to Q2 2021. The rest of 2021 received a smaller, yet still sizable boost. Shopify had been compounding volume at a lofty rate above 50% for years, but that growth accelerated close to (and in some cases beyond) 100% YoY. To make things even better, this company born to “arm the rebels” was enjoying the most rapid pace of new business sign-ups in its entire existence.

That all fostered a wildly successful year capped off by a holiday shopping season that lasted 3 months instead of 4 days. This gasoline on the fire was felt most within its usage-based merchant solutions bucket with subscriptions getting a somewhat smaller boost.

Adding to the uniqueness of this period, Q3 2020 is when Shopify’s extended free subscription trials began to expire. This led to a “double conversion effect” of 14-day free trial merchants and 90-day free trial merchants which propped up subscription growth further. For 2020 as a whole, revenue grew by 86% YoY with GMV rising roughly 100% YoY. That momentum carried into early 2021 with 110% Q1 2021 revenue growth.

Q3 2021:

While the catalyst did slow throughout 2021 as comps toughened and macro accelerants faded, its growth remained above a robust 40%. This was effectively a transition period in which operational tailwinds started to weaken, but were still materially supporting the business. Put plainly, Shopify kept boomin’.

Q4 2021 - 2022:

2022 is when tailwinds had finished waning and headwinds set in. Stimulus and lock down demand shocks turned into wildly difficult YoY comps. Beyond that, inflation and diminishing consumer confidence weakened e-commerce spend and a soaring dollar pressured Shopify’s growth rates by another 200 - 600 basis points (bps). This is why you can see the sharp drop-off in growth starting Q1 2022. Shopify’s overzealous guidance at the time certainly didn’t help sentiment either.

Amplifying growth headwinds for Q4 2021 - Q3 2022 further, Q3 2021 is when Shopify’s take rate reduction started which slowed subscription growth. Q4 2021 was the first full quarter of impact here with a $21 million hit worth 6% of its overall subscription revenue.

Shopify’s integrated POS bundle did help offset some of this weakness. As the world reopened, this segment enjoyed rapid growth pushing 100% YoY with in-person shopping recovering. Still, with that being a smaller piece of the overall business, the net impact was convincingly negative.

It’s important to note that throughout 2022, Shopify continued taking overall share of online and offline commerce. Slowing growth was just a matter of those share gains translating less directly into revenue as the economy abruptly slowed. It was expanding its market position in a temporarily halted sector instead of one that had experienced robust growth for decades.

For Q3 2022, there are two items in the YoY comp to address. This is when it launched its “Shopify Starter Plan” for creators. The package is essentially a slimmed-down bundle for entrepreneurs just getting started. That introduction led to faster merchant growth, yet slower MRR growth as the revenue contribution is lower for these merchants. Secondly, Q3 2022 was the first full quarter of Deliverr revenue contribution. This contributed 500 bps to total merchant solutions growth, meaning organic growth was 21% YoY, not 26% YoY.

In Shopify’s most recent Q4 2022 report, it was through the take rate comp headwind, but macro-obstacles continued to rage. As briefly discussed, its Q1 2023 guidance slightly underwhelmed, but has recently been called unreasonably pessimistic by management as they see the period play out.

7b) Margins -- This Section will Frequently Reference the Tables Below

Shopify -- like most companies -- enjoys better margins when demand growth is outperforming. This allows it to extract more value out of its fixed cost base with variable costs rising at a slower pace than incremental revenue. That feeds margin expansion. For this reason, the tailwinds that propped up Shopify’s revenue also had a very positive impact on its margin profile.

Mind the Mix Shift:

Without context, the gross margin contraction seems alarming. Importantly, this trend is as planned and intentional. It is not a matter of pricing power diminishing within product segments. That is not happening as Shopify continues to hike pricing on select items. You’ll notice that merchant solutions GPM has actually expanded over the last 5 years.

So what’s causing this? It’s predominately a matter of mix shift towards lower gross margin merchant solutions. That factor has been amplified by its aggressive investments in SFN and rapidly growing R&D. SFN has not reached scale to deliver profits, but Shopify has been incurring hefty upfront costs to build out the network. That’s why it called 2022 “the year of investment.” This was a fancy way of saying margins would contract.

As SFN continues to build, we fully expect to see a gross margin trough. Furthermore, as briefly mentioned, most merchant solutions carry a similar EBIT profile compared to subscriptions due to lower OpEx intensity. That’s why its EBIT margin contraction over the same 5 year period is less noticeable.

