Why I Bought Square

Investment Analysis Clubs Saul’s Investing Discussions
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Even though I’ve followed Square for a while, I was extremely hesitant to buy shares despite being impressed by many of the company’s moves. I always thought shares were overvalued (and they very well might be) and payment processing is an extremely tough space. For the most part, processing card payments is largely a commodity, something more than a few companies are capable of competently performing. Beyond that, a good deal of merchants will never see a need to change out an existing payment processing vendor because their needs are few and the process of switching payment processing companies causes far more work and pain than would be justified by any upgrade in service the switch would provide. I don’t want to put words in his mouth, but I believe this is basically what Tinker has conveyed about the payment processing needs of his practice.

That being said, almost immediately after going through their first quarter results I took a position in the company. A small position, to be sure, but one I hope to build out at better value points as time goes on. Here is why I took a position in the company despite being apprehensive about its valuation and the competition it faces. I don’t see a need to re-invent the wheel, so I’m going to borrow liberally from a few articles I’ve written about the company but will also add more color too where appropriate. Anything italicized will be a quote from an article, anything in plain text will be additional thoughts.

1. International opportunities. One of the biggest reasons I’m bullish on Square is because I believe it has lots of int’l opportunities ahead. The company just entered the UK, meaning it now has a presence outside the US in Australia, Canada, Japan, and the UK. The company certainly did its HW on where to enter too.

According to Square’s first-quarter shareholder letter, the United Kingdom features a “thriving entrepreneurial scene.” The country’s 5.5 million SMBs generated 1.8 trillion pounds in 2016, nearly half of the U.K.'s private-sector revenue. While 70% of the country’s consumers would prefer to pay by card, less than half of the market’s SMBs accept card payments.

Better yet, Square is not entering the United Kingdom’s market with just its point-of-sale solutions, but with most of its suite of products as well, including the company’s lucrative subscription- and services-based revenue category (previously called software and data product).

From https://www.fool.com/investing/2017/05/26/is-square-inc-a-bu…

That’s important to note because, thus far, its results in Australia, Canada, and Japan do not include earnings from its most profitable areas of business nor the stickiness of its entire ecosystem.

But even beyond all this, I believe Square is better positioned than any other payment processing company to capture market share in emerging economies where cash is still overwhelmingly the payment method of choice. A plug-in to a smartphone or tablet just seems to be a much more mobile and durable processing choice than clunky hardware in areas where the telecom infrastructure might be less than ideal. With many of the world’s biggest markets making this shift from cash to electronic payments (e.g. India), the int’l opportunities in the years ahead might be huge.

2. Square’s buoyant take rate. This might be the most impressive of Square’s metrics. I was convinced this number was going to be trending downward for quite some time.

Perhaps one of Square’s most impressive feats is keeping its take rate so high. “Take rate” is industry-speak for Square’s transaction-based revenue as a percentage of its gross payment volume (GPV). This quarter, Square’s take rate was 2.96%, up from 2.92% in the year-ago quarter.

That Square has managed to inch up its take rate while increasing the size of the average business it services is quite remarkable. Indeed, this was previously one of my chief concerns regarding Square. Larger businesses, while offering some advantages like higher payments volume, generally can negotiate lower take rates than smaller businesses. In the first quarter of 2015, large businesses, defined as businesses that contribute more than $500,000 in annual GPV, contributed 9% of Square’s overall GPV. Fast forward two years and these businesses contributed to 15% of Square’s GPV.

From https://www.fool.com/investing/2017/05/26/is-square-inc-a-bu…

Like I said, this was previously one of my biggest concerns with Square. In January, I wrote this in an article:

Square needs to be careful, though, that it doesn’t hurt itself with smaller margins on transactions and the higher costs associated with courting larger businesses. Square currently charges its smaller business clients (defined as companies with revenue less than $250,000 per year) 2.75% per swipe for credit and debit cards. Of that amount, the credit card companies and the issuing bank takes a cut take leaving Square with just 1.01% from each transaction.

In the pursuit of larger businesses, Square has clearly signaled it is not afraid to compete on pricing. On the company’s home page, prospective client businesses making under $250,000 per year are immediately shown the 2.75% fee per swipe. But potential customers making more than that are told to contact Square for “custom pricing packages.” Again, it is good for Square to pursue larger businesses, but only if it doesn’t kill itself on the margins doing so.

