The decline in Square (NYSE:SQ) stock has been swift and painful. Square stock has dropped by over one-third from early October highs. At one point, SQ stock had dropped 45% in just seven weeks.
The decline really isn’t all that surprising, either. SQ stock seems like the quintessential bull market stock. Indeed, at those October highs, Square had almost tripled in 2018 and traded at roughly 25 times the company’s 2018 adjusted revenue guidance. (Not profits; revenue.)
Even with the sell-off, Square stock isn’t close to cheap, as Will Healy pointed out this week. And its cyclical risk isn’t close to priced in.
Despite the valuation, there’s a bull case for SQ stock, though I argued it was overvalued at ~$75 back in August. But investors need to trust the company and get some help from the broader economy. That still seems too narrow a path.
Square Stock and the Bull Market
At the end of a bull market, investors tend to ignore risk. They forget about economic cycles, for instance.
Much of the broad market sell-off of late seems to be a response to increasing evidence that the cycle might turn and Square isn’t the only victim. Homebuilders like Lennar (NYSE:LEN) and D.R. Horton (NYSE:DHI) have been hammered, as have construction suppliers and distributors.
Semiconductor stocks, historically a highly cyclical group, have tumbled, with Nvidia (NASDAQ:NVDA) nearly halved and Advanced Micro Devices (NASDAQ:AMD) off 39%. Investors there started to believe the industry could grow forever only to be disappointed.
SQ stock seems to fit firmly into that pattern. While the company is moving toward acquiring larger customers, it’s still heavily weighted toward small businesses. And it’s that group that is most heavily at risk during an economic recession as was proven during the financial crisis. Fellow tech play Shopify (NYSE:SHOP) has a similar potential problem.
Square’s revenue could take a big hit when the macro cycle turns. And it appears the company, too, may have forgotten about the cycle. The company aggressively moved into lending this year just as interest rates were rising.
As Ian Bezek detailed in October, treating Square stock like a bank stock suggests huge potential downside. The more risk Square takes on, the more likely investors will be to price that risk in.
Is Square Stock the Play for a Rally?
Clearly even down 35% from the highs, Square has more room for downside, particularly if the cycle here turns.
Small business struggles will hurt both credit card receipts (of which Square gets a fee) and potentially pressure its lending business. And it likely will lead to further multiple compression for SQ stock which, as noted, isn’t cheap.
If the economy holds up or if Square’s model is just that good, there’s potentially room for upside, but I’m skeptical SQ is the right play.
SHOP stock is cheaper on a revenue and earnings basis. There is no shortage of contrarian plays in housing, semis, and industrials. Netflix (NASDAQ:NFLX) looks like an intriguing bet on a tech rebound.
In that context, it’s simply tough to choose Square stock as the “buy the dip” candidate. Yes, the dip has been particularly large. But at 12x+ next year’s revenue estimates, and something close to 60x 2019 EBITDA, the valuation remains particularly high.
And there’s still plenty of room for SQ stock to drop further, particularly if the cycle turns against it.
As of this writing, Vince Martin has no positions in any securities mentioned.