SHOP: Shopify Capital

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In Q3 2016, SHOP began to give cash advances to merchants. Here’s a recent Seeking Alpha write up on it.

https://seekingalpha.com/article/4083119-shopify-capital-ret…

Here are my thoughts on it.

*SHOP has visibility into the online sales of their merchants so they will be able to make prudent underwriting decisions.

*SHOP will earn a return on these loans to their merchants.

*SHOP’s merchants will likely increase their gross receipts when they have more working capital to investing in their business. SHOP gets an extra cut of this incremental revenue.

*SHOP’s relationship with their merchant customers will be enhanced due to SHOP’s Shopify Capital program.

*SHOP recently raised $560M in a stock offering. This cash can be put to use through Shopify Capital.

The growth of Shopify Capital can be seen by looking at SHOP’s balance sheet. In looking at the past balance sheets and the extra info provided on today’s earnings call gives us view into the VERY rapid growth of Shopify Capital. The line item on the balance sheet is called “Merchant cash advances receivable, net”. You will also notice that the Cash Flow from Operations (CFFO) is affected negatively by changes in the Merchant cash advances receivable, net balance; this will probably make CFFO negative for the foreseeable future but it should be backed out to get an accurate view of how the operations are progressing. The aggregate cash loans to merchants will grow over time but assuming that the underwriting is good it shouldn’t be a probably. Also, SHOP told us that the Canadian government insures these loans so the risk of loss is minimal.


          Merchant cash advances receivable, net ($M)
Q4 2015    0
Q1 2016    0
Q2 2016    0
Q3 2016    9.099 (Shopify Program started in this quarter)
Q4 2016   11.896
Q1 2017   17.337
Q2 2017   32.839
7/31/17   ~40** (see below)

**(In the second quarter, Shopify Capital issued $37.2 million in merchant cash advances, nearly twice the amount issued in the first quarter. Since its launch in April 2016, Shopify Capital has grown to $86 million in cumulative cash advanced by June 30, 2017. This figure climbed to more than $95 million by July 31, 2017. (from the Q2 2017 earnings press release) IT’S GROWING FAST!!

Russ Jones (CFO) on the call:

Yeah. In terms of the Shopify Capital, for a lot of our merchants, it is very difficult, if not in some cases impossible, to get working capital financing. And so, I think that we’re meeting a real need there. And again, although it’s its own revenue contributor, I think the bigger value is that it’s helping these merchants expand their businesses, which we also then participate in through things like Shopify Payments. We’re seeing a number of these merchants who paid off their first, second, sometimes now up to fifth advance, they’re looking to refresh that. I expect as we sort of get ready for the Black Friday, Cyber Monday holiday period, you’ll see more advances as they want to sort of build up their inventory for that side. So, I think using the tools that we now have at our disposal, as Tobi talked about, like machine learning, it’s really allowing us to make sure that we’re providing the merchant with the right proposal at the right time and making sure that we’re not taking on new risk. And further to that, the fact that these have been insured almost for 12 months really reduces our exposure.

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This concept of taking the place of a bank as a source of capital is in place for Square and Mercado Libre (MELI) as well, and seems to be working well for all 3 companies. The visibility that each of these 3 companies have into the workings of those on their platforms has to help them stear clear of overly risky loans.

I own some MELI and SHOP, with Square on my watch list (Baozun too, as the “Shopify of China” per some).

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Hi,
I am happily long SHOP. It is a substantial position for me and I have been in long enough to enjoy some of the bigger returns. Having said all of that, I come from a commercial banking credit background. I urge my fellow posters not to sleep on SHOP capital. This business can pose a larger risk than people think, even if the Canadian govt backs the loans. Has anybody looked into the details of that arrangement? What people have to keep in mind is that at some point the credit can act like a drug. SHOP needs more merchants/more revenue, extend more credit. Sales people there are under pressure to make a quarter-extend more credit. After all, they 2 years of sales and receivable history from their clients during a stable economy-what could possibly go wrong? And what happens when we enter a recession? They are going to want to squeeze all of their customers when they are already struggling? It is a real dilemma. And the info they have may make them over confident in their ability to predict future credit quality.

Many financial institutions throughout history have gotten into trouble doing activities that in a stable economy seemed almost risk less. Oh, by the way, any chance regulators may decide to stick their noses in if this credit book gets to big? You can have lawsuits.

Long/short, do not view this as upside only activities. It is something to watch.

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Many financial institutions throughout history have gotten into trouble doing activities that in a stable economy seemed almost risk less. Oh, by the way, any chance regulators may decide to stick their noses in if this credit book gets to big? You can have lawsuits.

Long/short, do not view this as upside only activities. It is something to watch.

