Updated from Nov. 18 to reflect Square is now a publicly traded company.
Priced at $9 a share, which values the company at $2.66 billion, that's less than half the $6 billion Square commanded during its last round of private equity fundraising in 2014. Despite the concern, Square is a classic tech IPO company: it lowers the cost of processing credit cards for 2 million businesses and counting, giving it a real value proposition and providing a solid, economic (and thus lasting) reason to become a Square customer. It has reached only about 15% of its potential U.S. customers and is just beginning to expand abroad. And it just turned profitable on an operating cash-flow basis, with promise of rapid improvement in profit margins as it gets bigger.
The model for tech IPOs over the last dozen years is that the best candidates make it cheaper and faster to do something important, they are growing fast, and they make some money now (at least in cash-flow terms) with a clear path to make much more soon. That's a model that gave the market Netflix (NFLX - Get Report) at less than $1per split-adjusted share, for one example. Square fits this template snugly.
The company is set to hit $1 billion in sales this year if it keeps up its pace from the first nine months -- meaning that its valuation is less than four times revenue. By comparison, arts-and-crafts site Etsy (ETSY - Get Report) still trades for four times sales, even as the share price as plunged to around $9, down from $16 when it went public and a high of $31 earlier this year. PayPal (PYPL - Get Report) , which some on Wall Street see as a comparable for Square, trades at four times sales, despite growing sales at a much slower 20% clip this year. That multiple makes Paypal worth $37 billion.
That's the difference a correction makes, both in the broader market and specifically in the market for shares in the so-called "unicorn" generation of tech startups. And Etsy is nowhere near the company Square is: It's growing slower, has bigger competitive problems, is much smaller and some of its profitability metrics are getting worse rather than better.
"The IPO market is fine," said Kathleen Smith, president of Renaissance Capital, which runs an IPO-focused exchange traded fund. "You just have to give us a discount."
Let's walk through the numbers, both from Square's prospectus and its roadshow presentation.
First, Square works because its services let small businesses save money.
Square charges merchants 2.75% of sales for handling everything involved in accepting credit cards -- and it accepts merchants whom more traditional payment processors consider too high a risk for merchant accounts.
Competitors' costs vary, but especially for small shops and service companies, Square is nearly always a money-saver. It also settles accounts faster than traditional merchant processors such, as soon as the next day, Square says - its video roadshow produces merchants who back that up. That's a pretty good assurance that, unless some still-unknown rival surpasses the scale Square has built up and can deliver the service even more cheaply and quickly, Square's business can get even bigger.
Second, Square works because it is turning profitable pretty much as we speak.
The second quarter was the first in which the six-year old company turned a profit before interest, taxes, amortization, depreciation and other non-cash charges. It lapsed back into the red in the third quarter as it invested in emerging businesses like its Square Capital lending division, Chief Financial Officer Sarah Friar said in the company's roadshow. (Under formal accounting rules, Square lost $131.5 million in the first nine months of the year, on $892.8 million in sales). On an operating cash-flow basis, Square made about $2.9 million in the first nine months of the year.
That means this is the perfect time to buy Square. Once a company like this reaches break-even, with its expensive build out mostly complete, it expands margins rapidly as long as sales keep growing. Excluding a deal with Starbucks (SBUX - Get Report) that ends next year, Square has boosted its transaction revenue 50% to $751.9 million in the first nine months of 2015. That's one reason Friar said on the roadshow that Square's longer-term margins will be about 35 to 40 cents of adjusted EBITDA per dollar of sales.
Here's what a little math shows: If Square grows its non-Starbucks payments revenue like this for two more years, and hits the middle of Friar's margin-target range, that's almost $845 million of 2018 EBITDA. That's before the company gets anything much from its foreign expansion or its early entry into small-business lending and business-management software. Revenue from those businesses, which aren't included in the transaction-revenue numbers, jumped to $35.6 million in the first nine months from only $6 million last year. That gives Square margin for error - and room for more growth.
Third, the valuation makes perfect sense if those are the numbers.
The worry about tech stocks and IPOs has been that the so-called unicorn companies of Silicon Valley have been wildly overvalued, leaving public investors holding the bag, but with a few exceptions like online data-storage service Box (BOX - Get Report) , that hasn't proven to be true, especially recently.
Instead, companies like Facebook (FB - Get Report) and LinkedIn (LNKD) got the IPO prices they wanted and lived up to them, and others like Pure Storage (PSTG - Get Report) are now seeing their prices correct at or before their IPOs as some mutual-fund companies write down some of their 2014 mistakes on companies like Dropbox. Now Square is biting the bullet -- even though medium-term stars are aligning in its favor. And that's okay.
This kind of painless, mostly out-of-view correction sets up public investors to make money. The deal on Square is that it's now being offered at about 4.5 times a reasonable estimate of cash earnings two years out, a fraction of the 20 times 2017 adjusted EBITDA estimates investors gladly pay for Paypal.
All that makes $12 a price that will let new Square shareholders expect to see their investment grow with the company. It might not happen overnight, true, with the market in a wary mood. But at this price, this IPO is a square deal.