It’s hard to argue with the success of Square Inc (NYSE:SQ) whose mobile credit card reader has revolutionized small business. It’s a great product, but investors remain skeptical. SQ’s IPO was priced at $9; it immediately advanced 45.2% on November 18, 2015, its first day of trading. Since then, however, Square stock has managed to gain just 12% through Feb 2.
Overall, it hasn’t done too badly, up 60.1% from its IPO, which compares favorably with the 9.8% return for the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) and 15.7% for the Technology SPDR (ETF) (NYSEARCA:XLK) over the same period. Even excluding the 45% first-day pop, Square stock has kept pace.
So, to say its stock has failed in any way, especially when you consider IPOs from the class of 2015, such as Fitbit Inc (NYSE:FIT), which is down 80% since it went public in June of that year despite a 48.4% pop in the first day of trading, would be inaccurate.
There’s a lot to like about the company, but before deciding whether investors ought to consider Square stock, I’ll look at some of the reasons why investors aren’t fully on the bandwagon.
SQ Stock Loses Money
Investing is tricky enough without sinking your hard-earned income into money-losing businesses, even those growing as fast as Square. Through the first nine months of fiscal 2016, SQ had an operating loss of $156.5 million, 23.6% higher year-over-year. In that same period, revenues increased by 40.9%, cost of goods by 34% and overhead by 45.9%.
On the downside, expenses are growing as fast as top-line revenue, which could become a problem if its card reader suddenly falls out of fashion with its users.
The upside is that SQ managed to generate an adjusted EBITDA profit of $15.1 million in the first nine months of 2016, a $50.1 million turnaround from a year earlier.
With $529.8 million in cash, short-term and long-term investments on the books, it’s certainly not going out of business anytime soon.
It’s hard enough to be the CEO of one public company, but Jack Dorsey feels he can handle the workload of both Square and Twitter Inc (NYSE:TWTR), since he took back the reigns at the 140-character company on October 5, 2015, TWTR stock is down 37% and Square stock, which went public six weeks after he returned to Twitter, is up 61%.
Clearly, of the two companies, Twitter has bigger issues to tackle despite it being larger from a market cap perspective. Considering the daunting task before him, he’s doing a pretty good job keeping all the balls in the air.
How long can that last? Who knows, but he definitely gets an “A” for effort.
Since SQ started lending capital to users of its credit card reader and payments processing service in 2014, Square Capital, its lending business, has lent more than $1 billion to more than 100,000 customers.
It’s a brilliant business for two reasons.
First, the more SQ customers it can lend money to, the greater the top-line revenue of its customers, which means higher payment processing fees, the linchpin of its business model. Secondly, it sells most of the loans to third parties in return for an upfront fee and an ongoing service fee, while eliminating most of its risk.
It’s a winning proposition for its users who don’t mind paying fees of 10% to 16% on top of the loan amount to gain financial flexibility for their businesses. Third-party investors win because they gain large loan portfolios that are relatively risk free with loan default rates around 4%, 470 basis points lower than the national average for business loans and Square stock wins because it gains an even closer relationship with its customers.
According to a 2013 statistic in Mashable, SQ had 250,000 merchants. Extrapolating its annual revenue growth rate of 70% over the past four years — $203 million in 2012 and $1.7 billion in 2016 –you’d have more than 2 million merchants, a number I’m hesitant to run with, but since SQ doesn’t release the number of merchants, let’s assume it’s one million.
If that’s anywhere near accurate, Square would be lending to 10% of its potential customer base; that number likely could be higher, much higher.
Which is why it’s strange that the company is looking to make loans outside its customer base after making the argument to investors that its internal data gleaned from its merchants is what allows it to keep the default rate so low compared to the national average.
Considering there are an estimated 28.8 million small businesses in the U.S., this inside/outside debate cuts both ways when it comes to evaluating Square stock. If Square Capital goes outside Square’s merchant base to generate further loans, it runs the risk of higher default rates, which could bring unwanted bad publicity to the company’s brand.
If Square Capital keeps upping the percentage of Square merchants that borrow from it, eventually it could run out of people to loan to within its ecosystem, and then it would have to go outside anyway.
Personally, I think they should keep focusing on converting the 28.8 million small businesses not using SQ and the numbers will take care of themselves.
Bottom Line on Square Stock
There’s an outdoor fruit and vegetable market in the neighborhood where I live in Toronto that’s open during the summer. It does huge business from the local residents; some of it processed using a Square reader attached to an iPhone. It’s a boon to small businesses everywhere.
As stocks go, I generally only feel comfortable recommending stocks that make money on a GAAP basis, but I can certainly see the attraction in Square stock, which is something I can’t say for Jack Dorsey’s other horse (TWTR) in the race.
I wouldn’t make SQ stock a core holding, but I’d have no problem recommending the stock for a small part of your portfolio because businesses that make or save people money tend to well in the long run; it does both.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.