More of Hochfeld's Thoughts on Square

Hochfeld released another piece today discussing Square, the payments solution company. As Bert does, in the article he rambles a bit, jumbling his thoughts, because he knows so much about the companies he writes about.

But one concept he seems to keep returning to about Square is that its moat exists not because of any one of its products, but because it offers such a breadth of products and services. This simplifies so many things for entrepreneurs starting their first business, whether its a proud new food truck owner or a tech startup.

For instance, while some payments companies offer some nearly identical services as Square - from mobile readers to instant deposit to loans - I do not know of any that offer payroll services. I wonder if Intuit does? But lesser payments companies, like TSS or GPN certainly do not. From Hochfeld’s piece:

The most obvious example of this is the synergy between Square Capital and the Square payment processing business. Square Capital is completely dependent on Square payment processing to find its customers. Its special sauce is that it costs almost nothing for Square Capital to acquire customers, and it is able to make loan decisions both more quickly and more effectively than bank rivals who do not have the ability to use a company’s own revenues as security for a loan. Given that Square raises 3rd party capital to fund its loans (merchant cash advances), and that it can service loans from its own payment platform, Square has invented one of the more potentially lucrative undertakings in the IT world. While Square Capital’s APR on its loans is high, the implied APR on the instant deposit option is remarkable. The CFO called it a high margin product since it is able to charge 1% for overnight access to money, which is as good as it gets.

While there is a strong temptation to simply look at the opportunities Square has in loaning other people’s money to its sellers at extraordinary rates of interest, the fact is that it really does offer a host of technologies that most of its customers will find useful. In aggregate, the company sold $35 million of what it calls software and data products. Most of that revenue is from Capital, Caviar and Instant Deposit, but the opportunities that this company has to sell just pure software is substantial. It is far easier for potential users to contract with Square for their requirements in terms of payroll, CRM and analytics than it is to try to select different products from different users and try to integrate the results.

Again, there is a huge amount of software designed and sold to SMB’s and it hard for most users to choose between all of the different offerings. There is nothing in Square’s software solutions that is particularly unique or cutting edge but it is easier and cheaper together, at least in terms of the total cost of ownership.

Read the entire piece at http://seekingalpha.com/article/4034012-square-becoming-warm…

Make no mistake, in the short to medium term any Square investing thesis is all about the company growing its payments services and then up-selling its customers its more lucrative services, like Instant Deposit and Square Capital.

But in the long term, CEO Jack Dorsey’s vision is much bigger. I think he wants Square to be a one-stop shop for small/medium businesses offering everything from loans to payroll to data analytics to payments services. I find this very interesting.

There are challenges to this vision of course. I think it is far from certain Square ever accomplishes these grandiose goals. For starters, the company is still not profitable, loses a lot of money on every single piece of hardware it sells, and I’m still not all certain Dorsey wouldn’t just rather be Twitter’s full-time CEO. If Dorsey’s not going to be at Square for long, I’m a lot less interested in Square as an investment.

Plus, I’m also not sure that offering all of these services (let’s not forget Caviar, a restaurant delivery service which Square acquired a couple of years ago) is more distracting than productive. Amazon didn’t try to be everything at once, it started by selling books and then slowly added more merchandise and services atop that foundation. I truly wonder if Dorsey is biting off more than he can chew.

But the long term vision is interesting. I think its David Gardner who says he likes companies with future “optionality”. Or companies with multiple futures. Something like that. Ah, here’s a good definition of optionality as I am using it:

Optionality

This means he looks for companies that have current or future earnings options. Potential multiple streams of income, to you and me. He mentioned in a Motley Fool ( which he started with his brother) interview that this separates him from Buffett ( who he couldn’t be more different from in investing style).

David Gardner wants to find companies that have the potential to turn into Amazon type stocks ( his 100+ bagger) that do many different things, not just selling books like they used to. Amazon sell everything, went into tablets, are doing cloud storage and a ton of other things. Multiple revenue streams. See’s candy still just mostly sells candy.

From http://waystofattenyourwallet.blogspot.com/2014/03/insight-i…

Well, I’m going to stop here as I am rambling and probably jumbling thoughts together just as I accused Hochfeld of doing in this same post! But Square has lots of optionality as I see it. And it intrigues me.

Matt
No position in Square
MasterCard (MA), Nestle (NSRGY), PayPal (PYPL), and Verizon (VZ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

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There are challenges to this vision of course. I think it is far from certain Square ever accomplishes these grandiose goals. For starters, the company is still not profitable, loses a lot of money on every single piece of hardware it sells, and I’m still not all certain Dorsey wouldn’t just rather be Twitter’s full-time CEO. If Dorsey’s not going to be at Square for long, I’m a lot less interested in Square as an investment.

