Description

I think Square (SQ) common stock has a high probability of doing well over the next several years.

The company has been written up as a long and a short on this site so you can see some of the bull and bear theses there. I’d like to make this write-up short and to the point, mention some due diligence resources, and answer questions in Q&A if there are any.

Square is a “payment facilitator” which you can think of as a layer of software and hardware that faces the customer and interfaces with the back-end of the payments value chain, namely the acquiring processor, the card networks, and the issuing bank.

Square started in 2009 with its dongle, making it easy for anyone to accept a credit card payment through their iPhone.

The company has built around that early success and today provides a cohesive ecosystem of hardware and software solutions that enable a business to start, run and grow.

Here are some key aspects that I believe are attractive about this business:

High return on capital: Square can earn a quick return on new acquired customers—payback is usually in three to four quarters—and from then on those customers tend to earn greater and greater revenues for Square. This results in attractive cohort economics and high returns on invested capital.

Huge TAM: Square addresses the commerce and payments industries, which are multi-trillion dollar industries. The ability to build software that addresses more pain points for customers—like payroll and accounting—increases the addressable market for Square.

CFO Amrita said recently: “I have been really surprised, at the breadth and depth of opportunity available to Square. And there is $9 trillion of consumer spend in the five markets that we're in today. And if you look at our trailing 12-months GPV of about $90 billion, it's about a 1% penetration of that opportunity, it's a large, growing and fragmented space.” (GS conf, 5/14)

Missionary management team: The company has a clearly stated mission of economic empowerment. Jack Dorsey is considered thoughtful and a great product guy. He has surrounded himself with a management team that believes in the mission and a top notch engineering team that is proud to work for Square. In a competitive world, this matters.

Cash app: The cash app can be thought of as a software-based checking account that has a fraction of the cost of customer acquisition compared with a traditional retail bank. Customer assets are still small (about half a billion) compared with ~$22 billion for PayPal for example, but these funds are up 3x over the past year. The company acquired 7.5m MAUs for Cash app in 2018 spending $158m or about $21/customer. Square has been trying to get a bank license and it'll be interesting to see what they continue to build around the Cash app.

Capital: The company makes small loans, about $6-7k on average, to its merchant customers, and nearly all of them are made algorithmically. They had $0.5bn in originations in Q1. This is a feature and a bug: it’s a bug because we all know of the risks during a downturn. It’s a feature because Square has a huge cohort of customers that could never get a merchant account if it were not for Square (that’s the whole point of the business), and Square knows more about these customers than any traditional bank could, since Square sees all the sales numbers, payroll, etc., so they are very well positioned to make low-risk loans. They are also very well positioned to get paid since payment is made automatically as the customer makes sales. Loan loss rates have been around 4%.

Scale: The company grows with its customers and its hardware and software can serve very small or very large customers, both offline and online through its acquisition of Weebly.

Valuation inputs:

Under the previous CFO Sarah Friar the company guided for long-term growth of ~25% and EBITDA margins of ~38%. Using those inputs and a terminal P/E multiple of 25x earnings, assuming an ongoing 3% stock dilution, and assuming free cash flow conversion improves over time as the company grows, I believe investors can achieve a high-teens IRR from the recent price of ~$72.55.

The stock is pretty volatile so long-term investors will probably get more bites of this apple over time (i.e., attractive entry points).

The key point to underline here is the following: the company believes that it is investing to acquire customers and it makes sense to do so at the expense of reporting profits. In order to invest in this business, you must believe that eventually Square will report profits.

Bear points:

The main bear points I’ve heard, besides Square Capital being risky in a recession, is competition. Yes, this is a competitive field. No, not all of that $9 trillion times 1% take rate is addressable. Square competes with incumbents (like Clover by First Data) and new entrants (like Shopify). That said, this seems to be a large enough market for multiple players to succeed. The proof seems to be in the pudding as Square is growing briskly.

As long as Square remains focused on creating value for customers, I think it’ll do alright.

In the GS conference on 5/14, Jack Dorsey articulated it thusly:

“And we weren't first-to-market, but I do believe we're best in terms of the experience and what we offer, and that's always been our mindset, which is like we don't need to be the first in any particular space, but we really need to focus on what sets us apart.

And number one is ecosystem.

Number two is the speed. Just how fast it is to get started, how fast it is to get your money, instant access or next day.

Number three is the elegance, just how everything works together.

And number four is self-serve. So if we can make all these things more and more self-serve, so that people can just come to it and use it immediately -- we're very ahead of our competitors doing similar things.”

Some key sources for additional due diligence:

A podcast episode about Shopify’s IPO – shows how much skepticism there was, how Verifone tried to compete on cash advances and shut that down due to fraud losses, etc:

https://www.acquired.fm/episodes/episode-43-the-square-ipo

Square’s 10-K – you can see a diagram of where they are in the payments value chain and get a bunch of stats on the business, like how their seller mix is moving towards larger sellers:

https://www.sec.gov/Archives/edgar/data/1512673/000151267319000003/a10-kfilingsquareinc2018.htm

Quarterly letters, which are nicely detailed and show a bunch of stats:

https://squareup.com/about/investors

The investor day webcast and materials, which shows the calculation of payback period (which by the way has held steady since the IPO), long-term margin expectations, etc:

http://square.q4web.com/Investor-Day/default.aspx

Catalyst

Doesn't hit a wall on growth.