1. Square, Inc.
Ticker: SQ (NYSE)
Although they have yet to make a profit, we believe Square Inc. is slightly
undervalued because the market underestimates the contributions of large
sellers to Square’s total Gross Payment Volume expansion into the global
market, their role as a provider of small business loans, and the
introduction of Service Based Revenue. We valued Square at a hold at its
current stock price.
The metric we believe to be the most important in Square’s potential growth
is its Gross Payment Volume (GPV), or the total amount of money spent through Square’s Mobile or POS kiosks.
Square reports their GPV in three categories: <$125K, $125-$500K, and >$500K. The most important category in the GVP
mix is large businesses which contribute more than $500K annually. As Square attracts more large sellers their GPV will
increase rapidly. Despite offering discounts to large sellers, Square has managed to keep their take rate at just under 3%.
Square’s growth rates have reached exceptional levels over the past years and we can expect this growth to further
accelerate due to their expanding global market, particularly in Canada. This expansion is promising, due to the fact that
Square has proven to compete with foreign competitors in the past. Although there has been a steady decline over the past
three years from 40% to 35%, and to 29% in 2017, 29% is still an excellent growth rate.
Square has recently introduced the merchant advance program, which will provide them with sustainable, long-term
revenue, and solidify their position as an essential partner for their customers. Square merchant cash advances range
anywhere from a few thousand dollars, all the way to $100K. Square earns on average from 9-11% on each loan. Also, as Square
is already in business with the companies being considered to cash advances, they are aware of all financial data and risk
associated with each company. This has allowed Square to maintain a default rate of “approximately 4%” according to CFO Sarah
Friar. This being far below the national average default rate on business loans.
Service Based Revenue has seen a 95% year-over-year growth of revenue. This is a huge component of Square’s
current business model, and is one of the aspects that differentiates Square from its competitors. Although only
accounting for about 10% of Square’s total revenue, this is where many of Square’s advancements are focused. Some of this
new advancement includes data analytics and inventory management. In addition to this, Square has tapped into the P2P
(Peer-to-Peer transactions) market by introducing its own version of Venmo, the Square Cash App. This allows businesses to
get paid through the app with a fee of 2.75%.
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2. Investment Summary
Square’s stock is highly volatile. Starting at the beginning of last
year, Square made headlines across the nation for being one of the
most promising growth stocks of the year. On November 24,
2017, the stock was up over 240% from where it was at year start.
The stock ended the day trading at $48.86. Then, between
November 24 and December 29, the stock proceeded to drop over
29%, ending the year at a dismal $34.67. Now a 29% drop may
not seem like much compared to a 240% spike, but keep in mind
that the 29% dip wiped away a gain of over 47%. Stocks
appreciate much slower than they depreciate, which is why
high-volatility stocks such as Square are sometimes avoided by
institutional investors.
However, we believe the pricing of Square is simply a byproduct
of the technology sector. Often start-ups struggle for many years
to become profitable. While this is true in the case of Square, it is
inching towards profitability. As seen in the graph, Square’s EPS
Surprise has been rising sharply since mid-2016, indicating that
profitability could be around the corner. Additionally, Square’s
business is essential to the success of its customers, thus
positioning itself to outlast the lifespan associated the other tech
start-ups. The development of Square’s loan program also ensures
it a steady income for years to come.
Comparing the enterprise value and revenue is also an important
aspect of tech companies. Square has an enterprise value of
17.44B and had revenue of $2.21B, resulting in a EV/Revenue of
7.88, which is high, however Square’s revenue will grow as they
continue to expand into new markets.
Square is a very promising growth stock that has a lot of upside
potential, but due to the volatility of the stock and the sector, it
may not be a good buy for an investor that is risk adverse, or an
investor that has weak hands. The pricing volatility distracts some
investors in the short term, but we believe Square’s business model
and strategic positioning have set the company up for long-term
success and profit.
Business Description:
From its inception in 2009, Square’s main business was to give
small businesses the ability to accept electronic payments with
extreme ease of use. They have stayed true to this business model
even after their initial public offering on November 19, 2015.
