Shopify Inc.: The Real Reason the Stock May Struggle to Sustain a Rally From Here

Shopify Inc. (TSX:SHOP)(NYSE:SHOP) plunged over 8% following its Q3 2017 earnings report. Could the “Left Effect” come back to haunt the stock?

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Shopify Inc. (TSX:SHOP)(NYSE:SHOP) recently released its Q3 2017 numbers which were solid to say the least. Despite clocking in record third-quarter revenues, shares fell over 8% following its release since the general public wasn’t happy with CEO Tobias Lütke’s response to short-seller Andrew Left’s claims.

Before Andrew Left’s short report, I urged investors to be cautious because of two major problems that could stop the stock’s impressive run dead in its tracks.

In several pieces, I pointed out that Shopify was turning into a dangerously speculative stock, despite its promising long-term growth runway.

While some investors may disagree with many of the points that Andrew Left made in his report, such as shady mid-level marketing and misleading campaigns, I believe investors should take some time to think about his other points, many of which I’ve also pointed out in the past, such as overvaluation and the long-term sustainability of Shopify’s subscriber base.

Shopify is absurdly overvalued

Sure, many high-flying growth stocks have sky-high valuations, and some investors may not even look at the valuation metrics when investing in such a growth stock, but I believe that’s an extremely risky proposition.

I understand that there’s a premium for innovative tech stocks that are few and far between on the TSX, but investors really need to ask themselves if it’s worth placing a bet on a company that trades at ~19.2 price-to-sales multiple.

For many investors, the bull thesis on Shopify is that its subscriber growth momentum is unstoppable and will continue to pick up, at least over the next few years. The main problem with this thesis is that investors may not understand the amount of churn that the subscriber base is susceptible to.

Subscriber growth momentum isn’t as remarkable when you consider that a huge chunk of subscribers may be heading for the exits over the next few years. Eventually, a tipping point will be reached, and once subscriber growth slows, subscriber losses may start to pick up, and that’s when things could really get ugly.

A huge amount of churn in Shopify’s subscriber base can be expected over the long haul

In one of my previous pieces published before Andrew Left released his short report, I noted a scary risk that nobody seemed to be talking about. Everyone was all about the bull case, and barely anyone was considering the real long-term risks associated with the business.

Small- and medium-sized businesses (SMBs) have an absurdly high failure rate. That’s just a fact, and unfortunately, Shopify caters to such businesses, so it’s not too far-fetched to assume that a huge chunk of Shopify’s subscribers may not stick around over the next five years.

The U.S. Bureau of Labour Statistics states that approximately one-third of new establishments survive more than a decade. In theory, that could mean Shopify could lose two-thirds of its subscriber base in a decade from now, assuming a superior product isn’t created by a competitor and all subscribers are legitimate business owners. These aren’t safe assumptions to make, so Shopify could potentially stand to lose an even greater percentage of its current subscriber base a decade from now.

To add even more salt in the wound, Andrew Left pointed out that many a chunk of Shopify’s current subscribers may not be legitimate business owners, and they may only be in it for a business opportunity or to recruit others for a referral bonus. If I were a Shopify shareholder, I would definitely lose sleep at night thinking about this.

Bottom line

Andrew Left seems to think that Shopify is a big scam, but I don’t think it is.

The company is likely operating legitimately; however, I’m still concerned about the long-term sustainability of the company’s subscriber base.

Shopify CEO Tobias Lütke claimed Andrew Left’s claims are “preposterous,” but investors should take any management retorts with a grain of salt, especially since many investors were unimpressed with Lütke’s response to Citron.

Things could definitely get uglier from here, so I think buying the dip right now would be an extremely risky proposition.

Stay smart. Stay hungry. Stay Foolish.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Joey Frenette has no position in any of the companies mentioned. 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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