Yesterday was an interesting day for mobile payments processor Square Inc (NYSE:SQ). SQ stock reported yet another clean beat-and-raise quarter after the bell on Wednesday (Nov. 8), adding firepower to the bull thesis that mobile commerce is a secular growth market. But the SQ stock price, which had nearly tripled over the past year heading into the third quarter report, sold off despite the strong numbers.
Sometimes, a growth stock failing to head higher after strong numbers is a sign of a maxed-out valuation and perhaps a downward inflection point in the stock.
Other times, it’s simply a sign of bulls taking a breather before the next leg higher.
When it comes to SQ stock, I think it’s the latter, and it looks like that breather is already over. The SQ stock price has recovered from its early Thursday morning losses and is back near its all-time high.
The Reason SQ Stock Went Down… At First
SQ stock sold off initially because investors got a little spooked about key growth rates coming down.
Gross payment volume (GPV) growth has shown a multi-quarter trend of slowing. Same with transaction-based revenue growth, which is simply a percentage fee of GPV. Subscription and services revenue growth is also slowing. The rate at which adjusted EBITDA margins are expanding is also coming down.
In fact, the only critical, underlying growth rate that picked up in the quarter was hardware revenue growth. That growth acceleration is mostly due to the company moving past a difficult lap in the first half of 2016 when the Square contactless and chip reader began shipping.
The Reason SQ Stock Rebounded
SQ stock then rebounded because the slowdown really isn’t all that bad.
GPV growth and transaction-based revenue growth is coming down by about 1 percentage point each quarter. That is fairly immaterial when the growth rates are consistently hovering above 30%. Subscription and services revenue growth is coming down more dramatically (about 10 percentage points each quarter), but that slowdown is natural when revenues are essentially doubling in that business.
Meanwhile, adjusted EBITDA margins are still expanding by seven percentage points, and adjusted EBITDA is expected to essentially triple this year. Plus, hardware revenue growth might get super-charged now that the company has launched Square Register, Square’s first all-in-one hardware offering.
All in all, then, this is still a secular growth narrative with super-strong growth rates that aren’t showing signs of slowing at any alarming rate. Investors realized this and gobbled up the stock on the dip.
Why SQ Stock Can Head Higher
I think the SQ stock price will continue to head higher for two major reasons.
First, this may be one of the best growth stories on the market. Square finds itself on the right side of secular growth in digital (and specifically mobile) commerce. Today, the entire payment transaction process can be completed with a phone and Square technology. The more and more transactions go mobile, the more and more payment volume will flow through Square.
This market is quite big, and Square is tapping only a small portion of it. Payments processing is a $26-billion-and-growing market. With the addition of ancillary markets like small-business loans and food delivery, Square believes its total addressable market is around $60 billion.
Adjusted revenues this year are expected to be under $1 billion.
Secondly, the valuation remains reasonable. Revenue growth is expected to be about 40% this year versus 50% last year. That is fairly robust growth. Given the company’s robust growth profile, 20%-plus revenue growth is likely here to stay for a while.
Margins are also exploding higher, and that is leading 40% revenue growth to 200% EBITDA growth and 500%-plus earnings per share growth. The margin expansion rate is slowing, so the days of Square earnings growth being 12.5x that of revenue growth are over. But margins are still expanding by a healthy amount, so Square earnings growth should significantly outpace revenue growth over the next several years.
Consequently, it’s easy to see that 20%-plus revenue growth should spill into 60%-plus earnings growth. SQ is only trading at 86x next year’s earnings estimates. An 86x multiple is a reasonable price to pay for 60%-plus earnings growth.
Bottom Line on SQ Stock
Square is a growth stock supported by secular growth in mobile commerce and digital payments. It took a momentary breather after third quarter results, but that breather is already over, and SQ stock is set to resume its long-term upward trend.
As of this writing, Luke Lango was long SQ.
