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Why Shopify Inc. Investors Should Be Worried About the Magento Deal

Shopify Inc. (TSX:SHOP)(NYSE:SHOP) was down 6% on Tuesday amid news that one of its rivals would be acquired by a big tech giant. Investors learned yesterday that Adobe Systems Incorporated (NASDAQ:ADBE) would be purchasing Magento Commerce for $1.68 billion. The Shopify rival has some big-name customers including The Coca-Cola Co. and Burger King, and the Adobe deal could result in even more growth for the company.

Adobe will look to strengthen its e-commerce solutions and provide a unique shopping experience for its customers. Brad Rencher, an executive in charge of the company’s Digital Experience Team, stated, “Embedding commerce into the Adobe Experience Cloud with Magento enables Adobe to make every moment personal and every experience shoppable.”

Why this is a problem for Shopify

Although Magento has some big customers, at less than $2 billion, it’s relatively small, which should worry Shopify investors. Adobe has a market cap of around $120 billion, and with almost $3 billion in free cash flow in just the trailing 12 months, the company has a lot of money to play with. Shopify, in contrast, has failed to even generate any free cash over the past five years.

This arms Magento with a multitude of resources that the company didn’t possess just a few days ago. You can bet that Adobe will be putting a lot into the company as it sees the potential that exists in the market and the opportunity to leverage its existing products and services.

While Shopify has been growing well over the years and has seen its sales triple since 2015, things have begun to slow down. In its most recent quarter, sales were still up ~70%, but the company did suggest a slowdown in its rate of growth, and having a stronger competitor certainly won’t help that outlook.

Increased competition will only make it more difficult for Shopify to turn a profit, as the company has constantly been plagued with rising costs.

Should you be selling Shopify?

Before this deal, Shopify was an expensive buy that was justifiable because of its growth and potential. And while it’s tempting to think Magento will thrive under its new owner, there’s no guarantee of that, as it’s still a long process that we won’t see the full impact of for many years. In the short term, Shopify is still going to do just fine growing its sales, but over the long term, the stock seems destined to run out of steam.

The share price trades at a whopping 15 times book value and 25 times its sales. Investors are paying a huge premium for a lot of growth and optimism, but not a whole lot of substance. The danger with the stock is it has been very reactive to news, particularly negative developments. Earlier this year, the share price took a deep dive after a short seller was overly critical of the company’s business model, and it wasn’t the first time it’s happened either.

Shopify’s a risky, volatile stock trading at high premiums, and investors holding the share may want to plan an exit sooner rather than later.

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Fool contributor David Jagielski has no position in any of the stocks mentioned. Tom Gardner owns shares of Shopify. The Motley Fool owns shares of Adobe Systems, Shopify, and SHOPIFY INC. Shopify is a recommendation of Stock Advisor Canada.

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