SQ (Square Inc.)

Square Inc.
by Luke On

Background and Products

Square (SQ), founded in 2009, is a financial services company for smaller businesses that focuses on technological solutions in software and hardware. Square’s customers, dubbed “sellers” for our purposes, use Square’s various integrated POS systems. Here, we are going to compile a list of SQ's products. Finally, a comprehensive background on all of Square's hardware and software products on one list! Note that their hardware (other than the Reader and the Reader for Magstripe) comes with a Square Reader. These include:

1.       Square POS (Square for Restaurants and Square for Retail ($60/month/location) is similar, but with a focus on restaurants and retail, respectively) – Their free app that works with Square Reader. It allows sellers to customize their products, manage employees (and their permissions), customer directory, inventory, feedback).

2.       Square Dashboard – SQ’s app that shows high-level metrics and in-depth analytics of the business, from multiple locations.

3.       Reader for Magstripe – a simple magstripe credit card reader that accepts payments on behalf of the sellers. The Reader plugs into a headset jack or a Lightning port. It comes free in the mail if the seller makes a free Square account. These payments made by customers contribute to the Gross Payment Volume metric (which the article discusses later).

4.       Square Reader - a contactless and chip card reader. It costs $59.

5.       Square Stand – This requires an iPad, it comes with a dock to place your iPad on (to run the Square POS app). It comes with a USB hardware hub, so sellers can add a receipt printer, cash drawer, barcode scanner, and the like. It costs $199 without the iPad.

6.       Square Register - a small computer that acts like the Square Stand, but without requiring an iPad.

7.       Square Capital – a segment of the business that offers loans to sellers so that they can grow their business. It is a growing part of the business.

·         This segment of the business includes Caviar, and smaller business solutions like Payroll.

8.       Cash App – a service that allows users to request and transfer money to another Cash account via its app. Then, users can choose to withdraw money with its debit Visa card (Cash Card) on an ATM or transfer it to any local bank. It added the option to buy and sell BTC on January 2018. It is yet to be a significant source of revenue.

Their main source of revenue is derived from Gross Payment Volume (GPV). Gross Payment Volume is the dollar value of the sellers’ revenues. In other words, when a consumer pays for a product at the seller’s Square Register, that full amount goes to GPV. Now, how SQ generates its revenue is taking (averages to about) 3% of total GPV. Along with other streams of revenue, which will be discussed in the quantitative portion of this article, SQ is a sleek player in the payments processing space and a potential threat for incumbents like PayPal. Please note that VISA, MasterCard, Apple Pay and companies that offer methods of payment for the average consumer are not competitors. SQ and PayPal are payment processing systems, that welcome VISA or MasterCard holders.

Qualitative Analysis

Our Lord Dorsey

We cannot begin without a brief coverage of superstar CEO Jack Dorsey. Apart from being CEO at Square, Dorsey has been running Twitter since July in 2015 - taking on an unusually heavy load of responsibilities. He does not have any plans to leave either company, which may indicate a problem in the long run. This will be troubling to business author and researcher Jim Collins for two reasons. His extensive study in Good to Great suggests that superstar CEOs do not correlate with successful upcoming companies. Like Lee Iacocca, they may do well while they are in tenure at the company, but things may change drastically once the beloved leader steps down. Dorsey may not necessarily need to change how he is viewed in the Valley or on Wall Street, but we as investors should take caution and remove our biases towards Mr. Dorsey.

This brings us to the second reason. Dorsey does not have an obvious candidate to replace him as CEO. We may be quick to dismiss it as a triviality, but these concerns are very material, for the long-term investor. What happens if Jack Dorsey leaves the company? Sarah Friar, the CFO, seems to the speculator like the most probable candidate to take over. Then again, will she be here when Dorsey steps down in 10, 15, 20 years? In Built to Last, visionary companies should have a clear protégé who will take over as CEO when the incumbent steps down from his throne. General Electric saw this in the early 1980s – when legendary CEO Jack Welch took over at the helm. He was “Home Grown Management” – as dubbed in the volume. Most visionary companies like The Walt Disney Company shared similar successes when the leader at the helm groomed his protégé, and saw success. As investors, this should be a fairly large concern. Is management capable of keeping the Square cogs turning for the long-term?

