Square: A Top Fintech And Crypto Play

Summary

• SQ's main segments in Seller (PoS) systems and Cash App showed outstanding growth in 2H '20 which looks set to continue.
• Seller ecosystem is recovering amid easing of restrictions and a long-term shift to larger enterprises and omnichannel sellers can grow transaction revenues.
• CashApp is the primary 'value creator' for SQ's revenue generation, at 63%, propelled by bitcoin with a few major tailwinds underway.
• SQ has the right combination of fintech and crypto to pave the way for significant future revenue growth and earnings leverage through 2025.

Photo by jetcityimage/iStock Editorial via Getty Images

Square (NYSE:SQ) is at the pinnacle of fintech and crypto, occupying the merchant, MSME space as well as a rounded P2P payment, crypto and investing ecosystem with CashApp. Even with the expected growth for Cash App and recovery within the merchant side, valuation remains quite high with a fair amount of future earnings growth looking to be priced in, although revenues could serve as a key driver of share upside. Risks do remain, regarding Cash App and revenue generation ex-crypto among others.

Seller Ecosystem

Square's seller/merchant segment ended the fiscal year with small gains to revenues, +1.9% y/y, with gross profit +8.4% y/y on low double-digit increases in Q3/Q4 as reopening measures expanded and restrictions lightened.

What once used to be the key segment, the seller ecosystem saw its contribution of 82% of gross profit generation in FY18 drop to just 55% in FY20 as Cash App grew tremendously. However, the segment has rebounded with some key tailwinds, and could see an increased contribution to bottom-line performance.

A high majority of Square's merchants are located in the United States, although international operations are growing, including in Australia, Japan, the UK and Canada. Lightening of restrictions in the US during 2H likely served as a tailwind to segment growth in hardware and transaction-based revenues, with more businesses operating (some at higher capacity levels and needing more PoS equipment) and more customer traffic facilitating transaction amounts. Tighter restrictions in the UK and Canada likely impacted some of the reopening benefit, but international revenues still account for just 3.3% of total revenues, so the overall effect is minimal. Even so, international revenues have nearly doubled from FY18 to FY20, reaching $311 million.

Longer-term tailwinds to the segment look to be in play, with continued recovery in MSME (especially in food-service, retail), merchant mix shift and contactless payment prevalence.

Continual reopening and easing of restrictions, as well as allowance of full capacities in foodservice and retail locations (although unclear of when exactly that will occur), should boost MSME traffic and transactions, providing some extra benefit to hardware. 2H already saw transaction revenues rise 25.2% relative to 1H, with subscription revenues up 11.9% and hardware up 29.2%; more sequential gains are likely both in the US as reopening continues and internationally as restrictions lighten and reopening accelerates.

Data from Square

Shift in merchant mix can provide a long-term growth runway, with Square seeing that the segment " continued to grow upmarket and attract omnichannel sellers." This has been a persistent trend over the course of the past five years, with larger sellers growing quite consistently from 39% GPV contribution to 60% (seen above), as the pandemic impacted micro-merchants to a greater degree. Omnichannel and online sellers have picked up, with retail seeing a shift to these channels as a pandemic tailwind; larger merchants are likely to have the capital and infrastructure to operate on these two channels with a higher presence than micro. With expected continual growth from the omni/online channel tailwind, mix to larger merchants who should be able to support such channel growth can provide a tailwind to transaction revenues.

Graphic from Square

Contactless payments go hand in hand with the pandemic-related shifts in retail, but the significant uptick in cashless transactions witnessed early in the pandemic has persisted well. For main market in the US, cashless business rose as high as 50% in the midst of April lockdowns, and has climbed to rest in the mid-40% range through February. 74% of Square's sellers accept contactless payments, up from 64% last year, and long-term adoption of cashless payments and digitization look promising, although it's likely that cashless transaction percentage will dip a bit in the upcoming months.

Graphic from Square

The shift to online/omnichannel selling on top of an uptick in hardware revenues illustrates some stickiness of customers, most likely in the larger GPV base. Even so, the seller ecosystem does have some risks, mainly due to competition. Cashless transactions are a competitive space, with PayPal (PYPL), Google (GOOG) and Apple (AAPL) major facilitators and Visa (V), Mastercard (MA) and American Express (AXP) among the main established cards accepted. While Square does offer integration for Apple, Samsung and Google Pay, there are other PoS systems that offer contactless solutions, some with lower fees; while Square's terminal remains the top pick per its cost, competitive forces with different PoS more suitable for different or larger business types.

CashApp Ecosystem

Square is touted as "a long-term winner within the underserved market...[with a] hard to ignore huge long-term opportunity." A majority of Square's growth and potential stems from CashApp, after Bitcoin's frenzy in FY20 pushed the ecosystem's revenue up 440%. As such, CashApp has become the primary 'value creator' for Square in terms of revenue generation, at 63% of total revenues.

Users have continued to grow at a solid clip, +50% y/y to 36 million monthly active users, at the bottom end of a prior projection, with the app seeing over 50 million downloads in 2020 as one of the top-ten most downloaded apps. More user growth and more user activity will translate to higher segment revenues (both including/excluding bitcoin). Key tailwinds stemming from strong historic and expected future user growth exist: increased monetization abilities from multi-function services/increased engagement and bitcoin-driven revenues.

