TL;DR — Square’s Cash App has strong growth potential. However, Square’s eroding unit economics should create caution for investors.

Square Enables Businesses to Accept Payments

Founded in 2009, Square was a pioneer in helping small and medium-sized businesses (SMBs) to accept payments. You may have seen Square’s trademark card-reader at your local coffee shop, restaurant, or yoga studio.

Their payment-enabled tablets and card readers that you see in the above picture are called point-of-sale (POS) terminals and are a massive part of the payments ecosystem. One thing to note here is that Square sells primarily to small and medium-sized businesses (your mom-and-pop coffee shop) vs. large enterprises (Safeway).

How Does Square Make Money Here?

Square makes some revenue by selling the hardware behind these point-of-sale terminals. However, it makes substantially more of its revenue by taking a cut of every transaction that occurs on these terminals (transaction revenue).

The easiest way to think about it is that for every credit card transaction that happens on a payment terminal, 2% goes to payment card networks (Visa, Mastercard) and card issuers (Wells Fargo, Bank of America) and 1% goes to Square.

Square’s Cash App Enables People to Pay Each Other

In 2013, Square launched its Cash App, which enables peer to peer (P2P) payments. The Cash App is a primary competitor to Venmo and Zelle. Recently, the Square Cash App has enabled the purchase of bitcoins on the platform as well.

The Square Cash App makes money in a similar way to how Venmo / Zelle makes money. They charge fees on instant deposit, credit-card usage, and bitcoin, among other things.

How the Square Cash App Makes Money

Putting This All Together

Square 2019 Adjusted Revenue

  • Transaction Revenue — Square takes roughly a 1% cut of every transaction on its terminals. This is called a “take-rate”.
  • Software and Services Revenue —This includes the money Square makes from its Cash App, as well as the money it makes from Square Capital (where it takes a fee from lending money to businesses)
  • Hardware Revenue— This is the revenue Square generates by selling its hardware terminals
Square’s 2019 Adjusted Revenue. “Adjusted Revenue” removes transaction costs and costs from Bitcoin and Weebly (a website builder that Square owns). Prior to Q3 2019, this was how Square presented its revenue.

Square Adjusted Revenue Overview

Investors and research analysts are excited about the company’s software and services revenue (e.g. the company’s Cash App) and expect it to be a key driver of growth going forward, in addition to growing transaction revenue from Square’s merchant customers.

However, as noted in the table above, analysts expect Square’s transaction revenue to decline in 2020 due to the impact that COVID-19 is having on small and medium businesses. If businesses are shut down, they can’t process transactions. If they don’t process transactions, Square doesn’t generate transaction revenue.

Why Investors Are Excited About Square

Square was transformational in the direct-to-merchant approach for card acceptance, making it super easy for businesses to process payments (which is quite complicated to set up). With a seamless onboarding process and sleek hardware offering, Square has been the payment platform of choice for many businesses across the world.

Over the long-term, investors believe Square:

  • Will be the primary beneficiary of the transition from the continued electronification of payments (cash-to-card)
  • Is uniquely positioned in the marketplace to serve SMBs that have been underserved by traditional merchant acquirers
  • Will be increasingly valued as a software company as software-like services make up a larger and larger portion of its revenue
  • Will continue to see big growth from “Cash App”, which they view as a leader within the Peer 2 Peer payments space
  • Will continue to be the brand leader for point-of-sale (POS) systems across the world

However, I believe investors should exercise caution before investing in Square….

Why Investors Should Be Concerned About Square

Profitability Concerns

When reviewing Square, I immediately became concerned with the long-run profitability of the company, which is currently running at a roughly breakeven operating margin (and slightly positive EBITDA margin). While research analysts expect the company’s profitability to increase, I think there will be a lot of challenges that will make it more difficult for Square to achieve better profitability (vs. another software/hardware company).

There Are Too Many Point-Of-Sale Companies

First and foremost, Square competes with a lot of other point-of-sale companies. A business looking for a point-of-sale system has a lot of options: Revel. Touchbistro. Lightspeed. Shopkeep. The list goes on and on (as shown by the logos above). All of these companies are acquiring customers through Google Ad search, where the cost of the “Square” or “Point-of-sale” keyword has been increasing over time. On top of that, these companies are turning to affiliate marketing sites (“The Top 10 Review sites” that you see for a lot of products), where the price of getting a favorable ranking has continued to increase. Square’s sales and marketing expenses increased from $411M in 2018 to $625M in 2019. On a percentage of adjusted revenue basis, it increased from 25.9% to 27.5%. It’s rare to see an increase on a percentage basis like that.

These Challenges Will Hit Square More Because It Serves SMBs

These challenges to sales and marketing will create more problems than normal for a business like Square since Square primarily serves small and medium-sized businesses. SMBs go out of business more often, and as a result, they churn (or leave) the Square ecosystem more often (they stop using their payment terminals because they go out of business). As a result, Square is very reliant on new customers to generate business. COVID-19 is hurting the amount of new customers Square is acquiring, but even more importantly, the cost of acquiring these new customers (through sales and marketing) is getting higher and higher.

Going Upstream Will Be Challenging

Investors expect Square to also go “upstream”, serving larger and larger customers. However, in doing so, Square will likely accept lower take-rates (the 1% fee they get from every transaction). That means lower transaction revenue than expected.

Stock Compensation

On top of these customer acquisition challenges, Square (like many technology companies) uses stock to compensate its employees. Its stock-based compensation was $298M in 2019 (13% of revenue). That’s a lot of expense that is not being properly accounted for.

Concluding Thoughts

Square has a massive revenue opportunity ahead of it, with an $85 billion TAM in the United States alone. However, if you believe that the market opportunity is “priced in” to the current stock price, given that it has been well-articulated to the market since its IPO in November 2015, you should look to other factors to value the company.

On the positive side, investors may increasingly look to the company’s high-growth Cash App, which may drive the stock up in the near-term. However, I believe that the positives are outweighed by longer-term concerns around the company’s unit economics (customer acquisition costs), the increasingly competitive nature of its market, and lack of a path to long-term profitability. While Square sounds like an enticing opportunity, I believe there are better opportunities available in the technology space.

The above thoughts reflect my own personal investment views and not those of my employer.

Technology Investor