Square

Square's (SQ) share price appears to have regained some vitality after the strong selloff of Q4 2018 and is up 26% so far this year. However, this article shows that in spite of an alluring siren, Square is, in fact, a stock best avoided.

Shares closed up 7% Thursday at $73.94.

Questionable Value Proposition

Square has been a highly rewarding stock for its shareholders over the past four to five years. However, I contend that Square's present risk/reward balance is very much negatively skewed.

Square positions itself as the go-to card payments provider and its narrative is focused on the assertion that it is innovative and has a market-leading value proposition. The problem, though, is that Square has a plethora of competition with similar assertions. Furthermore, while Square is positioning itself at the bleeding edge of fintech, this space is notoriously fragmented.

Part of Square's energy has been on deploying an all-in-one device which doesn't require a third-party tool, which in my opinion offers no lasting competitive advantage. Square claims this device, called Square Terminal, aligns its customers with Square's ethos of enabling sellers to make sales. But so, too, are its competitors, some of which have meaningfully more financial resources, such as PayPal (PYPL) . Furthermore, Square concedes that this device is a loss-margin product for Square and that it's viewing this hardware as a marketing tool.

Having said that, being amongst the first players to position itself in this fast-growing space is certainly a strong advantage which helps Square carve out market share. However, I would argue this is not enough. And even it was, investors are not likely to beneficiaries of this highly-valued company.

Financial Position

A strong positive for Square is derived from its financial position. While Square carries a meaningful amount of debt at roughly $1.2 billion, this debt is mostly made up of long-dated debt with the bulk of it not due until 2023. Moreover, this debt is largely offset by close to $1.2 billion of cash and equivalents, plus a further $0.5 billion of long-term investments maturing within five years. In other words, Square's balance sheet gives Square plenty of flexibility to press forward with its strategic goals. However, this is where the good news ends for shareholders.

Square's EBITDA Misguides Investors

For Q3 2018, Square wants investors to focus on the fact that not only was its adjusted revenue up by 56% YoY, but its adjusted EBITDA performed even better and was up 107% YoY to $71 million. However, once we dig a little into Square's adjusted EBITDA figure, we can see that the majority of the gains have come from its share-based compensation being backed into the EBITDA figure. Assuming that share-based compensation is a running cost of management (which it is), without this add-back, Square's EBITDA figure would have actually fallen to $13 million in the Q3 2018 quarter.

Lastly, we should bear in mind that this EBITDA figure also excludes Square's annual capex requirements of between $25 to $35 million. Consequently, once capex is factored in, Square is a cash-burning machine that is mightily overpriced.

Valuation - Red Hot

As the table above highlights, not only does Square carry a very heavy price tag, with a P/Cash Flow from Operations of more than 200x, but the whole sector is exuberantly priced as investors crave participating in this fast-growing space. If history teaches us anything, however, it's that it is very difficult to ultimately forecast which company will be the biggest winner from a nascent sector.

Takeaway

At close to a $30-billion market cap, Square makes it impossible for rational investors to make a suitable return as all of the good news is more than accounted for already, and there is no margin of safety being priced in for inevitable hiccups which are likely to happen sooner rather than later.

PayPal is a holding in Jim Cramer's Action Alerts PLUS Charitable Trust Portfolio. Want to be alerted before Cramer buys or sells PYPL? Learn more now.

The author has no positions in any stocks mentioned.