Square (SQ - Get Report) had been viewed by many as a company that could do no wrong. Its share price had been on a tear since its IPO and up until recently showed no signs of slowing down. However, recent Q2 2019 results appear to indicate Square's disruptive business model might be starting to mature, implying that its valuation will matter more soon.
For now, investors are best to call it a day and exit their positions. Here is why:
Square's Growth Is Slowing Down
Over the past two months, there appears to be an overall change in investor sentiment, which started off slow but appears to have picked up during the past several days. Investors are eyeing the potential of a weakening economy and as such are moving out of high-priced momentum stocks and once again seeking out value stocks.
As we can see in the graph above, Square's adjusted EBITDA growth rates are slowing down at a rapid clip. For 2019 its EBITDA growth is guided towards 60% growth, but investors are now starting to ponder what its 2020 EBITDA growth rates could look like.
Note that although bottom line EBITDA of 60% certainly appears impressive, this is being driven off of 43% guided revenue growth. In other words, there simply does not appear to have enough revenue leverage to continue to deliver this sort of growth next year.
Cleaner, Meaner and More Focused
Square's big announcement this past quarter was that it had sold Caviar to DoorDash for $410 million, meaning that going forward Square will be able to focus on executing on its two main offerings -- business (the seller ecosystem) and individuals (the cash app ecosystem).
On the surface, many investors were hypothesizing that Square was a fast-growing, up-and-coming competitor to Shopify (SHOP - Get Report) and going so far as value Square with this perspective in mind.
But despite being a cheap platform helping entrepreneurs to start their own businesses and individuals to transact, Square simply does not have the capabilities that Shopify has.
Moreover, notwithstanding its approximately $1.7 billion of debt (2022 notes and 2023 notes), Square does mostly offset that with close to $1.2 billion of cash and equivalents. Altogether, this means that it has plenty of maneuverability within its balance sheet, offering Square enough of a runway to continue to position itself for growth ahead.
Valuation - No Margin Of Safety
The problem for investors is that it's difficult to argue that shareholders are being offered a positive risk-reward balance (see table below).
For example, if one assumes that stock-based compensation is a "real" cash cost to shareholders, and one also backs out Square's regular capitalization of intangibles, Square is far from breaking even on its cash flows.
Consequently, investors are left with a dilemma; given that Square's market cap is approximately $20 billion, together with declining growth rates, as well the fact that it does not in practical terms generate any profit, are shareholders actually being rewarded, or are they just chasing hopes?
On the other hand, Square's cash app revenue went from close to zero to $135 million (excluding bitcoin) in just three years. Hence, it is not inconceivable that Square's CEO, Jack Dorsey, who also runs Twitter (TWTR - Get Report) , and his team can think up new and rapidly growing revenue streams for Square.
The Bottom Line
Square's business model offers tremendous underlying value. However, for now, investors are questioning whether its valuation has gotten ahead of itself. And given that there are so many bargain-basement stocks available elsewhere, investors are arguably better off avoiding Square until a cheaper entry point prevails.