Treepak,

It’s definitely something to watch. A few things make me feel ok about what they are doing:

  1. They will spread out the loans to many, many merchants.

  2. The disbursements will also be spread out and the payback times are short.

  3. They will use the merchants’ business metrics using machine learning so if this is done right they will be able to not only manage risk but also detect any systemic issues with the program.

As of July 31, 2017, SHOP had made loans of about $95M yet their balance sheet only has ~$40M (my estimate) in receivables. That means that they have received payback of $55M (not including interest).

The important thing is that these are short term advances that will be paid back quickly. I think this fact reduces the default risk.

Chris

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Shop is not a bank. Unlike a bank Shop will not be lending out multiples of other people’s money. Any losses for SHOP will be in the cash pile shop has and can be a one time write down. So the risk is not the same to bankrupt and possibly to jail risk that banks take w bad loans. Different animal.

Tinker

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Tinker
Yes and no. The truth is these things depend on how good the controls really are at the company and what the company perceives to be the back stop from the government. Again, desperate times can lead to desperate measures. If things get bad, business slows and they think they are back stopped by govt, who knows.

Overall, GouchChris and you make valid points. But, you need to remember that the funds don’t really come out of one person’s pocket. You have shareholders that fund this, a govt to backstop. You can’t anticipate what could happen in a recession or if the company has problems.

For now, not a reason to dump the stock. Something to be mindful of in my opinion.

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Tinker
Keep in mind, the investment banks and mortgage loan companies were not risking bank deposits when they collapsed. It was the same capital market financing that SHOP accesses. They use equity. The other institutions also used equity, debt and the securitization markets. It’s all capital markets funding. The management isn’t opening its wallet to fund this stuff.

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Treepak,

I am not aware of the mechanism for financing for those loans. SHOP has nearly a a billion in cash and a small portion of this is sufficient for the product.

If SHOP is going to the financing markets for the money, that would not be good business. That would make SHOP a reseller of other people’s money. They would need to borrow and pay for the money and relend it at higher rates. Pretty much the same thing Square does, but at a smaller scale at the moment.

IF SHOP is acting like a bank instead of with cash on hand, then that is a totally different matter that could get out of hand at some point. Not something of an issue now as you say. But worth looking at the financial mechanism SHOP is using.

These small business loans are also more dangerous than they seem. Just because a small business can make 3 or 4 payments does not mean they will pay back their 5th tranche of loans. Often times a small business will take out loans out of desperation to stay in business and not just to fund inventory for seasonal purposes. Out of desperation a small business can make it look like revenues are fine, but each tranche becomes more and more difficult to pay back.

Not my favorite part of their business. Worth looking into the details more. But for now it is not a material thing. They are just putting their toes into the water.

Tinker

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I agree. I think it is something that would make me a little more trigger happy if it seemed that we were heading for an economic slowdown then if they were not in this business at all. Anyway, thinks are good now and I am holding.

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Just because a small business can make 3 or 4 payments does not mean they will pay back their 5th tranche of loans.

My understanding is that it’s more like a cash advance than a loan. I don’t think they make payments like a loan but rather a percentage of their future sales is automatically deducted to pay down what they owe SHOP. This reduces the risk because the merchant can’t choose to pay other expenses first rather than repaying SHOP first.

Chris

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That’s how Square does it through its Square Capital program too, Chris. Payments of the loan are automatically deducted from each transaction of the business.

Matt
Long SQ

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RE: Concerns expressed on this board earlier this week re: Loans. TMF article refers to pilot program where SHOP makes loans to sellers to make to their customers. Also refers to new SHOP Credit card that is accepted wherever VISA is accepted.

…One particularly impressive area is Square’s business lending business, Square Capital, which offers loans to business owners based on their revenue history with Square, and automatically repays the loan with deductions from the merchant’s card payments.

During the second quarter, Square Capital made more than 49,000 business loans totaling $318 million, which is a staggering 68% more than it made in the same quarter a year ago. And there may be significant expansion potential ahead. In addition to just making business loans, Square recently rolled out a pilot program called Square Installments, which a seller can use to allow its customers to finance purchases over several months.

The Square Cash Card, the physical version of Square’s Cash peer-to-peer payment platform, was also rolled out in June, allowing users to spend their balance wherever Visa cards are accepted. Square’s goal with this is to build an “ecosystem of services” for individuals, similar to the one their payment-processing platform has provided for businesses.

These are just a couple of examples of Square’s promising businesses that could drive growth even higher. In addition, Square has lots of international expansion potential.

https://www.fool.com/investing/2017/08/03/square-earnings-sh…

sjo

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Yes, it’s one thing to watch in the future, but I just don’t share the concern about the short-term loans. It’s not like SHOP is slowing down and desperate for new business, so that idea doesn’t even enter in my view. In fact, I see the credit “side venture” as just another (huge, smart, overdue) confirmation point, confirming once again just how seriously focused us SHOP on doing whatever they need to do to make sure their customers (and their customers’ customers) have every possible tool needed at their disposable. Can you say building loyalty? Compare that to the resentment, distrust and distaste so often conferred on banks.

