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Square - The Truth Is Out There.

|Includes: Square, Inc. (SQ)
Summary

Last Monday, Square (SQ) shares tumbled 16.05%, marking the second-largest decline since going public on November 2016.

Media reports blamed the free fall in SQ stock price on a BTIG research report in which SQ stock was downgraded to a sell recommendation.

In this article, I will review the rational behind this downgrade. I urge you to read this one.

It's not about buying or selling SQ stock. It's all about inaccuracies vs facts.

Intro

Last Monday, Square (SQ) shares tumbled 16.05%, marking the second-largest decline since going public on November 2016.

So, what was the reason for this free fall?

Finding possible reasons is an easy task; the harder part is making sure these are the actual reasons for the decline. Monday, before market open, BTIG, a research firm, released a paper with a sell recommendation on Square's stock. I find it hard to believe this was the single reason for the free fall in the stock price, but considering high short positioning and elevated activity by retail investors in the last couple of weeks, it seems like the perfect storm was brewing.  

In the following paragraphs I will review BTIG's report.

Spoiler: it won't be pleasant.

BTIG's report

The BTIG report, spanning on no less than two and a half pages (the first page is a summary of next page and a half), is by all means superficial. Some of the 7 points made by the analyst are based on wrong assumptions. It is interesting to note that when SQ reached 20$, BTIG downgraded its recommendation to Hold. Since, the stock had reached 48$. All in all, Reading the report leaves the reader with the feeling it was written without checking data, verifying facts. Simply carelessness.

What are the 7 arguments made by BTIG?

Square Capital

BTIG points out the 3.4 million dollar write-offs in the third quarter 2017, stressing the absence of such write-offs in the same quarter, a year ago. Moreover, the analyst suggests that the annualized write-off rate is 25% of loans held by Square on its balance sheet, while management claims Square Capital loans are characterized by an annualized default rate of ~4%. 

Finally, the analyst urges investors to ask themselves if the write-offs in Square Capital are related to the decline in the dollar value of loan originations in the third quarter compared to the second quarter.

Comment:

The accounting method behind Square capital obliges the company to write-off non-performing loans only two years from the day of loan origination, the point at which Square can demand a bullet payment of the loan. If the loan is not repaid in full at that time, it should be written-off.

Square's management has been very conservative and has been reporting write-offs after just a year and a half since it began its merchant loan program in 1st quarter of 2016.

Why is there no such write off in the 3rd quarter of 2016? Simple. At that point, there were no loans this age (not in substantial quantities anyway).  

The analyst's calculation is wrong. He divides the write-offs by the value of loans on the balance sheets but by doing that he is ignoring all the loans originated in the cycle that were fully repaid. Loans held on the balance sheet include active loans and non-performing loans that have not yet been written down.

Because Square originated loans that amount to 195 million dollars during the period and the write offs in the second (2.7 million dollars) and third quarter (3.4 million dollars) together reached 6.1 million dollars, the default rate is actually 3.1%, even less than management 4% default rate "rule of thumb".

Should investors ask themselves if "the loan losses had anything to do with the sequential slowdown in the dollar volume of Square Capital’s loan originations during 3Q17"? Not at all. Square sees the decline in loan volume as a positive as it shows the quality of its algorithms. Economy slowing because of tornados? Let's slow down the pace of loan originations. This is actually a positive, not negative.

Industrial Loan Charter

The analyst claims some investors cheered when Square announced its intention to seek an Industrial Loan Charter. He believes this move would raise the credit risk the company faces. The analyst also praises PYPL's sale of credit portfolio to SYF in order to reduce risk. The analyst claims that if Square were to receive this confirmation it would reduce the chance of a buyout.

Comment:

First, it is important to understand that Square creates loans and then sells those loans to institutional 3rd party investors. Most analysts assume that only 20-25 percent of loans are kept on balance sheet. This is exactly the essence of the contract between PYPL and SYF. In PYPL's case, SYF is the 3rd party investor buying the loans. Praising PYPL in this context seems odd.

Second, Square has repeatedly stressed the aim of becoming a financial institution was to increase efficiency (by cutting out different intermediaries, providing loans faster and getting an inexpensive source of funding) while keeping the same business model mentioned above. Where does the analyst see more risk coming from?

Finally, the main reason the ICBA has opposed Square becoming an ILC (which is not a bank by the way…) is because an ILC is hardly regulated. After all, to some extent, an ILC can act as a commercial while avoiding the legal prohibitions and restrictions under the Bank Holding Company Act (BHCA).

Would the confirmation of Square as an ILC deter potential buyers? Maybe, but truth is many companies have interest in becoming an ILC. If Square becomes an ILC, it might actually attract more potential buyers. 

Bitcoin

The analyst believes much of the increase in SQ was driven by "the buzz created by the company’s launch of a trial that enables some users of the Square Cash app to buy and sell Bitcoin".  He also believes that that if the company's experiment allowing users to buy and sell Bitcoin succeeds it will be profitable but will also tie the company's fate with the volatile cryptocurrency.

Comment:

He's got it all wrong.

