Back in November, I warned investors that Square (NYSE: SQ) stock may be too risky for most considering the price it was trading at. Since then, the stock has gone on to outperform the S&P 500 by nearly 21 percentage points.
Square released an encouraging set of fourth-quarter earnings and a 2018 outlook that made me a bit more confident in the company’s future. But considering the stock’s continued price increase, that doesn’t necessarily make it a buy.
Let’s review what has and what hasn’t changed for Square since November.
2018 could be Square’s best year yet
Square’s fourth-quarter results showed continued strength in its subscription and services products — i.e., products that aren’t based on transaction volume. Revenue from those products not only grew 96% year over year in the fourth quarter, but growth also accelerated.
The growth implies higher attach rates for Square’s services, which is essential to its continued growth. Square’s entire strategy for winning and keeping customers is to develop an ecosystem around payments. Merchants using multiple Square products will experience higher switching costs compared to those that only use it to process card payments. That’s important in a market with fierce competition from other fintech companies like PayPal and Intuit, as well as old-school payment processing companies like Worldpay and Global Payments.
Last month, Square started working on ways to encourage more customers to use multiple products.
Square also provided guidance that indicated that it has solid plans to continue investing for growth. The company expects adjusted revenue growth of 34%, a modest slowdown from the 43% increase the company posted last year.
Importantly, it guided for adjusted EBITDA margin expansion of 5 percentage points for the full year, which is in line with CFO Sarah Friar’s previous comments about balancing growth with profitability. Too much margin expansion is a sign that Square is becoming inefficient with its revenue growth. The company has plenty to invest in, and it should be funneling a lot of money back into growing the business.
Finally, Square shared an update on the progress of Cash App, which now has 7 million active users. Cash App presents a ton of untapped potential, and its ability to grow despite competition from PayPal’s Venmo is quite impressive.
Square’s results in the last half of 2017 and its 2018 guidance are very encouraging. The company is coming into 2018 with a lot of momentum and a solid plan to continue winning market share and increasing attach rates for its other products and services.
Some things still haven’t changed
Square still doesn’t have much of a competitive advantage. As mentioned above, its main strategy to win and retain customers is to get them to use multiple Square products, increasing switching costs. The company has shown progress on that front, but it’s still not at the point where a large portion of its customers are deeply entrenched in the Square ecosystem.
Square’s management refused to provide details on attach rates for its software and services business when asked on the fourth-quarter earnings call.
Meanwhile, Square’s gross margin indicates that it doesn’t have very much pricing power. Square posted a gross margin of 37.9% in 2017. In comparison, Intuit’s gross margin was 80.7% during the same period, as it’s able to lock customers in into its software ecosystem.
Even a deeply entrenched customer isn’t guaranteed to stay. Just look at what happened to PayPal recently.
The valuation remains high
Even after a couple quarters of better-than-expected results, Square remains richly valued compared to its peers.
Company Enterprise Value-to-Sales Ratio
Square 8.67
Intuit 8.25
PayPal 6.74
Square’s valuation has come down slightly since November, but so has PayPal’s. Analysts are expecting Square to grow revenue much faster than either PayPal or Intuit, so perhaps it deserves a premium multiple.
But consider the fact that Square has yet to prove that it can be profitable, whereas Intuit and PayPal have produced GAAP net income for shareholders and are showing steady growth. That concern is eased by Square’s adjusted EBITDA margin expansion, but it’s still tough to put aside considering it doesn’t have a moat and hasn’t exhibited pricing power.
At a lower valuation than November and a stronger outlook for the future, Square is more appealing than it was a few months ago. But it still seems very risky and most investors interested in the fintech space might do well to invest in PayPal instead.
