Square is an intriguing company. Their founding premise was that there was a wide swath of merchants who weren’t properly represented in the payments landscape. The reason these micro merchants were ignored by existing providers was because they were too hard to acquire profitably. Square used the internet and hundreds of millions in marketing spend to reach those micro merchants (albeit still unprofitably) and build a billion-dollar enterprise.
Square has been given enough leeway by their venture capital investors – and now the public markets – to reach their current position on the promise of something different: prove that Square is not merely a payments company, but a software company.
Square has yet to report a profitable quarter. Revenues continue to march upward to the tune of 30% a year and are now stemming from a combination of low-margin processing and “software and services”. The former commands a crappy multiple, but the latter makes investors swoon… and it’s Square’s fastest growing stream at 95% year over year growth.
Subscription and services-based revenue for the year ended December 31, 2017 increased by $123.3 million , or 95% , compared to the year ended December 31, 2016 . The increases were primarily driven by continued growth of Instant Deposit, Caviar, and Square Capital, which in aggregate grew by $103.0 million when compared to the prior year.
Square now has an enterprise value of $18.5B, just shy of Global Payments’ enterprise value of $21.75B. Global Payments, a company founded in 2000, racked up 2017 revenues of $3.98B, practically double Square’s $2.2B. So why is Square valued so highly with such a small amount of software revenue?
Investors are betting on Square to outpace their competitors using their software culture. Software, unlike the traditional methods employed by Square’s competitors, allows for increasing growth at incremental costs. From Square’s 10-K:
Our direct, ongoing interactions with our sellers help us tailor offerings to them, at scale, and in the context of their usage. We use various scalable communication channels, such as email marketing, in-app notifications and messaging, dashboard alerts, and Square Communities, our online forum for sellers, to increase the awareness and usage of our products and services with little incremental sales and marketing expense…
Our products and services are mobile-first and platform-agnostic, and we are able to continuously optimize them because our hardware, software, and payments processing are integrated. We frequently update our software products and have a regular software release schedule with improvements deployed generally twice a month, ensuring our sellers get immediate access to the latest features.
Think about how that compares to First Data, who gave up on software just a few months into the purchase of Clover and instead turned to lower-multiple business lines of hardware and processing. Or Worldpay (Vantiv), who hasn’t even made a foray into point of sale as if interchange will perpetuate for eternity.
Square is being given enough slack to continue iterating on its software and services until they materially contribute to Square’s top line. And surprisingly, Square is starting to attract larger merchants to its platform. No doubt this comes from its POS partnerships with Vend and Touchbistro, but 20% of Square’s merchants now do more than $500K in gross processing volume. And larger merchants are critical for Square’s software and services platform because the farmer’s market merchant isn’t going to drop $1,000 a year on Square’s analytics.
Square also has a flat rate processing scheme that’s easy for merchants to understand; merchants don’t need to pore through monthly statements to see what make-believe fees their greedy payments provider decided to invent last month. That’s why Square also sees software-levels of happiness in their net promoter score:
Our Net Promoter Score (NPS) has averaged nearly 70 over the past four quarters, which is double the average score for banking providers.
Square’s loan business has a number of investors excited at the opportunity. And no, it’s not because Square is simply originating loans, which many of the processors do: it’s because Square is using software to reduce risk and create higher returns. JPMorgan sees Square Capital as the most profitable service Square has. Square’s onboarding service is fully automated and 99.95% of loan applications get authorized automatically. The average loan is only $6,000, but the portfolio loss size is significantly better than alternatives at 4%. (For reference, The World Bank sets the acceptable microloan loss rate at 5% globally. That might not sound like much but that’s a 20% improvement, and over tens of billions of dollars that’s very material.)
Square is also scaling without a conventional POS reseller network. Yes, Square has a VAR program, but they haven’t actively gone out and recruited the typical POS resellers that are now proving problematic 95% of the time. Investors are recognizing Square’s approach to disintermediating distribution via the internet and are bullish on the tactic since it better controls growth and costs.
There are still two large risks to Square’s optimistic valuation, however.
First, Square will only grow its software and services business substantially if it can find and keep larger merchants. Smaller merchants have very limited budgets and pay for very little, which is why Square is actively trying to move upmarket. As of today, those larger merchants are still attached to a “local-service” model. That’s not to say that larger merchants demand local resellers, they just demand the quality service a good, local reseller (i.e. Value Added Reseller – VAR) can provide.
It’s entirely possible that a number of these larger merchants opt for quality remote support with on-demand support as-needed. Boomtown is slowly making gains in this market but that payments companies haven’t yet learned how to do support properly is slowing down this entire evolution. Square will need to figure out how to placate these support concerns from larger merchants. That’s a massive change for Square considering they currently offer very limited support and have caught flack on this for years.
Second, Square will need to show it can sustain its rate of software and service growth despite large, well-funded competitors in the payments ecosystem. In essence, investors are betting that Square’s software culture will acquire market share faster than incumbents with larger market share will acquire a software culture.
Famed business management consultant Peter Drucker once said, “Culture eats strategy for breakfast.” There have been numerous examples proving Mr. Drucker proving right throughout the years, with Amazon perhaps being one of the most glaring: a software and data company eviscerates retail companies in any head-to-head competition.
Our personal observation has been that this is the predictable outcome when professional management is competing against founders and innovators. And in today’s world, innovation goes hand-in-hand with software and data adherence.
So what happens from here? We wait.
But we would never bet against Amazon.
Is Square the Amazon of the payments industry? Given the competition, the majority of investors are placing bets that say yes.
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