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What Citron Research gets wrong on Shopify

In general, I'm a big fan of short sellers and think they play a valuable role in markets. Collectively, investors have saved billions of dollars thanks to having watchful, well-incented eyes on hand to detect fraud, flawed business models and other market absurdities before they expand to epic proportions.

That said, short sellers do themselves no favors when they overreach and move beyond well-reasoned arguments into innuendo and one-sided bluster. That's exactly what Andrew Left and Citron research did in their recent report on Shopify. In this piece, I'm going to explain exactly where they went wrong. Up front, I'll disclose that I actually agree with Citron that Shopify's stock is likely overvalued today (even after the recent decline)- I was short Shopify personally before the piece came out, and am short today. However, that is no reason to malign a great company and accuse it of being a "A COMPLETELY ILLEGAL GET-RICH-QUICK SCHEME". I have known Shopify since its IPO, and based on my research as an equity analyst my last employer, Putnam Investments, was a top five shareholder of Shopify for a time after the IPO. I first met Tobi (CEO), Russ (the outgoing CFO) and Katie (IR) on the IPO roadshow in 2015 and have followed the company closely since, maintaining a financial model and even considering an early stage venture investment in a company built on the Shopify platform and distributed through its app store.

In this piece, I'll walk through each of Citron's major points. Citron paints Shopify as:

1) An illegal "get rich quick" scheme

2) A high churn business with no operating leverage and bad unit economics

3) Wildly overvalued even without considering #1 and #2

Point 1: Shopify is an illegal "get rich quick" scheme, which accounts for a significant portion of the merchant base

To make this point, Left highlights various online advertisements, blog posts and Youtube videos- some from Shopify itself and others from Shopify affiliates who earn commissions by referring customers (like any other affiliates). Left brazenly compares Shopify to Herbalife as "the most obvious comparison." Uh, no.

Here's what's really going on here.

First, Shopify has a very standard affiliate marketing program without pyramidal characteristics. While nothing prevents someone from being an affiliate and earning revenue by referring customers to the site at the same, in practice most of the affiliates are acting on their own accord without being merchants, and most merchants aren't affiliates, nor do they need to be affiliates and recruit others to "get rich," which is the core of a multi-level marketing model. Shopify cites 13,000 affiliates, a tiny fraction of the 500,000 active merchants. Any comparison to multi-level marketing schemes should stop there. Many of these affiliates are agencies that support customers by building them websites on top of the platform- a common business model in the small/mid-size business web services space.

Second, Shopify isn't pre-selling products into customers like Herbalife was- it sells monthly subscriptions to its product that can be canceled or downgraded at any time. It is hard to paint Shopify as taking financial advantage of its users, even if they ultimately fail to generate enough business to justify their sites. Even the drop-shipping model that Left maligns involves no transition of wealth from merchants to Shopify, beyond the subscription and payments fees which are minor on a per-merchant basis.

Third, per Left's own description and understanding, small merchants are a small piece of Shopify's overall business in revenue terms. Over half of revenue last quarter was tied directly to volume, and of the rest (the subscription component) it is easy to demonstrate that the vast, vast majority comes from operational businesses. Consider Andrew Left as correct that Shopify has 2500 plus merchants paying $2000/mo, and 20k advanced merchants paying $299/mo. That equates to $130m of subscription revenue, over half of the $240m that Shopify reported in the last twelve months. Even assuming that ALL of Shopify's non-plus/advanced customers have fallen victim to some kind of scheme and have been duped into paying Shopify, only 25% of overall revenue is impacted

That assumption, of course, would be garbage. The family business I grew up in is just one example of the countless Shopify Basic and Regular customers who are real businesses. I have no doubt that some portion of Shopify's subscriber base is struggling to succeed and will churn off the platform- such is life as a provider of web services to small businesses. That said, Citron's assertion that a few blog posts, some Facebook ads and aggressive affiliate marketing videos Shopify has very little control over is evidence that a huge portion of Shopify's merchant base is chasing a fantasy get-rich quick scheme is pure innuendo. Shopify reported $5.8bn of GMV transacted through the platform, equal to over $12,000/merchant. The business is very, very real.

Point 2: Shopify is a high churn business with no operating leverage and bad unit economics

If if was true that a huge chunk of Shopify's customer base had been hoodwinked, we should see high churn and a struggling business. Shopify doesn't disclose churn outright, but there's zero sign of a struggling business. Contrary to Citron's assertions about bad unit economics, Shopify is kicking ass.

Here's a chart I use to gauge how efficiently public SaaS companies are growing. The Y-Axis is growth- Shopify will be one of the fastest growing public SaaS companies this year, matched only by Okta in my dataset. The X-Axis is my own creation- Free Cash Flow margin, with stock base compensation subtracted so it is treated as a real expense. It isn't perfect, but it is my favorite way to get a gut feel for the profitability of a SaaS model.

The bottom line is that Shopify is one of the most exceptional SaaS companies I've ever seen in terms of the efficiency with which it is growing. It is true that profitability hasn't improved much in recent years- but growth hasn't slowed down either. If Citron has a problem with the economics of this business, it might as well short every public SaaS company.

Point 3: Shopify is wildly overvalued without considering points 1 and 2

This is the one point I can't push back on, and the only reason I was short Shopify personally going into this report. Simply put, the stock is pricing in a rosy scenario relative to peers. It trades at over 26x 2017 gross profit, while peers with similar metrics like ServiceNow, Okta and MuleSoft trade in the mid-teens on the same metric. Citron's comps analysis was overly simplistic and flawed in that it didn't adjust for growth or profitability, but the thrust of it was correct: Shopify is an incredibly expensive stock and is priced for perfection. There is a very real risk that the company crushes it from here and investors don't see strong returns as it grows into the valuation.

The bottom line here is that Shopify is a great, well-managed company, and most of Citron's assertions simply don't stick. However, as Citron rightly points out even fantastic SaaS companies sometimes get valued in a way that more than prices in their excellent characteristics, which is arguably the case for Shopify today. Still, that's no excuse to make poorly supported, self-serving allegations that the company is some kind of illegal get-rich quick scheme. Tobi and the team should be proud of what they've built, and I'm excited to watch them continue to change the world and prove my valuation concerns wrong by growing into their multiple.

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