Shopify (NYSE:SHOP) Beats Expectations in Strong Q2, Gross Margin Improves

E-Commerce software platform Shopify (NYSE:SHOP) reported Q2 FY2023 results beating Wall Street analysts' expectations, with revenue up 30.8% year on year to $1.69 billion. Shopify made a GAAP loss of $1.31 billion, down from its loss of $1.2 billion in the same quarter last year.

Originally created as an internal tool for a snowboarding company, Shopify (NYSE:SHOP) provides a software platform for building and operating e-commerce businesses.

Creating an E-Commerce business is a very technical and complex process that serves as a high barrier to entry for many entrepreneurs.

Before selling a product online a business needs to have a functioning website, a payment processing system, inventory management, and a fulfilment process at the bare minimum. Because of the high technical barriers to starting an online business, many E-Commerce companies could not function without a third party platform that handles everything for them. Shopify’s cloud based software aims to provide everything a business needs to sell online so that founders can focus on making products their customers love.

Many different types of online businesses trust Shopify with handling the digital infrastructure crucial for their operations. From solo entrepreneurs paying as little as $5 per month all the way up to large enterprises with much more lucrative contracts, Shopify provides the necessary tools to start, grow, market, and manage an online retail business.

While e-commerce has been around for over two decades and enjoyed meaningful growth, its overall penetration of retail still remains low. Only around $1 in every $5 spent on retail purchases comes from digital orders, leaving over 80% of the retail market still ripe for online disruption. It is these large swathes of the retail where e-commerce has not yet taken hold that drives the demand for various e-commerce software solutions.

Other providers of e-commerce software include: BigCommerce (NASDAQ:BIGC), GoDaddy (NYSE:GDDY), and Squarespace (NYSE:SQSP)

Sales Growth

As you can see below, Shopify's revenue growth has been over the last two years, growing from $1.12 billion in Q2 FY2021 to $1.69 billion this quarter.

This was a standout quarter for Shopify with quarterly revenue up 30.8% year on year, above the company's historical trend. On top of that, its revenue increased $186 million quarter on quarter, a strong improvement from the $227 million decrease in Q1 2023. This is a sign of acceleration of growth and very nice to see indeed.

Ahead of the earnings results announcement, the analysts covering the company were expecting sales to grow 15% over the next 12 months.

Profitability

What makes the software as a service business so attractive is that once the software is developed, it typically shouldn't cost much to provide it as an ongoing service to customers. Shopify's gross profit margin, an important metric measuring how much money there's left after paying for servers, licenses, technical support, and other necessary running expenses, was 49.3% in Q2.

That means that for every $1 in revenue the company had $0.49 left to spend on developing new products, sales and marketing, and general administrative overhead. While its gross margin has improved significantly since the previous quarter, Shopify's gross margin is still poor for a SaaS business. It's vital that the company continues to improve this key metric.

Cash Is King

If you've followed StockStory for a while, you know that we emphasize free cash flow. Why, you ask? We believe that in the end, cash is king, and you can't use accounting profits to pay the bills. Shopify's free cash flow came in at $97 million in Q2, turning positive over the last year.

Shopify has generated $202.8 million in free cash flow over the last 12 months, or 2.25% of revenue. This FCF margin stems from its asset-lite business model and enables it to reinvest in its business without depending on the capital markets.

Key Takeaways from Shopify's Q2 Results

Sporting a market capitalization of $86.5 billion, more than $4.78 billion in cash on hand, and positive free cash flow over the last 12 months, we believe that Shopify is attractively positioned to invest in growth.

We enjoyed seeing Shopify materially improve its gross margin this quarter. We were also excited that its revenue growth outperformed Wall Street's expectations, driven by better-than-expected results in GMV, GPV, and subscription and merchant services revenue. Overall, we think this was a strong quarter that should satisfy shareholders. Investors were likely expecting more, however, and the stock is down 1.67% after reporting, trading at $61.36 per share.

Is Now The Time?

Shopify may have had a good quarter, but investors should also consider its valuation and business qualities when assessing the investment opportunity. We cheer for everyone who's making the lives of others easier through technology but in case of Shopify, we'll be cheering from the sidelines. Its revenue growth has been solid, though we don't expect it to maintain historical growth rates. But while its very efficient customer acquisition hints at the potential for strong profitability, unfortunately its gross margins show its business model is much less lucrative than the best software businesses.

Given its price to sales ratio based on the next 12 months is 11.0x, Shopify is priced with expectations of a long-term growth, and there's no doubt it's a bit of a market darling, at least for some. While we have no doubt one can find things to like about the company, we think there might be better opportunities in the market and at the moment don't see many reasons to get involved.

Wall Street analysts covering the company had a one year price target of $55.1 per share right before these results, implying that they didn't see much short-term potential in the Shopify.

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