2019:

Shopify was non-GAAP profitable in 2019 -- before the pandemic struck. We say this because many seem to think this company is irresponsible with capital and unable to generate profits. That’s not true. The chart below shows just how consistent its operating leverage was before the pandemic.

Simply put, it greatly accelerated product investments in 2020 in response to pressing demand from merchants. This is when leadership decisions planted the seeds for 2022 execution disappointment and a subsequent reset.

Unique Items for Q2 2020 - Q2 2021:

Ramping OpEx and the 6RS acquisition led to negative GAAP EBIT and near-breakeven EBIT in Q1 2020. Starting Q2 2020, operational tailwinds began propping up margins with a few other added benefits helping. First, the debit shock from stimulus checks propped up margins for Shopify Payments (its largest merchant solution) for the reasons already covered. It also enjoyed the profit boost from the aforementioned release of credit reserves. To help operating unit economics even more, the company halted all brand marketing investments and cut its physical real estate footprint. Neither move impacted demand materially, but did create some nice cost savings outside of the temporary restructuring charges.

GAAP net income is quite weird here. During this period, mark-to-market equity gains from stakes in Affirm and Global-E massively propped up this metric beyond EBIT margin improvement. The GAAP accounting gimmick helped mightily at this time. Still, GAAP EBIT margin also inflected sharply positive as some incremental revenue flowed down the income statement. That shows the profit inflection wasn’t solely related to this quirk. In summary, throughout 2020 and into 2021, EBIT and net income margins were held-up by the perfect storm of exogenous tailwinds.

The gross margin boost was less pronounced for the exact same reason covered in the demand section above.

2H of 2021 - Q3 2022:

YoY margin contraction resurfaced in Q3 2021 as the environment became more challenging. The debit shock ended, and the take rate reduction weighed on margins as well. Leadership, still convinced that tailwinds would continue to rage as of early 2022, continued hiring in an overly aggressive fashion. This ballooned payroll growth and diminished profitability. With all of these headwinds, and Shopify thinking of 2022 as an “investment year,” margins plummeted.

But wait, there’s more. GAAP net income swung sharply negative in 2022 as mark-to-market equity investment gains pivoted to massive losses via Affirm’s and Global-E’s stocks tanking. Q3 2022 is also when Deliverr integration and its 400 on-boarded employees started to temporarily ding margins. Q3 however, is when management realized it was wrong about modeling the permanence of pandemic trends and made a necessary shift. It committed to losses peaking in Q3 2022 which it delivered on and dedicated itself to slowing OpEx growth. A big piece of this was firing 10% of its staff.

Rest of 2022 & Q1 2023:

All of its 2022 work to lean out operations and become more efficient started to take effect in Q4 2022. This is when it began once more generating positive EBIT and when OpEx growth (ex-restructuring charges) grounded to a near halt. We expect the sequential margin expansion to continue throughout 2023 as Hoffmeister guided to more OpEx cuts while revenue is set grow at roughly 20%. And again, that is vital for this investment to work!

Management has reiterated its commitment to profitability and positive cash flow for 2023 in several investor conferences while telling us how “conservative” the Q1 2023 demand guide is. Outperforming revenue will translate into outperforming profitability if it comes like we’ve been told to expect.

“The Q1 2023 guide was mindful of the environment we’re in… I would say explicitly, we’re not seeing what caused us to be more cautious on the overall economy [play out] in our business. Our business is doing very well. The guide was out of an abundance of caution as it relates to some of the news out there.” -- CFO Jeff Hoffmeister March 2023

As an important aside, this marks an encouraging change in Shopify’s approach to guidance vs. the last CFO. The team now assumes a worst-case scenario for exogenous headwinds and allows any surprise to be to the upside -- unlike late 2021 and early 2022. Under promise, over-deliver; rinse and repeat.

Going forward, SFN scaling and leaning on partners vs. self-operated capacity will be keys to leverage. It has been the largest drag on gross margin, by far, for the last several quarters. Subscription pricing power will help materially as well. These factors, based on continued expectations of flat OpEx growth, would power lucrative operating and cash flow leverage for the firm. But there’s one caveat here. There could be another SFN-type project in the future. Leadership embraces low margin ventures; it focuses on maximizing profit dollars instead of margins.

7c) Balance Sheet

Liquidity & Dilution:

Shopify’s balance sheet is solely equity-funded and so very clean. It has $1.65 billion in cash & equivalents with another $3.4 billion in marketable securities for over $5 billion in highly liquid assets. Its cash pile has taken about a $2 billion hit over the last 12 months due to the Deliverr purchase.

