Square: Strong Growth Rates, Still Undervalued

Investment Thesis

As I made the case for members of my Marketplace, Deep Value Returns, Square (SQ) is a very fast-growing company that has seen its stock go on a strong run of late.

However, realistically, the stock is very likely to slow down at some point soon. Having said that, Square’s underlying business is terrific and that makes its stock a highly attractive investment.

Indeed, there’s just so much potential ahead, that it’s difficult to assert a hard valuation to it. What I can declare is that the stock still remains cheaply valued.

Having said that, it’s not all rosy and there are some aspects to remain wary of here. Even though I’m positively bullish Square’s potential, I’ll attempt to give you a balanced argument for your consideration.

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Unpicking Square’s Growth Opportunity

Source: author’s calculations

The thing that should strike you above is that I’ve labeled the graph ‘adjusted’. That’s because of the Caviar sale from last year. This shows the revenue growth for Square excluding that business, but it does include bitcoin revenue.

Thus, your first thought is just how sustainable is this sort of revenue growth rate? If bitcoin turns south, this could imply that Square’s business model rapidly decelerates? Well, not really, because there’s a lot more to Square than just transacting bitcoin revenue.

Furthermore, Square was forced by SEC to account for its bitcoin as revenue. However, we should note that Square doesn’t make practically anything from bitcoin, because it’s also forced to buy and sell bitcoin in the market.

Therefore, I believe that a better indicator could be to look at Square’s gross profits, as this figure would exclude the costs of managing bitcoin. In Q2 2020, Square’s gross profit margins were up 32% y/y.

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As a reminder, Square has a legacy segment, Seller Ecosystem is facing intense competition and therefore struggling. Meanwhile, Square’s Cash App continues to positively surprise investors. I’ll address these in order.

Seller Ecosystem, Not so Hot

Square’s Seller Ecosystem is Square’s biggest segment, for now.

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This is Square’s commerce solution for facilitating payments.

Square’s Seller Ecosystem helps payments transactions in many different ways, from a tap, swipe, dip of a card, as well as card-not-present transaction where payments happen online.

As you know, during Q2 the US was in lockdown. With Sellers in the food and drink, as well as beauty and personal care verticals experiencing the greatest slowdowns in volume.

This segment’s revenues were down 17% y/y, driven by a significant decline in transaction-based revenues, which was also down 17% y/y. From its earnings call, we can see that aside from the 4th of July holiday, Square’s Seller Ecosystem is flat from June into July.

Put another way, Square’s Seller ecosystem is struggling to reignite its growth opportunity. Even though Square points to an increase in Seller GPV (Gross Payment Volume) for the month of July, it also notes that this is mostly from international markets which historically carry lower profit margins.

Consequently, if that was all there was to Square’s investment potential, I would not be hanging around here and would have exited this position. But what I’m truly attracted to is Square’s Cash App potential.

Cash App — The Reason to be Bullish this Stock

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As you can see above, putting aside bitcoin revenue which could go either way in the future, Cash App’s revenues are soaring. To illustrate, transaction-based revenues were up hugely, albeit from a low base, while its subscription and services-based revenue was up more than 129% y/y.

However, the key to Square is to understand that Square’s older legacy, Seller Ecosystem carries attractive margins, but that Square’s Cash App is not yet as profitable at the gross profit level. Having said that, Square has minimal intention of maximizing profits this early in its journey.

Cash App: Gaining Market Share at a Rapid Pace

For now, Square’s Cash App is on a land grab expedition whilst attempting to gain positive mindshare amongst users. Think of Facebook (FB) and WhatsApp, if a company is able to, it’s much better off to gain unprofitable market share in the first instance, rather than maximize profits by targeting a very small pool of customers. The game for Cash App is to gain a huge international scale.

Later on, after going viral, it’s able to turn its economies of scale towards more profitable growth, for now, the opportunity is too large to embark on maximizing profits.

As an aside, that Square’s transaction-based revenues truly outshine those of PayPal’s Venmo (PYPL), which reported 60% revenue growth rates in July.

Back on Square, despite not offering Q3 guidance, Square did note that the month of July continues to positively benefit from government funds related to the stimulus and unemployment benefits.

Consequently, even though July’s Cash App gross profits were up 200% y/y, investors should not expect this sort of gross profit rate to continue.

Thus, while some could instinctively argue that Cash App grew so much faster than PayPal’s Venmo partly due to bitcoin revenues, the fact that Square’s Cash App gross profits were up 200% fundamentally reflects that Cash App is growing fast irrespective of bitcoin volumes.

However, realistically, nobody, even the most bullish dreamer is hoping for those sorts of growth rates to be sustainable over the medium term.

The key for investors is that although we don’t know just how dramatically Square’s Cash App gross profits will slow down, nobody expects those sorts of growth rates to be sustained.

However, even if Cash App slows down by more than half, that would still point to more than 50% growth rates, leaving investors with plenty of margin of safety from a post-COVID-19 inevitable slowdown.

Valuation — Still Huge Potential Ahead

As I noted in the introduction, despite being a value investor whose job is to attempt to value businesses, it’s very difficult for me to assert a valuation to Square’s intrinsic value.

The reason being that Square’s Cash App is growing so fast, that it makes a huge difference just how long it can continue to gain market share, and at what pace.

However, even though for now, Square’s Cash App gross profits are growing at 200% that is clearly not sustainable. But even when these dramatically slow down over the coming several quarters, it would still be highly likely to be growing at north of 80% for some time, maybe even into the back end of 2021 or possibly 2022.

Indeed, comparisons are difficult, but to make the point, let’s discuss PayPal again. PayPal has a much strong online presence than Square. What’s more, PayPal’s profit margins are significantly better too.

For example, PayPal’s gross profit margins are in the mid 40% range, whereas Square’s gross profit margins barely reach 40%.

However, PayPal’s revenue growth rates are around 22%, whereas Square’s gross rates are likely to remain at high 30s% for much longer, if not remaining around 40% — double PayPal’s revenue growth rates.

PayPal is priced at just under 10x forward sales, while Square is actually being priced at less than 9x forward sales.

The Bottom Line

Square has two segments, its Seller Ecosystem, and its Cash App.

Even though its Seller Ecosystem is Square’s biggest segment, making up 53% of gross profits in Q2, this segment is slowing down and is less appealing.

Saying that, Square’s Cash App is highly likely to become Square’s biggest segment by next quarter. At that point, investors will be predominantly focused on Square’s Cash App and that story, and less attracted to Square’s Seller Ecosystem.

Lastly, Square is being priced a full turn cheaper on a forward revenue multiple than PayPal despite growing faster than PayPal.

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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.

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