Though their business model was simple early on, with only one
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3. offering of hardware and software, they have since expanded their product matrix rapidly.
With their headquarters in San Francisco, and tech celebrity CEO Jack Dorsey, Square has seen extreme growth over recent years with
their stock price rising over 150% in 2017. This is due mainly to massive growth in Transaction Based Revenue (32% year over year
increase), but has also been helped by the introduction of Services Based Revenue (95% year over year increase). Though Service
Based revenue still only accounts for about 10% of Squares revenue, this is where many of Square’s advancements are focused. They
have introduced many new services to its commerce ecosystem including data analytics and inventory management. One of the most
interesting new services being sold by Square is their ability to give loans. Their loan volume is up over 45% over the past year. These
loans are originated through Celtic bank, but this service has clearly caught the eye of Square’s Management as they have submitted an
application for their own Bank Charter which would allow them to originate their own loans through its Square Capital Program. In
addition to this, Square is trying to tap into the P2P market with their own
version of Venmo, the Square Cash app. This app allows individuals to
send money using a linked debit card or via email. It also allows
businesses to get paid through the app with the Square’s usual fee of
2.75%.
Ownership:
Investing institutions own nearly 20% of shares. With two of the top five
increasing their positions by around 30%(Vanguard and Allianz Global
Investors), and Blackrock increasing its position by just over 137% to be
the fifth largest shareholder. The other two institutions, Fidelity and
Capital World Investors, have held their shares for the most part with only
a change of -3.76% and -3.73% respectively.
Management:
Square has a core executive team consisting of Jack Dorsey, Sarah Friar,
Francoise Brougher, Alyssa Henry, and Hillary Smith. Their titles being
CEO, CFO, Business Lead, Seller Lead, and General Counsel and
Corporate Secretary respectively. We have omitted the outlier of Jack
Dorsey from our chart as he was compensated only $1,503 for the year of
2016. Thus, ignoring Dorsey, the average percent of executive
compensation that is attributed to equity is approximately
93.2%. As a swiftly growing tech corporation this is good news
for investors and shows that executives compensation packages
are almost completely driven by the success of the firm itself.
Jack Dorsey
Jack Dorsey officially serves as the President, CEO, and
Chairman of the Board for Square. This shows that despite his
dealings with other major tech companies such as Twitter, he is
fully invested in the success and growth of Square. This
however is not to say Dorsey is running Square on his own. For
example, the hiring of Sarah Friar as Chief Technology Officer
was excellent as she has experience at companies such as
Salesforce and Goldman Sachs. This shows that she has
experience both in next generation technology and how to
navigate the financial world at an extremely adept level. This
also may ease some fear that some people still harbor about
Jack Dorsey.
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4. Many investors still associate the name Jack Dorsey with his failure at Twitter and his stumbles on the road to Square's IPO. However,
in recent years Dorsey has been brought back on as CEO of Twitter and seems to be a different man when it comes to choosing his
leadership partners. In the case of Square, he identified the importance of mobile pay early on and struck a deal with Apple back in
2016 to make it available at every square appliance. Once again, we would like to point out the CFO hire of Sarah Friar, who has
helped Square’s stock to nearly triple under her guidance. She also identified Square’s ability to give loans and was important in
pushing the company to file an application for their own bank charter. These facts along with others make us fully confident in
Dorsey’s ability to lead Square.
Industry Overview and Positioning:
In the ever-evolving space of fintech, Square knows that its
product is not a silver bullet. They know Canadian based
Shopify is right on their tail and they must innovate and attack
their markets constantly. They are targeting their customers
based mainly around Seller Size. The metric this is measured
in is Gross Payment Volume(GPV), or the total amount of
money spent through Square’s Mobile or POS kiosks. Of this
total GPV, Square keeps their standard 2.75%. However, for
larger companies or specific transaction methods there are
slightly different rates. Square is acquiring and maintaining
these clients through 3 core methods: low-cost hardware,
ability to give loans, and services offered after purchase.
Larger Seller Size
Firstly, it is important to understand Square’s broad market
segments. They measure their sellers in 3 sizes shown to the
left. The key to this graph is that larger sellers(>$500K) are
contributing more and more to Square’s total GPV. This is
important because if Square can continue to gain these larger
clients their revenue will continue to grow at a very high rate.
