We’ll begin with why the company is worth learning about in the first place. In May 2020, Shopify became the largest company in Canada. It claimed the spot from the Royal Bank of Canada, an institution that was founded in 1869 and employs 80k+ people. Shopify was founded in 2004 and currently employs 5k+. 

Since its IPO in May 2015, Shopify’s shares appreciated 4,000%+ as of Aug. 2020. On top of a meteoric rise to its current market capitalization of ~$120b, Shopify’s Lütke is one of the few CEOs who have publicly tweeted about audacious goals like buying Amazon in 2029. 

COVID-19 and Shopify:

Amid the pandemic, Shopify made headlines as it saw Q2 2020 gross merchandise volume (GMV) increase 119% YoY. It also established partnerships with Facebook to allow its 1m+ merchants to sell directly through Instagram and Facebook Shops. The company additionally partnered with Walmart to allow Shopify merchants to sell directly into Walmart.com. 

The company's recent success despite the pandemic and investor interest in its potential emphasizes the importance of understanding the fundamentals behind the business – and, specifically, understanding how it makes money.

Shopify’s Business Model

Shopify’s company mission is focused on "making commerce better for everyone." It offers a product plan priced between $29 to $299 per month. Through its software, Shopify provides what could be considered an "end-to-end" service for a store merchant.

I’ll break this up between the front-end and back-end:

• The front-end is the actual store website or everything that the merchant’s customers will see when they go to their website. It's similar to what you see while creating your own website with Squarespace or Wix.
• The back-end includes inventory management, payment processing, financing, data analytics, fulfillment, and reporting. 

Shopify's essentially about providing a core value proposition of making it easy for a merchant to start and operate an online store. It’s also not obvious to shoppers that they are shopping on a Shopify platform; Ben Thompson from Stratechery noted how 218m people who bought products through a Shopify store didn't even know the company existed.

Shopify’s Customer Makeup

Such ownership over their own brand is a key value proposition that brings merchants onto their platform, Shopify argues. As of Dec. 31, 2019, there were  1m+ merchants on Shopify’s platform across 175 countries with 52% in the U.S, 7% in the U.K., and 6% in Canada.

Additional information on Shopify’s customers:

• Per the FY 2019 annual report, a large majority of merchant plans cost less than $50 per month.
• No single merchant represented more than 5% of total sales in a year.
• The 1m+ merchants include the 7,100 merchants on Shopify Plus, their enterprise-level solution, which includes clients like Gymshark, Nestle and Staples.

What seems evident from the customer distribution is that Shopify primarily serves small and medium businesses (SMBs). It might also be appropriate to note that the failure of their SMB merchants will not have a material impact on the company unless it happened to a large majority together. 

Shopify’s Revenue Breakdown

Shopify breaks its revenue down into Subscription solutions and Merchant solutions. From Shopify’s 2019 total revenue of $1.57b, Subscription solutions made up ~40%, a continued decline from 46% in 2017. 

• Subscription solutions are the monthly subscription plans all merchants pay to use Shopify’s software platform. This includes the enterprise-level Shopify Plus, which sees annual or multi-year terms when merchants sign up. 
• Merchant solutions include payment processing fees from Shopify Payments, financing from Shopify Capital, Shopify Shipping, Shopify Fulfillment Network (including warehouse solutions), Shopify POS (point-of-sale terminals) and various solutions that round out the platform. Though there is much to be excited about in this revenue segment, management has shared that a significant majority of sales are from Shopify Payments. 

Merchant solutions revenue grew 53.9% in 2019 and 67.4% in 2018. Shopify Payments attributed for ~73% and ~72% of the growth in respective years. As of FY19, Shopify noted 2/3 of their merchants in 15 countries enabled Shopify Payments. Though they did not share which countries and how many merchants, ~85% of their 2019 revenue was generated in four countries so we can estimate the bulk of future adoption could come from these countries (Canada, U.S. U.K., and Australia) in the near term. 

A quick look at Shopify Payments:

• It allows merchants to accept and process payment cards online and offline. 
• It was first introduced in 2013 in the U.S. and Canada.
• Revenue is earned through transaction fees. These fees are calculated as a percentage of GMV.
• Shopify’s 2019 GMV was ~$61b.

Compared to Merchant Solutions, Subscriptions Solutions grew ~38% and ~50% in 2019 and 2018. Though this segment saw ~50% lower growth rates compared to Merchant Solutions, not all revenue figures are equal, and we will start with gross profit to examine what that means.

Quality of Revenue

Over the last three years, Shopify has shown gross margins in the mid-50% though we can see a small decline over this period. When we examine the revenue segments, it is evident that Subscription solutions contributed ~59% of 2019’s gross profits despite accounting for ~40% of sales. 

The three-year average gross margin on Subscription solutions and Merchant solutions segments were ~79% and ~37%, respectively. The Subscription solutions are arguably the more profitable component of Shopify. The cost of revenue for both segments include compensation and data infrastructure costs as a major expense item, but the Merchant solution also incurred additional fees (i.e., interchange, network) related to processing payments. 

There is also a consideration of the nature of the transaction as well. Subscription revenues are paid upfront for monthly, yearly, or multi-year plans. This upfront payment means Shopify receives money before rendering the service. Compare this to Shopify Payments, where they are paid after a transaction happens. The upfront cash payment can be considered similar to ‘float’ that Warren Buffett commonly uses when referring to insurance companies as they also receive payment upfront before processing any insurance claims.

The implication of this ‘float’ is that Shopify is able to use the funds from its higher-margin Subscription solution business to invest in other areas like Shopify Fulfillment Network that make up Merchant solutions. This cycle of reinvesting their float may already be showing up as Merchant solutions went from representing ~35% of gross profits in 2017 to ~41% in 2019. 

Management has noted the importance of Shopify Payments in creating higher retention with merchants. The expansion of more services like Shopify Payments to help merchants may lead to higher GMVs over time to propel further the growth of revenues from Shopify Payments over time. As of Q2, 2020, Shopify Payments processed $13.4b of GMV from $2.2b in Q2 2017.