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1 Number Shopify Investors Should Watch

Image source: Shopify Blogs.

Shopify (NYSE: SHOP) may be one of the fastest growing companies you have never heard of. The company has developed an e-commerce platform that helps small businesses and entrepreneurs to get online, making it easy to set up a website, build a product catalog, track inventory, collect payments, and more. Shopify has been so successful with its platform that over 325,000 merchants depend on them every day. Even Amazon.com has ceeded this business to Shopify.

Shopify's revenue growth has been explosive. The company grew 112%, 109% and 95% respectively for the last three full year periods.  Shopify breaks out its revenue into two segments for reporting purposes.  The first, subscription solutions (as shown in green in the chart below), represents the recurring monthly fees that merchants pay to be on the Shopify platform. The second, merchant solutions (in blue), are the fees collected by Shopify when one of its customers makes a sale. Merchant solutions has been a significant contributor to growth accounting for just 19% of revenue in 2012 to 45% of the overall revenue in 2015.  

 

  

Image Source: Shopify.com 

The one number to watch

The merchant solutions business allows Shopify's customers to accept payments on its platform and has driven significant additional revenue, but it comes at a cost. The margins are much lower than the subscription business. As the merchant solutions revenue grows to be a larger portion of overall revenue, gross margins will continue to decline. But, this is good for Shopify.

Shopify wants to provide its customers with more value so that they will continue to use the platform. Having payments integrated as part of Shopify's offering helps to keep merchants on the platform as they grow their businesses. The key benefits to merchants are that they don't need to set up a separate relationship to accept payments and they have a clear, up-to-date view of their business performance. This convenient feature is popular with merchants; as of the end of 2015, 83% of Shopify customers in the U.S. use Shopify's payment service.    
 
When customers sell more, they are likely to move up to higher priced monthly subscription plans to gain more tools and value from the Shopify platform. And a benefit to the merchant is their price per transaction goes down.

Image Source: Shopify.com

Shopify says the payments business has two benefits. First, it will likely drive higher customer retention rates and second, it is beneficial to operating margins. Retention is important for any business and especially for Shopify. Since merchants dedicate time and energy to set up with Shopify, if they decide to leave, the merchant has to do all of this set up again. This is commonly referred to as switching costs. When this happens, it's very likely that Shopify has lost this customer forever.

In the most recent earnings call, management also brought attention to the importance of merchant sales when discussing retention of new customers on the platform.

...the thing we find is if there is going to be people leaving the platform, generally it's because they are closing their business. And that happens within that sort of first three to six months period. Once you as a merchant start getting some sales and so time to that first sale is something that we are always looking at how do we improve that for the -- or help the merchant to improve that, the churn potential goes down significantly. 

In its most recent annual report Shopify disclosed that retention rates are best with its largest customers that sell the most -- those with the highest Gross Merchandise Volume, or GMV.

While our Basic and Professional plans are our most popular plans, the majority of our GMV comes from merchants subscribing to our Unlimited and Plus plans. Also, merchant retention rates are higher among merchants on higher-priced plans.
Merchant solutions revenue growth is the one number to watch. When this number grows, it's an indication that Shopify's customers are growing their businesses and are therefore more likely to stick with Shopify for the long term. 

The Foolish bottom line

Tobi Lutke, the Founder and CEO of Shopify, understands the challenges his customers face. Tobi and his co-founders started selling snowboards and became the first merchant to use the Shopify platform. Tobi wants to continue to build a simple and powerful e-commerce platform for the long term, as he stated in Shopify's filing to go public.
Shopify is exactly this: the only platform you need to build your empire. Shopify is the first thing our merchants log into in the morning and the last thing they log out of in the evening. It's at the heart of their business—a responsibility that we take very seriously.  
 
This is a prime example of how we approach value and something that potential investors must understand: we do not chase revenue as the primary driver of our business. Shopify has been about empowering merchants since it was founded, and we have always prioritized long-term value over short-term revenue opportunities.
Shopify's mission is to make commerce better for everyone. I love the fact that Shopify's business results are aligned with the success of its customers. Having Shopify's merchant solutions revenue grow means that Shopify customers are selling more -- and that's a good thing for Shopify.  
 

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Brian Withers owns shares of Amazon.com. The Motley Fool owns shares of and recommends Amazon.com and Shopify Inc. Class A Subordinate Voting Shares. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.