Heading into Wednesday’s earnings report, Square Inc (NYSE:SQ) stock is not far from its all-time high. Shares of the fintech firm have gained 25% since Nov. 1, in fact, and SQ stock jumped Friday when Citigroup Inc (NYSE:C) upgraded it to a “buy,” slapping it with a $20 price target implying upside of 37%.
That looks aggressive considering Square’s recent performance. And the rising optimism does seem to put uncomfortable pressure on Square earnings for the fourth quarter.
Expectations are rising, clearly. And that means Square earnings have to support the higher-priced SQ stock. To do so, CEO Jack Dorsey needs to put out a report that hits on a number of key points — and I’m not sure that he can.
Merchant Growth Is Vital
The long-term bull case for Square stock has to, on some level, include further growth in larger merchants. The ability to provide payment processing for “mom and pop” stores and websites is nice, but it’s also a relatively small market with a ceiling rapidly coming into view.
For its part, Square is successfully targeting that group. “Larger seller” GPV (gross payment volume) grew 55% in Q3, for instance. But that number actually was a deceleration from Q2 and Q1, when the rates were 61% and almost 70%, respectively. In contrast, small seller payment volume (those who sell under $125,000 annually on the Square platform) has grown roughly 14% through the first nine months.
It’s likely that declining revenue from Starbucks Corporation (NASDAQ:SBUX) is adding some pressure. But larger seller volume needs to stay elevated through Q4 and into 2017. At least. While the Square stock price might look affordable under $15, SQ stock is not cheap. Shares of the San Francisco-based company have a market capitalization of over $5 billion fully diluted, despite being unprofitable on a net basis this year.
Adjusted Ebitda will be positive, but it will be dwarfed by the amount of stock-based compensation. Therefore, the current valuation means Square stock still is pricing in a tremendous amount of long-term revenue growth. But its own performance of late shows that growth is reliant on larger sellers. If Square misses on that front, the narrative toward SQ stock could change quickly.
Square Stock Needs Operating Leverage
Traditionally, for a stock like SQ, bottom-line figures aren’t quite as important. It’s easier to cut costs later than to jumpstart growth, as so many highfliers have learned through the years. That means investors usually focus more on revenue than on profits, at least in the early stages of a growth story. But in the case of Square stock, there might be more focus on the bottom line.
Again, SQ stock is valued rather dearly at the moment. And long-term margins have to be a concern. The same larger-seller growth investors are looking for on the top line also hits the bottom line a bit: Square takes lower payment fees for that higher volume, which can pressure gross margin (as reported) or Square’s own adjusted earnings figure.
Admittedly, Square has done a solid job on this front. Adjusted Ebitda margins are guided to increase 14% this year alone, as Square earnings turn positive (at least on that line). But Square stock still trades at hundreds of times 2016 adjusted Ebitda, as the company calculates it. It needs a lot more margin expansion to drive the consistent free cash flow implied by the current price. And that might mean the bottom line will figure more largely in the market’s reaction to Square earnings than might otherwise be the case.
Square Stock Needs a Strong Quarter
Square notably shares its CEO, Jack Dorsey, with Twitter Inc (NYSE:TWTR). I still believe that arrangement doesn’t get nearly as much as attention as it should. Imagine Bo Jackson playing baseball and football, at the same time, year-round.
Part of the reason Dorsey isn’t more criticized is that Square seems far more organized than Dorsey’s other company. Twitter executives are leaving left and right, and there’s a general sense of chaos around TWTR. In contrast, Square seems almost serene.
That said, Square might look well-managed more by comparison than anything else. There have been some missteps here. The Starbucks deal didn’t work from the jump. Default rates around the Square Capital loan program have weighed on the stock, and Square still is heading into what for it is largely uncharted territory as a short-term lender.
Stock-based compensation isn’t as ridiculous as it is at Twitter, but Square still is issuing almost 3% of the share count in SQ stock to employees every year. So there are some management concerns — the most basic of them whether a part-time CEO can navigate a brutally competitive industry at a critical time in his company’s development.
Fourth-quarter earnings seem unlikely to answer Square’s management questions one way or the other. But strategic questions have tripped up SQ stock before — and could do so again. More broadly, there’s a lot that can go wrong here, and very high expectations.
Square has done a nice job over the past two quarters of meeting those expectations. But Square earnings expectations now look even higher — and so do the risks.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.