From https://www.fool.com/investing/2017/01/24/3-concerns-for-squ…

3. Culture of innovation. This one is harder to quantify, but it is definitely present. And it’s hard to say it creates a durable moat because innovation can stop at any time. But every quarter they seemingly come out with a new trick, a new way to solve a customer’s pain point and, in the process, make more money. In 2016 Q4, the company released Square for Retail:

As with Square Point of Sale (previously named Square Register), Square for Retail is an app that sellers can download and start using within minutes. Merchants who download and use the app are then charged a monthly subscription fee per device.

Why would merchants pay more for a payment processing solution like this? According to Square’s shareholder letter, the platform “is optimized for retailers, with a search-based user interface and fast bar code scanning, while advanced inventory management supports tens of thousands of items and manages cost of goods sold, purchase orders, and other capabilities that a retail business needs.” In the conference call, Dorsey added more color, saying the platform solution will give sellers the ability to “build customer profiles and provide purchasing history” right from the POS terminal.

From https://www.fool.com/investing/2017/03/04/two-key-growth-dri…

This past quarter, the company solved the traditionally tricky chip-and-PIN authentication int’l markets require with a software solution, not an expensive hardware add-on. From the quarter’s shareholder letter (available for download from the company’s IR page):

We built a new, secure way to enter PINs into the Square app on a mobile device, eliminating the need for expensive hardware PIN pads and making card acceptance more accessible. Also, our solution is quick and easy to update because it is software based, ensuring that our sellers always have access to the latest technology. We are working alongside industry partners to evolve standards for this new mobile PIN acceptance capability, which is the first of its kind for payments.

This past quarter Square’s Caviar, a food delivery service the company runs, launched Caviar Pickup, which is essentially an app that allows customers order their food ahead from their favorite restaurant. While larger chains like Starbucks and Domino’s famously have similar apps, this allows smaller restaurants to offer the same type of service. On March 1st, when the company announced the app, more than 3K restaurants already used Caviar’s delivery service.

This is on top of past innovations which have included such lucrative services like:

Instant Deposit

This service allows retailers to receive money instantly in their bank accounts upon swiping a customer’s credit or debit card. The usual processing time can take up to four days and create cash flow problems for small businesses. In the company’s 2016 third quarter shareholder letter, Square stated that since launching this product a little more than a year prior, over 200,000 merchants had already made almost 4 million instant deposits. For each instant deposit, Square charges 1%. This could be an incredibly lucrative area for Square, as the service amounts to little more than a three-to-four day loan that is virtually guaranteed.

From https://www.fool.com/investing/2016/12/22/3-business-segment…

Square Capital

Square Capital is a service Square offers which facilitates loans to its business customers. The merchants can then pay the loan back gradually, as a percentage of transactions. In the third quarter alone, Square processed over 35,000 loans totaling more than $200 million, an approximate 70% year-over-year increase.

The average loan size, according to CFO Sarah Friar, is about $6,000. These loans especially appeal to small businesses that do not normally have access to capital to cover unexpected expenses or purchase new equipment.

…

Because Square is so intimately familiar with its customers’ businesses, it can choose who to offer these loans to with a high amount of discretion. Thus far it’s working. Square Capital has maintained a 4% loan loss rate for every single quarter in 2016 thus far. That’s less than half the national default rate across all small businesses this year according to WAIN Street’s Business Default Index.

From https://www.fool.com/investing/2016/12/22/3-business-segment…

When Square’s invoice services, data analytics, inventory management, etc. are taken into consideration, along with the above, I believe you have an incredibly sticky ecosystem, one that will almost be impossible to leave for SMBs.

Now, as far as, other businesses leaving their existing payment processing vendors for Square, it might be tough slogging. Winning over law practices, doctor offices, and other businesses that don’t really need the smoothest point-of-sale checkout experience to succeed, will probably never switch over. But restaurants and other fast-moving retail businesses might consider a switch. But if Square can grab the lion’s share of new small businesses and grow with the businesses they already have under their umbrella, I think they will be very successful over time.

