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Things Are Going to Keep Getting Worse for Square Stock

Even after a big drop, Square stock still has issues

By Ian Bezek, InvestorPlace Contributor

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Square stock SQ stock

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Square (NYSE:SQ) is at the intersection of two troubling trends. As a result, speculators have been dumping Square stock for months now. SQ stock has plummeted from $100 recently to as low as $50 two weeks ago.

In October, I warned, “If This Analyst Is Right, Square Stock Is About to Crash.” At the time, Square was still trading for $80/share. Mark Palmer and Giuliano Bologna of BTIG released a scathing report at the time suggesting that SQ stock was worth just $30/share. And give them credit, it’s been a great call so far.

At the time, I suggested that $30 was a pretty fanciful target, but that Square stock certainly did seem like a sell. But what’s happened in the ensuing three months? Is Square’s current $58 price reasonable?

Square: Valued Like a Bank?

One way that investors manage to lose lots of money, over and over, is by falsely labeling companies as “tech” outfits. Investors tend to give tech stocks, particularly in bull markets, extremely generous valuations.

The so-called Fintech sector was clever in marketing themselves as tech first, rather than as quasi-banks. Tech companies get way more investor enthusiasm than financial firms. This is a central part of the bearish case for Square stock in particular.

Bulls have long touted Square as a tech platform that should be valued in line with other innovative software or application firms. BTIG suggested otherwise, saying Square is much closer to a bank than the bulls would like to admit.

You could also make the middle ground argument that Square should be priced like a credit card company such as Visa (NYSE:V) or Mastercard (NYSE:MA).

However, both of these more favorable comparisons miss a major point. Pure tech companies usually don’t lend to their customers, and the credit card companies tend to offload all the credit risk onto banks.

There is a reason the credit card operators routinely trade for 20-25x earnings while big banks are often under 15x earnings. Visa makes money on every transaction with minimal risk, whereas the bank issuing the credit card shoulders the risk of the consumer not paying.

Square is planting itself firmly in the bank category by lending directly to small businesses. This is arguably even riskier than normal credit card lending. Most consumers pay their credit card bills faithfully and generally only default if they lose their jobs or experience some catastrophe.

Small businesses, on the other hand, go bankrupt exceptionally often. More than 20% of restaurants fail in their first year, and more than 50% within the first three years, for example. You wouldn’t lend to small businesses for long without taking major credit risk.

Core Business Isn’t That Large

There’s always been an issue of just which customers Square should target. On the one hand, you had it making flashy deals with the likes of huge companies like Starbucks (NASDAQ:SBUX). On the other hand, Square’s bread and butter has been small  (often very small) businesses.

Currently, Morningstar estimates that about half of Square’s clients execute $125,000 or less in annual payments using Square’s platform. In other words, just a few hundred dollars a day of payments on average.

That’s fine and well, if Square can get tons of business of this size to stay loyal to its platform, it can eventually make profits. However, once businesses start doing more annual revenues, they tend to want to switch to much cheaper payments providers such as Global Payments (NYSE:GPN).

Thus, Square faces an inherent problem. You need tons of micro-businesses to reach profitable scale as a payments processor. But if you target more mid-sized businesses, then your profit margin on each transaction needs to come down a lot to stay competitive.

So far, it seems Square has struggled to find the right balance to achieve consistent profitability. That, in turn, is probably why it is spending so much energy on newer products like Cash App along with riskier direct lending to its customers.

Square Stock Has Further to Fall

For Square stock, everything comes down to how the economy goes. If the economy keeps on humming and tech stocks recover from this correction, SQ stock will also come flying back. If the stock market and FAANGs hit new highs, SQ stock could even reach $100 again. But I’d argue Square is far from the best pick even if you are bullish on the market.

It’s important to keep your downside risk in mind. So many tech companies with fantastic balance sheets, strong profits, and little credit or recession risk are trading down 30-40% over the past few months. Square, on the other hand, is much more of a gamble. We have no idea what sort of returns Square Capital, its lending arm, will produce during a recession, but odds are they won’t be good.

More generally, Square’s business model is still relatively unproven. Are there enough small businesses willing to pay Square’s higher payment processing rates?

The company has been around quite awhile now and still hasn’t found a path to consistent profits. Instead, it seems to be adding ancillary services such as lending, the Cash App, bitcoin trading, and so on to try to augment a core business that just isn’t that promising.

If Square does reach solid profitability, a large part of that will probably come from its lending business. In that case, expect investors to view Square stock and trade it accordingly.

Put it all together, and you have a company that has more downside risk than other tech firms in a recession. The combination of credit risk and tech stock selling has formed a vicious circle for Square.

Even if things do turn around, Square will probably still underperform other tech outfits that have more compelling business models. With so many great tech companies on sale now, you can do better than SQ stock.

At the time of this writing, Ian Bezek held no positions in any of the aforementioned securities. You can reach him on Twitter at @irbezek.


Article printed from InvestorPlace Media, https://investorplace.com/2019/01/things-getting-worse-square-stock/.

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