Ron Shuttleworth

The Eaton's Catalogue, an analog precursor to Digital Commerce? During this crazy year it has been evident that there is a new emerging sector of strength in the Canadian technology space. It’s not Artificial Intelligence, although there are a lot developer skills residing there. Mobile, gaming, blockchain, fintech and cannabis have all had their day in the sun and Canadian strength in telecommunications remains solid. But investors are now finding a new sector muscling onto the scene delivering enormous returns. Over the past several years, and culminating with the current pandemic crisis, Canada has emerged as a significant player in Digital Commerce. Increasingly, online shopping and all the magic that happens behind the scenes to get a product from your screen to your doorstep is being facilitated by Canadian tech companies. It is obvious that Shopify has become a world leader in digital commerce, to the point where it is beginning to challenge the hegemony of Amazon. Clearly, arming the rebels is a good strategy. Increasingly, there is more to the #cantech Digital Commerce story than Shopify alone, and more opportunities to derive outsized shareholder returns in the future. Unlike some recent emerging investment opportunities like blockchain, cannabis, AI and cybersecurity, these digital commerce opportunities are entrenched because of several sustainable market advantages. Let’s dig in. First, this is a meaningful segment. The eleven public markets constituents that we have identified as being part of the Digital Commerce group have an aggregate market cap of $190 billion or 67% of the total market cap of the entire Canadian Tech Sector. Separately, this Digital Commerce group would constitute the seventh largest sector out of twenty on the TSX, and ahead of the remaining InfoTech sector. Although Shopify represents about 85% of that total, the remaining $30 billion of market cap of the remaining 10 stocks cannot be dismissed. If we were to temporarily remove Shopify from the equation, the remaining ten Digital Commerce stocks would represent 25% of the market cap of the entire InfoTech segment, which includes 281 issuers (again, removing Shopify). Total revenue generated by these 11 companies is over $4.2B with NTM growth forecasted to be 38%. Investors should be confident that the opportunity is not going anywhere soon. Second, there is enormous domain expertise and history in the sector. Most of the public companies in the Digital Commerce cohort, including Shopify, have been around for a decade or more and have built significant market credibility. In addition, there are dozens of other meaningful privately held Canadian vendors that participate in the sector. As a result, plentiful retained local expertise exists in cities such as Toronto, Montreal, Vancouver, Kitchener-Waterloo and Ottawa. To provide some context, according to Computing Technology Industry Association (CompTIA) in August 2020, there are now approximately 1.7 million tech workers in Canada, with about 280,000 working in Toronto alone. Since 2016, when according to a Brookings Institute report published in January 2020, there were approximately 1 million tech workers, a significant inflow of capabilities has come from local STEM programs, and from skilled worker immigration. As the pandemic created surges in demand, access to ample local expertise helped these companies better handle it, and more importantly to shareholders, deploy capital efficiently to capture demand compared to competitors from elsewhere. Geographically, Canada’s long and complicated domestic and transborder supply chains has created a history of forced innovation as shippers have struggled for decades to capture adequate margins. These conditions contributed to the emergence of software solutions that have been the focus of companies like Descartes Systems (Descartes Systems Stock Quote, Chart, News, Analysts DSG-TSX), Tecsys (Tecsys Stock Quote, Chart, News, Analysts TCS-TSX) and later Kinaxis (Kinaxis Stock Quote, Chart, News, Analysts KXS-TSX). Each now plays an important role at various positions within global supply chains that drive digital commerce. Due to a history of catalog mail order shopping (Hey there, Eatons!) and strong adoption of electronic banking (shoutout to Interac), Canadians were aggressive early adopters of online commerce as the industry emerged in the late 1990s with Amazon, eBay and thousands of other mostly American consumer sites. Traditional Canadian retailers attempted to create their own online presence but failed because, by comparison to American counterparts, access to innovation capital was weak, and economies of scale were nearly impossible to reach. Similarly, with limited consumer brand management skills, and lack of access to adequate formation capital, online consumer shopping startups also failed. Lack of venture capital also failed to stop graduating software engineers from prestigious Canadian universities from emigrating to The Valley to make their fortunes, so there was also a chronic lack of developer depth locally. To adjust to limited capital pools, successful entrepreneurs focused on exploiting inherent strengths resulting from an entrenched “branch plant” culture – business-to-business technology and, most importantly, associated local commercialization skills. And it was quite a run. From Research In Motion to Open Text to CGI and a plethora of Nortel/Mitel spinoffs, the Canadian tech industry began to thrive. To this day, the Canadian focus on B2B