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Shopify Inc.: Take Advantage of Fear and Buy the Dip

There are two ways to react to one of your holdings taking a massive hit. You either freak out and immediately sell, or you analyze what happened and determine if the thesis that first got you to buy holds true. If the thesis remains true, you should immediately take advantage of the discount and start buying shares.

I believe that’s the case with Shopify Inc.  (TSX:SHOP)(NYSE:SHOP). In the beginning of the month, Citron Research released a report questioning the legality of some of Shopify’s marketing tactics. Specifically, Citron argued that the company was a “get-rich-quick scheme” and that the FTC would go after the company.

Although I am not an expert on all FTC rules, I do know that running an affiliate program is not inherently illegal. On the contrary; even the biggest companies in the world run affiliate programs.

Nevertheless, the market freaked out when Citron released its report, and shares dropped quite aggressively and are now down by 20%. Are Citron’s claims sound, or is there something else here?

There’s one thing to take into consideration when it comes to listening to a firm like Citron. They are short sellers, which means they borrow shares, sell them, and then wait to buy them at a lower price. Citron is biased and incentivized to push shares lower. The lower they go, the cheaper the shares are when Citron buys back, so the more profit the firm makes.

Frankly, I believe Citron’s claims are unfounded, and I believe you should be taking advantage of the fear and buy the dip.

Here’s why.

Shopify has created a strong business model that incentivizes small businesses to move over to its platform. It’s a business model that allows it to generate recurring monthly revenue as well as incremental revenue.

Let’s break it down:

The first business is Shopify’s Subscription Solutions product, where a customer pays anywhere from US$9 to US$299 per month to launch an online store. This gives Shopify a strong base, since it knows that it can expect those payments each and every month.

The second business is Shopify’s Merchant Solutions group, which generates revenue based on how much Shopify’s customers (the merchants) earn from their stores. That includes payment processing, shipping label purchasing, and other services. As gross merchant volume increases, the amount of money it earns from this division also increases.

In the second quarter, Shopify had $151.7 million in revenue, up 75% from the second quarter of 2016. Subscription Solutions revenue increased by 64% to US$71.6 million, while Merchant Solutions boosted revenue by 86% to US$80.1 million. Remember that gross merchandise volume? It was US$5.8 billion in the quarter, up 74%.

Did Shopify deserve to be trading at nearly $150 a share? Perhaps not. And maybe this pullback is healthy to shake out weaker money. However, Shopify has not even started to reach its full potential. I believe that over the coming years, as hundreds of thousands more merchants sign up and gross merchandise volume increases, Shopify’s revenue will make this quarter’s revenues look small.

When the market is scared, take advantage and buy the dip.

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Fool contributor Jacob Donnelly has no position in any company 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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