My Thoughts On Square Inc

Square Inc (NYSE: SQ) is a fintech company that provides seller tools, financing for small businesses, and peer-to-peer payments for individuals.

It started life as a company that enabled small businesses to accept card payments with a mobile phone and an attached square “scanning device”. Since then, Square has widened its offering to sellers, and launched Cash App, a mobile payment service that allows individuals to transfer money to each other using just their phone.

Square has been one of the darlings of the US stock market, with its share price up around six-fold since the first day it went public in late 2015. The strong adoption of Square’s POS (point-of-sales) system and Cash App’s surging popularity have led to that strong stock performance.

But I think there is still more to come from this fast-growing Fintech firm.

Huge market opportunity for payment growth

As with other payment solutions, Square takes a cut of every dollar transacted using Square’s software. 

The more payments Square processes, the more it earns. In 2019, despite a 25% increase in transaction-based revenue growth, Square still accounted for only a small fraction of the total gross payment volume (GPV) in the US. In 2019, Square’s GPV was US$106.2 billion, compared to total US gross sales of more than US$10 trillion.

Square started off as a payment tool for small businesses but has since begun targeting larger businesses, which provides a much larger market opportunity.

Square has done quite well in reaching out to larger businesses. In the first quarter of 2020, percentage of GPV from larger sellers (more than US$125k in GPV) increased to 52%, up from 47% and 51% in the same quarter in 2018 and 2019, respectively.

Cash App growing in popularity

Square launched Cash App in 2013 to compete with peer-to-peer payment services and e-wallets such as Paypal’s Venmo.

Since then, Cash App’s popularity has exploded and has been one of the key drivers of growth for Square. The beauty of payment solutions is that the bigger the network, the more value the system holds for users. Cash App’s growing popularity will be a virtuous cycle for more users and transactions in the future.

The Covid-19 pandemic has also led to an increased adoption for Cash App services. Users now use Cash App as a tool to send funds for fundraising, donations, and to reimburse one another for supplies during this period of social distancing.

Square disclosed that Cash App’s gross profit skyrocketed 115% year-over-year in the first quarter of 2020.

That’s a continuation of a longer-running trend. The charts below show the growth in Cash App’s monthly active users.

In addition, Square has been able to increase the monetisation rate of each active customer it has on its platform.

Cash App is currently available in the US and the UK. However, it was only in March that Cash App allowed cross-border payments, further increasing the value proposition that Cash App brings to the table.

Cash App started small, but has since grown astronomically and now accounts for close to 40% of Square’s total net revenue.

Product-focused management

Square’s CEO and co-founder, Jack Dorsey, is one of the most respected entrepreneurs today. He is also known as the visionary leader behind the popular products that his companies produce. Besides Square, Dorsey is also the co-founder and CEO of the social media platform, Twitter.

While some argue that Dorsey should focus his energy squarely (sorry) on one company, so far the results of Square have been extremely strong. And there is nothing to suggest that Dorsey is out of wits leading two companies at the same time. 

Square has also been successful in implementing new features into both its POS software and its Cash App. The increase in revenue and user growth are also testament to Square’s solid execution of its growth strategy.

Solid free cash flow and decent balance sheet

While Square is still reporting a GAAP loss, the company has turned free cash flow positive. The payment solutions provider generated US$101 million, US$234 million and US$403 million in free cash flow in 2017, 2018 and 2019 respectively.

In 2019, it recorded a free cash flow margin of 8%. For a company that is growing revenue fast, I expect its margins to improve in the future.

Square’s balance sheet also remains strong with US$2.5 billion in cash, cash equivalents, and short-term investments in debt securities, as of 31 March 2020. It only held US$1.8 billion in long-term debt, giving it good financial standing to continue to invest in growth.

Black marks?

However, Square is not perfect. Despite reporting strong free cash flow generation, Square’s only GAAP profit was in 2019. The company then returned to the red in the first quarter of 2020 as increase in expenses exceeded revenue growth.

One of the big reasons why the company has been reporting losses but generating cash is its heavy stock-based compensation. Stock-based compensation does not burn cash but it increases the number of outstanding shares and dilutes existing shareholders.

In Square’s case, stock-based compensation has resulted in an increase in the number of diluted shares from 341.6 million in 2016 to 466.1 million in 2019. The dilution has resulted in existing shareholders owning a smaller fraction of the company.

It is normal for fast-growing tech companies to pay out a large chunk of its compensation in shares. That said, Square’s revenue has increased at a faster rate than its stock-based compensation which is a good sign. But the company’s stock-based compensation is still something I’m watching.

In addition, Square also sports an expensive-looking valuation to me. As of the time of writing (20 May 2020), Square had a market cap of US$34.8 billion. That translates to around nine times trailing sales and more than 90 times free cash flow, assuming a 10% free cash flow margin.

I think that Square can justify such a high valuation, but it needs to execute its growth strategy perfectly and any hiccups could see a valuation compression in the stock.

Final words

There are risks, as I mentioned earlier. But there is also much to admire about Square. From a company with ambitions to help small businesses accept credit card payments, Square has grown to a company that offers a wide range of fintech services and now serves individuals through its Cash App.

The company boasts a strong track record of growth, has an innovative leader who is willing to invest in new products, and a balance sheet that is flushed with cash. All of which puts it in a strong position to ride on the tailwinds of the expanding payments ecosystem.

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