Square (NYSE:SQ), founded in 2009, is a merchant service aggregator and provides management tools as well as financing to small- and medium-sized consumer-focused businesses. The company also offers a peer to peer payment app geared towards individuals. Square has a strong competitive position in a large and growing addressable market. However, there is a current valuation disconnect as a result of near-term COVID-19 related disruption. In our view, this provides long-term investors an attractive opportunity with a positive risk-reward.
Square was founded by Jack Dorsey and Jim McKelvey in 2009. Jack Dorsey currently serves as the CEO of Square as well as Twitter (TWTR). The company went public in 2015. It is headquartered in San Francisco and over 95% of the company’s revenue comes from the United States.
Square operates in two distinct segments, Seller services and Cash App. Seller ecosystem offerings include card readers, Square POS software, Square Dashboard, Square Card, Square Capital and Square Payroll. These offerings help sellers accept payments, manage inventory, manage employees, enhance customer engagement, secure capital and create an online presence among other uses. The company processed $106 billion in Gross Payment Value (GPV) in 2019.
Approximately 45% of the sellers had GPV of less than $125,000 as of December 2019. Sellers from food and beverage and retail industry account for 43% of total company GPV.
Square Capital offers loans to merchants. The company then sells majority of these loans to institutional third-party investors. The Square Capital business adds to the company’s core offering by attracting new merchants and growing existing ones. In fact, Square recently received FDIC approval for a banking license.
The Cash App ecosystem focuses on consumers through its mobile payments app “Cash App”. The app allows individuals to store and transmit funds as well as invest in Bitcoin (BTC-USD) and equities. The company also provide a free Cash Card that works like a debit card but is linked to Cash App balance instead of a bank account. There were 24 million active Cash App users as of 2019.
The company earns the majority (60%) of its gross profit from transaction fees charged to sellers as a percentage of total GPV. Gross profit margin of this segment is 37%. The rest of the gross profit is earned from subscription and services, Cash App, Square Capital and other software and services offered to sellers including instant transfer. This segment has gross profit margin of 85%. Revenue from Bitcoin has a gross profit margin of just 1.6% while the Hardware business yields negative gross profit margin of 61% as the company aims to make money via transactions and subscription activity and not hardware sales.
Industry overview and TAM
The company’s raison d'etre is to better integrate the SMB seller (SMB is small- and mid-sized business) with modern payments and retail ecosystem. Typically, small- and medium-sized businesses were and still are ill-equipped to accept new age payments as well as use software to manage operations and customer communication. Square’s Seller services segment essentially provides the SMB sellers an opportunity to level the playing field to some extent. The Seller ecosystem has an addressable market of more than $85 billion in the U.S. alone and over $100 billion in additional TAM (total addressable market) opportunity exists in the form of current international markets ($16B) as well as new countries and products/services.
Peer to peer payment apps such as the Cash App use technology to streamline money transfers and provide a user-friendly experience when compared to traditional banking avenues. As per the company, the Cash App ecosystem has a revenue opportunity of over $60 billion in the U.S. which is primarily made up of sending and spending money on the company’s platform. The market should see strong double-digit growth for the foreseeable future. Given the large addressable markets, the company’s penetration in Sellers and Cash App segments is less than 3% and 2%, respectively.
Given the large growth opportunity, several players in the fray
While the addressable market is large and growing rapidly, the company will have to be on the top of its game in terms of execution as competition is formidable. While there are a number of players in the market, in terms of Square’s core opportunity, Shopify (SHOP) is the closest peer. Although they initially started with a different value proposition, their focus areas are increasingly overlapping as both companies try to expand their addressable market. Square’s roots are in offline store POS and payment offering while Shopify’s roots lie in SMB e-commerce. However, at present, both offer online store front services as well as integration and handling of transactions in offline environments. Those roots still color how businesses look at these solutions. Additionally, a key difference between Square and Shopify is also how they monetize their user base. Square’s universal POS solution only applies transaction-based pricing model, while to avail Shopify’s solutions, customers have to pay both monthly subscription fees as well as transaction fees. Finally, it is important to note here that Square is more versatile in terms of types of customers that can use its systems; however, Shopify tends to be restricted to traditional e-commerce/retail customers.