Square is the first to allow transactions with bitcoin. Yes, Square will earn a small fee from any bitcoin transaction but the biggest advantage for Square will be the network affect, the expansion of Square cash app user base. Those users who originally joined in order to buy and sell bitcoin, will eventually use the cash app for other purposes as well hence, expanding the number of users and then empowering the network effect. More users, more activity, more revenue for Square.

While the report mentions unjustified stock rally based on "the buzz created" by the bitcoin trail, I would point out that Square Cash has been holding the first place in downloads on the App store and Google play (under the finance category) since September 2017. Even PYPL's crown jewel, Venmo, ranks lower.

Macro backdrop for SMB's

The analyst thinks the rally in the stock came at a time that the business environment was supportive of SMB's. He reminds investors "the significant underperformance in Square shares in early 2016 when U.S. recession fears emerged".

Comment:

Back in early 2016, the behavior of the stock price was highly correlated to the broader market as most stocks. SQ shares did see a bottom on 2/8/2016 while the S&P500 saw its bottom on 2/11/2016. I tend to agree SQ shares will probably reflect any fear of economic recession in its stock performance but the current economic environment is very different than early 2016.  

During the first quarter of 2016, economists forecasted 0.7% GDP growth. The first GDP reading was 0.5% and the third and final reading was 1.1%. There was, no doubt, a fear of economic slowdown.  The private consumption, which is most important for Square, grew 1.5% in the first quarter of 2016 which is not great but also not too bad. Unlike 2016, Third quarter 2017 GDP growth rate (released today) was 3.3% and 2.3% in personal consumption. The forecast for GDP growth rate and personal consumption growth in the fourth quarter 2017 is 2.7%. Either BTIG knows something economists don’t or the economic backdrop has nothing to do with this downgrade.

Tax reform

The analyst claims investors see Square as a company that would benefit from tax reform and "if tax reform efforts stall, the stock could be particularly vulnerable".

Comment:

It's true Square would benefit from tax reform and lighter regulation which would lead to economic growth and support SMB's but if we examine the company's valuation model (as analysts should) we'll find that most of Square's value is derived from the terminal value and not the next one to two years. To sum it up - the pain from tax reform delay should be marginal.

Rising competition

The analyst notes that Square is moving upmarket and targeting larger merchants (gross annual sales above 500k dollars); he believes Square will meet fiercer competition in this area of business.

Comment:

The potential in Square's market is enormous, whether in the SMB universe or larger merchants. Square's products are premium products and were not once referred to as the iPhone of the POS market, hinting to the loyalty of its clients which are willing to pay more for a better product. The advantage of selling the Square register (price: 999 dollars), a product that combines payment solution, hardware and software (again, same as iPhone), is great. Although moving upmarket, seems like Square still has a lot of pricing power. Just yesterday, management noted sales of Square Register have been stronger than expected while charging 2.5% + $0.10 per transaction which is maybe lower than Square's traditional rate of 2.75% for small businesses but higher than square's main competitors.

Valuation

BTIG's $30 price target for SQ is based on 20x FY20E adjusted EBITDA of $610mm. the analyst notes the "in contrast to SQ, FDC trades at just 9.2x FY20E adjusted EBITDA".

Comment:

On 2/22 this year, the same analyst gave a 20$ target for SQ based on 24x FY20E adjusted EBITDA of $470mm. I find it very odd that the analyst chose to lower the multiple while raising his 2020 EBITDA forecast by 30% in just 9 month!!!

Now let's move on to the claim SQ is expensive compared to FDC. FDC competes with Square mainly with two products: Clover and Clover Go POS.

FDC did not disclose the year-over-year growth rate of Clover and Clover Go during 3Q17, but management stated that GPV from the devices should approach $50bn annualized by YE17. That means GPV of ~12.5 billion dollars in fourth quarter 2017. In second quarter 2017 FDC stated that the annualized GPV was 45 billion dollars which implies a quarterly GPV of ~11.25 billion dollars, i.e growth from second quarter to fourth quarter is around 11%. For the same period the growth in Square's GPV is expected to be 10%. Not that big a difference. The big difference is the actual number – Square's annualized GPV will be approximately 70 billion dollars in the fourth quarter of 2017, 40% higher than the 50 billion dollars at FDC. 

Most importantly – clover is relatively small part of FDC's business.

According to BTIG's numbers, FDC will grow top line just less than 5% and EBITDA at about 12% in 2018. The same analyst claims Square will grow top line at about 26% and EBITDA at 75% the same year.

All of the above makes us wonder: is the comparison to FDC relevant?

To sum things up:

Short interest rocketed from 20.4 million at August end, to a level of 34.4 in mid-November. Seems like most short sellers were hit hard in the stock's latest rally

Looking at the trades in SQ from the past week it is noticeable most trades were made by Virtu (a broker formally known as Knight Capital) which is a low cost broker servicing mainly retail investors and Algo traders.

The combination of the publication of a downgrade report (mediocre or not) and the mentioned above created a delicate situation in SQ shares.

Is Square an attractive long term investment? I think so. But I would like to emphasize that convincing you on that point is not the intention of this article. My message is simple and clear: get your facts right before making investment decisions.

Disclosure: I am/we are long SQ.