Still Hip To Be Square

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About: Square, Inc. (SQ)
by: JP Research
Summary

Strong performance in 3Q18 with a beat across street estimates.

Subs and services segment remain the strongest business line, partially aided by continuous investments in new businesses.

SQ adjusts forward guidance, we believe they are achievable and that growth momentum will continue at least in the near term.

Strong 3Q performance ahead of street estimates

Square (SQ) had a solid quarter in 3Q18, with adjusted revenue at $431 million compared to $257 million in 3Q17. The 68% yoy growth was also ahead of the street estimates by around 6%. The pace of top-line growth accelerated in this quarter from a c60% yoy growth in the previous quarter (i.e. 2Q18 vs 2Q17). Adjusted EBITDA for 3Q18 is $70 million compared to $34 million of 3Q17, ahead of the consensus estimate of c$66 million. EBITDA margin was at 16.5% vs consensus estimate of 15.9%. The results also beat street EPS estimates by 2 cents - $0.13 actual vs $0.11 estimates. Total Revenue for 3Q18 increased by $296.9mn or 51% as compared to 3Q17.

We believe that this robust performance by SQ is going to continue driven by the company’s strategy to invest in strong new businesses. For this quarter, subs and services segment was the star performer.

GPV growth ahead of estimates

Revenue from transaction based services was at c$145.4 million mainly due to the yoy growth in Gross Payment Volume (GPV) of 29.2% in 3Q18, which continues to benefit from growth in processed volumes from the existing sellers, in addition to the contributions from new sellers. In this quarter we saw that number of sellers clocking more than $125,000 in annualized GPV represented 52% of GPV which is a surge of 48% from 3Q17, outlining an up-market push. The GPV growth was marginally ahead of the consensus estimates. Net transaction yield was broadly stable, at 1.07% in the current quarter.

Total cost of revenue for the 3Q18 increased by $162.9 million or 44% yoy. Cost from transactions in the 3Q18 surged by $86.4 million or 26% yoy. Profit from transactions resulted from higher margin products together with the improvement in transaction cost.

The star of the quarter: Subs and services

Contribution from subs and services - which was the strongest performing business this quarter - was mainly driven by Instant Deposit, Caviar, Cash Card, Square Capital, as well as acquisitions in the second quarter, increased by $101.2 million or 155% compared to 3Q17. Organic growth was at c125%, comparable to the rate last quarter, which excludes the contribution from Zesty and Weebly. Subs and services contribution towards total net revenue increased to 19% in 3Q18 from 11% in 3Q17.

Cost of Subs and subscription in 3Q18 got inflated by $28.9 million or 159% yoy, mainly emphasising increased costs related to the growth of Caviar and also with the growth of Cash Card and Instant Deposit (albeit at a rate much lesser than Caviar). Cash and capital products remain one of the key drivers in this segment and will continue to see some runway in our opinion.

Hardware sales driven by Square Register

Hardware revenue for the 3Q18 increased by $7.5 million or 74% yoy primarily reflects growth in shipments of Square Register, which is their first all-in-one offering that includes hardware, point-of-sale software, and payments technology. It was also driven by continued surge in sales of contactless and chip readers, as well as growth in sales of their Square Stand and third-party peripherals.

The Hardware costs for 3Q18 surged by $4.5 million or 24% yoy where the increase reflects growth in sales of Square Register, Square Stand, third-party peripherals, and contactless and chip readers. Also the ASC 606 adoption resulted in an increase of $1.3 million in hardware costs for the 3Q18, which is primarily related to earlier recognition of costs of hardware sold through retail distribution channels and hardware instalment sales in line with the revenue recognition for such sales under ASC 606.

Bitcoin in Cash App

The company’s Cash App started to provide customers the facility to buy and sell bitcoin. Revenue contribution from bitcoin consists of the total sale and transfer of bitcoin to the customer's account. This added c$43 million to the top-line in the last three months, and c$114 million in the last nine months. We see the impact of this new revenue channel to normalize in FY19 as revenue figures become comparable.

OpEx increase moved hand-in-hand

Operating expenses increased in 3Q18 by $129 million or 55% yoy mainly due to a surge of $53.2 million (or 64%) in expenditure from product development (personnel costs related to engineering, data science, and design teams). In addition, sales and marketing expenses for 3Q18 increased by $49.8 million or 75% yoy as volume of activity with the Cash App peer-to-peer transfer service and Cash Card issuance costs increased. Also, advertising costs from online, mobile, and televised marketing campaigns during the period and sales and marketing personnel costs saw an increase during the quarter.

General and administrative expenses for 3Q18 increased by $21.2 million or 33%. Transaction, loan and advance losses increased by $3.7 million or 19% and amortization of acquired assets increased by $1.1 million or 483% yoy.

Amortization expenses saw an increase of $0.7 million, or 46% yoy, primarily due to the addition of customer assets post acquisition.

Interest expense for the 3Q18 saw surge of $4.1million yoy, which is attributable to the issuance of convertible notes.

All in all we observe that the operating costs increased hand in hand with the revenues. Signs of operating leverage are yet to be visible in the business. However, we believe that with gain of scale, SQ will display operating leverage in few years, driven by margin expansion.

Updated forward guidance lowers the bar

SQ raised its 4Q18 adjusted revenue guidance to $446-451 million and that of FY18 to be $ $1.569-1.574 billion (from an earlier guidance of $1.520-1.540 billion). Both the ranges imply a c60% growth from last year’s actuals to the range midpoint. Considering the momentum in SQ’s performance, we believe that this run rate is achievable. Further, lowered EPS guidance of $0.12-0.13 for 4Q18 and $0.45-0.46 for FY18 also look achievable. Interestingly, the 4Q18 EPS guidance saw a tightening from the earlier $0.42-0.46.

Strong performance expected from the stock in the near term

While all appear in favor of the stock, and we believe that investors should capitalize on the growth momentum, we would like to highlight some risks in the business. Being a disruptive play focusing on the small business sector, the landscape is prone to economic instability (quite dependent on macro conditions) and disruption from new entrants. Credit risks also remain critical to the business. However, near term, we see the strong performance continuing.

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.