Description

Square (SQ) is a payment processor which caters to small businesses, for a more detailed business description we will refer you to Mason’s timely write up from 2016 or the slide decks published on their investor relations page.  At $62.00 we think SQ has 40% downside to fair value of $36.00.  The basic premise of the short thesis is:

• FDC is the industry giant with close to 40% market share, over the past 18 months they have put a ton of resources behind their Clover product which is aimed directly at SQ, it is currently growing 50% and is on pace to be a larger business than SQ by 2020.  Additionally, they have finally gotten their act together with digital customer onboarding (SQ’s primary early competitive edge) and will launch the capabilities through their massive distribution channel starting in the 2H 2018.  Odds are slim that this will not impact SQ competitively and slow their growth rate.

• SQ’s core payment processing business growth has in fact already slowed and accelerating top line growth is being driven by more cyclical and risky businesses such as short term working capital loans (Instant Deposit) and lending origination (Square Capital).  As a point of reference, Square does not control underwriting for their Square Capital product, if banks decided to stop lending to their micro merchants and originations dried up it would take EBIT down by about 35%.

• SQ’s customers are by far the most exposed to any kind of economic downturn, close to 60% do less than $125k in volume every year and close to 85% do less than $500k.

• Given the above points SQ’s valuation is absurd.  It trades at close to 20x sales and 68x EBITDA.  This is even more disgusting given that of the $245M of EBITDA the street is expecting this year about $215M will be stock comp which everyone is happy to back out (the share count was 360m in 2016 and it will end this year at 480m).

• Our fair value target is 30x our 2020 eps estimate of $1.20.  Our estimates assume continued strong growth in both processing and services with steady economic growth, should a recession occur there would be significant downside to our estimates/target.

First Data

• As mentioned above, FDC is the 800lb gorilla in the industry.  We think SQ has been a benefactor of the issues FDC has been having in their bank JV channel for the past 18 months or so stemming mostly from WFC’s branch commission scandal.  The JV channel was always a crown jewel for FDC because anyone who walked into a major bank to apply for a small business loan would have the processing relationship jammed in their face upon closing the deal.  Starting in Q4 of 2017 the leads generated from this channel flattened out after declining by roughly 20% and it feels like the bottom has been reached, as the banks start generating more leads its reasonable to assume some portion would be at SQ’s expense.

• SQ’s early competitive edge was digital onboarding.  It takes 10 minutes and can be done without assistance.  Expenses are lower and the customer doesn’t have to deal with greasy salespeople.  Until now FDC had been way behind the curve but starting in the 2H of this year they will roll it out across all channels.  This is particularly important in the JV channel given their bank partners have a combined 6m small business accounts.

• At current run rate SQ will do about $80B in GPV for 2018 its growth rate will be around 30%.  Over the same time period FDC’s Clover will do $60B in GPV and growth 50% or so.  Clover is a direct competitor to SQ and industry chatter on the platform is increasingly positive.  We think that if nothing else this shows that SQ does not have a “moat” and the payments processing industry is mature and quite competitive.  SQ’s valuation suggests it’s business model is unique and difficult to replicate, Clover’s success and growth indicates the opposite.

Square Capital and Instant Deposit

• Another reason SQ gets such a fancy multiple is because investors are excited about the accelerating revenue growth rate driven by the “Subscription and Services-Based” segment.  This accounts for 33% of the total business and grew 98% y/y in Q1.  About 65% of this segment is Square Capital and Instant Deposit and the remaining 35% other odds and ends with the largest chunk being their restaurant delivery service Caviar.  While the growth is both real and impressive we don’t think investors are baking in the cyclical risks of the lending businesses. 

• The risks to Square Capital are pretty obvious.  Banks originate the loans and SQ takes 8-15% off the top.  No originations = no revenue and its basically pure profit.  We believe this will be $70m in revs/EBIT this year.

• Instant Deposit has been the major growth engine for the past 12 months.  In 2016 it didn’t exist and this year it will likely be a $180M business.  Merchants get charged a 1% for instant settlement of funds versus the standard T+3.  First of all this is very expensive, PYPL does it for a $0.25 flat fee and larger banks do it for free.  So why does SQ get this?  Our guess would be that nobody else wants to extend credit to these merchants.  SQ claims the risk is minimal because payments are taken directly out of the merchant’s gross receipts, however, there is nothing to stop them from abandoning their terminal if business gets tough.  The company has always said a lot of their customers didn’t take cards before signing up, so there isn’t a lot stopping them from going back to cash.  This will be about $190m of revs this year with high contribution margins.

Valuation

• On a day to day basis SQ seems to want to trade with the FANG complex and it wears a valuation to match that characterization trading at close to 20x sales.  Our issue is that there is nothing recurring about the business model, attrition is close to 20% annually, and their customers will be the first to fold in a downturn.  We think its true comps are FDC/WP/GPN which trade at between 12-19x forward earnings.  SQ deserves a premium due to its growth rate so we think 30x 2020 eps is reasonable.

Catalyst

• core revenue growth continues to slow
• investors catch on to the nature of Instant Deposit/Square Capital's cyclicality
• the FANG complex comes back down to earth