The curse of the first-day pop, and why Shopify deserves better
Another week, another money-losing tech IPO has an eye-popping rally on its first day of trading.
The latest shooting star is Shopify. Like the better-managed IPOs of late, Shopify is positioned for more growth in a promising market. Founded in 2006, Shopify offers a commerce platform for smaller businesses, whether they operate purely online, in brick-and-mortar stores, in pop-up shops and trade shows, or all of the above.
Larger retail and restaurant chains have plenty of resources to set up point-of-sale systems that handle all of these retail channels, from checkout lines to smartphone purchases, making things simple for employees to use while syncing multiple inventories and churning out analysis of the sales data collected. Shopify has tried to level the playing field by offering the same to the smallest retailers in a simple way, even hosting all of the data and services on its own servers.
Shopify also courts a community of developers to create apps that, for example, integrate its platform with Facebook and Mailchimp or that make customized printouts easier. Its app store has 900 free and paid apps available, and the company offers resources to help developers submit their apps to the store. As any smartphone manufacturer knows, an active community of developers is essential in drawing more customers into a platform.
All of this seems to be working. So far, 160,000 merchants with an aggregate $8 billion in sales are using Shopify's platform, and growth is coming quickly. Revenue last year rose 109 percent to $105 million and rose 99 percent to $37 million in the first three months of 2015.
But like so many IPOs in the past year or so, Shopify is debuting with a history of losses. After reporting an operating loss of $22 million in 2014, the company showed a loss of $3.5 million in the first three months of 2015. With so many IPOs losing money, however, investors start to look at whether those losses are likely to endure for long in the future.
One encouraging sign is that Shopify doesn't have to pump up spending to keep revenue growing. Overall, operating costs as a percent of revenue have been declining. Operating costs such as marketing and R&D fell to 67 percent of revenue last quarter, down from 94 percent a year earlier.
A little more worrisome is that new areas Shopify has been expanding into to keep growth strong are higher-margin businesses. Shopify has been adding payment processing for merchants to its offerings. Revenue from these and similar services grew 160 percent last quarter, while its traditional platform-subscription revenue grew 71 percent. The payments business, which now makes up 40 percent of total revenue, has gross margins of 29 percent, twice as high as those for subscriptions.
Shopify also faces competition from other small-business commerce platforms like the open-source Magento and from Square and other payments processors. But the company's products and handholding tutorials are tailored to address one of the key challenges of the small-business enterprise market – that business owners often aren't tech-savvy enough to give consumers the seamless expereience they've come to expect, and are often too harried to try and learn. Shopify's plug-in-and-go offerings are designed to address that issue.
As 2015 IPOs go, Shopify's business model has a fair amount of promise. So investors lined up: Shopify initially priced its IPO shares in a range between $12 and $14, but the offering was priced at $17 a share, giving it a market cap of $1.1 billion in the offering, or around ten times its revenue last year.
As pricey as that IPO was, the stock shot up in its first two days of trading, closing Friday at $28.31 a share, or 67 percent above its offering price. Shopify is now valued at 18 times its 2014 revenue without a dime in profit. Let's say revenue doubles again this year. The stock is still valued at nearly 10 times its expected revenue - a risky valuation for any company, let alone one in a competitive market.
Because 2015 has been such a dry year for IPOs – only 9 have debuted nearly five months into the year - companies that go public are almost guaranteed a dramatic first-day pop. But the average post-IPO return of those tech IPOs is only 1.6 percent, well below the returns of financial or pharmaceutical IPOs.
How can it be that so many tech IPOs have spectacular first days but also such middling post-IPO returns? Because so few are able to hold onto those initial gains. Box has fallen 27 percent from its first-day close, while Etsy is down 43 percent. Investors who bought into these stocks on their first days in the public market are out a significant amount of money only a few short months later.
While the lion's share of the most promising young tech companies are still securing financing in private rounds, the first-day pops are starting to draw in a few more candidates into the IPO pipeline. So far this month, Fitbit, Mindbody, Appfolio, and Xactly have filed to go public. Of those four, only Fitbit has an operating profit, making it – in the words of Jake Gittes – the leper with the most fingers.
Shopify's IPO was greeted as a success last week. But those headlines mask what's really happening in the IPO market this year. Second-tier companies are going public with losses. Their stocks surge supernaturally on the first day but drift down in the following weeks, but those first-day headlines lure in more second-tier companies.
Which is too bad for a company like Shopify. The company is finding its way to success in a difficult market, but the early surge its stock saw last week will haunt it in coming months. It sets a high bar of expectations that will be hard to meet in coming months. Like so many IPOs this year, Shopify is now priced for perfection. And what tech IPO these days is perfect?