When Square, Inc. (NYSE:SQ) came out with its card reader that plugged into the headphone jack of a smartphone, it seemed as though this little dongle had the potential to disrupt the entire electronic payments industry. Companies as large as Starbucks to individuals wanting to accept credit or debit cards at their garage sales jumped at the opportunity to process payments utilizing Square, Inc.'s platform. Hairdressers, cupcake shops, flea markets or even people just exchanging items listed on craigslist, the future was clear, the days of cash-only transactions looked numbered. Companies such as VeriFone Systems, Inc. (NYSE:PAY), Intuit Inc. (NASDAQ:INTU), Shopify (NYSE:SHOP) and PayPal Holdings, Inc. (NASDAQ:PYPL) were quick to bring their "me too" devices to the market. Overnight, consumers had dozens of choices between platforms to accept credit and debit cards. With the moat around smartphone payment processing devices breached, companies started to compete against Square, Inc. the most obvious way, on price. Although Square had a running head start, investors took a deeper look at Square, questioning whether it was the disruptive payment company they had been sold.
The inclusion of fingerprint readers on smartphones allowed Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) to build Apply Pay and Google Wallet. These technologies would allow consumers to leave their cards at home turning their smartphone into a virtual wallet, further cutting the need for Square's services out of the picture. Not only were all these developments a negative for Square's core processing solution, the pace they were coming to market was brisk compared to how the payments industry had progressed in the past. Square was in an inopportune situation; it had sold itself as a high-growth tech company but found itself getting attacked from all angles. Square's gross payment volume was growing at a respectable 42% YoY (year over year). However, competitive pressures meant it just wasn't seeing that growth transfer to the bottom line. Even though it processed $12.5Bn in gross payment volume, it still lost $27mm in the most recent quarter Q2, 2016 (Source: squareup.com). Square needed another growth driver, preferably one with higher margins.
Enter Square Capital, the division used Square's credit card processing data to identify potential businesses that might need additional capital in the form of a loan. It also used this same data to determine that the companies it was thinking about lending to had the ability to service that debt. It was a slick platform, taking the two hardest parts of small business lending origination, marketing to clients and then discovery on those clients. When a bank makes a loan to small businesses, if it doesn't already have a relationship with that business, it needs first to get the client to walk into their doors or contact them via phone, email, etc. Then it needs to dive into the businesses tax records, income statement, balance sheet, receipts, etc., figure out sizing and the terms of the loan that particular business could afford to hold on its balance sheet while making the necessary installment payments. Square already had clients using the Square platform to process a large portion of their revenue; it also had much of the information a lender would need to underwrite a loan already on its platform if they had been with Square for some time. In fact, Square wouldn't even need a human loan officer for many of the smaller loans it might extend; a computer could just crunch the data and immediately extend loans to clients that qualified directly through the Square app.
Extend these loans Square did; it's how the majority of its clients found out that Square could even provide capital. They got to work one day, opened the Square App and discovered Square was offering a $5-100k loan to them. The business could apply for the loan paperlessly right in the Square app. Small business loans are often unsecured. Unsecured means there is no collateral backing the loan. Collateral for small biz loans can come in form as real estate, expensive equipment, accounts payable or even the inventory itself. A popular method of getting around the unsecured nature of these loans has been for lenders to take over the credit card processing of the small business it is lending. They would then work out an agreement on how the loan is paid back utilizing these credit card receipts. For example, a firm who borrowed $50k and had on average 20k of monthly credit card receipts might work out a schedule in which the lender keeps 30% of the credit card receipts per month until 58k is paid back. Because the lender takes custody of the credit card receipts first, these receipts act as a kind of pseudo collateral. Although this does open up the lender to some gaming of the system (a business owner might endeavor to get more people to pay in cash under such an agreement), this form of misuse hasn't been seen on a large scale. An advantage of Square underwriting these loans is that it is already the card payment processor; with Square loans, no changes are needed to the businesses hardware or software backend.
Square Capital offers one of the better "FinTech" applications available in the market right now; it gets rid of a great deal of the "pain points" experienced in small biz lending. By reducing so many pain points, growth at the Square Capital's division has been booming. In Q 2016 Square Capital extended $189mm of capital to clients growing 123% YoY and 23% sequentially (Source: squareup.com). Square extended these loans to 34,000 businesses making the average loan amount $5,500 per customer. These small loan amounts highlight another benefit of the platform, as loans are executed electronically, and Square has the data and processing already in place, loans that typically wouldn't make sense for banks are economical for Square. Typically, it wouldn't be worth the headache for a bank to extend a $5,500 loan to businesses, Square has the platform that makes loans these small not only easy but profitable. It's clear that Square getting into small business lending was a good decision, the question is, just how big could this business be?