Both Shopify and Square’s volumes have been growing at strong double digits and the differential between their growth rates has been narrowing as evident in the chart below. Shopify’s growth rates have historically been higher than Square’s as the company benefits from both low market penetration as well as structural growth in e-commerce coupled with a lower base. Square’s gross payment volume was $106B in 2019 as compared to $61B of GMV at Shopify.
In the Cash App business, Square faces competition from PayPal’s Venmo (PYPL), Apple Pay (AAPL), and Google Pay (GOOGL) (GOOG), among others. Generally speaking, there is less room for differentiation in the basic peer to peer transfer and storage of funds. However, companies are trying to differentiate by offering some additional features. For example, Square’s Cash App now allows users to also invest in Bitcoin and stocks. Square offers free Visa (V) debit card which is linked to Cash App wallet balance and with it comes Cash Boost, i.e., special discounts on spending through Square’s Cash Card. Apple and Google Pay compete based on their ability to use their core offerings to push their payment app penetration.
Strong, consistent performance over the last few years
The company’s revenue has grown at a 5-year CAGR of 39%. GPV processed by the company has grown at a 5-year CAGR of 31% from $35.6 billion in 2015 to $106.2 billion in 2019. The number of sellers has gone up 70% between 2015 and 2019 on a cumulative basis.
Besides increasing market penetration for its existing services, the company has also consistently launched new products and services to grow its addressable market and increase revenue per customer. It has also started to focus on higher volume, mid-market customers, as opposed to its earlier focus on micro businesses. Indeed, Square has come a long way from the days its core offering was a single card reader device that would enable sellers to accept card payment from their mobile devices.
Square Sellers Ecosystem Product/Service Offering Development:
Square Cash App Ecosystem Product/Service Offering Development:
Cash App’s active user base has reached 24 million, up from just 7 million users in 2017. Square Capital has advanced loans of over $6.3 billion since its launch and $2.3 billion in 2019 alone while maintaining default rate below 4% in last 3 years (see 4th quarter shareholder letter).
Increasing contribution from Cash App in overall business
Cash App’s monthly active customers in December 2019 stood at 24 million, up 60% from 15 million users in December 2018. Also, the annualized revenue per monthly active customer excluding Bitcoin is now over $30 and has doubled from December 2017. Substantial growth in Cash App has led to increase in its contribution in company gross profit from 19% in Q4 2018 to 27% in Q4 2019 making it a meaningful contributor to the company’s overall business.
Cash App started issuing free visa debit card called Cash Cards in 2017 which enables users to use Cash App wallet balance to pay for products and services. It also started to support Bitcoin trading in early 2018 and launched Cash Boost in May 2018 to increase engagement of Cash Cards through attractive discounts. In 2019, it began offering its users the ability to invest in equities and redesigned its interface to improve navigation and discoverability of app features.
Ample opportunities in international markets
The company currently has operations and offices in the United States, Canada, Japan, Australia and the UK and aims to expand the offerings in these countries and enter new markets. The company has launched various solutions like Square Cards for sellers, Online Store, and Square terminal in the U.K., Australia and Canada in 2019. Revenue from international markets has grown at 3-year CAGR of 60% from $94 million in 2017 to $241 million in 2019. International markets account for just 5% of company revenue but opportunities remain immense. In comparison, Shopify, which operates globally in over 175 countries, derives 32% of its revenue from non-US markets.
Improving margins as the company grows
Along with the increase in the company’s seller base, gross profit per seller has also increased by 130% cumulative over the last 5 years. Gross profit as a percentage of GPV has remained stable within 1.03%-1.08% range during this time frame. The over 1,000 bps increase in gross margin as evident in the chart is due to operating leverage as well as rising contribution in total revenue from subscription and service-based revenue which has much higher gross margins relative to gross margin of transaction based revenue.
