Shopify's Huge FCF Margins Imply SHOP Stock Could Still Have Upside

Last week Shopify Inc (SHOP), the online selling platform, announced excellent Q2 results with huge free cash flow (FCF) generation and high FCF margins. These imply that SHOP stock could still have a substantial upside, as much as 28% more. 

SHOP is trading at $74.71 in midday trading on Friday, Aug. 16, up substantially from when Shopify released its Q2 results on Aug. 7. The day before it closed at $54.22, so the stock is now up over $20 or 37.8% in the past week and a half.

But it could still have more upside over the next year, based on an analysis of it strong free cash flow (FCF) and FCF margins. I project that SHOP stock could be worth over $95 per share, +28% in the next 12 months. This article will explain why.

Strong Q2 Results

The latest quarterly results showed that people are increasing their shopping at Shopify and its sites. The online selling platform generates fees from its online sellers that use its hosting services, its fulfillment platform (inventory placement and shipping to customers), and other revenues.

As a result, Shopify's gross merchandise volume rose 22% YoY during the quarter, sales were up 21%, and its free cash flow skyrocketed to $333 million, up 3.4x from $97 million. More importantly, its FCF margin (i.e., the percent of sales that FCF represented) shot up over 16% from 6% a year ago.

For example, the $333 million in FCF was 16.3% of the $2.045 billion in sales for the quarter. That means that after all its cash expenses, including capex spending and even net changes in working capital cash flow, over 16% of each revenue dollar went straight into its bank account.

Moreover, the company said it expects its Q3 sales to continue to grow at a rate equal to 20% to 25% on a YoY basis. In other words, its FCF margins are likely to stay strong.

This has huge implications for the value of Shopify stock going forward.

Setting a Price Target Based on FCF

One way to see this is to look at analysts' ongoing revenue forecasts. Seeking Alpha shows that 41 analysts project sales this year of $8.63 billion and 47 analysts forecast 2025 sales of $10.39 billion.

That means they project 21.5% revenue growth this year (up from $7.1 billion in 2023) and 20.4% in 2025. Last year the company generated $905 million in FCF, an FCF margin of 13%.

So, if the company can continue to generate 16% FCF margins going forward, this implies that its FCF could rise to $1.38 billion (i.e., 0.16 x $8.63b). And next year, using the same FCF margin, FCF could reach $1.71 billion (i.e., 0.16 x $10.39b).

That means that over the next 12 months (NTM), its average FCF could be $1.545 billion (i.e., (1.38b +$1.71b)/2).

So, if the market values Shopify stock on a 1.0% FCF yield basis, as it has done in the past, this implies the market cap could rise to $154.5 billion (i.e., $1.545b/0.01). Even using a 1.25% FCF yield metric, results in a projected market cap of $123.6 billion (i.e., $1.545b/0.0125).

This is 28% higher than the stock's existing market cap of $96.59 billion. In other words, SHOP stock could be worth 28% more than $74.71, or $95.63 per share sometime in the next 12 months.

Shorting OTM Puts as an Income Play

Shopify does not presently pay a dividend. One way existing shareholders can generate income while they wait for the stock to rise is to sell short out-of-the-money (OTM) put options in nearby expiry periods.

For example, look at the Sept. 6 option expiration period, 21 days from now. It shows that the $71 strike price put option, which is over 5% below today's price, trades for 83 cents on the bid side.

That means that any short seller of this put strike price can make an immediate yield of 1.17% (i.e., $0.83/$71.00). And keep in mind that the short-seller of these puts will not have an obligation to buy 100 shares of SHOP stock unless it falls to $71.00. Even then, the breakeven all-in cost will be $71.00-$0.83, or $70.17, which is over 6.4% below today's price.

SHOP puts expiring Sept. 6 - As of Aug. 16

For more risk-averse investors, it may make sense to short the $70 strike price puts. That trades for 63 cents on the bid side, providing a 0.90% yield to the short-put investor.

Keep in mind that every three weeks the investor can repeat this trade. As a result, assuming the stock stays flat and the $71.00 strike price play continues to yield 1.17%, an investor stands to make an expected return of 4.68% every quarter (i.e., 1.17% x 4).

That is a very high yield for most investors and shows that this is a good way for existing investors to wait until SHOP rises to its target price. The bottom line is that SHOP stock still looks undervalued here.

On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.