Square (NYSE:SQ) stock has been on a tear this year. Cash App, its mobile payment service, rocketed in popularity as Americans turned to the app for unemployment benefits and stimulus checks. Some analysts now estimate that Cash App is worth 60% of the total value of SQ stock.
And that makes me excited about the stock.
Today, Square no longer looks like a payment processor for retail stores. Instead, it’s become a P2P platform with 30 million active users and $260 million net revenues. In other words, it’s now a fintech company.
But putting aside the hype for a moment, is Square a good investment for 2021? With shares at all-time highs, here’s what you need to know about investing in SQ.
SQ Stock: An Accidental Success
Things weren’t always so bright for high-flying Square. Despite growth averaging 43% per year between 2013 and 2019, the company failed to cover its massive overhead costs. And for good reason: Square had to fight against industry heavyweights: Fiserv (NASDAQ:FISV), Fidelity National Information Services (NYSE:FIS), and Global Payments (NYSE:GPN).
Together, the three incumbents made Square’s life hard. Client retention rates are high in the point-of-sale (POS) industry, forcing Square to heavily discount (and give away free products) to gain precious market share.
In other words, Square was in the wrong industry.
The company, however, stumbled upon its own success in 2017.
Cash App and Network Effects
It was admittedly a slow start. Square launched Cash App in 2013 to a relatively muted reception. The app itself was relatively simple. Users would link their debit card to a Cash App account, create a $cashtag username, and send money to anyone else with a $cashtag.
However, few people used the app because no one else did.
As anyone who’s ever used a fax machine knows, fax machines are only useful if your intended recipient also has one.
All that changed in 2017. And it wasn’t the fax machine.
In a brilliant marketing blitz, Square created “Cash App Friday,” a weekly giveaway of money to people who tweeted to Cash App’s account. Note that Twitter (NYSE:TWTR) is also owned by Square’s CEO, Jack Dorsey.
Giving away free money might sound like a strange business strategy to some. But it worked. By 2020, the company boasted 22 million users.
Then Came the Coronavirus …
… And Cash App’s popularity went through the roof.
By making it easy for individuals to accept stimulus checks and unemployment benefits, Cash App had stumbled on a magic formula. Deposits shot up 250% to $1.7 billion, and users topped 30 million.
Almost overnight, Square has moved away from POS and into online payments processing, a far better industry. And that’s the reason investors should take a closer look at Square stock for 2021.
Can Cash App’s Success Last?
Cash App’s network effects create a virtuous cycle in good times: adding more users makes the network better, drawing even more users, and so on.
But the same flywheel can also run in reverse. MySpace and AOL chatrooms quickly collapsed as users left for other services.
So, what are the three things that might cause Cash App’s flywheel to run in reverse?
Risk 1. Banking Regulation Could Shut Cash App Down
As I’ve previously written, fintech companies had an unexpected helper in their success: banking regulations.
After the 2008 financial crisis, governments created a slew of new laws to prevent a repeat. Among those was Basel III: regulations that forced banks to hold far more capital.
Non-bank fintech companies skirt these new rules. For instance, non-bank Rocket Mortgage (NYSE:RKT) can write mortgages virtually without limit, while its banking competitors face stiff capital requirements. That’s how, in just three years, Rocket has become the largest U.S. mortgage originator.
Square also sidesteps banking regulations. But it’s starting to look more like a bank. Unsatisfied with generating 1.5% off transactions, the payments company began to invest a portion of its customer funds in short-term marketable securities in 2019. Today, 56% of Square’s deposits are invested in less-liquid government securities.
And where banking regulators “giveth”, they can also “taketh” away.
If regulators categorize Cash App as a bank, Square’s high-growth business model will come to a screeching halt.
Risk 2. Bad Loans Might Sink the Company
If that weren’t enough, Square has also decided to dip its toe in lending. In August, Cash App announced a feature that would allow select users to borrow $200 for four weeks at a 5% interest rate. While 5% might sound low, it comes to 60% APR, or around three times higher than the average credit card. And that opens Square up to usury lawsuits.
To me, however, there’s one even more pressing issue: Cash App has started Square down the path of pure banking. Rather than offload loans to other lenders (as Lending Club and Prosper do), Square seems poised to keep loans on their own books.
And lending is risky.
That’s why banking startups like SoFi and OneMainFinancial are valued at just 4 times revenue, compared to Cash App’s 8.3 times. If Square starts overextending credit, it could quickly collapse in a financial crisis.
Risk 3. Bitcoin Prices Could Plummet
Finally, Cash App has a little surprise for any would-be investor: 45% of Q2’s net revenues came from bitcoin transactions.
That’s because Cash App makes buying bitcoin easy.
There’s no cryptocurrency wallet to worry about … no hashed passwords … In fact, it’s the simplest way to buy bitcoin I’ve ever seen. Even Robinhood investors need to create a separate crypto account. Bitcoin alone could be a massive winner for SQ stock. Here’s a company that’s finally found it’s “green-pasture” in fintech.
But reliance on bitcoin also comes with significant risks.
If bitcoin prices suddenly plummet, it could become a PR disaster for Cash App as customer crypto accounts get wiped out. In 2018, a similar story played out at Coinbase, a popular cryptocurrency platform, when user numbers collapsed as crypto prices fell.
What’s Next for Square Stock?
Despite these three risks, Cash App still looks poised to succeed in 2021.
Since 2008, U.S. banking regulations have carved out a niche for “non-bank” fintech companies that provide bank-like services. Cash App falls squarely in that space.
That said, I’d like to caution readers about Square stock. As Cash App grows, Square WILL be tempted to look more like a traditional bank. That’s because, absent banking regulations, few companies have ever resisted the siren’s call of using customer deposits to make more money.
History is littered with examples. In the 1990s, Savings & Loans (S&L) failures lost investors billions as they collapsed. Two decades later, leasing arms of companies from General Motors (NYSE:GM) to General Electric (NYSE:GE) would almost bring their parent companies down in the 2008 financial crisis.
So, if Square’s balance sheet starts to resemble a traditional bank, I would sell immediately. The stock will perversely keep going up (Square will be raking in extra cash), but its risk profile would quickly worsen.
What’s SQ Stock Worth?
Assuming for a moment that Square resists the urge to become a traditional bank. In that case, we can use standard discounted cash flow (DCF) modeling and NOT worry about putting in a significant banking risk discount.
Analysts currently estimate Square’s EBITDA to grow from $83 million in 2019 to $1.4 billion by 2023. Using those numbers come to a fair value of around $132, or a -4% downside.
However, Wall Street’s estimates might show a massive lack of imagination (an issue rarely seen at venture capital firms).
Suppose Cash App integrates with other payment systems. It’s not hard to imagine Square generating PayPal (NASDAQ:PYPL) like revenues down the road. (PayPal earned $5.4 billion revenue in Q2). Increasing SQ’s EBITDA to $2.7 billion in 2023 and $11.9 billion by 2029 raises fair value to $240, a 75% upside from today.
How to Play Square in 2021
Investors looking to cash in on Cash App’s growing popularity might seriously consider buying Square stock.
But there are three caveats to this super-charged stock.
Firstly, investors should make sure Square never takes on too much bank-like risk without the needed capital. Secondly, Cash App is only as powerful as its network; the moment we see a decline in active users, it’s time to get out. Finally, investors should watch out for new banking regulations that could force non-bank financial firms to start acting more like banks.
Get all three right, and investors will likely win in 2021 with SQ stock.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing. On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.