I do think there is an excellent chance for volatility ahead. As I’ve said, shares sport a high valuation right now. I plan to add to my position over the next several quarters if the thesis remains intact. Just thought I would share some thoughts on my newest position.

Matt
Long SQ
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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Is there any concern with Shopify entering some of the spaces Square plays in?

I won’t get the exact biz segment names correct so I’ll refrain from using them. But Shopify is in the payment space online and recently developed a credit card swipe/insert device for in-person transactions. Shopify is also beginning to offer loans as well, I believe.

They seem to be inching into Square’s sandbox.

FWIW, I like Square’s credit card device that plugs into a phone. As a customer, it is quick and easy and allows you to get out of the taxi quickly. When using Uber or Lyft, that isn’t even an issue though. And if everyone accepted Apple Pay, that would be the best of all worlds.

It doesn’t seem Shopify is a concern now, but they do have special relationships with many SMB.
Is this a future concern or am I looking into it too much?

Take care,
A.J.

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Is there any concern with Shopify entering some of the spaces Square plays in?

It’s a big market…enough for multiple participants.

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Is there any concern with Shopify entering some of the spaces Square plays in?

AJ, this is my sense of it and I could be wrong. I don’t own Shopify and have never really had a chance to really sit down and study it (much to my chagrin).

Shopify is more suited to e-commerce while Square is more focused on point-of-sale (POS) retail. While both have limited offerings in each other’s spaces, those remain the primary focuses of each business. Because commerce is so blurred these days, often merchants will need checkout solutions in both physical retail and e-commerce. To better satisfy its customer base, both companies have moved into each other’s space. But I don’t think of this as head-to-head competition for each other’s customers, but to keep its own customers in their respective ecosystems. Does that make sense?

I think an example is the best way to describe this:

Person A and Person B both make phenomenal homemade crafts and want to start selling them. Person A lives in a tourist-y area. So Person A opens up a small store space sells their goods to tourists. Square is a perfect solution for this merchant. Eventually Person A might get it in their heads to sell their goods online too. So Person A will probably use Square’s online processing solutions too, to keep things simple.

Person B does not live in an area conducive to this kind of store front retail. So Person B begins by selling their goods online. Shopify is perfect for this merchant. Eventually though, Person B might want to occasionally rent spaces at festivals or special events and now needs a way to physically accept card payments. It only makes sense for Person B to stay under Shopify’s umbrella and utilize their POS processing solutions.

In both cases - Square’s move to online and Shopify’s move to physical retail - I believe the companies were much more trying to keep existing customers than to capture new customers. It seems to me that each company’s focus is still almost exclusively on their original respective markets: Shopify with e-commerce, Square with POS retail.

In my head this makes sense, so I hope I’m explaining it right. And, again, that’s just my overall sense of the situation. I don’t know that for a fact.

FWIW, I like Square’s credit card device that plugs into a phone. As a customer, it is quick and easy and allows you to get out of the taxi quickly.

I agree, AJ. A couple of months ago, my family attended the Florid a Strawberry Festival for some state fair-like family fun. There were a million small vendors selling refreshments, produce, handmade crafts, etc. The vendors with Square seemed to offer a much quicker and smoother experience than those with First Data or other processors. Much to my wife’s chagrin, I asked all those with Square how long they’ve been with the company, how they liked it, etc. All seemed fairly enthusiastic about it but most had never had experiences with another processor. But, from my perspective, Square seemed to be the class of the field.

When using Uber or Lyft, that isn’t even an issue though.

Uber uses PayPal’s Braintree for processing and Lyft uses Stripe (private company). I still much prefer PayPal to Square as an investment. It is a much broader payment company with great growth prospects but much better valuation (imho).

Matt
Long PYPL, SQ
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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“Shopify is more suited to e-commerce while Square is more focused on point-of-sale (POS) retail. While both have limited offerings in each other’s spaces, those remain the primary focuses of each business. Because commerce is so blurred these days, often merchants will need checkout solutions in both physical retail and e-commerce. To better satisfy its customer base, both companies have moved into each other’s space. But I don’t think of this as head-to-head competition for each other’s customers, but to keep its own customers in their respective ecosystems. Does that make sense?”