In 2015, Goldman Sachs estimated the total market size in the US of small business loans stood at $186Bn (Source: GS The Future of Finance via betandbetter.com). With the economy recovering from the great recession, one might think the market size of these loans has been growing as well. Market growth hasn't been seen with the 10 largest banks lending $44.7Bn in 2014 down from an all-time high of $72.5Bn in 2006 (Source: WSJ.com). We can see how drastically small business underwriting has shrunk from the below chart:
With the big banks continuing to de-lever their balance sheets in the wake of the credit crisis, SME (small medium enterprises) lending has been a segment banks haven't been interested. Firms such as Kabbage (Private:KBGE) and OnDeck (NYSE:ONDK) have stepped in, trying and fill the gap left by the big banks moving away from SME loan underwriting. They haven't been able to fill this gap left by the big banks completely, and many small businesses have resorted to using their company credit cards as a source of capital, funding their day to day operations or growth initiatives. Small businesses charged an estimated $445Bn to credit and charge cards in 2015 up nearly 100% since charging $230Bn in 2006 (Source: WSJ.com). Using credit cards as a source of capital with rates as high as 20% isn't ideal when small business loans used to be available at 5 or 6%. Presented with the choice between shrinking the business, not pursuing a growth opportunity or perhaps its very survival, it would appear companies have decided just to pay credit card rates instead of those alternatives. When someone leaves a business rapidly, as in the case with large banks SME lending, often an opportunity is created. This is the opportunity that Square Capital is looking to capitalize.
The question remains, just how big could Square Capital grow? OnDeck (ONDK) is a publicly listed company, because of this we find ourselves in a beneficial situation, having a comparable company that legally has to disclose its data once a quarter. In Q2 2016, OnDeck extended $590mm in various loans to small companies (Source: ondeck.com), up YoY by 47%. OnDeck underwrote 200% more loan value than Square Capital did in the same quarter. OnDeck did this without the benefit of having clients already on their platform and all their revenue data already at their fingertips, a huge advantage that Square holds vs. its competition. Kabbage, another competitor to Square Capital, was on a $5mm of loan originations per day run-rate as of October 2015 (Source: crownfundinsider.com). By now, it is likely about on par with OnDeck but back in 2015, our last data point would indicate a $450mm per quarter of originations, 140% more than Square Capital did in Q2 2016. Kabbage actually can use Square's data to help it determine whether to fund a loan or not; it however needs to get that privileged info from the business first. If Kabbage is asking potential clients for their Square records if they use the service, Square Capital in a clearly advantageous situation as it is already privy to all that data. PayPal isn't letting this opportunity pass it by either. On its Q2 2016 earnings release, it stated its working capital loans program had originated $2bn of loans since launching in 2013 (Source: PayPal.com). Not be left out is Intuit who is also facilitating small business loans. It is in a unique position as it has its client's tax data it can draw from when making lending decisions.
When I'm looking at the opportunity size that Square Capital is looking, I want to look more at the pre-financial crisis figures. We've already seen that this borrowing didn't vanish, small businesses just decided to use their credit cards to fund their capital shortfall needs. Between OnDeck, Kabbage, PayPal and Square, the total loans funded in 2016 are probably in the range of 5 to 8 billion dollars (I'd go with $6-7Bn as the more likely figure based on the data points I have). These loans represent 4-5% of the loans originated in 2007 and 8.5% of the 2014 small business loans originated. We know from the massive jump in credit card use, companies tapped $215Bn more credit card capital in 2015 as the availability of SME loans decreased. I'd venture to say if banks didn't stop lending forcing small biz to use credit cards 2015 loan originations would probably be well north of $200Bn. We already saw that GS estimated the total small biz loan market at $186mm, if you added just half the additional credit card use, you'd be close to $300bn. $300bn is rather aggressive so for the purpose of this article I think $200Bn is a good estimate of the market size. If that figure is accurate, these four lending platforms likely have around 3-3.5% of the market; that is an absolute drop in the bucket. Could these companies command 15% of the market? 20% or even 25%? They could; the banks have made it clear their time is better spent elsewhere. Now that we know the opportunity size is massive, how can Square make sure it can capitalize on this opportunity, and it's not another highly competitive, low-margin race to the bottom that their payments business appears to be?