Product development and G&A expenses have come down as a percentage of revenue. This has been partially offset by increase in marketing cost at Cash App mainly due to increasing free P2P transactions. The expense leverage together with higher gross margins have led to a strong improvement in adjusted EBITDA margin from negative 3% in 2015 to positive 9% in 2019.
Potential impact from COVID-19 and measures taken
COVID-19 is likely to have a significant impact on the seller ecosystem. The company earns transaction fees based on the gross payment value processed at micro to mid-sized businesses which will be severely impacted from the decline in consumer spending during the lockdown as well as post-lockdown. The food and drinks industry and retail industry account for 43% of the company’s annual GPV while home and repair and professional services account for 25%. Although subscription and services-based revenue is expected to be less volatile, it only accounts for 40% of the company’s gross profit as compared to Shopify which generates nearly 60% of gross profit from its platform subscription and related services including domain name registration. Finally, a large portion of Shopify’s GMV is transacted online which is relatively speaking less impacted as compared to Square’s largely offline GPV. Due to these reasons, we believe Shopify’s business model is more resilient in these times as compared to Square.
Square has updated the market on business trends post lockdown. On March 24th, Square announced that its total GPV was 25% lower in the trailing 10 days period on a YoY basis. The decline was more than 45% in large cities due to shutdowns. International markets GPV was also down by 40% during the same 10-day period. The company has revised its Q1 2020 gross profit guidance to $515-$525 million, down $35 million from previous guidance while still 30% higher than Q1 2019. Please note that Q1 just saw a couple of weeks of economic slowdown and Q2 is likely to bear the full brunt of it.
The company is shoring up finances to create a buffer in case of longer-term lockdowns and a protracted slowdown. Square issued $1 billion of convertible notes in March 2020 to ensure sufficient liquidity. The company is also postponing go-to-market investments, pausing non-essential hiring and cutting down other discretionary expenses. Please note that the company had more than $2.1 billion in cash and short-term debt securities as of 2019, implying plenty of buffer already to weather a storm over the next few quarters.
While we realize that a substantial portion of Square’s profit is driven by transactions (as opposed to subscriptions at Shopify), and that Square has a higher mix of offline sales (vs. e-commerce oriented Shopify), the valuation gap between the two has expanded to head-scratching levels as evident in the chart below. The valuation disconnect is especially puzzling as the company has added the Cash App revenue stream to its business which is becoming an increasingly meaningful part of the mix. The valuation discount is not just relative to Shopify but also Stripe (privately held, STRIP) which just raised fresh money from investors at a valuation of likely between 10 and 15 times revenue as compared to 5-6 times EV/sales at Square.
Competing innovation: While innovation is the birthplace of Square’s growth story, it is also a potential threat. The company operates in the very dynamic payment enabling and processing industry which is seeing increased investment in new technologies and payment systems by both large companies as well as startups. As such, the company needs to move fast to create a competitive moat and scale around its businesses to fend off competition from new and existing peers.
Credit risk from Square Capital: As mentioned earlier, Square sells the majority of its loan origination to third-party investors to mitigate risk; however, its inability to do so or changes in its business model in the future could significantly increase the credit risk and deteriorate the company’s balance sheet. The company’s solid liquidity position mitigates this to a large extent, in our opinion, for now.
Economic weakness: We have already articulated our thoughts on the impact of the current COVID-19 crisis on the company’s business. Given the reliance on SMBs, it is important for investors to monitor this risk going forward.
While we are cognizant of the risks to earnings power this year as a result of the COVID-19 outbreak, Square’s long-term growth opportunity and its ability to monetize that opportunity remain intact. Additionally, the company’s stock trades at a significant discount to peers such as Shopify (read our recent Shopify article here) and Stripe (private market valuation). We have included Square as one of our top ideas (The Chosen) on our May list. As an investor, if you are willing and able to absorb volatility in the near-term, Square’s current valuation presents an attractive risk-reward.