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Growth Investors Should Take a Good Long Look at Square Stock

There aren’t many growth stocks in this market that look reasonably valued, but Square (NYSE:SQ) stock has become one of them. Square stock isn’t cheap, to be sure, but with a 24% decline since earnings at the beginning of this month it’s certainly cheaper than it’s been.

Growth Investors Should Take a Good Long Look at Square Stock
Source: Shutterstock

There are risks. I’ve long been skeptical (in fact too skeptical) toward Square stock. It remains to be seen how the likes of SQ, rival PayPal Holdings (NASDAQ:PYPL), and Shopify (NYSE:SHOP) will perform in a recession.

And, again, SQ stock isn’t cheap, as it currently trades at 56x 2020 consensus EPS estimates.

Still, in a market where growth stocks have defied gravity for years, SQ seems oddly weighed down. Q2 earnings look fine as far as they go, and the company’s Cash App is seeing increasing adoption. The risks here can’t be ignored, but for growth investors in particular SQ stock seems worth those risks.

SQ Stock Sells Off After Earnings

Even looking closely, it’s not clear why Square sold off so sharply after second-quarter earnings. The obvious culprit is its third-quarter guidance. Square expects an adjusted EPS of $0.18-$0.20, against pre-earnings consensus estimates of $0.22.\

But one might think that investors would have figured out that Square guides conservatively. The company hasn’t missed even analyst estimates since 2016. As I noted before earnings, the same pattern played out in the two previous quarters as well: Square beat estimates, Square fell on disappointing guidance, and then SQ stock eventually rallied.

That pattern may well repeat, because for the most part the quarter looks solid. Full-year guidance was reiterated, which might disappoint investors looking for a raise. But expectations aside, Square did what it should have.

Revenue increased 44% year-over-year, with adjusted revenue up 46%. Expenses did rise almost in tandem with revenue, but modest leverage and a small increase in gross margin led Adjusted EBITDA to climb 54%.

This is a good quarter in terms of growth. Q3 guidance is solid, too: at the midpoint, revenue would increase 38% year-over-year and Adjusted EBITDA margins will improve more than they did in the second quarter. There’s not a lot in the actual numbers for investors to dislike – and focusing on guidance seems to ignore Square’s own history.

Cash App Growth

Beyond the headline numbers, Square also disclosed strong figures surrounding its Cash App. Excluding bitcoin revenue (which was $100 million-plus, interestingly) Cash App added $135 million to Square’s top line in the quarter.

That’s a $540 million annual run rate – which appears far higher than the ~$300 million run rate PayPal disclosed for Venmo after Q1. Meanwhile, an analyst noted last week that Cash App downloads are accelerating. The gap between Cash App and Venmo downloads is now the largest ever.

Cash App is a big potential driver for Square stock. The increased disclosure and strong growth should be a positive.

The Key Factor for Square Stock

There simply aren’t that many stocks in the market trading at even 56x forward EPS while growing revenue 35%+. Admittedly, that may say more about the market, particularly in tech. But at least on a relative basis, SQ stock looks reasonably attractive.

Indeed, would an investor rather pay 59x forward earnings for Paycom Software (NYSE:PAYC), whose sales should increase ~25% next year? Or 49x for Salesforce.com (NYSE:CRM), with consistent low-20s growth?

From that standpoint, Square stock seems undervalued. But there’s a catch: margins. There’s a real concern that Square margins aren’t going to be all that high, given lower gross profit in payments. Cash App, too, has real questions in terms of profitability.

It’s those margin worries that likely explain the reaction to Q3 guidance. Investors are looking for significant leverage and margin expansion. So far, it hasn’t arrived. And the obvious worry is that it never will.

But those worries seem potentially overwrought. Guidance does project margin expansion. Analysts, anyway, see a big year on that front in 2020.

Square still has room to expand in high-volume customers, and a move into Canada perhaps sets up international expansion down the line. There’s a nice growth story here – one that simply isn’t getting the same respect as others in this market.

As of this writing, Vince Martin has no positions in any securities mentioned.

Article printed from InvestorPlace Media, https://investorplace.com/2019/08/growth-investors-look-square-stock/.

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