Our Lord Dorsey

In an article from Business Insider, “a person close to the company” puts it this way: There is “absolutely not” anybody who could take over Jack Dorsey’s position as CEO. This is in 2015, and it seems troubling that since then, our most obvious candidate to the position, Ms. Friar, has joined two major companies’ boards as a member. That says a lot about the scattered focus that the management team seems to possess. Running two companies at the same time is difficult enough – I am sure that this issue has not really plagued Dorsey’s mind, as he is at the height of his career and is focused on growing it, rather than grooming his replacement. I do not blame him – although I would like to see a more focused approach in Dorsey and the management team as opposed to our candidates joining boards of other companies left and right.

A quick look on Glassdoor shows that SQ’s major problems are a lack of work-life balance, no clear direction of moving up in the company, and a high turnover rate. These are all issues that lead to employee dissatisfaction that will leave only the most ambitious people, who may not necessarily be the most talented, and who have little interest in growing the company. This may be an overgeneralization, but it is definitely not much of a stretch, if the reviews truly outlined the ambition-driven, Jack-Dorsey-obsessed culture at Square. SQ should focus on retaining the best people, rewarding them with opportunities, and growing management so that the best people remain at Square, and everybody has the company’s best interests at heart.

The New Kid at School

We do not believe that Square, or at least, its products, are yet to be seen to be as main competitors in this industry. In a mature space like the payments industry, players like Moneris, PayPal, and Chase Payments are reaping the great benefits of entering an industry early, and they feel comfortable with the market share that they own.

Not for long. Square’s goal is to disrupt the payments space, while simultaneously introducing new business solutions for small sellers. In fact, SQ has challenged these business’s customers to look at the rate that they are paying for each transaction, and for them to compare rates (for businesses generating more than $100k in sales). Despite its high profile in Silicon Valley, as of the moment, SQ is still a small player in the industry and lacks market capitalization, profits, and ability to take market share to be seen as a threat to major players in the space.

Quantitative Analysis

An overview of its main driver of growth

Square’s stock (SQ) has had a monstrous growth of over 180% in the last year alone. Its GPV and therefore, Transaction-based revenue (TBR) has increased 32% from 2016 to 2017. Its TBR is Square’s largest portion of total net revenue (about 86%). This means it is a main indicator of how the company is doing financially and in terms of growth. Looking at PYPL, SQ’s main competitor in this segment of transaction revenues, we observe that PYPL’s transaction revenues are growing at 20.15% - an astonishingly high growth rate when compared to its absolute revenues. SQ had 2017 TBR of $1,920,174,000 while PYPL had 2017 TBR of $11,402,000,000. Almost ten times as much as SQ’s TBR!

Furthermore, we see that PYPL’s TBR growth rate has increased from 2015-2016. 2016-2017 TBR Growth was 20.15%, up from 16.76% in 2015-2016. This is notable, as SQ’s TBR growth rate has declined.

Revenue: SQ	2013	2014	2015	2016	2017
Transaction-based revenue	$               433,737	$               707,799	$            1,050,445	$          1,456,160	$          1,920,174
		63.19%	48.41%	38.62%	31.87%
				% of total revenue	86.72%

PYPL	2015	2016	2017
		(In millions)
Transaction revenues	$                 8,128	$                9,490	$               11,402
		16.76%	20.15%
% of total net revenue	87.89%	87.53%	87.08%

It is a worrisome picture to paint. How can the incumbent in this payment space add more users to its platform while SQ is struggling and slowing its main driver of revenue? To analyze this issue, we can look to its expenses. Are they spending their money wisely?

Burning Cash in the Right Areas?

Operating expenses:
Product development	82,864	144,637	199,638	268,537	321,888
		74.55%	38.03%	34.51%	19.87%
				% of operating exp	36.03%
Sales and marketing	64,162	112,577	145,618	173,876	253,170
		75.46%	29.35%	19.41%	45.60%
				% of operating exp	28.33%
General and administrative	68,942	94,220	143,466	251,993	250,553
		36.67%	52.27%	75.65%	-0.57%
				% of operating exp	28.04%

First, we see that in order, they spend the most on Sales and Marketing, Product Development, and G&A. These are the daily expenses. The last portion is attributed to miscellaneous cost (Transaction, loan and advance losses) and likely are recurring, but not very relevant in valuation (similar to returns, or allowances for doubtful accounts). 