How Square Makes Money on Loans:
As of Q2 2016, Square has $423mm in net cash on its balance sheet, clearly not enough capital to become a lending powerhouse. Square Capital makes money by constantly unloading the loans it originates to third parties that want these loans for a variety of reasons. The lion's share of loans Square Capital makes end up in the hands of Celtic Bank, a bank headquartered in Utah.
A typical deal works as follows; Square lends 100k to 10 small businesses at say a guaranteed 14% rate of return, Square takes this block of loans and sells them to a third party. Due to Square Capital selling these loans to the third party at a lower rate of return, it sells them at a premium to the value they were underwritten. If the third party informs Square it will buy those loans at 12%, Square simply sells the $100k block to the bank at $101,700 collecting $1,700 on the transaction. In addition to the $1,700, Square Capital charges origination fees on the loan to the SMEs, if it underwrote those 10 loans for $100k the borrowers might see $98k of the capital. Square collects the $2k difference between loan amount and capital deposited as well. If you translate all this into the actual APR (Annual Percentage Rate) Square Capital collects, Square is underwriting loans that yield 20-30% annualized, a healthy rate of return seeing it can unload them to its investors at low double-digit returns.
Looking at the APR for loans extended by OnDeck and Kabbage, however, makes Square Capital seem far less aggressive. Effective APRs for OnDeck and Kabbage loans can be as high 120% with average rates landing in the 40-80% range. Why can Square lend at 20-30% when Kabbage and OnDeck need to lend at 40-80%? It comes down to data and control. First, Square typically has more data on the client than the others have. If Square has been its primary payment processor for some time, it has a great deal of data on that potential borrower. Secondly, Square has access to the credit card receipts first, enabling it to take its payment directly from these receipts before the business can even touch the money. Custody of these receipts makes Square Capitals loans "collateralized" to a certain degree while its peers have true unsecured debt on their hands. OnDeck has seen the issues with having unsecured loans on one's balance sheet fist hand. During its last quarter, its unpaid principal balance (UPB) increased 57% YoY due to it holding more loans itself. Because Square Capital has found solid partners to sell its loans to, it has been able to deliver 60% margins in the Square Capital vertical (Source: Nasdaq.com).
These margins are significantly higher than its core business, payments gross margin, currently sitting at around 35%. Higher margins had led many analysts to look deeper at Square Capital and were likely the vertical that Point72 Asset Management was targeting when it made a 5.4% investment in Square, reported in August on 2016. Unfortunately, with Square Capital's financial data buried in the statements of Square under "software and data product revenue" and "software and data product costs". Included in this segment are additional Square product offerings including Caviar (Square's food delivery service), and other SaaS platforms it offers (Software as a Service). We've gone over Square Capital itself, the SME loan market and dug into how the platform works. The next step is to start modeling and ascertain how much this business might move Square's needle.
This first model I created was built to give an idea how much Square Capital makes on a hypothetical loan tranche of $100k. Across the X axis, I've listed the APR that the loan tranche was underwritten, along the Y axis is the APR that the investor would buy the tranche from Square. The data points show the revenue that square see's per $100k of loans wrote at those various interest rates:
It's a rather simple concept for one to get their heads around. If Square Capital issues a loan at 30% and sells it at 9%, it would make more money than if it issued a loan at 20% and sold it at 15%. What's interesting is that if we take the mid-point of 25% issued and 12% sold and apply that to the $189mm of loans Square Capital underwrote in Q2 2016 the model spits out $23mm of revenue to Square Capital. This figure is not significantly different from the $29.7mm we know the Software and Data products segment did in Q2, and we know that Caviar and other verticals are classified to that segment. These other verticals are likely making up the difference. I think it would make sense for Square just to break out Square Capital on its own, especially as it is highlighting the growth of this segment more on its earnings calls.
