Square Q1 Earnings: Great Fundamentals, Bad Stock?

Summary

• Square's rapid growth continued in Q1.
• GAAP revenue growth was helped by the introduction of Bitcoin transactions.
• Adjusted revenue grew 51%, so the core business is doing well regardless of Bitcoin.
• Strength in the services business will enable Square to increase customer retention.
• Valuation is a big concern for the stock. Square is not on sale yet.

Square (NYSE:SQ) printed decent Q1 numbers last week. Headline revenue and EPS both came in above analyst estimates and guidance was positive as well. Even though the company delivered on growth, with adjusted revenue up 51% year over year, I still have no appetite for the stock.

I am not overly bearish however. For a high growth stock like Square, it often just takes one bad earnings for investors to temper their expectations, followed by multiple compression (i.e. lower prices). Unfortunately for bears, I don’t see any meat that they can sink their teeth into in Q1.

Growth Continues

Square’s growth engine is firing on all cylinders. GAAP revenue rose 45% year over year from $462 million to $669 million, accelerating from Q4 2017’s growth of 36%. A major contributor was Bitcoin, which generated $34 million of sales in the quarter, or 739 bps of growth. If we exclude Bitcoin from revenue growth, Square still grew 37%, showing no sign of deceleration in its core business.

Adjusted revenue, a metrics that subtracts transaction based costs and Bitcoin costs (i.e. what the company bought it for) from GAAP revenue, showed a much stronger growth rate of 51%. While this Non-GAAP metric looks like one of those accounting tricks that the management uses to confuse investors, I actually think it is a reasonable gauge of the business. By subtracting extrinsic costs, investors can see a clearer picture of the company’s “core” revenue growth. Imagine if there is interchange fee increase that the company is passing on to its customers, GAAP revenue will see a jump, but adjusted revenue will not; this would be an accurate depiction of the business trend.

The payment processing revenue saw gross payment volume increase 31% year over year to $17.8 billion. Note that this lags the adjusted revenue and GAAP revenue growth. The big reason is that services revenue increased by a whopping 97% from $49 million to $97 million, a slight acceleration from Q4 2017’s 96%. Given that payment is a highly competitive business, generating more revenue from the more differentiated services business is a positive development. The services business also feeds nicely into the payment business, as services could be seen as a way to retain existing customers by making them more invested in the Square ecosystem. Some services that make Square more “sticky” include payroll management and customer engagement tools.

What I Don’t Like

The business is great, but the valuation is not. The company trades at an astounding 14.6x current year’s adjusted revenue estimate.

Much of the price appreciation came from multiple expansion, meaning that the company has gotten progressively more expensive. Contrast this with Visa (V):

We can see that there hasn’t much change in Visa’s valuation multiple (here we are using P/E since Visa is profitable), but the stock price has risen nevertheless. This means that the stock has not gotten more expensive, instead the stock price is getting rewarded purely as the result of better fundamentals (i.e. higher earnings).

No matter how good the business is, if you pay too much, you are going to get a bad return. I certainly do see a lot of potential for Square, but I believe that the current valuation is too rich. There is a limit to valuation expansion, because fundamentals ultimately catch up. A stock can’t triple its price-to-sales multiple every year. That being said, there has always been rumors of Square getting acquired, so perhaps the market is pricing in a premium based on that possibility. Should the rumor intensify, perhaps we will experience another jump.

Conclusion

I see no major red flags in first quarter results. If I were a bear, I wouldn’t be too happy as the business is firing on all cylinders as demonstrated by high adjusted revenue growth and services revenue growth.

Valuation is still a big question mark for me. Much of the stock’s run can be attributed to multiple expansion. While nothing is out of the question, it is highly unlikely that we will experience multiple expansion of a similar magnitude in the future. Speculators can take a gamble on a takeover, but that is the extent of my bullishness on the stock.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.