Reading the notes on Sales and Marketing line, they should focus on this account and allocate expenditure here the most to acquire new sellers via direct selling. This expense also includes manufacturing and distribution of magstripe reader for free for marketing purposes at trade shows – although they expect that this portion of costs should go down in the future. This is noteworthy. This line also includes the maintenance and acquisition of new “cash app” accounts.

Seeing S&M at these levels should worry the long-term investor. It seems as though they are allocating costs into the right areas. If this is true, why is TBR not growing as fast, in absolute terms, as PYPL? Is SQ not differentiated enough with its hardware line? I do not think so. It is a very attractive business proposition to the small business owner, but I think PYPL’s TBR is growing because of two reasons: one,  customers are buying more in the economic upswing, and two, sellers are reluctant to switch POS’s – i.e. high switching costs. Why would I switch to Square when PYPL or SHOP POS meets all of my needs? Note: The reason SHOP’s TBRs were not analyzed is that POS is not their main business, and thus, not a major competitor in this space.

I also think that SQ would do better if it chooses to focus primarily on cashless countries. Right now SQ is focused on expanding in the cash-infused and competitive space that is the US. The war on cash should be fought on advantageous ground. It should look into countries like Canada (the second most cashless country in the world), the UK (the third), and Sweden (the first). Before other companies present better POS alternatives, SQ should make its move, and quick. A Medium column wrote: “McKinsey forecasts that from a volumes standpoint, by 2021, global payment volumes will surpass 2.2 trillion US dollars [1] — a massive increase from just 450 billion US dollars in 2017.” If SQ has big plans, and they do, they should focus on the global payments space accelerates its growth.

Moving away from TBR

We see that 11.4% of SQ’s revenues come from Subscription and services-based revenue. It is also growing and is a major point of differentiation that analysts and investors alike point to when they pitch the stock.

Subscription and services-based revenue	-	12,046	58,013	129,351	252,664
			381.60%	122.97%	95.33%
				% of total revenue	11.41%

This is truly a unique differentiation. Most of this comes from Caviar, Square Capital and Instant Deposit. Since the company is still relatively young, it can experiment and continue to come up with new solutions that sellers do not even know they need. With this in mind, the costs associated with launching these services appear to be relatively insignificant – this high ROI suggests that it is an investment worth looking into for now, and has the potential to make up a large chunk of SQ’s future earnings.

TBR will always be the fundamental driver of revenue for this company. For that reason, SQ should focus on creating efficiencies in Transaction-based revenues. This will result in higher margins. Compared to PYPL’s transaction expenses (33.52% of total operating expenses), SQ’s is an inefficient 54%. If the incumbent can conduct these very similar, “commoditized” services, then SQ should look into how it can make its operations more efficient.

Financial Position

How leveraged is SQ? At this early stage of an up-and-coming tech “unicorn”, we should expect that Debt is high – leveraged so that it can supercharge its growth. Compared to PYPL, SQ has an impressive financial position. The Debt to Equity ratio is a mere 1.78 compared to PYPL’s 1.55. This does not tell us much except that for a POS player trying to go big, SQ is fiscally responsible and is a conservative player in the industry. We may even be skeptical of SQ’s over-conservatism, and argue that they should borrow more so that they can fund R&D, S&M, and the many necessary components of an early tech company. I believe SQ should use its name as leverage to raise more capital so that SQ can explore international opportunities in the cashless societies aforementioned.

Looking forward

SQ should focus on retaining and growing their employees and management. We have briefly covered certain aspects of their income generation and pointed out some areas of improvement. At SQ’s dizzying valuation (with EPS and P/E impossible to calculate, and thus, compare, because of its Net Loss) in an environment where the market teeters on the cusp of an economic downturn, I would caution buying SQ today. Investors like me who bought SQ early would be wise even to exit their (significant) positions either now, or soon, depending on your risk tolerance. Yes, it would be unbearable to see the stock price soar while we miss out on potential gains, but I am going to take my profits now and enter my long position if SQ continues to perform in the long future. I see a huge potential in the industry and especially this company if it decides to take international opportunities, and will continue to follow its story and the stock price to new heights. However, shareholders of SQ who seek not-dear, true value in their portfolios would be wise to exit their long positions and find other sources of value. Not only can they find better risk-adjusted returns with their capital, reading up on other companies on our blog - but also, so they can sleep better at night.