Square's Marketing Expenses Spiking

Investment Analysis Clubs Saul’s Investing Discussions
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Good article and catch from Foolish contributor Adam Levy:

One thing that stood out on Square’s (NYSE:SQ) second quarter earnings report from earlier this month is the surge in sales and marketing spend. The line item grew to nearly $60 million last quarter, up about 50% year over year and 20% sequentially.

The growth spurt in marketing spend could be a sign that Square is facing intense competition. The increase outpaced revenue growth, which climbed 26% (41% on an adjusted basis). That’s despite Square boasting of its marketing advantage over competitors since it’s in direct contact with its merchants nearly every day.

Here’s what Square’s management had to say about the growth in marketing expense in the second quarter.

Read the entire article at https://www.fool.com/investing/2017/08/22/squares-marketing-…

Matt
Long SQ
MasterCard (MA), PayPal (PYPL), Skechers (SKX) and Square (SQ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

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The growth spurt in marketing spend could be a sign that Square is facing intense competition. The increase outpaced revenue growth, which climbed 26% (41% on an adjusted basis). That’s despite Square boasting of its marketing advantage over competitors since it’s in direct contact with its merchants nearly every day.

I wonder if the person who wrote this article even read the last earnings transcript. This was discussed during the call. Expenses were higher due to the launch of lots of new products. Product launch has one-time expenses.

Chris

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Hey Chris,

Read the whole article. He quotes that and discusses it in the second section. I thought he brought up some good points but that could just be me.

Matt
Long SQ
MasterCard (MA), PayPal (PYPL), Skechers (SKX) and Square (SQ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

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Read the whole article. He quotes that and discusses it in the second section. I thought he brought up some good points but that could just be me.

Matt,

OK, I’ve read the whole article. Here’s what I think:

  1. The title “Square’s Marketing Expense Is Exploding” is misleading at best. It seems to insinuate that SQ’s bottom line is shrinking which is not the case. If you look at the 50% y/y increase in marketing spend and compare that to the revenue growth in their subscription and services revenue growth, it looks pretty good to me. A 50% increase in y/y growth compares to a 103% growth in recurring revenue. Even if you look at the 20% sequential increase in marketing spend and compare that to the 20.6% sequential increase in recurring revenue. Now consider that a portion of that extra spend is because of new product launches in the UK, I’m really happy with how they are controlling expenses. SQ’s profitability is increasing as seen by increases in EPS. So I’m seeing a company that’s not only growing fast but also gaining operating leverage.

  2. The growth spurt in marketing spend could be a sign that Square is facing intense competition. Not sure how Adam makes this leap. It’s not backed up with solid evidence and arguments. Seems like conjecture to me. And then the last paragraph focuses on competition. I don’t buy the premise that SQ has intense competition from Shopify and PayPal. First, Square Capital is really a captive market (SQ’s existing merchants) while Shopify Capital is a captive market (Shopify only targets Shopify’s merchants). I would argue that almost all of the growth in getting new merchants in from merchants that use neither SQ or SHOP. PYPL has traditionally focused on customers and not merchants. Second, switching costs (from SQ to SHOP or SHOP to SQ) are high; each solution is an effort to set-up and who wants to go through that especially when the merchants are gaining a lot of benefits from each offering. If you knock down the premise that SQ is facing intense competition from SQ and PYPL then the whole article focus of the article is off base.

Chris

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I read this wrong from the article:

But revenue growth from its subscription and services business – the segment that includes those new products – didn’t change from the first quarter to the second quarter.

I thought he was saying revenue was flat sequentially. It wasn’t. The YOY revenue growth rate was just the same. I even double checked the numbers to make sure I was reading it right. When that growth rate is explosive like it was in this case, I’m fine with that. So that takes a lot of bite out of the article.

I don’t buy the premise that SQ has intense competition from Shopify and PayPal. First, Square Capital is really a captive market (SQ’s existing merchants) while Shopify Capital is a captive market (Shopify only targets Shopify’s merchants).