Because these larger firms can afford to pay for transaction
services from the credit card companies themselves, their
reasons for choosing Square are different than smaller firms.
Mainly, these larger contributors are choosing Square more
and more due to the services offered by Square after initial
purchase of hardware. Specifically, these larger sellers tend to
want to take advantage of Square’s payroll and inventory
management software. Square has a higher profit from these
services as opposed to card based transactions, and these extra
revenue options help the retention rates of businesses.
Merchant Cash Advances
One of the most important factors in decision making for new
businesses is the barrier to entry. Often brand-new companies
are extremely strapped for cash. In fact, 27% of businesses
surveyed by the NSBA claimed they were not able to acquire
the funds they needed. Both Square and Shopify know this and
have launched loan programs to target these businesses.
Because all loans are given to individuals who have previous
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5. business history with Square/Shopify, the cash advancement can be accepted and be given out within a matter of days. These cash
advancements come with no interest rates or late fees. Instead they are paid back over time through a percentage of transaction revenue
day by day. That is, if business is slow, the loan will be paid back slower than if business is booming. Both companies have a range of
rates they charge on these advances, but it appears the majority of loans are between 9% and 13%. These provide a good method for
cash inflow as they have high yields for Square with Sarah Friar quoted as saying the default rate is a mere 4%, well below the
national average.
Fees
On top of this, Square also has a lower barrier of entry for
their hardware across the board. All of their base products
are cheaper than the alternatives offered by Shopify.
Shopify has attempted to counter their higher costs by have
a lower minimum transaction rate of 2.4% as opposed to
Square’s 2.75%. However, Shopify has mandatory monthly
fee packages that can go as high $299 a month. This
fee/service based revenue comes with a much higher yield
than transaction based revenue and as such has benefited
Shopify greatly. They have been able to capitalize on their
smaller customer base very well to maximize profit.
However, Square has recently started to accelerate their
marketing services to their customers. In fact, these and
other services are Square’s fastest growing form of revenue,
now accounting for 11% of revenue with an 84% year over
year growth rate for the 3rd Quarter. Shopify also has a
high year over year growth rate of about 68%, but this
accounts for much more of their revenue. This indicates
that Square will be able to earn much more high yield
revenue from services going forward as they expand this
sector of their business.
Hardware
Though both companies have relatively similar priced
hardware, Square has managed to undercut Shopify in this
sector. This is likely due to Square’s ability to absorb losses
in initial hardware sales and make it up through the higher
volume of transactions and larger customer base. This
advantage is slight however, as both companies offer a base
level Magstripe Reader to new customers for free. This
being their tool to attract small businesses and gain their
customer loyalty going forward. One piece of hardware
being offered by Square that is not offered by Shopify is
Square’s fully integrated Point of Sale register. Being the
first of its kind, Square has reported that it is the first of
their Point of Sale products to reach $1 Billion in total GPV.
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6. Operating Income
Both companies are obviously growth stocks based in the tech world. As such both companies are fine with taking operating income
losses to get their product into the hands of more businesses. This results in both companies having extremely high growth rates with
lackluster profit margins. As shown by the graphs, both companies have great revenue growth over time and are pushing down their
operating margin gradually. When analyzing how each company spends their revenue, we can see that Square has a much higher cost
of revenue as compared to Shopify. This is due to Square getting much more of its revenue from transactions as opposed to services.
Service based revenue provides a much higher yield and has allowed Shopify to allocate more of its revenue towards advertising and
research and development. Square has recognized this reality though and services are its fastest growing revenue division (a 95% year
over year growth). Shopify has capitalized on this low-cost revenue by infusing a large amount of revenue into marketing and research
and development. However, as Square continues to increase
its high yield revenue through services and Merchant Cash
Advances, their margins will continue to improve
substantially. This was shown in Square’s most recent 10-K
where they reported that they cut their operating income by
116 million. Square’s volume is much larger than Shopify
and the company is still maintaining this growth rate.
