Square: Buy The Toll Booth To Digital Commerce
Summary
- SQ is a toll booth of sorts for all things digital commerce.
- The stock has come well off of its highs but growth rates still look strong.
- The valuation has improved immensely, and shares look cheap as long as risk is defined for shareholders.
Growth stocks of all kinds have been hammered in recent weeks. The media would have you think it is due to interest rates, inflation worries, or whatever else is the flavor of the day. I don't know why growth stocks suddenly fell out of favor, but one thing I do know is that there are bargains to be had if you know where to look.
One such bargain is in payments leader Square (NYSE:SQ).
Source: StockCharts
Square has not performed well since the growth stock selling began in February. Shares are $70 lower than they were just over a month ago, and that's after a small bounce recently. However, there is cause for optimism.
Square has very defined support in the area of $195, so downside should be limited to there. If Square moves below $190 on a closing basis, that's your cue to get out and cut losses. Given how strong that support zone has been, however, I don't see that as likely.
In addition, the momentum of the selling is slowing, as shown by the PPO in the top panel. Up until the most recent downturn, each move lower was met with a lower PPO reading. The last bout of selling wasn't, which can mean selling is nearing exhaustion. Combined with the bounce off of support, it appears the worst is behind Square.
Finally, the accumulation/distribution line has never wavered and has indeed strengthened during the selling in the past six weeks or so. That means people are buying the dips, taking the opportunity to add on weakness. That's bullish as well, and with the weight of the other evidence pointing to a likely bottom having been struck, I think Square looks good for a buy.
But apart from the short-term setup, Square has an enormous runway for growth in the coming years, and its valuation, while steep, is cheaper than it has been by miles in recent years. All in all, I like the stock.
Torrid growth is just beginning
Square has grown immensely in recent years. The company has moved into creating a payments ecosystem that helps businesses large and small, as well as consumers, store money, pay for goods and services, receive payments for goods and services, and more.
Source: Seeking Alpha
The amount of growth the company has seen is absolutely staggering, as seen above. Revenue more than doubled last year as the pandemic took hold and accelerated Square's adoption among consumers and small businesses in particular. Square is expected to add more than $4 billion in revenue this year and another ~$2.5 billion next year.
Square has thrived because it offers small businesses a full ecosystem of business services such as hosting their website, point of sale software, appointment keeping, and of course, a range of payments options. In an economy where millions of people suddenly became unemployed, Square stepped into the void and helped people start a business online, open a food truck, a retail store, etc. The gig economy plays right into Square's hands as people that would have traditionally worked for someone else are working for themselves. Square can handle just about anything a person in such a position would need on a turnkey basis, very quickly, and for a reasonable price.
Square is essentially two different businesses, one of which is more mature than the other.
Source: Investor presentation
The Seller business is what I just discussed and you can see the massive list of services the company provides to customers. It really is a one-stop solution for businesses of all sizes, with small businesses likely seeing the highest value proposition from buying the Square ecosystem.
The opportunity is huge and is not limited to simply a pandemic-stricken economy. Indeed, as I said above, Square's growth was almost certainly accelerated because of the pandemic and resulting job losses. As people were left without other options, they became entrepreneurs and boosted Square's revenue accordingly.
Source: Investor presentation
Square reckons the Seller business has a total addressable market of $85 billion today, which should only grow over time. After all, as the economy grows, this pot should get bigger and bigger, allowing not only Square to grow but also its competitors. This is the best kind of market to buy into for investors because everyone in the group can win. This is not a case of competitors fighting over leftover scraps of a dying market; there is plenty to go around, which greatly increases the chance of growth for individual stocks.
Speaking of competition, it is true there are many places for a business owner to host a website, and there are ways for them to take payments, or find point of sale software. However, Square's ecosystem is unique and has been a proven winner, it is easy to use, it is easy to buy, and it takes the guesswork out of backend support for a small business owner that almost certainly doesn't have the time or inclination to build it themselves.
