It was bound to happen. Square Inc (NYSE:SQ) had an absolutely torrid run, with the SQ stock price doubling between just late August and its all-time high near $50 reached on November 24. Square stock looked due for a pullback — and that pullback has come.
The SQ stock price has pulled back some 25% in just six sessions. A bearish note from BTIG analyst Mark Palmer last Monday did much of the damage — but SQ stock has continued to fall.
I don’t see the drop as a buying opportunity. I argued a month ago that Square stock looked too expensive at $35, and I haven’t changed my opinion as the stock returns toward that level. SQ had gone parabolic in large part due to questionable optimism toward its Bitcoin offering, with the stock making simply unsustainable gains.
The current price looks similarly unsustainable. I like Square as a company. The growth opportunity in small business is real, as I’ve argued in staying bullish on Shopify Inc (US) (NYSE:SHOP), which targets the same space. But valuation matters, and so does risk. For Square stock, both are too high at the moment.
Whatever you think of bitcoin, it’s close to silly to suggest that cryptocurrency will be a significant driver for Square stock. And yet, SQ jumped 11% simply on the news of the company’s pilot program to accept bitcoin payments.
It’s a move that makes little sense for a number of reasons. Credit Suisse analysts — who are bullish on the stock — estimated a $30 million annual revenue opportunity for Square. Even valuing that revenue at a whopping 20x, that opportunity would be worth about $600 million, or roughly 4% of Square’s current market capitalization.
From a longer-term standpoint, there’s another obvious issue. At least in theory, bitcoin and other cryptocurrencies are supposed to compete with legacy payment offerings — the same offerings driving growth for companies like Square. So when it comes to bitcoin, SQ bulls are trying to have it both ways.
Even with the 25% pullback, valuation concerns persist. An analyst at Baird pointed out that Square, near its peak, was valued well above larger, established peers like First Data Corp (NYSE:FDC) and Vantiv Inc (NYSE:VNTV). In his downgrade, Palmer cited a 28x multiple to 2020 adjusted EBITDA — a figure that still is in the 21-22x range after the recent decline. That’s a hugely above-market multiple to profits that remain three years out, and thus should be discounted by investors.
From a business standpoint, Square looks well-positioned. From a profit standpoint, that’s not quite as true. Square isn’t profitable, which is why analysts and investors are using revenue and EBITDA multiples. Margins in payments are slim, even after the end of the low-margin deal with Starbucks Corporation (NASDAQ:SBUX). Competition will be intense from FirstData’s Clover, let alone somewhat more indirect rivals like Paypal Holdings Inc (NASDAQ:PYPL) and even Apple Inc (NASDAQ:AAPL).
Square is trying to get around the margin problem by creating subscription revenue from Instant Deposit, Caviar, and Square Capital. But that revenue still is less than a quarter of the company’s total adjusted revenue so far this year. As such, Square’s 13% adjusted EBITDA margins are much lower than many other tech plays.
Operating leverage will grow those margins. But even that valuation looks priced in.
Investing isn’t black and white. I don’t see SQ stock as a short, or anything close to a bubble — although the recent run came close. Square is a company with an innovative product, an intriguing opportunity, and real growth potential.
But it’s also competing with giants, and steadily adding to its risk. Square’s plans to become a bank sound great in a strong economy. But a book of loans to small businesses in the next recession could be a very dangerous holding. Getting involved with volatile bitcoin creates its own risk, in terms of both fundamentals and sentiment.
And SQ stock still is trading at about 14x adjusted revenue (which excludes Starbucks revenue and other costs.) It is unlikely to be consistently and materially profitable until the next decade.
Square has value. But that’s not the same as saying the stock is worth any price, or even the current price. Simply put, the market has overbid Square stock. As such, the stock likely has more room to fall.
As of this writing, Vince Martin has no positions in any securities mentioned.