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Square’s Business and Where It Stands Today
While Square (NYSE:SQ) has certainly enjoyed the technology/payment tailwinds of COVID-19, it seems unlikely that Square can maintain its current or future suggested growth rates and thus it appears to be the most overvalued offering among its competitors. Since the quarter ending June 30, Square has officially separated its business into two reporting segments – Seller Ecosystem and Cash App. Before we go into detail, you might want to take a look at Table 1 below and check out this article to get a better idea of the “who is who” in the payment processing industry.
Table 1. The Payments Ecosystem
Source: BUSINESS INSIDER Intelligence: The Payments Ecosystem 2020
When Square onboards a seller, it not only provides them with online and offline point-of-sale (POS) services but it also acts on behalf of small sellers as the Merchant of Record (MOR). Generally, when a seller does not have the resources to become their own merchants of record, as many small businesses do not, Square comes in and bridges the gap. Square assumes financial responsibilities for its sellers and that’s why when customers order goods from businesses utilizing Square, they see Square as the name of the seller on the receipt rather than the sellers name.
The actual payment processing, however, is done by third parties. As of June 30, 2020, Square disclosed that two of its largest 3rd party payment processors process between 50% and 35% of its total settlement receivables. Those two processors are believed to be Chase (NYSE: CCF) Paymentech and Wells Fargo (NYSE: WFC) Merchant Services. Thus, in some ways, we can think of Square as a service reseller or distributor, making complex processing services more accessible to small businesses. This business model works because Square adds value to both parties: it solves painful admin problems for a lot of small businesses all while bringing extra business to payment processors. The ability to efficiently connect supply with demand has always been an important and monetizable value-add in any economy.
Furthermore, on the small business side, Square also provides instant transfer, payroll services, issues prepaid debit card and extends loans. Sound familiar? Well, it is akin to the boiled down services of a bank. In fact, this article here explains this with great details.
Its Cash App ecosystem includes even more bank-like services, such as fund transfer, cash cards for in-person spending and brokerage services for customer investments into equities and cryptocurrency. With recent regulatory approval to establish a chartered bank, Square becomes one of the first fintech firms to plant its feet in banking industry, which makes me wonder whether its goal all along was to become a digital bank, while the seller and cash app ecosystems are just ways of building out its customer network.
All that being said, its shares have gained almost 400% in value from its March low and institutional analysts have been chasing retail investors increasing their target prices time and time again. The jump in price can largely be explained by the overall increased market liquidity seeking “COVID-safe” outlets to invest and a company that has largely benefited from the where others have faltered during the pandemic is an obvious choice. The consensus target price, in my opinion, have merely chased retail trends, desperate to ensure they are not too far off from market valuation.
Thus, the question we must ask ourselves as investors is, “do we believe in the potential that has clearly been priced in?” “Do we have the confidence that the priced in expected growth is sure to happen?” Here, reverse-engineering, while simple. is still a quick and handy way to seek guidance surrounding existing valuations.
Reverse Engineering True Value
Square has yet to achieve steady and consistent profits, all the while its current valuation is based on high expectations of continued future growth as well as injected liquidity. Moreover, inflated stock prices are the case for the entire market, in particular the digital payments space. As investors, particularly long-term ones, we need a quick way to filter and choose relatively cheap or reasonably priced stocks with strong promise of consistent future growth. While most reader’s will undoubtedly associate “reverse engineering” with discounted-cash-flow analyses, here we will assume a return on investment we would like to achieve with long positions on Square, and then we will analyze what would have to transpire to realize those returns as well as the relative likelihood of those transpirations.
Let’s start by assuming that the current valuation is correct, then go backward and deduce what growth rates are implied by this valuation and just how likely such growth rates will become realized.
Of course, many assumptions must be made and one of the most important ones is the price that Square should be trading at. When Square one day matures and investors/analysts are relatively confident in its growth trajectory, it should not be trading at its current sky-high level. Just as a rough guide, the forward price/earnings ratio (P/E) of established competitors Visa (NYSE: V), MasterCard (NYSE: MA) and PayPal (NASDAQ: PYPL) are 35.77X, 40.73X, 45.01X, respectively. Now, let’s first assume Square will be trading higher, at 60X and 40X earnings five and ten years from now, respectively. We also need to account for how much capital gains we want to realize through investing in Square. If we focus on long term and are happy earning 7% on our SQ investment each year, then we would be looking at stock price of $221.15 and $310.18 in five- and ten-years’ time. Such prices would imply earnings per share (EPS) of $3.69 and $7.75 five and ten years from now, respectively.
Table 2. Forward expectations for SQ
Table 3. 5 year and 10 year profit margins for SQ matched with P/E
Source: Yahoo Finance
If you are wondering whether or not it is likely for Square to double its share price in 10-years’ time, let’s quickly take a look at Visa, the golden child of the industry. In March 2013-5 years after Visa’s initial public offering (IPO), its stock was trading at around $40 per share and now, 7 years later, its risen over 400%. During this time, Visa’s revenue and net income compounded annual growth rate (CAGR) were 11.78% and 15.91%, respectively (as of fiscal year-end 2019, based on company filing). Thus, if you truly believe SQ is set to have a double-digit year over year top- and bottom-line growth consistently over the next decade, then doubling its price is actually considered cheap.
Now back to our assumption on margin improvement; as Square’s operations becomes more efficient and its expansion stabilizes, we assume an 8% and 11% profit margin (PM) 5 and 10 years from now, as compared to an almost 0% right now and an ~13% PM from its peer PayPal. To simplify the calculation further, we can assume the number of shares outstanding goes unchanged over the next 10 years. Considering these assumptions would lead us to the implied future Net Income and Revenue, from which, we can finally calculate the implied growth rate. In our case, under the previous assumptions, the CAGR would be 25.41% and 16.85% for the next 5 and 10 years, respectively.
Looking at the latest several quarters and taking out the Bitcoin (BTC-USD) business (which has very low margin) and the effect of COVID-19, we can see that Square is already growing its revenue at a declining rate that is below 30%. Thus, to sustain a 25% revenue growth for another 5 years would be very difficult and unlikely. More importantly, its business is not without competition and has relatively low barriers to entry. Small businesses can choose between Venmo, Zelle, Google (NASDAQ: GOOG) Pay and PayPal — some of which are free services. Going forward, the card networks might also enter the arena since their reach, processing capacity, security measurements and network of users have already provided them the advantages of building almost any fintech application.
As for the profit margin, using PayPal’s 13% as a general guide makes sense, but only for now. Going forward, with digitalization being the center theme of most everything, competition will intensify and margin will be narrow. Eventually it undoubtedly becomes a judgmental call and different investors bring different biases to their analyses. For me, based on the aforementioned findings, I do not believe in the high CAGR implied by Square’s current valuation.
We are now in a less than rational market defined by inexplicable investment behavior with still a lot of uncertainties and unexpected events on the horizon. In financial markets, it is almost always the case that no matter how fundamentally correct we are, we would still lose money going against the market. Therefore, instead of going against the current trend favoring SQ, I would suggest shorting some out-of-money calls or buying some out of the money put LEAPs. SQ has a historical volatility of 60.59% and an implied volatility (IV) of 57.3% for its September 2020 190 call. This means that this call is reasonably priced relative to its historical level. By receiving a ~$2 premium per share, we are looking at a break-even level of $192 per share, which is higher than almost all street analysts’ Dec. 21 target price. If we were to use longer-term options, perhaps to pass the uncertainty of election and hoping to get more recovery from COVID-19, I would be looking at short positions in Jan. 15, 2021, 200 call, with IV = 60% and premium of $10.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.