Shopify: Getting Rid Of Its Logistics Business

Shopify (NYSE:SHOP) dropped two stunning announcements as the leading e-commerce platform provider released its FQ1'23 earnings.

The company decided to sell its logistics business (Deliverr, most of Shopify Fulfillment Network, or SFN) to Flexport, a "leading tech-driven global logistics platform." As such, it reverses a buildout that started in 2019 when it started to develop SFN.

The company focused on developing an "asset-light" and less capital-intensive logistics infrastructure, culminating with the Deliverr acquisition in 2022. However, that acquisition was poorly received last year, as it caused a massive downgrade in Wall Street's estimates of its free cash flow or FCF profitability.

Notably, the acquisition of Deliverr was initially expected to "affect its FCF margins markedly through FY24."

Management also alluded to the dilutive impact at its earnings conference as CFO Jeff Hoffmeister stressed that "Deliverr historically has been a headwind to margins."

Therefore, we assessed that the strategic U-turn by Shopify management in further building out its logistics infrastructure was a nod to recovering its profitability metrics.

Notably, management updated its FCF outlook for FY23, accentuating that the company "plans to achieve free cash flow profitability for each quarter of 2023."

That's a significant revision from the previous consensus estimates, which projected negative FCF through FY24. Therefore, with Shopify Logistics expected to be disposed of, management demonstrated that the focus is on higher-margin software platform-driven profitability.

Despite that, investors must account for revenue growth headwinds after Q2, as Deliverr was expected to be a critical revenue driver for Shopify. Morningstar highlighted in a previous commentary that "SFN should continue to drive strong revenue growth over the medium term."

However, Deliverr's dilutive impact on Shopify's gross margins and FCF profitability should be mitigated markedly, as indicated by management's outlook.

Despite that, management was cautious in its Q2 guidance, as it guided "gross margin percentage in Q2 is expected to be similar to the Q1 level."

Accordingly, Shopify posted a GAAP gross margin of 48% for FQ1, below last year's 53% (pre-Deliverr). It's largely in line with the consensus estimates. However, the accretive impact should be felt after Q2, in line with the more optimistic FCF outlook moving ahead.

The other critical announcement was the shedding of about 23% of Shopify's headcount, which reached 11.6K at the end of 2022. While the company didn't disclose the exact contribution from its logistics business, we expect most of the impact should be attributed to that segment. Management also highlighted that "the sale of the logistics business will be a factor in the 23% reduction in Shopify's workforce."

The OpEx guidance for H2 (post-logistics disposal) is uncertain for now, as management was reticent to provide more clarity. However, management stressed that the company will see a "partial impact" in Q2, with "more guidance will be provided in the quarterly results next quarter."

Nevertheless, Shopify guided for sequentially lower OpEx in Q2, indicating a decrease of "mid-single-digit percentage versus Q1."

We assessed that SHOP's valuation has surged into highly unattractive zones, given the 25% post-earnings pop, as market operators attempt to price in the expected profitability improvement.

As such, by the time you read this update, the entry levels are already not constructive, even though SHOP is no longer mired in a medium-term downtrend.

Our assessment indicates that dip buyers have returned since late last year, buying significant dips, with momentum investors coming on board in early 2023 (as SHOP's trend reversed from negative to positive).

However, chasing momentum when SHOP's valuation is given an F grade by Seeking Alpha's Quant is probably not the smartest thing to do, no matter how tempting it is to jump on board.

Rating: Hold (Reiterated).

Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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