CashApp's original P2P function remains key in terms of customer acquisition, with more transactions to more individuals driving new users to the app. 2020 saw a "50% increase in peer-to-peer transactions sent per customer," and more transactions equals more chances for monetization from higher engagement levels and more transaction based revenues like instant deposit and Cash Card/Boost.

The broad ecosystem and multi-function abilities of Cash App increase monetization channels - Square saw "increased adoption of Cash Card, Boost, direct deposit, stock brokerage, bitcoin investing, and business accounts [as] new customers adopt[ed] products like Cash Card and bitcoin within their first month at a higher rate." It's quite important for Square to keep growing the amount of customers adopting two or more products, as these customers transact 3-4x more and generate 3-4x more gross profit than simple P2P users. Subscription and service revenue is up 87% in 2H with this rise in engagement, and gross profit per MAU has risen 70% to $41.

That same ecosystem also provides a moat in the face of competing platforms like Venmo, and creates a higher level of customer stickiness. Cash App's "existing customers have remained on the platform and increased their engagement with...particular strength in retention during recent years." The ability to invest and buy bitcoin and stocks, send money, spend at retail locations and earn rewards, and deposit paychecks keeps customers locked in to the platform due to the convenience factor of having all in one place.

Bitcoin has provided the main tailwind to Square's growth during 2020, generating 48.1% of total revenues to the company at $4.57 billion. Seen below, Bitcoin has been a primary generator of revenue growth during FY20, although Q4 revenues flattened sequentially.

Data from Square

With such revenue growth, Square's ability to maintain high Bitcoin engagement is key, in order to drive future growth; the Bitcoin ecosystem has a few major tailwinds to growth:

• accessibility: Square is "making bitcoin more accessible for our Cash App customers by providing a streamlined onboarding process, fast settlement, and the ability to buy, sell, and transfer bitcoin easily." Many different crypto wallets and platforms like Robinhood exist, so easier accessibility can keep Cash App customers transacting within the app and not through outside platforms.
• volume: over 3 million customers traded Bitcoin in 2020 - Q4's "bitcoin volumes per customer were up more than 2.5x year over year...as new adopters bought even greater volumes," and January 2021 had "more than one million customers purchased bitcoin for the first time." Easier accessibility to Bitcoin should be a driver of higher volumes, but more volumes not only translates to more revenues, but more multi-function engagement driving higher gross profit per user, a trend seen within Bitcoin adopters.
• demand and price: high popularity in Bitcoin has persisted, so Bitcoin demand and Bitcoin generated revenues should remain high for Q1 and Q2. Bitcoin's price rising above $50,000 during Q1 (much higher than 2020's levels) and heightened volatility could have spurred more trading, so revenues from fees (~2-2.3% per transaction) are more frequent. This could be a key factor in a possible upside beat for earnings (in terms of gross profit).

As such, Square has become a crypto 'play', and shares are a bit more correlated to Bitcoin's price during 2021. Rising Bitcoin prices can serve as a catalyst for shares due to some correlation of the two as well as revenue growth through Cash App; falling Bitcoin prices can serve as a major headwind, again with correlation as well as with less revenues and possibly less engagement and multi-function engagement.

Data by YCharts

While Cash App still has seen a solid uptick in overall revenue ex-bitcoin (from more P2P transactions/more users/more engagement), the ecosystem has some risks: competition and Bitcoin volatility are the main two to watch.

Bitcoin popularity and prevalence of crypto wallets and other methods to buy and sell increase the importance of customer retention, as many of these apps do witness customer overlap. Coinbase's (COIN) growth in users and crypto pure-play is a major force to compete against; Cash App's ecosystem (as well as PayPal's) use crypto as engagement vehicles, and while they do derive significant revenues from crypto, the overall benefit in terms of gross profit comes from higher engagement levels.

Bitcoin has proven to be quite volatile so far during the calendar year with more popularity and increased corporate awareness and adoption. While more volatility and higher transactions serve as tailwinds, volatility exacerbates the probability of quick downside to prices, which could emerge at any time and potentially cause revenues to plateau or decline; gross margin of Bitcoin is simply the fees attached, 2-2.3%, so stagnation of revenues would adversely impact gross profit contribution. There's also higher marketing and processing costs stemming from higher volume of trading and usage, and impacts to revenues would be felt before costs can be reined in, thus prolonging impacts to bottom line growth.

Overall

Square's growth trajectory has been rocketed higher on the backs of Cash App and Bitcoin, primarily, although the Seller ecosystem and PoS reopening benefit has shone through the second half of 2020, with strong growth rates amid broader economic reopening lightening of restrictions. As vaccinations continue, further easing of restrictions and a return to normal provide tailwinds to more growth in the Seller segment, while more engagement, more active users, and more Bitcoin transactions and higher prices serve as major tailwinds for Cash App. Square has the right combination of fintech and crypto to pave the way for significant future revenue growth, and with that, earnings leverage, growing at ~20% and 48% CAGR through 2025 to $24.5 billion and $5.60 in EPS. While competitive risks are aplenty for both segments, Square's multi-faceted ecosystem for Cash App can keep customer retention high amid customer overlap for these trading and P2P apps, and the value proposition for PoS and ease of use can keep adoption of Square's terminals and services high. Square has multiple different outlets for growth and success, although a growth into its current valuation could take some time to pan out, thus reaffirming a cautiously bullish stance.

Analyst’s Disclosure: I am/we are long SQ. 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.