There’s no traditional debt on the balance sheet. Shopify does have $913 million in convertible senior notes. These carry a 0.125% interest rate and mature in 2025. The split-adjusted strike of this offering is about 100% higher than where Shopify’s valuation presides today.

There’s no leverage or insolvency-based risk here. The balance sheet risk is entirely in the intensity of dilution to fund growth. While Shopify was born as a bootstrapped start-up, that’s no longer the case. Most recently, it raised $1.5 billion in Q1 2021 to achieve the flexibility needed to aggressively invest during the pandemic. A year before that, it raised another $1.5 billion with a secondary equity offering; it has a consistent track record of shareholder dilution every one to two years.

It’s authorized to issue an unlimited supply of class A shares. With Tobi’s new voting share, that can be done while he maintains his authority. That’s not an ideal setup for shareholders, although is less concerning given how reliant his net worth is on Shopify’s valuation. We expect dilution to decelerate with the enhanced focus on profitability, cost base rationality, layoffs, slowing hiring and no more M&A. It’s time to start funding growth projects with cash flows for this nearly 2 decade-old company.

You’ll notice that share growth has slowed throughout the last 5 years as it effectively tightens its belt. This improvement coincided with the company’s “flex compensation” package debut in 2022. Shopify describes this as a way to make its compensation structure as employee friendly as possible for retaining and winning lucrative talent. In reality, this refresh was likely a response to its tanking share price and so previously issued options coming with strikes making them worthless. So? These packages and strikes were eliminated and re-set with more employee jurisdiction over pay format. Either Shopify did this themselves, or highly coveted talent surely would have left to join another firm with new option issues. This was a necessary byproduct of the pandemic sugar-high jacking up its share price and valuation to (candidly) ridiculous levels.

The new package allows employees to customize their compensation by toggling equity and cash proportions by payment period. If they choose equity over the default amount, they get a 5% bonus. The effect of this new plan, along with layoffs, was precipitously falling 2022 stock compensation guidance. Despite Deliverr adding $50 million to that figure, Shopify lowered its original $800 million comp guide to $750 million and then $575 million as the year progressed. It ended up paying out $550 million. That still represents a somewhat lofty 9.8% of 2022 sales. As it slows hiring in 2023 and pays out more cash compensation, dilution intensity should keep slowing.

Section 8 -- Valuation Modeling & Our Approach

8a) Valuation Tables

The valuation tables below clearly depicts why we’ve trimmed the position a few times in recent months. 2023 price appreciation has made this company quite expensive. Even generational firms like this one must be purchased at a reasonable price to enjoy strong returns. You have to wait until 2025 based on current estimates to get a barely positive FCF yield. That leaves very little margin of safety for investors.

EV = Enterprise Value; MC = Market Cap

Fortunately, we think margin estimates are overly pessimistic today. And that must be true for this to work well. As briefly stated, the investment case relies on all of the current cost cutting providing more operating leverage than currently anticipated -- with the same level of growth. This is why we view what Uber and Airbnb did from 2020-2022 as the roadmap for what Shopify must do from 2023-2025. Cut costs. Keep demand humming. That is not easy to execute; hence the trims.

8b) Modeling Assumptions

Shopify does not disclose revenue by specific product and wouldn’t give us that information in interviews. That forced us to lean on public market comparisons and make an educated guess at what each solution would represent as a percent of total sales. Guessing inherently means uncertainty and risk, so we leaned pessimistic in building out our model.

While we see significant upside to current forecasts, we will wait for that upside to become less speculative and more clear to get more optimistic here. Ironically, the bull and best case scenarios in our simplistic model below are the two scenarios we view as most likely. For an appropriate margin of safety however, we built more conservatism into the assumptions. We want any surprise to be positive and created the base case in this context.

Demand Assumptions:

Shopify compounds over the next 5 years at a rate of 19%. This is somewhat conservative and offers an appropriate margin of safety. It assumes industry e-commerce growth accelerates back into the double digits as pandemic comps are lapped and macro improves. It also assumes that Shopify keeps taking share like it has for nearly 2 decades. Considering it grew over 20% YoY with its toughest comps ever, we think this is appropriately prudent and overly pessimistic if anything.