Source: Investor presentation
You can read the points yourself but the idea is that Square is not just an app that does one thing; it's a full service business solutions provider, and as it scales, that will allow further investment in this ecosystem and strengthen its competitive position. And, as customers find more value in the full suite of services, they become more valuable over time for Square.
The other business is Cash App, which is a consumer-facing all-things-considered financial services solution. The app allows consumers to store money, pay for things, and invest, all in one place, including Bitcoin.
Source: Investor presentation
Like the Seller business, Square hasn't had a novel new idea; rather, it is improving on what already existed and is building it out with scale. Cash App offers consumers unparalleled convenience in terms of having one place that fits all (or at least most) of their needs.
Total addressable market is smaller than the Seller business, which certainly makes sense, but keep in mind that Square is still in the early stages with Cash App. The runway for this business is potentially longer than Seller because it is still in its early stages, and adoption is still low.
Source: Investor presentation
The good news is that adoption continues to grow at a rapid rate, particularly among younger consumers that are more willing to make digital peer-to-peer payments, or making investing decisions like buying cryptocurrencies. Square's profit potential from adding Bitcoin capabilities alone is huge, and with the runup in the price of the largest cryptocurrency, interest in buying it will only grow. Cash App offers fractional equities as well, which is popular among Cash App's target audience because it allows consumers to invest very small amounts of money at a time. The convenience offered by Cash App is extremely high, which is driving quick adoption rates, and down the line, higher revenue and gross profit.
Valuing the stock
I think Square has a terrific ecosystem of business and consumer solutions for a variety of financial matters. There is competition everywhere, but Square has brand name recognition as a leader in the space, particularly for businesses, and is rapidly gaining adoption among consumers that want convenience for their finances, and don't care about having a physical bank branch nearby.
With Square still very much in its growth stage, profits have only begun to accrue.
Source: Seeking Alpha
The company has been profitable since 2017 on an annual basis, and despite a huge amount of revenue growth last year, didn't grow profits noticeably. Square invested heavily in growth initiatives last year to take advantage of the economic situation that drove higher adoption rates of its services. Square knows that acquiring customers is expensive at first, but pays off as those customers increase their use of the ecosystem in the out years, so these investments make a lot of sense from a long-term strategic perspective. Profit growth for 2022 is much higher than projected revenue growth in part because of this.
However, given where Square is as a growth stock, I'm not bothered with whether it makes $2 per share next year or $1.50 or $2.50; Square should still be valued on a price to sales basis, which is what I've done below.
Source: TIKR.com
Square's peak valuation was three years ago when it hit an eye-watering 22X forward sales. Today, shares go for ~7X forward sales, which is well below its long-term average multiple of 10X. It is difficult to say a stock with a forward sales multiple of 7 is cheap, but in this case, it seems to be. Investors have proven willing to pay much more for this stock, even very recently, and with Square's growth having been accelerated by the events of 2020, I don't see why it cannot trade for 10X sales again.
Even if it takes some time to get back to a multiple of 10X, the above chart shows that 7X forward sales is a trough valuation for Square, so the risk of buying today is much lower than those purchased at 15X or 20X sales a couple of years ago.
Final Thoughts
Buying any stock at 7X forward sales requires some faith that the growth plan will work out. As with any growth stock, it is certainly possible that someone else comes along and out-innovates Square. That's unlikely in my view, given that Square is so entrenched at this point with so many businesses and consumers, and that the solutions Square offers have reasonably high switching costs. However, that is a risk.
Should that risk come to fruition, the multiple would decline, and so would the company's forward estimates. That's why it is important to keep stop losses in place for growth stocks, so you don't end up holding the bag if things go south.
Square's impressive adoption rates should drive continued growth in revenue and profits in the years to come, and as Square continues to innovate, its competitive position should only grow stronger. This is not a sleep-well-at-night stock, but given the way shares are trading, and the fundamental picture, I think risk/reward is skewed firmly towards the bulls, and I see Square as a buy.
This article was written by
I've been covering financial markets for nine years, using a combination of technical and fundamental analysis to identify potential winners early, particularly when it comes to growth stocks.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SQ over 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.