The puzzling silence at e-com darling Shopify

Technology star’s response to allegations from Citron Research has been anemic

At one level it’s easy to see why Shopify adopted a low profile following allegations from Citron Research that its share price is overvalued and its marketing practices “illegal”.

Ottawa’s e-commerce technology star just last week closed the books on its third quarter and is therefore constrained in what it can say publicly until the results are published in three or four weeks.

Even so, Shopify’s response to Citron managing editor Andrew Left’s incendiary attack was surprisingly anaemic.

“We vigorously defend our business model and stand resolutely behind our mission and the success of our merchants,” the company wrote Thursday morning on its website, buried inside the investor relations section.

No one signed the message, which is odd for a young company built by entrepreneurs whose integrity has been mauled.

Undoubtedly this was a calculation involving multiple trade-offs.

For one thing, chief executive Tobi Lütke and his fellow executives and board members are well aware that their company’s stock is expensive. They may well take issue with Left’s argument that Shopify shares were trading at twice their real worth, but Left is entitled to make it.

Shopify’s top seven executives — including Lütke, chief creative officer Daniel Weinand and chief financial officer Russ Jones — combined have sold more than $140 million U.S. worth of shares in the past two years, most of them considerably below the current price.

Even after Shopify’s share prices plummeted to $126.19 Thursday on the TSX, from $145.70 at the close on Tuesday — a two-day loss of $1.9 billion in market value — they were still expensive by conventional measures.

For instance, Shopify shares are now trading at roughly 15 times revenues — in an industry in which a ratio of 10 times revenue is considered high.

Investors in Shopify justify paying a premium because the company’s revenues are growing so quickly.

Shopify is expected to post sales of roughly $650 million U.S. this year, up 67 per cent year over year. Independent analysts are forecasting revenues the following year of $907 million U.S., along with profits.

Provided growth keeps coming, Shopify’s share values should eventually move into more conservative territory.

But will the sales growth persist? This is where we get into the heart of Andrew Left’s allegations — namely, that Shopify is relying on thousands of third-party affiliates who use misleading tactics to promote the use of Shopify’s technology to online merchants for a cut of the proceeds.

Paying for referrals is common in business. The issue is whether Shopify’s affiliates are misrepresenting the business opportunity. Citron Research points to Shopify’s use of social media, particularly Facebook, in which it holds out the possibility to would-be online merchants of becoming millionaires. Left also has difficulty with the notion that Shopify is helping some merchants find stuff to sell, viewing this as a “get rich quick” scheme, not a legitimate online business.

Shopify’s basic premise is that nearly anyone can become an online merchant with the right tools — and Shopify provides the latter. Shopify charges smaller merchants anywhere from $9 to $299 per month for the basic online sales platform. Larger customers pay up to $40,000 per month for the premium service. These subscription fees account for nearly half of Shopify’s total revenues.

The company generates most of the rest of its revenue through the sale of applications and services to merchants once they are in the system.

Citron Research has taken aim at Shopify’s subscriber base, which contains more than 500,000 online merchants. About half of the new additions each year come through referrals from Shopify’s affiliates. This is the part of the Shopify ecosystem Citron managing editor Left thinks is “dodgy”.

It’s certainly the case that Shopify and its affiliates have been aggressively courting new customers and encouraging people to become online entrepreneurs. Whether this has veered into illegal behaviour is unclear based on the evidence presented by Left. Nor is it his call to make.

Further, Left seems to be missing the bigger picture. Several quarters ago, Shopify stopped referring to the number of online merchants in its investor presentations — not because the numbers were suspect but because they didn’t reveal much about the company’s underlying worth.

Ronald Bookbinder, an analyst with IFS Securities pointed out in his extensive report two months ago that just 2,500 of Shopify’s merchants — its largest ones — accounted for 18 per cent of the total subscription revenue. Since Shopify shifted its marketing focus to large retailers last year, the relative importance of new online entrepreneurs to the firm’s revenue base has been falling.

So why doesn’t Lütke lay out the facts based on historical company data in an effort to refute Left’s claims?

Part of it may simply be a reluctance to take on a shareholder activist with a record of taking on giants such as Valeant Pharmaceuticals. In the age of Twitter, you don’t want this guy as your long-term enemy.

Shopify declined an interview request but undoubtedly its lawyers have advised Lütke to wait until the end of the October, when Shopify is expected to unveil financial results for its third quarter, which ended Sept. 30. Since it first issued shares to the public more than two years ago, Shopify has not disappointed its investors. If the same holds true for the third quarter, that would help to alleviate some of the damage done to Shopify’s reputation.

During its first 30 months as a public company Shopify has had a very smooth ride. By running up its revenues and share price so quickly, it inevitably became a target. Left just gave Shopify an introduction to the bigs.