This is my thinking also. I believe we are in a secular change from bricks and mortar store fronts.
We in the US are about 5xs larger in retail space per capita than the next highest country. Just as many emerging telecom markets bypassed wirelines in favor of wireless infrastructure I think the trend nowadays is to go 1st to an online presence which plays into SHOP’s wheelhouse. In case the retailer does have a physical presence, SHOP seeks to address that need.

Rob

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Excited to see this, Matt! Hope you’ll continue to share your great coverage here as you get more and more intimately familiar with Square. They definitely got some people’s attention with the quarter they turned in a few weeks ago, and what strikes me, as I’ll elaborate on in my monthly review Wednesday, is the potential I see for them to start bringing some serious dollars to the bottom line.

As far as competition goes, I agree about Shopify – different target customers. However, I think Square does have direct competitors. It certainly seems like Square has a dominant lead, so I think it would be interesting to know more about the upstarts and copycats – how do they think they can win? And why do some businesses choose them? One that I’ve seen at a couple local businesses is Clover. Have you heard of them? https://www.clover.com/

Bear

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Hope you’ll continue to share your great coverage here as you get more and more intimately familiar with Square.

Thank you, Bear, for the kind words. It was my oversight to not thank you for bringing Square to this board and providing me with my first catalyst to look at the company. I just wish I had followed you quicker into a position!

However, I think Square does have direct competitors…One that I’ve seen at a couple local businesses is Clover.

Indeed, Clover is First Data’s (FDC) flagship payment processing platform. First Data is probably the biggest pure payment processing player. Other competitors would be Total System Services (TSS) and Global Payments (GPN). If you’re interested, I did an article a month or two ago comparing these three companies. This is what I wrote about First Data at the time:

First Data Corp (NYSE:FDC) consists of three business segments: global business solutions, global financial solutions, and network ad security systems. The company’s global business division is by far its largest, accounting for 55% of the company’s total revenue. This segment offers commerce solutions like mobile payment capabilities and Clover, the cloud-based point-of-sale operating system. Unfortunately, revenue was down in this segment 1% year over year…

…Other segments aren’t exactly coming to the rescue. While the global financial segment increased revenue 5% year over year, network and security saw a revenue decline of 2%. First Data’s stock is certainly more attractively valued than most of its peers at an adjusted P/E of just 12.3.

From https://www.fool.com/investing/2017/02/28/most-investors-hav…

Personally, I would worry more about GPN than FDC. But they are all competitors in this space. And that’s not to mention Stripe, PayPal’s Braintree, and others. It’s a tough crowd. Coupled with the valuation, it is what held me back from investing in Square for so long. And I’m still cautious. It’s why I’m slowly going to build the position over time.

Another oversight: I meant to include the numbers I have for Square:


Revenue (millions)		Q1		Q2		Q3		Q4	
2014										250
2015				374		310		332		374
2016				379		438		439		451
2017				462						

Adjusted Revenue (millions)	Q1		Q2		Q3		Q4
2014										82
2015				89		111		118		135
2016				146		171		178		192
2017				204

EPS (diluted) 			Q1		Q2		Q3		Q4	
2014										(0.25)	
2015				(0.34)		(0.20)		(0.35)		(0.34)
2016				(0.29)		(0.08)		(0.09)		(0.04)
2017				(0.04)

EPS (Adjusted)			Q1		Q2		Q3		Q4
2015										(0.05)
2016				(0.05)		0.02		0.01		0.05
2017				0.05
			
GPV (billions)			Q1		Q2		Q3		Q4
2015				7.1		8.8		9.5		10.2
2016				10.3		12.5		13.2		13.7
2017				13.6

2017 Q1 Earnings:

Quick note: Adjusted revenue is much more important than revenue for Square. Adjusted revenue is essentially the money SQ gets to keep after giving card-issuing banks their interchange fee and the credit card companies their cuts.