Based on the $200bn yearly small business loan estimate Square Capital has approximately 35bps of the SME loan market. Square's payment market share is a bit of a conundrum, although it has over 2mm merchants using the platform the number of active users is a quarter of that. It currently is on a run rate to process nearly $50bn of card transactions this year, the entire market in the US is multiples larger. 15% of US GDP is transacted on credit and debit cards totaling over $2.4Trillion in gross market value. Using these figures, Square has approximately a 2% share of the total market. With that in mind, would it be unreasonable for Square Capital to have 1-2-3% of the small biz loan market? I don't think it would be unreasonable at all, in fact, I think that could be just the beginning. So what would annual loan underwriting look like if Square Capital could command that market share:
If Square Capital penetrated just 2% of my estimated $200bn small biz Loan market, it would be underwriting $4Bn of loans per year. While this is a long way from its current $800mm run-rate, it's not egregiously different from what OnDeck and Kabbage is doing. And we know that Square Capital is in a rather advantageous position compared to those firms. Gaining 2% of the market could indeed be just the tip of the iceberg, it's a good start. How much would Square Capital make originating that percentage of small biz loans:
The above chart shows the yearly revenue Square Capital would generate under different market share figures using three different underwriting and selling interest rates. As we saw earlier, it's advantageous for Square Capital to issue loans at higher interest rates and sell those loans to investors at lower interest rates. Obviously, it has to find some happy medium where it can make sufficient revenue in the division, while still having plenty of investors standing ready to purchase these loans. Because using 25% underwrote and 11% sold produced a revenue figure that was somewhat in line with what Square did on the division in Q2 2016. I'm going to use those as the base case. With base case underwriting and selling figures, if Square Capital grew its market share to 2%, the division would generate over $450mm in yearly revenue. This revenue would be over four times the Software and Data Product division's current yearly run rate, and using the gross margins currently enjoyed by the segment would generate over $275mm in gross profit. That would bump aggregate gross profit by over 50% looking at the most recent quarter.
That's assuming it captures 2% of the market. Although Square processes approximately 2% of total card transactions, its percentage of accounts to total merchant accounts is much higher. Square has over 2mm accounts. The US Small Business Admin - Office of Advocacy estimates there are $29.6mm small businesses in the US. Using these figures suggests Square's penetration across all businesses is over 6.5% in the US. Square typically targeted the $26mm estimated small businesses that didn't qualify for traditional merchant accounts with payment processors, so a higher percentage in numbers of accounts makes sense. Square used technology to make electronic payment processing accessible to the hordes of businesses it didn't typically make sense. It makes sense Square Capital can use technology to extend these same businesses capital to grow. The paperless, electronic nature of the service means businesses can borrow as little as $2,000, a loan amount that wouldn't even be entertained by banks or even new facilitators Kabbage and OnDeck.
With its data pipe and robust platform, Square could effectively corner the ultra-small business loan market. This small loan market is the opportunity that many who view Square in a favorable light are hanging their hats. With current metrics, Square Capital would have to underwrite $12Bn in total loans per year for its segment to grow larger than the core processing segment itself. If it grew to that size with current gross margins, remaining, Square would be an absolute cash cow. With that in mind what could go wrong or perhaps horribly wrong as Square Capital looks to ramp this business?
Risks to Square Capital:
- Small Businesses or SMEs are inherently riskier than their larger peers. Most SMEs fail within 18 months of opening, with 80% of all SMEs expected to fail eventually. These stats are from the SBA (Small Business Administration) themselves, which is rather disheartening. The agency was set up to support and foster small business. With these statistics in mind, clearly anyone starting an SME would be crazy even to try, and anyone looking to lend to these new entities likely even crazier. Year in and out people just don't care, the allure of being one's own boss is a compelling proposition. People tend to have an "it won't happen to me bias" with everyone starting a small biz convincing themselves, they will be in the 20% that succeed. With all this in mind, you'd probably expect default rates on Square Capital loans to be massive; you would be wrong. Square Capital has seen default rates as low as 4% (Source: squareup.com). But the economy is relatively good right now, at least nowhere near as bad as was in the depths of 2007 and 2008. What happens if things slow down? The SBA reported default rates on small business loans as high as 32% in 2007 (Source: riskgroup360.com). 2006-7-8 were much worse than past recessions, but the risk remains. Square Capital could see increased defaults in the event of a recession, capital from investors that buy the loans on the backend would dry up. This would stop Square Capital's growth in its tracks.