I think Adam was saying Square has no advantage approaching new potential clients with their secondary offerings, like Square Capital, when competitors like PayPal and Shopify offer the same services. On that point I believe he’s right, and its my biggest concern with Square. Can they innovate faster than competition can copy? I don’t know. So far yes, but others will keep mimicking.

Matt
Long PYPL, SQ
MasterCard (MA), PayPal (PYPL), Skechers (SKX) and Square (SQ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

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I think Adam was saying Square has no advantage approaching new potential clients with their secondary offerings, like Square Capital, when competitors like PayPal and Shopify offer the same services. On that point I believe he’s right, and its my biggest concern with Square. Can they innovate faster than competition can copy? I don’t know. So far yes, but others will keep mimicking.

If that’s what Adam meant, then it’s completely wrong.

  1. Square does not offer Square Capital to new customers, only existing customers where Square has some history of the customers sales transactions.

  2. Square (and Shopify too) will only provide cash advances (loans) to their own customers (merchants).

  3. Square (and Shopify) have a HUGE advantage because they have insight to their merchants’ sales transactions which allows Square to manage risk of these loans to their merchants.

  4. Square (and Shopify) can and do structure the repayments of the loans by automatically taking a cut from the merchant’s transaction revenue.

  5. Average advances are around $6000. There’s no way that a competitor can offer a Square merchant a cash advance without collecting a lot of information. This creates work for the merchant and work for the competitor. It also takes time. Square and Shopify can instantly offer these advances because they already have a wealth of information about their customer (merchant). It’s a win-win. Square gets a return on the loan and the merchant gets access to capital the he would otherwise not be able to get. The customer is happier which strengthens the relationship between Square and the merchant. It also helps the merchant grow his business which enables Square to collect more revenue from that merchant in the future.

So, Matt, once Square gets a customer and that customer uses Square Capital, he’s a LOT less likely to switch away.

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There’s also this:

Square’s gross payment volume has grown by 32%, and the company has done a great job of getting its product into larger businesses, which are still a relatively small part of the company’s revenue stream…
I would add “so far”.

Square Capital… grew its loan volume by 68% year-over-year, but it is utilized by just a small fraction of Square’s customers…
Again, “so far”.

…Square is only in five countries so far, and two-thirds of businesses around the world don’t accept card payments yet. It is estimated that the total international card payment volume will reach $45 trillion annually by 2025 (Square processed $56.9 billion over the past year), so it’s fair to say that Square’s market opportunity is massive.

https://www.fool.com/investing/2017/08/22/3-monster-stocks-i…

I think this is Square’s secret sauce: it allows small P2P businesses to accept credit card payments from their customers painlessly. We’re talking about small businesses like farmers market and festival vendors, craftspeople, street food vendors and other entrepreneurs globally, for all of whom accepting plastic is a major breakthrough. The inability to take credit card payments readily and affordably is painful to the first-level business; SQ makes it stop hurting. That SQ is taking hold with larger merchants as well shows they provide a solid solution.

Onboarding is easy. At its most basic, the device attaches to a smartphone and runs an app. I got into SQ after having seen that iteration some time ago and, more recently, having seen SQ terminals in use at a retail farm market. (They’re slick.)

SQ also rides the megatrend away from cash.

I have difficulty imagining a small merchant, having once made the pain stop, even wanting to explore another option before starting to use Square’s secondary features and getting sucked firmly into the ecosystem. I’m in.

regards,
Jackson

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We’re talking about small businesses like farmers market and festival vendors, craftspeople, street food vendors and other entrepreneurs globally, for all of whom accepting plastic is a major breakthrough. The inability to take credit card payments readily and affordably is painful to the first-level business; SQ makes it stop hurting. That SQ is taking hold with larger merchants as well shows they provide a solid solution.

My cab driver’s normal credit card machine did not work today. He had Square and suggested we use that for my credit card. The driver popped the device into his phone, swiped my card, had me choose a tip and away I went.

