Square's (SQ) - Get Report recent Q1 2020 results surprised investors by missing its EPS estimates, although its shares still rallied. Indeed, Square's stock has been very volatile, as have most stocks of late, and although Square missed bottom-line estimates due to having to take reserves for transaction and loan losses, these are one-off and there's more here than meets the eye.
Square's smaller peer-to-peer payment service, Cash App, makes up 33% of total gross profits, but it's growing very quickly at triple digit revenue growth rates and shows no signs of slowing down.
Square is priced at 7.4 times trailing sales, but its revenues continue to grow rapidly year-over-year by 44%.
Square’s Largest Segment, Seller Ecosystem, Loses Steam
Square reports that before the impact of COVID-19, the company was growing its gross profits 51% year-over-year, excluding its divested Caviar business. Gross profits are Square's preferred key performance indicator rather than revenues, since its cost of revenues includes processing fees and bank settlement fees paid to third-party payment processors, which are largely out of its control.
Performance before the impact of shelter-in-place has been a theme among most reporting companies this quarter. Square notes that Q1 was performing strongly, but that in the second half of March, its results severely contracted.
Further, similar to most companies, despite Square stating that it expects a "material impact" to its upcoming results, investors are willing to look past that on the expectation that once the economy reopens, companies will be performing strongly once again.
It has long been understood that although Square derives 66% of its total gross profits from its Seller ecosystem, making it by far Square’s biggest segment, this segment's revenue growth rate is rapidly decelerating.
Specifically, despite Square’s strong performance in the first two months of Q1 2020, the final two weeks of Q1 dragged down its Seller ecosystem segment’s performance so that it ended the quarter growing its revenues at 18% year-over-year.
Looking back to 2018, Square’s Seller ecosystem was growing its revenue growth rates at 38%, then in 2019 it was growing its revenue growth rates at 30%. And Square exited Q4 2019 growing at 27%. Hence, even without the impact of COVID and shelter-in-place, the trend on Square’s Seller ecosystem was already slowing down. Why?
This space’s economics are simply too attractive and face intense competition from numerous players, such as PayPal (PYPL) - Get Report, Shopify (SHOP) - Get Report and Stripe. What's more, the latter weeks of March and in early April were particularly challenging for Square’s Seller ecosystem, as it mostly relies on person-to-person card contact.
However, starting in the second half of April, this business unit started to stabilize as many businesses adapted their operations. Indeed, Square’s Gross Payment Volume bounced back slightly compared with the start of April, driven by new sellers adapting to contactless commerce, the timing of the Easter holiday and government stimulus programs.
Cash App, The Crown Jewel
If Square’s story ended there, the allure of this stock would be wrongly placed. But although Square’s Cash App segment only accounts for approximately a third of Square’s total gross profits, this segment continues to grow its revenues at a breakneck pace.
This latest quarter saw Square’s Cash App gross profits grow by 115% year-over-year. The readers' first question will be, was this a one-off, somehow related to COVID? Absolutely not.
Looking back to Q4 2019 this segment was up 147% year-over-year, and for Q3 2019 this segment was up 115% compared with the same period in the prior year.
Square’s Cash App is also attractive because it has very strong network effects since when a friend or employee adopts Cash App, they ask someone else to join them so that they can send payments to each other.
Accordingly, not only is Cash App seeing increased customers using Cash App to send payments, including celebrities sending funds to help support their fans and followers during this troublesome period, but its increased array of products are resonating with its existing customers, which is increasing the lifetime value of each customer, driving an increase in profitability.
Valuation - Not Irrationally Priced
On the surface, Square has is barely profitable. Furthermore, this quarter saw Square’s EBITDA fall 85% year-over-year, as Square took reserves for transaction and loan losses. However, investors are seeing past this bumpy period and are willing to give Square’s diversified portfolio the benefit of the doubt.
Presently, investors are paying 7.4 times Square's trailing twelve-month sales, which is in line with what investors have been paying during the 2018-2019 period.
Square's portfolio has two main segments. Its larger segment, Seller Ecosystem is still growing its revenue growth rates, but at a decelerating rate.
It also has a smaller segment, Cash App, that accounts for approximately 33% of total gross profits and it's posting triple digits growth rates and showing no signs of slowing down any time soon.
It's still early days for its Cash App segment, but its performance looks very promising.