Square is still taking losses in the interest of growth and as
the more mature company it will be able to leverage its size
to continue to offer services and products on a scale that
Shopify will not be able to keep up with. This effect will
compound once Square’s market share in Europe begins to
develop as well.
Expansion to Europe
CEO Jack Dorsey has expressed plans to expand to much of Europe in the coming years. Their investments in the region have been
very conservative so far, with the United Kingdom being their only European market. Europe is the next logical step forward for
Square with small businesses dominating the private sector in that part of the world. However, international markets have accounted
for only about 4% of revenue in the past year. Furthermore,
the marketplace for Square is much more competitive in
Europe than it is in North America. This will impact
profitability substantially and require much more spending
on marketing. Though CFO Sarah Friar has said she
expects ongoing momentum, we are not confident in
projecting growth at this time as Square has yet to face a
challenge such as this before.
Cash App
Square is mostly known for their POS systems and services
they provide to small businesses. However, their Square
Cash has been gaining a lot of traction. Through this app,
people can send money easily, either for personal or business use. The app achieved 7 million active users in December, which appears
to be on par with that of Venmo. Venmo has not yet released their monthly active users, but Square is currently the No. 1 downloaded
free finance app in Apple’s U.S. App Store. Venmo currently sits at No. 2, so while it is difficult to compare the applications directly
for now, it is clear that Square Cash is establishing itself as a real competitor in this market.
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7. Market Risks:
Risk of New Entrants:
Bear Case: Square is tapping into a market with huge upwards potential and with that comes the risk of new entrants into the market,
whether it be start-ups or large established corporations. Square has proven to dominate the former of these two. Companies such as
Shopify, with a nearly identical business model and product, have consistently remained in the red since their inception. However, the
latter, companies such as PayPal, with digital transaction capabilities (i.e. Venmo), have far greater capital and their status as an
established intermediary puts them in direct competition with Square.
Our View: We believe that their role as a small business lender, as well as service provider, holds the key to Square’s long term
success. PayPal has household name recognition and the financial means to provide a similar service to Square, leading us to believe
that if they choose to enter the market, then they may become the provider of choice for many small businesses. If a company such as
PayPal were to enter the market, their products would be priced very competitively.
Financial Risks:
Defaults on Square Capital Small Business Loans:
Bear Case: Square’s small business loans are essential to long-term sustainability, however by issuing loans to small businesses they
are exposing themselves to considerable risk. According to Bureau of Labor Statistics, 50% of small business do not survive into their
fifth year of operation. If large quantities of Square loans were to default, the company would take very serious losses.
Our View: We believe that Square is in a good position to make safer loans that will have a lower than average default rate. Through
their product, Square is able to view any potential recipient through a microscope. A study by Paul Graham stated that 82% of small
business fail because of cash flow problems, so Square Capital will help offset this issue. Additionally, the maximum loan offered is
only $100K, so an individual default would have marginal effects. However, small businesses often cannot survive extended economic
downturns, and in the case of a recession, Square would likely suffer massive losses.
Cryptocurrencies as part of business model:
Bear Case: Recently Square started to allow their customers to start to buy and sell Bitcoin through their Square Cash app. It is unclear
how fluctuations in the price of Bitcoin would affect to profits or the pricing of Square, but the transactions fees for trading allow
Square to capitalize on currency noise traders. It is also unclear if Square plans to incorporate cryptocurrencies into their long-term
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8. business model, but at this point the volatility of both Square’s pricing and that of Bitcoin are likely to deter investment and lead to
lower valuations.
Our View: It seems that Square is not strongly tied to success or failure of Bitcoin; they are simply being advantageous. Say what you
will about individual cryptos, but many believe that blockchain will become instrumental to business operations in the future. If
Square were able to position themselves as an easy means for businesses to enter the chain, it could prove to be very beneficial.
Security Risk:
Breach of Customer Business Data:
Bear Case: In recent years, we have seen the work of hackers inflict detrimental damage on some of the most established names in the
corporate world (think Target and Sony), so naturally there is an assumed risk for any company that possess confidential personal and
financial data of their customer base. A partnership with Square requires bank account information, a social security number and an
individual taxpayer identification number. The Square Cash app also reveals credit or debit card information and allows for easy
transactions, both of which may be exploited by someone targeting Square and their customers.