During the 30 seconds or so for the transaction to be completed including fumbling the phone back and forth between each other, I asked him how he liked Square. He said he liked it due to lower fees than normal and for the fact the money went directly into his bank account.

No wonder his regular machine “didn’t work today.”

Good points all. I have had some concerns about Shopify competing with Square. However, they seem to serve different types of customers. Still not 100% sold on Square though.

Thanks,
A.J.

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Chris,

I’m not disagreeing with any of your points. Truly! I understand how Square Capital works and the advantages of it and you described them perfectly. However…

Square and Shopify (and PayPal which offers an identical loan service) do compete on some level. So the fact that Shopify and PayPal (and probably soon others) offer the same services means that when Square is competing on the open marketplace for a new customer, the fact that others can offer a similar service to Square Capital negates that selling point.

So when a Square sales rep approaches a merchant to sell Square’s services that sales rep can’t say that Square is the only one to offer such a loan program, because others (e.g. Shopify, PayPal) can say the exact same thing.

And yes, this platform is going to be copied by others. Just like Square’s other innovations have been by competitors.

But anyway, Square’s marketing and sales expenses went up. I was just pointing that out. Still long.

Matt
Long PYPL, SQ
MasterCard (MA), PayPal (PYPL), Skechers (SKX) and Square (SQ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

PS - Chris, you’re the best. Seriously, I love your contributions to this board. They are spectacular. And, since we’re on the subject of your awesomeness, I just wanted to thank you for this post two and a half years ago. When you wrote it, I copied the link and emailed it to several friends and family members: http://discussion.fool.com/the-invisible-workers-31677596.aspx?s…

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Matt,

Thanks for your kind words. I’m glad that you’ve found some of my posts useful.

I understand how Square Capital works and the advantages of it and you described them perfectly. However…

Square and Shopify (and PayPal which offers an identical loan service) do compete on some level. So the fact that Shopify and PayPal (and probably soon others) offer the same services means that when Square is competing on the open marketplace for a new customer, the fact that others can offer a similar service to Square Capital negates that selling point.

So when a Square sales rep approaches a merchant to sell Square’s services that sales rep can’t say that Square is the only one to offer such a loan program, because others (e.g. Shopify, PayPal) can say the exact same thing.

And yes, this platform is going to be copied by others. Just like Square’s other innovations have been by competitors.

Sure, these companies compete generally, but they are mostly competing for new business rather than taking share from each other. When I read what you wrote above, I’m not sure if you fully understand the loan services that Square and Shopify offer. Square and Shopify are in no way competing to make loans because they are only offering loans to their own customers (and probably only those customers who have been a customers for some minimum period). Furthermore, they do not offer loans to all of their customers. Whether they offer a loan (and the size of the loan offer) varies depending on Square’s or Shopify’s view of the merchant’s business. The reason this program can work is because Square has a real-time and direct view of the merchant’s transactions with the merchant’s customers. Square can see if customers are buying, how much they are buying, whether they are repeat buying, whether they are returning products, etc, etc. All of this information allows Square to make an reasonable and probably very accurate assessment about whether the merchant will be able to repay the loan. If there is not enough transaction history for a particular merchant then Square has no way to make an accurate prediction about if the merchant can repay. Therefore, Square is very unlikely to offer loans to their new merchants. Thus, Square would never offer a loan to a Shopify merchant. The other important reason why the merchant needs to be on the Square platform is that the loan repayment can be set up (and this may be a loan condition) so that Square takes a cut of all future sales of the merchant to the merchant’s customers until the loan is fully repaid. Without this automatic percentage of sales repayment plan the merchant would be able to prioritize other business expenses over repaying the Square loan which would reduce increase the repayment period and increase the default rate. As far as using Square Capital as a selling point, I think it might help a little bit but I very much doubt is a top reason why a merchant would choose Square. “A sales rep approaching a merchant”: most of the business gained by Square and Shopify is not through sales reps. Most business is gained through much lower cost channels. Customers will chose the platform primarily based on the features and benefits of these platforms. Shopify and Square continue to improve their platforms which creates an increasing barrier to entry (moat) and an increasing cost to switch.