Subscription Solution Margin Assumptions:

Our model assumes Shopify’s subscription revenue bucket eventually represents 20% of total sales vs. the 27% figure it represents now. This implies merchant solutions continue to grow faster than subscriptions. It contemplates all of the following factors which will slow the revenue bucket shrinkage vs. recent years:

• The end to Shopify’s take rate change stops hurting YoY subscription growth comps.

• The usage-based shock that merchant solutions enjoyed continues to diminish.

• Price hikes across several plans accelerates subscription growth for the next 4 quarters. Near future hikes to Shopify Plus accelerates subscription growth further.

• Free trial extensions slow down.

When looking across pure-play software comps like CrowdStrike, Salesforce, ServiceNow and Workday, we feel comfortable with pessimistically assuming a 25% FCF margin for this 20% of total revenue bucket. The CrowdStrike’s of the world will likely push 35% at maturity for context.

Merchant Solutions Margin Assumptions for the remaining 80% of revenue:

Payments (including installments) should continue to be the largest merchant solution revenue contributor. 32.5% of total sales is a solid estimate based on all the volume data we have. Adyen is the closest pure-play comp in public markets. Its average FCF margin from 2020-2022 sat around 50% (using net revenue like we should). That’s not realistic for Shopify as it was helped by the debit shock and involves fewer 3rd party partner fees; Adyen doesn’t go through a processing partner such as Stripe like Shopify does. Furthermore, Shopify Payments also doesn’t enjoy the massive scale-based margin advantages that Adyen does. For these reasons, we assumed a run rate 20% FCF margin for this segment.

Shopify’s cross-border business should be somewhere around 7.5% of total sales at maturity. The added fees from currency conversion and compliance make this a higher margin segment vs. domestic payments. We assumed a 25% FCF margin here.

We assumed POS hardware (software is included in subscription revenue) combined with Shopify Balance to also represent 7.5% of total sales at maturity. Margins for both products should be razor thin considering hardware is sold roughly at cost and Balance doesn’t monetize that meaningfully. It could in the future, but we did not include this possible upside. So? We assumed these two products would in aggregate carry a 5% FCF margin.

We think Shopify’s Marketing Solutions will continue to rapidly grow as a percentage of total revenue. It’s a small piece today, but a core focus area going forward. We assume this suite of tools can reach 10% of total revenue. This is a purely software-based offering built on top of the existing platform for seamless cross-selling with little incremental CAC. That should make it Shopify’s highest margin merchant solution category. We believe the margin profile here will be on par with the subscription bucket as leadership expects. Unlike for other merchant solutions categories, we believe that this is achievable, and we assumed a 25% FCF margin.

Shopify Capital should see violent FCF margin fluctuation as economic cycles ebb and flow. Violent fluctuation leads us to be overly conservative with expectations here. We assume a 15% FCF margin with a contribution of 10% of total revenue.

SFN is the most difficult bucket to model. It’s far more partner-first and asset-light than a legacy courier like FedEx. At the same time, mounting competition from Amazon should weigh on segment margins here in the short and long run. We don’t think this will bring the FCF margin down to 5% like FedEx and others roughly boast today. We also don’t see this segment carrying a premium margin profile like its other software-heavy buckets. So? We settled on a conservative 9% FCF margin here (torn between 7.5% and 10%). This is far lower than typical software margins, but a tad higher than couriers. We think there could be upside, but refrained from assuming it considering all the execution risk left. We think this will get to 12.5% of total sales over time.

Blended Free Cash Flow Margin:

This all leaves us with a blended FCF margin of 18.9% at maturity to combine with our assumption of 19% compounded revenue growth. This is the base case, and we’ve included four other scenarios to account for all of the uncertainty inherent in these PROJECTIONS. Actual results will surely differ somewhat from all of these scenarios.

8c) Modeling & Out Approach:

In conclusion, the success of this investment, as usual, is reliant on execution and margin expansion. The expected returns are not as compelling as they are for some of our other holdings given the 2023 run-up. For this reason, we have trimmed our position a few times in recent months and are not adding at these levels. We have no plans to trim again at the current multiple. We will continue to trim if the multiple materially expands from here and would welcome several quarters of price chop to drum up some multiple contraction to add shares. We have significant room to do so.

This is a clear compounder with ample product differentiation, obvious areas to cut costs and miles of demand runway to enjoy. While that’s compelling, it must coincide with the right price to foster appropriate risk/reward to justify our investment dollars. We still see that risk/reward as compelling enough to own a smaller piece, but again have skewed towards trimming in recent months given the price action.

Thank you for reading. Airbnb will be the topic of our next deep dive.