Plus, I’m also not sure that offering all of these services (let’s not forget Caviar, a restaurant delivery service which Square acquired a couple of years ago) is more distracting than productive. Amazon didn’t try to be everything at once, it started by selling books and then slowly added more merchandise and services atop that foundation. I truly wonder if Dorsey is biting off more than he can chew.

Matt,

I can’t help thinking maybe you’re missing the trees for the forest. Caviar seems like a tiny bet. There’s a limit to how “distracting” it can be.

Are we really to worry about Square being profitable eventually? They were cash flow positive in the Sep quarter. Look at the revenue growth…the EPS losses are fairly small (8 cents and 9 cents the last two quarters).

Why are you so worried about the long term? I feel like Square has plenty of time. Current liabilities are covered by cash on the balance sheet…doesn’t seem they’re in any kind of peril to me.

Bear

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Hey Bear,

I can’t help thinking maybe you’re missing the trees for the forest.

Well, it wouldn’t be the first time :slight_smile:

I am growing more bullish Bear. It just takes me a while to come around to stocks like this. I am much slower and less nimble than you and Saul.

I did have concerns though and wanted to express them. But, by and large, I am impressed with the company. The vision is much grander than I first thought.

The problem is that in the near term their revenue and earnings will depend upon the very low margin business of facilitating credit card payments and such for small and medium-sized companies. If their vision doesn’t pan out, that’s where they’ll be stuck. Is Dorsey the guy to get it done? I don’t know. But I am seriously considering a small, speculative position to get started.

Again, I am mostly impressed the more I learn about the company.

Also, for those interested, there was a really good Motley Fool podcast on the company a few months ago. you can listen to it here: http://www.fool.com/investing/2016/08/23/a-deep-dive-into-sq…

Besides diving into the company’s own materials and the Hochfeld articles, it was one of the most valuable takes on Square that I found while doing my research. If you haven’t given it a listen, it’s worth the time. There’s also a transcript you can browse through.

Matt
MasterCard (MA), Nestle (NSRGY), PayPal (PYPL), and Verizon (VZ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

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I am growing more bullish Bear. It just takes me a while to come around to stocks like this. I am much slower and less nimble than you and Saul.

That’s not necessarily a bad thing. You saw my returns last year. Slowing down is more of a goal of mine than a failing of yours.

The problem is that in the near term their revenue and earnings will depend upon the very low margin business of facilitating credit card payments and such for small and medium-sized companies. If their vision doesn’t pan out, that’s where they’ll be stuck. Is Dorsey the guy to get it done? I don’t know. But I am seriously considering a small, speculative position to get started.

I just don’t know about that. They’ve improved margins and are losing much less than they were even just a couple quarters ago. They have actually exchanged loss leading revenue for revenue that is more profitable. Here’s a little snip from the podcast you linked to:

Priestley: Absolutely. But they did raise their adjusted revenue guidance up 6% to $655 [million] to $670 million. Adjusted EBITDA to $18 million to $24 million from previously guided $8 million to $14 million. That’s a big jump, there.

Lewis: One of the things that pops out most to me when I look at their numbers year-to-year, 2014 they had a gross margin of just over 26%. In 2016, they’re up around 31% now. And that steady march up, we talk about the idea of their bread and butter business, payment facilitation, not being super great for margins. I think you’re starting to see the effect of all these other business segments contributing to that margin number.

Priestley: Yeah, you’re completely right. The reason for this margin enhancement is basically being driven by the product mix. If you look, transaction right now is about 76% of their income. Software and data, which is what Square Capital falls under, is 18%. And then hardware revenue is 6%. Hardware revenue, as they grow the number of people they supply, this will grow. But what we really want to focus on as investors is software and data. We want to see that become a bigger slice of the pie.

And it seems it is becoming a bigger slice of the pie, quickly. You even threw out the number 70% for Square Capital growth here: http://discussion.fool.com/initial-notes-on-square-32504200.aspx…

But more than anything check out the software segment growth. From 14,694,000 in the Sep quarter of 2015 to 35,320,000 in the Sep16 quarter. 140% growth. And software moved from ~12% to ~20% of adjusted revenue in the same time frame. That’s where the profit is. That’s the number to focus on. If that keeps growing for quarters and quarters to come, Square is an absolute steal right now.

Bear

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