Our View: We believe there is no outstanding reason that anybody would target Square specifically. Anyone seeking to attack Square
would likely target customer information or point-of-sale transactions at Square customer businesses. Unfortunately, the integrity of
Square’s hardware and software security is something that will only become known in the case of an attack, so any sort of speculation
concerning the risk of a breach relating to valuation of Square is highly speculative.
Valuation:
We used a weighted discounted cash flow evaluation and comparable multipliers to arrive at a target price of $56.22. We assigned a
weight of 90% to the DCF and 10% to the comparable multiplier. We gave the DCF such a high weight because of the lack of relevant
data of similar companies and our belief that Square will continue to grow and take
more of the market share. Also, we gave the comparables such a low weight due to
the fact that most companies similar to Square were also not generating profit yet,
so their metrics were not accurate estimates of Square’s future.
DCF (90%)
We weighted the Base case worth 50% of the total evaluation.
The Bear and Bull cases are only worth 25% of the weight
because their likelihood of happening is not as probable as the
Base case. The adjusted WACC that we used was 10.69% with
a 3.5% idiosyncratic risk included in this because of the high
volatility associated with Square’s stock. We used a beta of
1.77, which we determined by running a linear regression with
Square and the Nasdaq. For more detail see Appendix 5.
Comparables (10%)
We weighted the comparables as follows: 50% to
Software-Application companies like Square (Shopify, Intuit,
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9. Workday), 40% to Credit Services (PayPal), a field Square has
recently entered with their loan advancements to small
businesses, and 10% to Network Security (Palo Alto
Networks). More can be seen in Appendix 7.
Financial Analysis
Revenue
Square’s revenue has been growing year by year at rates of
40%, 35%, and 29% for year 2017. We believe that Square’s
excellent trend in growth will continue due to their expanding
global market and increasing subscription revenue due to them
financing smaller businesses. In addition to this, Square’s
hardware revenue keeps on increasing with demand for their
Square Stand and contactless chip reader rising in Canada.
This could be an indicator that the Canadian based Shopify is
losing a grip on their market. Also, their revenue should be
perhaps even higher because the preorders for their Square
Register are going to count for their 2018 1Q revenue instead
of the 2017 fiscal year.
Gross Profit
We are optimistic that Square’s gross profit margin will
continue to increase year by year due to their historical growth
in revenue and their high cost of revenue likely due to new
products being released recently like the Square register.
Square will be able to cut down their cost to produce some of
their hardware, while also cutting out the middleman with
their new register. A possibility of the revenue not being cut
could be due to Square’s nature to keep on innovating, which
will involve experimenting with new products and perhaps an
increase in their cost of revenue.
Contribution Margin
Our projections show that Square will be able to increase their
revenue over time quicker than their cost of revenue. This is due
to more focus being placed on high yield services. As can be
seen by the chart, Service Based Revenue has the highest
contribution margin of almost 50%. This type of revenue also
has the highest growth rate of about 95% year-over-year growth.
As Square’s large customer base begins adopting these services
more it will improve their yield and push them toward
profitability.
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10. Linear Regression
In Excel, using linear regression we were able to
calculate the beta of Square which was found to be
1.77. We calculated this by comparing the volatility of
the Nasdaq -Rf versus Square - Rf in the past year. This
high beta indicates high volatility meaning the price
point of the stock fluctuates a lot. This could be
because of the uncertainty surrounding the company
and their still relative youth. In addition to his high
volatility, square’s stock has grown by nearly 176% in
the past year. This indicates although the stock is highly
volatile it is moving in the right direction. This test is
somewhat significant, but with such a low R^2 of 28%
it means that only 28% of the variance in the market
explains the variance in Square.
Operating Margin
We believe that Square’s operating margin will increase
overtime with the decline in time and money put into
operating expenses. We think that Square’s marketing
will continue to be pretty high with them trying to
expand globally and market to other countries, but we do
believe that they can cut down on their research and
development expenses due to their vast variety of
products they already have in the market.
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