Square: Cracks Forming

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About: Square, Inc. (SQ)
by: Stone Fox Capital

Summary

Square actually traded down following a big Q3 beat.

A lot of the negative signal from prior to the quarter contributed to the weakness in the stock.

The market has missed that share counts are exploding, up 15% YoY.

The stock still trades at about 23.5x '18 adjusted revenue estimates.

As some shareholders hate, my previous articles on Square (SQ) pointed out the substantial risks in owning the mobile payment provider with limited profits at stretched valuation multiples. Following the release of Q3 results, some more cracks are starting to form in the runaway growth story where my investment thesis already identified negative signals.

Square Terminal Image Source: Square website

Slowdowns

Though mostly ignored now, the GPV (gross payment volume) growth slipped below 30% for the first time. The majority of Square revenues are still based on the transaction fees and growth continues to decelerate as Square shifts toward subscription and services revenues.

Source: Square Q3'18 shareholder letter

Another issue is that the Weebly and Zesty acquisitions closed in Q2 provided an incorrect view of substantially accelerating revenues. In reality, these deals added $25 million in additional revenues that contributed a large amount of the accelerated growth and beat in the quarter. Without these deals, revenue growth was 56%, not the headline number of 68%.

The midpoint growth rate for Q4 dips down to 59%. Square typically beats their very conservative guidance, but adjusted revenues at nearly $450 million will require another substantial beat to match the Q3 growth rate.

Remember that the CFO leaving was a negative signal that some growth rates weren't sustainable at these levels. In addition, the company is almost spastically moving into new areas like installment loans, corporate catering and website building. All areas moving away from their core payment processing business and related fintech business opportunities.

These moves all add to revenue growth in the next year, but all revenues aren't equal. Square is going to have a difficult time managing a full suite of business tools with best of breed products as the company becomes extremely diversified. At some point, the company might need to let some other company handle food delivery, catering and website building. The company is better suited to developing the tools to integrate payment processing with online food ordering and delivery.

Surging Share Counts

The hidden costs of the Weebly and Zesty deals plus continued large amounts of stock options given to employees is that the exploding share count. Square only listed 432 million diluted shares last Q3. The amount surged 15% to 496 million in the last quarter and my calculations in the previous article only used 470 million.

For this reason, the market value of the company is now an incredible $37 billion even after this 25% dip from the highs to $75. A lot of the focus on revenue increases will now require investors to start shifting toward per share measures.

The key P/S ratio continues to show the stretched valuation even after these dips. Even with the inclusion of the new revenue streams, Square only forecasts adjusted revenues of $1.57 billion for the year. The below metric is crazy high, but it's far behind the actual metrics. The forward P/S ratio is closer to 23.5x using the correct market cap.

Chart SQ PS Ratio (Forward) data by YCharts

For this reason, investors need to keep an eye on the divergence of these key metrics for next year. Revenue estimates have surged by ~$600 million in the period, but EPS estimates remain virtually flat, having hovered around $0.75 all year.

Chart SQ Revenue Estimates for Next Fiscal Year data by YCharts

The point here is that the per share metrics aren't improving due to a confluence of higher share counts and soaring costs. In Q3, operating expenses were up 56%. The farther the company expands away from payment processing and some of the related financial modules like payroll and business loans, the more difficult the ability of the company to generate leverage in the business.

Takeaway

The key investor takeaway is that Square appears to be chasing business at this point. The exit of the well respected CFO Sarah Friar is still a red flag while the stock trades at elevated levels as if the payments company has a highly profitable core business growing at the headline growth rates.

The market will probably like the stock back at $70 again. An investor needs to keep in mind that even down at $50 that Square will have a $25 billion market cap. The stock will still trade at a crazy P/S multiple of 11x '19 revenue estimates.

Disclaimer: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.

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.