But anyway, Square’s marketing and sales expenses went up.

I think it’s more useful to look at this expense as a percentage of revenue rather than as a dollar amount increase. Over time we want to see operational leverage playing out: OpEx expenses drop as a percentage of revenue (but may still increase significantly in aggregate dollars). This enables more of the revenue to drop to the bottom line.

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Sure, these companies compete generally, but they are mostly competing for new business rather than taking share from each other.

Chris,

I promise I understand the business model and everything you’re saying. And your statement above is accurate as far as it goes, but…when these companies are competing for new customers who are they competing with? Each other!

Let’s say I start a new food truck business and I’m in the market looking for a payment processing company so my food truck can accept credit cards. I do my research online and find that basically any of the processing companies - Total Systems, First Data, Global Payments, Vantiv, and now even Shopify - can fulfill my card-acceptance needs. Its about as commoditized a service as you will find.

So my next consideration is price. I will go with the lowest-cost vendor. That is, unless, one of these companies can also offer me services I value. For those companies, I might be willing to pay a premium. If I think I might need a loan at some point in the future, a loan platform like Square Capital would be appealing. But, in this scenario, so would PayPal’s/Shopify’s loan platforms, right? So Square would be competing with these companies for my business and the attractiveness of its Square Capital program would be effectively negated when I was comparing it to competitors who offered a similar service.

And, yes, let’s throw in the caveats that as a brand new customer I would not have access to any of these loan platforms just yet. But legitimate merchants will understand the value that this service, and others, could bring to their business somewhere down the road. So I believe Square competes in a very real way with PayPal and Shopify on the open market for new merchants that do not yet subscribe to any of these processing services.

These services are what separates Square from the pack I believe; they represent Square’s moat. They are also the primary reason the company is able to keep its take rate so high. So the fact that competitors can offer similar products is at least something to keep an eye on IMHO. Also, as I believe I said up-thread, investors just need to make sure Square can keep innovating faster than competition can copycat. So far, I believe they have been very successful at doing this.

Also, just an FYI, Square has floated the idea of offering Square Capital to non-Square merchants. I will find the conference call later, but it was probably 2016 Q3 or Q4, when this idea was mentioned as a possibility? I obviously hope they don’t do this because they would lose the advantages of how these loan risks are considered, but the company has considered the idea in the past. In fact, now that I think about it, it might have just been an analyst that asked the question and Square maybe just answered that they might one day consider it. I’ll try to look this up later. I’m pretty sure the idea hasn’t been mentioned since, which is probably a good sign.

Basically, Chris, I think we agree on everything except this:

As far as using Square Capital as a selling point, I think it might help a little bit but I very much doubt is a top reason why a merchant would choose Square

I think these services are a primary reason merchants choose Square.

But I can agree to disagree. I could very well be wrong.

Matt
Long PYPL, SQ
MasterCard (MA), PayPal (PYPL), Skechers (SKX) and Square (SQ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

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Here’s a new Fool article from Danny Vena on PayPal’s ramped up attention to this space: https://www.fool.com/investing/2017/08/24/paypal-is-swiftly-…

Matt
Long PYPL, SQ
MasterCard (MA), PayPal (PYPL), Skechers (SKX) and Square (SQ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

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Great discussion, Matt.

I promise I understand the business model and everything you’re saying. And your statement above is accurate as far as it goes, but…when these companies are competing for new customers who are they competing with? Each other!

Let’s say I start a new food truck business and I’m in the market looking for a payment processing company so my food truck can accept credit cards. I do my research online and find that basically any of the processing companies - Total Systems, First Data, Global Payments, Vantiv, and now even Shopify - can fulfill my card-acceptance needs. Its about as commoditized a service as you will find.

