Square’s (SQ) business is centered around commerce and payments, and given the trend towards digitization in both of these spaces, Square is positioned to capture value in coming years.
My investment thesis can be summarized as follows:
1. Square has created two strong ecosystems, both of which provide valuable services to buyers and sellers. These ecosystems are fortified by high switching costs and network effects.
2. Square’s Seller Ecosystem and Cash App Ecosystem both have a large total addressable market, and the global shift towards e-commerce and digital payments will drive growth in coming years.
3. Discounting recent headwinds related to the pandemic, Square’s business is expanding quickly, as is evidenced by the annualized 41% revenue growth since 2015.
Reason 1: Square’s Ecosystems Engage Buyers And Sellers
Square has built two strong ecosystems: the Seller Ecosystem and the Cash App Ecosystem. The Seller Ecosystem provides an array of products and services that help democratize commerce, enabling merchants to run their business. While less robust, the Cash App Ecosystem provides a mobile wallet that allows individuals (and businesses) to send and receive P2P payments, in addition to other functionality.
While Square has numerous competitors, Square’s ecosystems offer a more robust solution than any competitor’s products. To truly appreciate this, it’s necessary to discuss Square’s product offering and the numerous ways in which they generate revenue.
Square sells point-of-sale hardware. This primarily includes the Square card reader ($49), Square Terminal ($299), and Square Register ($799).
In addition to the Square POS application, which is free, Square offers other applications through a SaaS business model. This includes Square Online Store, Square for Restaurants, Square for Retail, and Square Appointments.
Square Online Store allows merchants to easily set up an online storefront, helping them take advantage of the shift towards e-commerce. A free version exists, but with limited features compared to the three paid tiers, which range from $12/month to $72/month. Merchants already using Square at brick-and-mortar locations are able to upload their existing inventory to create an online presence instantly. Merchants can also establish a social media presence by linking their online store to an Instagram Business Account. Finally, merchants have access to shipping options through third-party carriers, enabling them to provide a seamless customer experience.
Square Appointmentsenables merchants to create a customer booking website, allowing clients to schedule appointments. This also includes Square Assistant, an automated digital messenger that handles client confirmations and rescheduling requests. Square Appointments can be linked to Square Online Store to provide a more complete web experience. Pricing depends on the number of employees, ranging from free (1 employee) to $90+/month (6-10+ employees).
Square For Restaurants is a version of the Square POS application optimized for restauranteurs; additional features include close of day reports, sectional sales reports, table/seat management, and many third-party integrations. Square For Restaurants also syncs with Square Online Store for digital ordering. For full functionality, Square charges $60/month for each location (using one POS device per location). Each additional POS device costs $40/month.
Square For Retailis a version of the Square POS application optimized for retail; additional features include inventory management, sales reports, employee time-clock, and many third-party integrations. For full functionality, pricing starts at $60/month per location.
In addition to the software discussed above, Square offers optional add-ons that provide further service to merchants. Square Payroll allows merchants to manage all aspects of employee payroll, from direct deposit to providing tax forms. Merchants pay $29/month plus $5 per person on payroll each month. So a business with 10 employees would pay $79 per month. Square Marketing allows merchants to create email marketing campaigns. These campaigns can also be posted on social media, such as Facebook. Merchants can choose to setup automated campaigns for birthdays, new customers, regular customers, or lapsed customers. Pricing depends on the audience size, ranging from $15/month (less than 500 customers) to $425+/month (75,000+ customers).
Finally, Square’s app marketplace offers a variety of third-party integrations with the Square POS applications, such as Wix or Intuit QuickBooks. And Square charges a monthly fee for many of these integrations.
Square provides payment processing and gateway services. This allows merchants to accept digital payments both in stores and online. In general, Square charges the following fees for payment cards and digital/mobile wallets:
- In-Person: 2.6% + 10¢ per transaction
- Online: 2.9% + 30¢ per transaction
Square Capital:Square offers loans to small businesses, ranging from $300 to $100,000. Because they have access to granular seller data, Square is able to asses credit risk in a prudent manner. Square charges a fixed fee for this service, typically 10% to 16% of the loan amount. Then, based on the payback terms, a portion of the merchant’s non-cash sales are deducted daily to repay the loan.
Square Cash App:Square’s P2P Cash App allows users to send and receive payments, including paycheck direct deposits. The Cash App also allows users to invest in stocks and purchase bitcoin. The application can further be used to make in store purchases, though this requires the merchant to have the app or the buyer to have a Square Cash Card (Visa branded debit card linked to Square Cash balance). Square charges users 1.5% for instant transfers and 3% for P2P payments funded by a credit card; merchants are charged 2.75% per transaction when the Square Cash App is used to make in store purchases.
To summarize, Square’s Ecosystems can effectively engage users and generate revenue in many different ways. And due to easy integration, each product makes it more convenient to start using additional products. This is a powerful concept that should continue to drive adoption for both new and existing users over time.