Adjusted Revenue Growth (millions)
2016 Q1 TTM Revenue = 510
2017 Q1 TTM Revenue = 745
YOY TTM Adj Revenue Growth = 46%, previous quarter 51.7%

EPS Growth (diluted)
2016 Q1 TTM Earnings = (1.18)
2017 Q1 TTM Earnings = (0.25)
YOY TTM EPS Growth = NA

P/E (Check Current Price) = NA

1YPEG = NA

Cash/cash equivalents: $990M

Matt
Long PYPL, SQ
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’ve been liking Square for a while but been caught between Square and Ppal (as well as clearing out the Junk in my investing cupboard - that Saul’s posts continue to embarrass me on - more on that another time).

Anyhow one of the trades I was considering - was cashing in my Grubhub which has been good to me and is still growing very fast, but has risk and uncertainty written all over it; and swapping it for Square which apart from representing the online payment space has its own fast growing food delivery service - thus keeping me in the game (which I see as a secular trend).

The one fly in the ointment as far as this strategy goes is this threat and what it might represent to both GRUB as well as Square’s Caviar.
https://seekingalpha.com/news/3270270-analyst-grubhub-facing…

Other interesting findings from searching the Square website:

  1. When I search for square payment website on google the first entry coming up is SHOPIFY.

  2. On the home page it talks about ecommerce platforms and partners and names WIX (but not Shopify) - If you wanted WIX exposure maybe Square gives you that

  3. I don’t recognise a single restaurant partner our of Caviar’s logo collection (but I’m not in the US) - either they are small restauranteurs or tier 2 chains

  4. Square are the size they are and growing at the rate they and they are only in UK, Canada, US, Ireland, Japan and Australia - either they have plenty of potential left or they are no where near the global level that PayPal is achieving

Ant

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Matt,

Re: SQ you said this:

Quick note: Adjusted revenue is much more important than revenue for Square. Adjusted revenue is essentially the money SQ gets to keep after giving card-issuing banks their interchange fee and the credit card companies their cuts.

Recently there was an SA piece on Shop criticizing them for using unorthodox accounting for revenue and gross margins. Thus the growth rates Shop has been reporting for revenue are skewed, considerably lower than Shop is reporting.

https://seekingalpha.com/article/4071818-shortify-shopify-pa…

From the article:

…This accounting practice is not illegal and is used by another new issue, Square (NYSE:SQ). However, Square at least discloses non-GAAP net revenue guidance/metrics (along with other public payment processors) to investors and analysts. This net revenue guidance provides a clearer picture of growth and profitability.

While this by itself can be uncontroversial, executive management decided it needed to protect its gross margins as well:

“Historically, the Company classified chargebacks related to Shopify Payments in merchant solutions cost of revenues. The Company’s new policy is to classify chargebacks related to Shopify Payments in general and administrative expenses. Management has determined that the new policy is preferable…” - Source: SHOP 20-F
This unorthodox accounting practice is not shared by any of its peers in merchant processing. Therefore, shareholders should take caution; executive management is earning a reputation of manipulating financials to enhance results…

Any concerns w/ Shop here?

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Adjusted revenue is much more important than revenue for Square. Adjusted revenue is essentially the money SQ gets to keep after giving card-issuing banks their interchange fee and the credit card companies their cuts.

Rizzz, what Square is doing is sensible, conservative, and ought to be standard if it isn’t. Maybe you don’t understand exactly what they ARE doing. If they receive $100 in fees from helping a merchant accept payments, but $20 of that goes immediately to the credit card company (Visa, MC, etc) they only count $80 as revenue, not the whole $100. What can you possibly see deceptive and manipulating about that? It actually reduces the revenue that they report.

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Any concerns w/ Shop here?

Rizz, I really don’t know that much about Shopify. But yes, given what you’ve said, I would rather revenue be accounted for the way Square does it and not Shopify.

That being said, no matter what’s left back in or taken out, the fact that Shopify is growing revenue so much obviously counts for something.

Matt
Long SQ
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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given many emerging economies seem to be going straight from cash transactions directly to mobile/electronic payments, i do wonder whether Square gets cut out… or if not what their role is?

Whether customers are using cards or phones at POS checkouts, merchants will still need hardware to accept and process payments. So that shouldn’t affect Square too much.

That being said, if everything went to paying via an app, like Starbucks or Domino’s…hmm…not too sure about that scenario.

Matt
Long SQ
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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