Square Loses Its Edge

Jon Markman

Shares of Square Inc. ((SQ) -Get Report) have tripled since March. Investors love its consumer mobile wallet business. Its legacy merchant business may be more problematic.

That’s the big idea in a note to clients Thursday from George Mihalos, a research analyst at Cowen and Co. The firm downgraded Square shares to “market perform” from “outperform”.

I agree completely. Most of Square’s business is stuck in the legacy world. And that is not good.

Square used to be best known for its iconic postage stamp sized dongles, point of sale terminals and customer relationship management software. The combination helped countless bodegas, hair salons and neighborhood coffee shops accept credit payments. Pop the reader into the 3.5mm headphone jack on any smartphone and it became an instant checkout system. It was the epitome of cool.

In a great economy, like February, this was an amazing growth story. Stores were bustling. Square was pulling in new customers at breakneck pace. The stock even expanded aggressively into small business banking.

Traditionally, banks competed fiercely to court small businesses. The game changed with the Great Recession of 2008 when banks recoiled under the weight of increased regulation. Mom and Pop businesses were left in the lurch.

Last year, the outline of Square’s banking ambitions came into full view.

According to a Wall Street Journal report, Square Financial Services would grow into a full service, virtual bank with loans, deposit accounts and the whole shebang. The company would use its prowess in data science and machine learning to make instant small loans. And with an initial capital base of $56 million, that business was set to become the backbone of a legitimate fintech ecosystem.

Then the pandemic happened. Being a lender to small businesses, many of them shuttered, was problematic at best.

So Square business managers began to talk about the good parts of the business. Cash, its peer-to-peer smartphone payment app, is all digital. It’s also growing very fast.

Jack Dorsey, chief executive officer, explained that Cash accounted for more than half of revenues. People are using the app to pay rent and exchange money with family and friends. That is leading to more downloads, and more network effects.

Without anyone noticing, Square managed to build a big digital payments platform. It has well-developed person to person, mobile and online channels. It’s all good.

The problem is the other half.

Small businesses, and lending to small businesses, is in a world of hurt.

James Hammond, chief executive at New Generation Research, a bankruptcy tracking firm, told the Washington Post the level of defaults will eclipse what anyone has seen in their lifetime. Small businesses, he explained, will be hit hardest.

You don’t have to tax your imagination to envision of armies of small business owners returning their cool Square point of sale systems or worse, defaulting on those easy to get Square loans.

The stock is valued like it’s Amazon.com (AMZN). At 136x forward earnings and 11x sales, investors believe Square’s business is dynamic and digital. It’s not. A big portion of what made the company is still rooted in bodegas, hair salons and neighborhood coffee shops.

The pandemic has made that business is terrible.

Investors should use the current strength to circle the wagons and lighten up on Square.