technology during the early stages of the internet revolution informs the success of the sector today. Of the approximately 79,000 technology companies operating in Canada, more than 99% of them sell primarily to enterprises and SMBs. This underlying culture of B2B in the Canadian tech industry forms a straight line to the current global success of Canadian Digital Commerce vendors right now, including Shopify. Every single Canadian Digital Commerce vendor supplies the enterprises and SMBs with the tools to be successful B2C brands locally and worldwide. The apparent “genius” and “audacity” of Shopify to “arm the rebels” is inherently Canadian. It is in its nature and should not be surprising. As Canadian vendors become more recognized within the Digital Commerce space, some are beginning to be valued similarly to peers in the US. Apart from some historical outliers like Nortel and RIM, this trend is a relatively new phenomenon, and not only in the Digital Commerce segment. Historically, there has been a prevalent Canadian discount of between 20% and 30% in relative valuation among international tech sector peers, usually regardless of market sector. For the most part, these discounts have been highly subjective due to conservative equity research practices, opaque business models, lack of profile, and capital markets ambivalence. We think that these conditions are changing. The dominance of the SaaS licensing model has created a type of global standard practice that has helped to reduce some of the reporting opacity that hurt Canadian B2B companies in the past. After the collapse of parts of the extraction industry earlier in the past decade, domestic investors began to pay more attention to the technology sector after nearly a decade of ignoring it. Similarly, the Venture Capital market attracted more institutional support, and along with US VCs looking for better risk profiles, simply provided more scaling capital for early stage companies to IPO on both Canada and US exchanges with more heft, which helped companies like Shopify, Lightspeed (Lightspeed Stock Quote, Chart, News, Analysts TSX:LSPD) & Kinaxis among others to deliver sustained post-IPO success. At the same time, Canadian exchanges upgraded policy & reporting policies which helped to diminish perceived risks by international investors, further strengthening the potential investor base. Canadian technology sector has never been healthier, and the Digital Commerce segment is particularly robust. This leads to relative opportunities within the space, and also creates a basket of opportunities that captures returns throughout the Digital Commerce value chain, and across market cap stratification. For example, SHOP and LSPD investors could fill out their position by adding lower-multiple TCS to portfolios to capture additional value in the supply chain, especially related to healthcare. Alternatively, investors in DSG could capture potential in the sector by adding a position in lower-multiple MDF (MDF Stock Quote, Chart, News, Analysts TSX:MDF) which has emerging strength in enterprise-level online ordering, especially in the grocery segment. Investors in TCS and DSG could use We Commerce as a proxy to get access to unrealized returns within the SHOP ecosystem. The point is that the portfolio combinations within the group are nearly endless to maximize returns and momentum themes. And there are more coming. Emerge Commerce, We Commerce, and soon, FoodX represent depth opportunities for investors to diversify further. Increasingly, Digital Commerce is becoming non-linear. Consumer brands are increasingly being empowered to bypass traditional retail channels and affect continuous buying patterns essentially on their own. We have added junior listed companies Datable (Datable Stock Quote, Chart, News CSE:DAC) and Wishpond (Wishpond Stock Quote, Chart, News, Analysts TSXV:WISH) as examples of marketing automation platforms evolving towards transactional systems, which induce customer transactions. These are examples of emerging, well-supported business models that enhance online consumer demand. These stocks should also form part of the Digital Commerce basket to capture the broadest aspect of the segment. So, here is the takeaway: If an investor were prescient enough in 2019 to own the basket of Digital Commerce stocks identified, and also buy the IPOs earlier this fall, the combined return would be 123% with 135% return for the primary constituents, and 104% for the junior stocks. For the most part, these companies are battle-tested and excellent at what they do so operational risks are relatively low. There is some market risk that, once a vaccine is distributed enough to enable a return to normal social interactions, online commerce will decline. Based on the outlooks that we are hearing from constituents in the group, the digital commerce shift is relatively permanent, and simply accelerated by three years. As a result, although investors should not expect huge leaps in future usage, they should expect accelerated investment in improving online experience and maximizing returns on the supply chain. In addition, some of the constituents of this group retain relatively modest multiples compared to peers, so despite the significant returns of 2020, there is probably room for more in 2021. Disclosure: Oak Hill has three clients identified in the group: Tecsys, mdf commerce, and Datable and the company has a stock position in Datable.

Ron Shuttleworth

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