Exactly how profitable is Shopify after accounting for stock-based compensation?

After years of rapid expansion, the jury is out now on Shopify (STORE 0.67%) Stock. The e-commerce software giant is branching out into new areas to advance digital commerce for small businesses and entrepreneurs, but it’s costing a lot of money, not to mention diluting existing shareholders with equity compensation. Amid the mayhem, Wall Street punished this former market darling. Shares are down more than 80% from all-time highs reached at the end of 2021.

But how profitable exactly is Shopify? And is there an effective way to track its progress in terms of investor returns? Yes there is. Let’s dig.

Free cash flow is back on shaky ground

When I last wrote about Shopify after the Q2 report, I discussed what explained the company’s massive $2.68 billion net loss (according to GAAP or generally accepted accounting principles ) in the first half of 2022. In a nutshell, the problem is the company’s investments in Affirm Assets and Global-E onlinewho both took a hit and reversed their massive 2021 gains.

But that only tells part of the story, since stock market declines are listed as a non-cash expense. GAAP net profit or net loss doesn’t really tell the true profitability of Shopify’s actual operations. This is where free cash flow comes in. Free cash flow is operating income minus capital expenditures (cash spent on property, plant and equipment).

Over the past 12 months, Shopify has generated $58.8 million in free cash flow. This includes a negative free cash flow of $206.2 million in the first half of 2022. This is not a net loss of $2.68 billion, but a negative $206 million is not not great either.

This is a more recent trend for Shopify, as it started to achieve respectable free cash flow margins in 2020 and 2021 as e-commerce activity boomed at the onset of the pandemic. But all of a sudden, this trend has drastically reversed. For a company that made $5 billion in revenue in the past 12 months, why is it now operating in the red on a free cash flow basis?

The gears of innovation are turning forward

With many of the effects of the pandemic ending this year (namely people doing most of their shopping online rather than in person), Shopify was at a crossroads. He could have sat back and enjoyed the little empire he had built and started focusing on profitability. Or he could follow the playbook Amazon established during the 2000s and 2010s: Spend free cash flow, sometimes almost all of it, to promote After expansion. Shopify chose the second option.

Sales and marketing expenses increased by 62% in the first half of this year, and research and development increased by 81%. With revenue growth slowing to just 19%, this sharp increase in operating expenses is weighing on profitability. Shopify justifies this expense, as it sees many opportunities to deepen its relationship with merchants with new services. It’s also gearing up for a big push into logistics and order fulfillment with the building of Shopify Fulfillment Network (which will ramp up next year) and the acquisition of Deliverr.

These expenses include many stock-based compensation paid to employees, which dilutes the ownership of existing shareholders. Stock-based compensation has totaled $257 million so far in 2022, or about 0.7% of the company’s current market capitalization.

As free cash flow heads into negative territory for the whole of 2022, how can shareholders track growth progress while factoring in stock-based compensation? Use earnings per share. Even taking into account all those shares issued to employees over the years, Shopify’s returns using this metric have been impressive. And up until this year, the growth in free cash flow per share was also impressive.

Data by YCharts.

Of course, none of this will matter if the company doesn’t start making a profit again. Over the next two years, heavy spending to promote new services and build out its fulfillment business will likely limit free cash flow. As investors currently punish loss-making companies, Shopify shares may struggle to gain traction. But if the company can jump-start revenue growth, there’s still a lot of value to unlock here in the long run. However, it will take patience.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a board member of The Motley Fool. Nicholas Rossolillo and his clients hold positions at Amazon and Shopify. The Motley Fool holds positions and recommends Affirm Holdings, Inc., Amazon, Global-e Online Ltd. and Shopify. The Motley Fool recommends the following options: $1140 January 2023 Long Calls on Shopify and $1160 January 2023 Short Calls on Shopify. The Motley Fool has a disclosure policy.

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