Reason 2: Square Has A Large (And Expanding) Total Addressable Market
Square estimates its total addressable market at ~$165 billion, more than 26x TTM revenue. So, while Square has grown significantly in the past, there is still plenty of growth left ahead. And the global shift towards e-commerce and digital payments should be a powerful catalyst for both the Seller Ecosystem and the Cash App Ecosystem.
The Seller Ecosystem
The Seller Ecosystem generates revenue in three different segments:
- Hardware:revenue is earned for the sale of hardware.
- Subscriptions & Services: revenue is earned through Square Capital, Instant Transfers, and through the sale of Software-as-a-Service solutions.
- Transaction Fees: revenue is earned as a percentage of gross payment volume when Square provides payment processing and/or gateway services.
Hardware represents only a fraction of revenue (less than 2% in 2019), but Subscriptions & Services and Transaction Fees represented a combined 87% of revenue in FY19. And these two segments should see strong growth in the coming years, driven by increasing e-commerce sales (Square Online Store) and increasing volumes of digital payments.
But how much growth should investors expect?
Square estimates its total addressable market (NYSE:TAM) through the Seller Ecosystem at ~$102 billion. This is further broken down in the graphic below:
Source: Created by the author using data from Square Investor Relations.
In 2019, Square generated $3.46 billion in revenue from the Seller Ecosystem, representing YoY growth of 27%. Even so, this figure accounts for less than 4% of the estimated TAM.
But I believe Square will continue to execute on this opportunity. Since 2015, the number of active sellers has increased 1.7x (roughly 14% per year). At the same time, gross profit per seller has increased 2.3x (roughly 23% per year).
In other words, Square is not only increasing its seller base, it is monetizing its seller base more effectively. Square’s business is scaling and gross margins are expanding as more sellers join the ecosystem. This dynamic has powerful implications for future growth and profitability. And it should only strengthen over time, as Square offers merchants a turnkey solution, helping them manage nearly every aspect of their business, from payments to payroll; this creates high switching costs, as merchants would find it difficult to find another provider who could offer that level of support.
Also of note, the Square Card (not to be confused with Square Cash Card) allows merchants to spend the balance of their Square account, giving them instant access to revenue generated by their business. And Square is using this product to create a network effect within the seller community, as Square merchants receive a 2.75% discount when using their Square Card to make purchases from other Square merchants.
The Cash App Ecosystem
The Cash App Ecosystem generates revenue in three different segments:
- Bitcoin:revenue is earned when users purchase Bitcoin from Square.
- Subscriptions & Services: revenue is earned through Instant Transfers, P2P transfers funded by a credit card, and interchange fees charged when purchases are made with the Square Cash Card.
- Transaction Fees: revenue is earned as a percentage of GPV when merchants accept P2P payments through a Cash App business account.
In FY’19 low-margin Bitcoin revenue accounted for 11% of total sales. But, as mentioned earlier, higher margin Subscriptions & Services and Transaction Fees accounted for 87% of revenue. This mirrors Square’s outlook for the future, as 97% of the Cash App market opportunity lies in the sending and spending of money, both of which will benefit from increasing digital payment volume.
Square estimates their TAM through the Cash App Ecosystem to be ~$63 billion. This is further broken down in the graphic below:
Lately, the Cash App Ecosystem has been growing even faster than the Seller Ecosystem. In 2019, Cash App generated $1.11 billion in revenue, representing 157% growth YoY. And this growth accelerated substantially during the pandemic. In Q2’20, Cash App revenue reached $1.2 billion, increasing 316% YoY—this means Cash App generated more revenue in one quarter than it did for the entirety of FY’19. Likewise, the number of monthly active users reached 30 million in Q2’20, representing 93% annualized growth since 2016. While this was due in large part to Cash App’s facilitation of pandemic-related stimulus payments, it still created an incredible number of new users. And the strong network effects created by the P2P functionality will likely keep many of these new users engaged with the platform. But investors should pay attention to these metrics in future quarters.
Even with the recent growth, Square’s monetization of the Cash App Ecosystem is still in the nascent stages. For instance, Square only recently started exploring payment functionality beyond P2P transfers. In 2017, Square introduced the Cash Card, a debit card that allows users to make purchases (both in stores and online) with their Cash App balance. This plays right into the digital payments trend (and potentially, e-commerce). Up to this point, Square only benefited when merchants accepted digital payments. Now they benefit when Cash App users make purchases with digital payments.
In Q2’20, the number of Cash App users making purchases with the Cash Card increased to over 7 million—more than 100% growth YoY. This positively impacted Subscription & Services revenue, which includes interchange fees collected by Square when users make purchases with the Cash Card. In Q2’20, Cash App-related Subscription & Services revenue increased 130% YoY. Of equal importance, an increasing number of merchants began accepting payments via the Cash App. This positively impacted Transaction revenue, which includes transaction fees collected by Square when merchants collect payment through the Cash App. In Q2’20, Cash App-related Transaction revenue increased 215% YoY. Both of these are positive trends, and demonstrate the power of digital payments to act as a catalyst for overall revenue growth.