So my next consideration is price. I will go with the lowest-cost vendor. That is, unless, one of these companies can also offer me services I value. For those companies, I might be willing to pay a premium. If I think I might need a loan at some point in the future, a loan platform like Square Capital would be appealing. But, in this scenario, so would PayPal’s/Shopify’s loan platforms, right? So Square would be competing with these companies for my business and the attractiveness of its Square Capital program would be effectively negated when I was comparing it to competitors who offered a similar service.

And, yes, let’s throw in the caveats that as a brand new customer I would not have access to any of these loan platforms just yet. But legitimate merchants will understand the value that this service, and others, could bring to their business somewhere down the road. So I believe Square competes in a very real way with PayPal and Shopify on the open market for new merchants that do not yet subscribe to any of these processing services.

These services are what separates Square from the pack I believe; they represent Square’s moat. They are also the primary reason the company is able to keep its take rate so high. So the fact that competitors can offer similar products is at least something to keep an eye on IMHO. Also, as I believe I said up-thread, investors just need to make sure Square can keep innovating faster than competition can copycat. So far, I believe they have been very successful at doing this.

I agree that they will compete with each other. However, I think you are assuming that their offerings are for the most part undifferentiated which would be required for commoditization which would lead to downward pricing pressure and margin compression. I argue that the offerings of SHOP and SQ are differentiated. For example, SHOP offers a direct and almost seamless link into eBay and Amazon; this adds a lot of value to merchants. SQ offers Caviar to its restaurant merchants which allows them to expand their business beyond the limitations of seating capacity. Both companies offer plenty of data analytics to the merchants which can help in making business decisions; such features keep getting added and improved and provide added benefits in relation to the other processing companies. SQ and SHOP should continue to take share from these processing competitors without having to compete on price. The market opportunity for SQ and SHOP are huge and they don’t need to compete on price; they care more about getting more business than competing directly with each other. For now the competitiveness will be focused on adding more capabilities to delight their current and future customers. Furthermore, the longer a merchant has been on either the SHOP or SQ platform, the stickier that service becomes. The historical data and insights from that data would be lost if they switch. A commodity is highly influence by price and merchants would migrate to the lowest priced solution. SQ and SHOP have the opportunity to build more and more loyalty as merchants use the service; loans to merchants is one way the loyalty will build. In addition, SHOP and SQ will continue to new capabilities (SQ called this giving their merchants new superpowers). This will all increase differentiation which will prevent price cuts and margin erosion.

Chris

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PayPal first debuted its Working Capital service back in 2013, and since then has provided in excess of $3 million in funding to more than 115,000 merchants.

$3M to 115,000 merchants is $26 per loan. Did he mean $300M? $3B?

The acquisition of Swift will allow PayPal to expand its underwriting capabilities, increase its loans to $500,000 for larger merchants, and expand its offerings to smaller businesses.

Yikes. Isn’t the average Square loan like $6,000 or did I dream that? $500,000 sounds like a totally different ballgame, risk-wise, and a little scary. Matt, any thoughts about this? Are you concerned?

Bear

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Chris, very good discussion. I think we’re agreeing on 99% of everything.

Bear, I honestly haven’t looked into PayPal’s new acquisition of Swift yet so I don’t really know if I’m concerned or not. Yes, Square’s average loan is ~$6K. In theory, same advantages should hold: PayPal will know business of borrower, will take repayment directly out of sale transactions, etc.? But I haven’t looked at it closely yet, so I really don’t know.

Matt
Long PYPL, SQ
MasterCard (MA), PayPal (PYPL), Skechers (SKX) and Square (SQ) Ticker Guide
See all my holdings at http://my.fool.com/profile/CMFCochrane/info.aspx

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Just a little anecdotal confirmation . . .

Took my wife to get her hair done, small salon maybe 4 chairs. Paid with a Square dongle on an iPhone.

Went to a new, small, Turkish restaurant in a local strip mall. Payment via a Square terminal.

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