- As we have seen recently with the turmoil at LendingClub (NYSE:LC), underwriting standards that Square Capital applies could come into question. When the economy is quite good like it currently is, these standards might not get as much attention as you would expect. If investors suddenly found themselves sitting on big losses from loans underwrote by Square Capital, you better believe all the assumptions used to make these loans will be questioned. If an investor can determine that Square Capital was negligent in ANY regard, Square itself might find itself on the hook for these losses. If Square Capital fully discloses how it underwrites, the investors agree to the terms and accepts the inherent risks. There really shouldn't be much liability on Square's behalf if the loans do in fact sour. That's rarely the case when things go bad. Someone always forgets to dot an I or cross a T; someone is always just a bit more aggressive than they should have been. These situations can unwind quickly, the saying "There is never just one cockroach" I've found generally holds true in times of distress. If Square Capital's ship is tight and it does as it said it would there should be no issue. In reality, it's unlikely there isn't at least one leak.
- Square Capital's Q1 2016 growth from the previous quarter was quite muted. The problem was it simply didn't have enough investors for it to unload loans. Investors' appetite for loans can change on a dime, a dynamic that LendingClub is currently experiencing first hand. Square Capital was able to on board five new investors, continuing its robust growth in the second quarter. There is no guarantee investors may fail to appear again. If there was a big enough scare in the market, born from home or even abroad as we saw during Brexit, investors' appetite for loans could be halted in an instant.
- Competition, Square Capital, is not the only company that has access to client's data. PayPal, who is a juggernaut compared with Square, is also privy to this data and is also underwriting loans. Intuit, who has the small business tax data is also underwriting small business loans. Some might think tax records might be better than the revenue data from card receipts. What you report to the government has to be the best data right? Well, not really, most accept that Square's data regarding granularity is some of the best data out there when it comes to underwriting loans. Tax data is skewed lower; businesses are always trying to convince the government they're making less than they are. The data that firms try to present to potential investors is skewed the other way. You always submit the best data you have when trying to woo potential investors. Square takes both those skews out of the picture. If you are selling hotdogs out of a truck and Square is your only processor, Square likely has all your data, unless you sell some cash dogs off the books. Square isn't just a processing company, it's also a POS system. If Square is processing your card payments, it is likely seeing the cash payments coming into the business as well. Competition is, of course, of possibility, but it will be hard to get better data than Square has. This puts it in a beneficial position.
- Demand, money is a funny thing. When it's available very few would ever say no to it. If you are a small business owner, no matter how things are going, I'm pretty sure you might have an idea or two what you could do with a few extra shekels. Regardless, the possibility exists that SMEs might not want the loans Square Capital is offering up. Whether it be sufficient cash flow or perhaps cheaper alternatives that might come up, unbridled growth isn't guaranteed. Using a credit card to fund some of the SMEs working capital, expansion or equipment needs might be enough for some the businesses out there. Nothing is certain regarding the demand for capital that Square is offering. While I see people saying no to money as a rather small probability, it exists nonetheless.
Square Capital is one of the most robust product offerings in the Small Business Lending space to come along in a very long time. Very few entities have more information about the inner workings of SMEs' capital flows as Square does. Access to this data puts Square Capital in a unique position; it simply has more data than any of its competition. Square's shares are going into the back half of the year, which is a good place to be in the rather shortsighted world we live. Although investors should view numbers calendar adjusted, the fact of the matter is people just spend more money in Q3 and Q4 with Summer in its peak and the November to December holiday spending boom. Square Capital has solved its near-term investor access dilemma, and we haven't seen any large macro events that would have tempered its appetite. I expect all the above to be supportive of SQ stock in the near term. I don't see any reason now that Starbucks leaving the platform has been disseminated, for SQ stock not to trade up to its 52-week highs. Square's Q3 2016 earnings will be released on November 1st, 2016; I haven't seen anything in the quarter to indicate that either the Payments or Capital businesses had hit a bump in the road. Square's guidance on the Q2 call surprised the Street to the upside. It now has had a full quarter where the Capital business had sufficient investors to gobble up as much as it could underwrite. We already know the margins are better in this segment. If it can lay down another strong quarter of growth, investors will be forced to look Square Capital's prospects in more detail. Square Capital's business could rival the core payments business if it was able to gain more market share. For a business that's currently less than 7% of the total business in revenue terms to have that much runway is a huge lever for Square to pull on to deliver growth. 2% of the total small business loan market is achievable, but I believe it could just be the start. I'd buy SQ stock here and let the next two quarters hit the market; I'll know more about the trajectory of Square Capital then. But I'm not willing to wait until after to invest; I want exposure to Square Capital right here.
Disclosure: I am/we are long SQ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.