After trying many times this year to break out above $80 a share, Square (NYSE:SQ) instead backed off. The latest downtrend, which followed after its second-quarter earnings report, sent the stock to a recent closing price of $59.75.
Valuations are still on the high side. If investors have better credit services stocks to choose from, why should they still consider Square stock?
Square trades at a forward price-to-earnings ratio of 53.8 times, compared to 28 times for Visa (NYSE:V) stock or 30.5 times for Mastercard (NYSE:MA) stock. The elevated valuations for SQ stock are justified for many reasons. Its seller and Cash App ecosystems have plenty of growth potential ahead. Its seller ecosystem is 10 years old. The unit benefits from improving efficiency, and has scaled profitability, as its CFO Amrita Ahuja said at a Deutsche Bank Technology Conference on Sept. 10. As this business grew, Square succeeded in growing an entirely new ecosystem around Cash App. Cash App helps its users manage their money.
In the last three years, Cash App grew so successfully that it now enjoys a $500 million run rate in monetization. Square attributes its success to rapid product iteration. By updating and tailoring the app quickly to users’ needs, the app has more room to grow. Having offered the service ahead of its competition, Square has a sizable lead and positive momentum to sustain growth. In the long term, continued investments in this business will accelerate profitability.
Square’s Cash App
Square added many notable features to Cash App. Cash Card, Bitcoin and direct deposit are just a few examples of things its user may choose from. But higher costs to support the App may hurt near-term profits. The stock’s sharp drop from $80 at the end of July to below $60 is due to the company’s lower Q3 outlook. Square has to increase its sales and marketing spend to build awareness for the new features offered in Cash App. The company must also continue spending on product development.
For Q3, Square forecast adjusted earnings per share between 18 cents and 20 cents, below analyst estimates of 22 cents. Revenue in the range of $590 million – $600 million will come in slightly below the $599 million consensus estimate. It still forecasts Q3 year-over-year growth of 52% and 60% for the full-year 2019. The lower profits are likely due to the higher sales and marketing spending ahead. These are necessary expenses because they will unlock Square’s addressable market opportunities.
Strong Balance Sheet
Square has a strong balance sheet to support its long-term growth ambitions. It ended Q2 with $1.7 billion in cash and cash equivalents. For 2019, Square forecast total net revenue of $4.4 billion to $4.5 billion. Though its net income per share will be between a loss of 6 cents and a loss of 10 cents, its adjusted EPS is between 74 cents and 78 cents.
Marketing efforts for its seller business is driving positive revenue retention. Its sales and marketing investments have a three- to four-quarter payback period, so it is clear that weaker short-term results will pay off as long-term growth improves.
SQ Stock Valuation
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Investors need to weigh in the returns that Square’s brand awareness campaign, which launched in April, will bring. After the campaign, activations grew in the double-digit rate. If investors assume Square sustaining revenue growth in the 20%-40% range as shown in the table below, then the stock has an upside of 21%.
Investors may model a slower growth rate to account for stumbles along the way. In that scenario, the 5-year discounted cash flow growth exit model will result in a fair value that is closer to the current $60 share price.
The trading momentum in SQ stock eased in the last few months because Square issued a lower short-term forecast. The higher operating costs are necessary to support long-term growth. When Square reports stronger numbers in 2020, the stock will trend higher.
As of this writing, Chris Lau did not hold a position in any of the aforementioned securities.