If Square can continue to build on this functionality, perhaps by offering a means of using the Cash App directly at NFC terminals, this could be a very powerful growth driver, as it would reinforce the burgeoning network effects and help the company further capitalize on the shift towards digital payments.
Reason 3: Square’s Business Is Growing Quickly
As I mentioned earlier, a good portion of Square’s revenue is generated through transaction fees. And because these fees are assessed as a percentage of gross payment volume (GPV), investors should watch this metric very closely. The graph below shows GPV from 2015 through the most recent trailing twelve months.
Source: Created by the author using data from Square Investor Relations.
As indicated above, GPV has increased an annualized rate of 27% since 2015. However, growth slowed significantly in Q1’20 and GPV actually declined YoY in Q2’20. But this was a result of the COVID-19 pandemic, as Square’s business is heavily exposed to brick-and-mortar retail. However, there is a silver lining here. In Q2’20, GPV from online channels increased over 50% YoY, as both new and existing sellers made the transition to digital sales. During this quarter, GPV accounted for over 25% of total GPV. This bodes well for Square going forward, as Square Online Store, Square Online Checkout links (allow merchants to sell on social media or through email without a website), and various developer APIs (add Square payment functionality to any e-commerce site) allow sellers to benefit from the shift towards e-commerce.
Given the overall upward trend in GPV, it’s no surprise that Square’s revenue growth has been stellar over the same time period. Since 2015, Square has grown revenue at an annualized 41%. And despite slow or negative GPV growth, revenue growth actually accelerated in both Q1 and Q2’20 (reaching 44% and 64%, respectively). However, gross margins took a significant hit in these quarters, as low margin Bitcoin revenue contributed significantly to the top line. Despite this, revenue growth of this calibre is encouraging, especially given Square’s exposure to brick-and-mortar retail during a time period characterized by social distancing and government-mandated business closure.
The graph below shows TTM free cash flow from Q1’17 through the most recent quarter.
Free cash flow has also grown quickly, achieving a 103% CAGR between Q1’17 and Q1’20. But as the graph above indicates, free cash flow trended sharply downward in Q2’20. This was primarily a result of capital being tied up in loans. According to Square’s most recent 10Q filing: Square Capital facilitated roughly 80,000 Paycheck Protection Program (NYSE:PPP) loans. And PPP loans facilitated, less loans sold, accounted for a $465.5 million decrease in operating cash flow. But I don’t think investors should be overly concerned at this point. Risk associated with the loans is low due to government backed guarantees. Furthermore, despite the negative impact on cash flow, these loans offered a lifeline to many sellers. This is a valuable service during a turbulent time, and in offering this service, Square further reinforced the high switching costs associated with its platform.
While Square has a robust offering of products and services, they also have strong competitors. For instance, PayPal (PYPL) offers similar hardware and payment functionality. And, while PayPal does not provide an e-commerce solution or software tailored to retail/restaurants, they have partners that do offer these products. Likewise, PayPal and Square offer a similar fee structure, though PayPal charges cross-border and currency conversion fees—Square does not. But Square merchants cannot use hardware outside of the country in which the account was created.
Shopify (SHOP) is another formidable competitor. And recently, these two companies’ markets have started to overlap in a bigger way. Whereas Square started by providing payment functionality in stores, Shopify started by providing an e-commerce solution. Now, Shopify has started offering POS hardware and Square Online Store helps merchants build a digital storefront. And, while Shopify does not provide some of the in-house functionality that Square provides, such as payroll or software tailored to retail/restaurants, merchants can gain this functionality through Shopify’s app store. Regarding fee structure, Shopify and Square offer similar pricing per transaction, though Shopify charges cross border and currency conversion fees. But Shopify Payments has the benefit of being more widely available, as it exists in all of Squares markets (US, UK, Canada, Japan, Australia), plus several other countries.
But what do users think?
Software Advice ranks retail software based on several criteria, all relating to customer satisfaction. And as the chart below indicates, Square POS compares favorably to these two competitors:
Source: Software Advice
So, despite the competition, customers still like Square’s POS application, and Square still has a significant market opportunity. Moreover, this is not a zero sum situation—there is plenty of room for all of these businesses (and others) to be longterm winners.
As a final note, Square is not an inexpensive stock, at 11.3x sales and 222x earnings. However, it compares reasonably well to these competitors, as PayPal trades at 11.4x sales and 84x earnings, and Shopify trades at 52x sales and a negative earnings ratio.
Square’s Seller Ecosystem offers merchants a turnkey solution, helping them manage nearly every aspect of their business. This portion of Square’s business is fortified by high switching costs and, to a lesser extent, network effects.
Supplementing the Seller Ecosystem, Square’s Cash App Ecosystem affords users with P2P functionality, allowing them to receive, send, spend, and invest money. This portion of Square’s business is fortified by a strong network effect. And, if Square can continue to expand purchase functionality within the Cash App, this network effect could get a lot stronger.
At current valuations, Square is a pricey stock. But both of Square’s ecosystems should benefit from global trends towards e-commerce and digital payments. For this reason, Square is a buy for longterm investors.
Disclosure: I am/we are long SQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.