Canadian success story is 'extremely overbought'

With Canada under lockdown and being fed a daily news diet of COVID-19 fatalities, a Nova Scotia mass shooting and, ahem, a U.S. president who advocates drinking disinfectant, good news is the equivalent of finding one of Willy Wonka’s golden tickets.

That partly explains the excitement last week at the news Shopify, an e-commerce software company based in Ottawa, had become the country’s second-largest company by market capitalization. Its value surpassed $100 billion, beating all the Bix Six banks except RBC, which is now firmly in its sights.

Shopify allows businesses to quickly and easily set up and maintain an online store, allowing it to compete against the all-conquering beast of Amazon. Recently, it has expanded to provide tools in payments, inventory control and shipping. Shares surged 65% over the past month, even beating headline-grabbing Zoom, which for all its popularity has been hit by privacy and security concerns.

However, there are warning signs. Despite growing by more than 40%, Shopify’s revenue in 2019 was less than $8 billion and had operating losses of more than $140 million. An ambitious firm, it is pouring cash into development but one portfolio manager said investors should be cautious of this homegrown success story.

Nick Mersch, portfolio manager at Purpose Investments, said it is “extremely overbought” and reflects the lack of viable alternatives in the Canadian tech space.

He said: “The tech space in Canada has been historically lacklustre. Investors have been searching for a star since the fall of Nortel and Blackberry. Shopify is Canada’s best shot at the big leagues in quite some time.

“Unlike roll-up or service firms like Constellation and Opentext (good companies in their own rights, but more conservative in strategy), Shopify is growing quickly and heavily reinvesting cash flow in order to capture an outsized opportunity.”

His reference to Nortel and Blackberry will ring alarm bells for many. Amber Kanwar, business anchor at Canada’s BNN network, captured this sentiment in a tweet that pointed out how the number one market cap position in Canada has often been a poisoned chalice. Blackberry’s slide is well known, while Nortel suffered Canada’s largest bankruptcy case and Valeant Pharmaceuticals was struck down by fraud allegations and criminal investigations.

While Mersch, who works on Purpose’s Global Innovators Fund, applauded Shopify’s cultivated image as the anti-Amazon, enabling smaller businesses to compete, he believes it has short-term problems amid the impact of COVID-19.

“The goods provided by these digital small businesses are niche purchases that are nice-to-haves, not need-to-haves. As more jobs and consumers are affected by the coronavirus, disposable household income starts to shrink.

“Consumers then shift their spending towards groceries and essentials, creating a demand problem for Shopify merchants. To make things worse, the average small business has a median cash buffer of just 27 days.”

With that in mind, he said that while Purpose believes in the long-term prospects for Shopify, its current position is too elevated. He pointed to the fact the stock now trades over 30x EV/Revenue versus software peers averaging below 10x EV/Revenue, while, from peak to trough over the pullback, it fell 41% only to surge 95% in the span of 25 trading sessions. Mersch said it's difficult to justify this performance in the face of economic headwinds.

He said: “The US continues to have a much broader market for growth stocks, particularly in tech. In the Purpose Global Innovators Fund, we are focused on the stay-at-home portfolio that wins in a prolonged period of social distancing and well after a return to normal.

“Our holdings in this theme include Activision, Zoom, Peloton, Slack and Everbridge. We also have a high concentration in software companies with large net cash balances, strong free cash flow and defendable moats. Our holdings in this theme include Microsoft, Salesforce, Adobe and Servicenow.”