• The average right now is roughly $6,500 per borrower, not that much, although of course no one wants them to lose it either.
• It is terribly difficult for a new small business to get credit, even if they have a great business plan and a good (albeit short) track record of financing their business.
• How many wee businesses actually fund with owners’ credit cards? Shame on banks for offering only loans garnering interest at 25-30% for small businesses. What ever happened to usury laws?
• SHOP has an opportunity to fill a tremendous need here that is long overdue for small businesses.
• I don’t think SHOP is making these loans just to “get more business.” Do they look desperate with their growth numbers? Have they done anything so stupid so far?
• I trust that a management team smart enough to deliver such great products to their customers and ramp up the scale with such few serious problems as has SHOP, is certainly smart enough to keep a sharp eye on credit extended to their clients. Maybe I’ll eat those words some day, but I don’t think so.
• As far as what happens to their credit function in the case of a recession, I would repeat the above statements.
• If you want to set the world on fire, if you want to disrupt your field, you don’t do everything the “accepted” way—you invent new ways, just like this.

It will be interesting to see what their loss rate will be for the credit portion of the business going forward. If it is anything more than 1-2%, I will be very surprised and very disappointed. Then again, I own Mastercard and Visa is once again on my watchlist so maybe my pain tolerance is too high. But If done right, credit can be a very attractive business, and so far I think the SHOP team has shown all the right indications of having a well thought out plan and a well controlled system for vetting clients before extending credit.

Yes, I fully realize that I could be wrong, but then my whole thesis on Shopify would be proven wrong and the investment would surely blow sky high. I just don’t see that happening. I see a pile of profits. Of all the things that are wonderful to see and hard to fake, high on the list sits cash in hand, and SHOP already sits on a pile of it. Better still, I think they’re just getting started.

I know I sound like a cheerleader for Shopify. I don’t mean to and I dislike cheerleaders for stocks. It’s just so rare that I see a company doing everything** exactly like I want them to, that I feel compelled to speak up. I admit that I often own shares of companies, and that’s the way I feel about them. They’re all on notice that they must behave or be gone. While owning SHOP for only a few months, I feel for the first time in a long time that I want to own the company. Does that make sense?

SHOP, don’t you dare let me down.

Dan

** almost everything. To balance the scale, I will say that I will be watching very closely for dilution of my few shares. Give employees a gold star for good work. Give them a raise, take them to lunch. Do not give them my company. They can buy shares in the same market as the rest of us if that’s their desire.

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Many financial institutions throughout history have gotten into trouble doing activities that in a stable economy seemed almost risk less. Oh, by the way, any chance regulators may decide to stick their noses in if this credit book gets to big? You can have lawsuits.

Long/short, do not view this as upside only activities. It is something to watch.

Treepak,

Just read the following in SHOP’s 2016 annual report:

We have mitigated some of the risks associated with Shopify Capital by entering into an agreement with a third party to insure merchant cash advances offered by Shopify Capital.

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Dan
I appreciate your response. And again, I am saying that this concern is not something that is keeping me out of the stock for now. I have a large position. But, you also are missing the point of my point. Obviously, right now in a stable economy and still early in its growth cycle, SHOP is obviously not desperate for growth. And, I am sure right now they aren’t doing things that look stupid in lending. But as I said, data points based solely on time frames of economic stability are fairly worthless in predicting outcomes during recessions when it comes to capital markets activities.

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GauchOChris
Almost every financial institution in the country entered in third party insurance contracts to insure the cash flows from their CDOs, ABS and MBS’s. How did that work out? That statement is absolutely meaningless unless you can analyze the condition and activities of the third party. Even the blessings of the ratings agencies on these third parties turned out to be fraudulent.

Anyway, I’ll move on from this issue. I do believe it will be something to keep an eye on.

Thanks

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… data points based solely on time frames of economic stability are fairly worthless in predicting outcomes during recessions when it comes to capital markets activities.

Hi Treepak,

Agree 100%. However, the same could be said about everything regarding Shopify. No one knows what the transition will be like for them in a downturn; we can only imagine. But with their cash pile building as it is, I just don’t see their small loans as a focal point for worry. On the other hand, what will an economic downturn do to their sales, to their income? This isn’t retail, after all, but then again, it’s not that far away from retail either. Will people flock to Shopify to start a small business when they get laid off in a recession, or will they stay home and wait for better times? I don’t know.

Take care,

Dan