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The Single Biggest Risk for Shopify Inc. Isn’t Immediately Obvious

Canadian tech darling Shopify Inc.  (TSX:SHOP)(NYSE:SHOP) has seen incredible growth since its initial public offering (IPO) a little more than two years ago. Since its IPO in May 2015, shares of Shopify have rocketed higher, trading at a level which is more than three times what the company opened at when it first began trading on the Toronto Stock Exchange.

Shopify’s growth model is one which has taken advantage of one of the most highly touted and proven markets in the tech space of late: a shift to e-commerce from traditional brick-and-mortar retailers. The company is looking to cash in on a sector-wide transition in the way consumers shop for goods. The growth rates seen at Shopify have exceeded those of many other high-flying tech leaders, allowing Shopify shareholders to reap the benefit of increasingly optimistic growth projections for the medium to long term in this space.

Bulls favouring Shopify point to the tech company’s ability to continue to create customers from a base, which appears to be somewhat stagnant, as its main strength. The company’s marketing and business development team appear to be doing a first-class job at recruiting and retaining customers from a base of small business owners, which has largely been considered to be difficult to nail down.

However, herein lies the single biggest risk factor many analysts have pointed to with Shopify’s business model, highlighted in a recent report from infamous short-side analyst Andrew Left of Citron Research: Shopify’s ability to maintain long-term stability with its existing customer base, and the ability of Shopify to continue to grow its base given the extremely high churn rate in the small-business segment, remain questionable in the medium term.

Small businesses fail at a very high rate, and studies have shown that the churn rate (the percentage of customers who leave over a specified period of time, for whatever reason) for tech companies is one of the key factors in determining a valuation for companies like Shopify, given the subscription nature of the company’s business model and the pre-earnings nature of Shopify’s business model.

While growth at these early stages remains the priority for Shopify’s management team over profitability, continuing to grow at rates thatmay turn out to be unsustainable in the long run due to high churn rates is a concern investors are starting to consider, with Shopify’s share price seeing a decline of more than 20% since it’s 52-week high, reflecting these concerns.

Bottom line

The churn rate concerns, which have become the focus of some analysts of late, may continue to provide a headwind for Shopify moving forward. That said, it is equally as likely that in the near term, investors may ignore these risks, should Shopify continue to beat expectations, as it has been since its IPO more than two years ago.

I expect high volatility to remain with Shopify over the medium term, and for that reason, I remain on the sidelines.

Stay Foolish, my friends.

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Fool contributor Chris MacDonald has no position in any stocks mentioned in this article. Tom Gardner owns shares of Shopify. The Motley Fool owns shares of Shopify and SHOPIFY INC. Shopify is a recommendation of Stock Advisor Canada.

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