Saturday, January 23, 2021

Why Square has potential 100% upside (in the long term)

Square stock had a strong run up in 2020 with year to date returns of 247.84%, and currently it is trading at a price to sales ratio of 14, and price to earnings ratio of 310. Such nose bleed valuations implies that high growth expectations has been baked into the stock and investors are betting on the company to deliver stellar growth.

When I added Square

When the news of the discovery of Covid 19 vaccine broke, there has been a slow rotation of ‘work from home’ stocks to ‘back to office’ stocks and I took the opportunity nibble some Square shares with the hope to increase my position as it drops further. Unfortunately, the dip was short lived, and currently Square is just $18.7 away from its all time high of $241.58. After doing some research, I decided to add a few more shares near its high as I believe there is still plenty of growth remaining.

History of Square

Square’s root can be traced back to 2009 when James Mckelvey who run a studio business faced a dilemma on whether to accept credit cards. Accepting credit cards would mean profit margin gets eaten up by the credit card fees, whereas not accepting it would mean losing its customers who only has credit cards at the point of purchase. He then got in touch with his friend, Jack Dorsey to build a device to accept credit card payments in the form square shape reader which can be plugged into a headphone jack. After it was invented, the duo approached Cheri Mims, owner of Lilybelle Flowers who just lost a sale from a customer who could only pay by credit card. Back then, banks were reluctant to work with small shop owners to setup credit card terminal due to insufficient credit worthiness. She was initially sceptical at first but decided to give it a try and the rest is now history. 

Square then began shipping many readers to small business owners for free and their business grew from all the transaction fees it collected. In Oct 2015, Square filed an IPO to be listed in the stock exchange.

As Square became widely adopted, they launched Square stand, which replaces the need for a cash register and a range of accounting software. It is sleek, stylish and easy to set up which also attracted mid to larger size companies to use its services.

While on its way to build a payment ecosystem, Square launched Square capital, where they partner with financial institutions to financing to small business seller which solved many of the pain points merchants faced. Back then the business startups could not get access to capital from traditional banks due to lack of customer basic and lack of management. They have to turn to their family members for funding. In Square Capital, they access the loan size without using traditional credit scores, but artificial intelligence based on real time revenue and the number of swipes on square terminal. In turn, the merchants pay back their loans by the average daily card swipes.

Cash App

To go beyond serving business needs, Square launched its digital wallet called Cash App, which is a peer to peer payment service to compete with fintech companies like Paypal’s Venmo, GPay and Apple Pay. The app enables consumers to make payment via their mobile devices and transfer funds to their friends and family, via email.

In Singapore’s context it is very similar to Grab Pay app, DBS’s PayLah and Singtel’s Dash.  If seller and consumer can transact via Cash App, Square earns money from both parties: by charging 2.75% per transaction to business and a fee when consumers use credit card on Cash App.

Square’s four sources of Revenue Stream

Square classifies its revenue into four categories: (1) Transaction Based Revenue (2) Subscription and services based revenue (3) Hardware Revenue and (4) Bitcoin Revenue. Effective from June 2020, Square further split its sales to 2 components: Seller app and buyer App to reflect two big ecosystem which it serves.



(1) Transaction Based Revenue

This is where most of the Square’s revenue comes from and it’s the bread and butter of Square’s business. Square basically collects a fee when there is a transaction:

Sellers App

i. Sidecar payments using Square’s terminal. The standard processing fee is (2.6%+$0.10)

ii. Apps such as virtual terminal/Square Register/invoices 

iii. Square for Retail/ Square Appointment (2.5% to 2.6% +10 cents) processing fee below 10 staff calendars as well as other 3rd party apps (charges vary)

Cash App

Square collects a fee when topping up Square’s debit card using credit card and cash for business. The latter is essentially a business version of cash app, where users can set up a business account using their cash app to collect payments and Square earns a fee from the transactions.

https://www.fundera.com/blog/square-cash-for-business

(2) Subscription and Services (SaaS model where square collects a subscription fee for using its software)

Seller App

i. Apps such as Square for Retail & Appointments/ Square Team Management
Team management allows the employer to track the team members working hours using timecards

ii. Flexible loans repayment and instalment

iii. Square instant transfer and square card

iv. Website hosting services- Weebly which they acquired in 2018

Cash App

i. Cashcard Interchanges and boost Rewards- a discount programme attached to cash card and gives discounts to various retailers. It’s quite similar to shop back Go but this programme is only available to Square’s Cashcard. Find out more here: https://www.youtube.com/watch?v=JWrA1PSbXYo

(3) Hardware Revenue

Sellers App

i. This segment’s profit is still in the red as their focus is to attract more new and bigger sellers to use Square Terminal and Register. Hence, they have been lowering their price to increase the adoption rate of their hardware which translate to more transaction and subscription revenue.

(4) Bitcoin Revenue

Buyers App

This revenue includes value of bitcoin transaction and hence not a meaningful segment of Square’s Revenue.

Growth Drivers

1.Moving Up-Market

One of the ways to grow its business is by having more new sellers adopting its services which then translates to more transaction and Saas Revenues. And the chart below shows that is not only able to increase its clientele but also improves the gross profit per seller. Management has commented that it is due to the newer customers acquired continued to be in the upper segment, i.e. mid market and above.

Gross Profit per seller went up 2.3X in 2 years!



I have touched on earlier on how Square had their humble start in serving micro merchants and it continues to be their bread and butter. They are currently expanding to serve the mid-market.

While there are more micro markets seller than the remaining sellers combined, the combined SMB and Mid-Market adds up to $5.5 trillion, which is 12.3X of the current market they are currently serving.

One of the key drivers that allows Square to capture larger merchants is through its Open API which essentially means allowing more technically sophisticated customers to write their own point of sales system using Square Reader SDK to meet their exact needs and specifications.

For instance, Shake Shack has partnered with Fuzz to build a self-service kiosk where customers can order and make payment own their own using Square Reader SDK to build a customer, in-person checkout experience. Similarly, Joe and Juice adopted Square Reader SDK and integrated with Square stand to build a customized checkout flow for customers buying coffee. Currently they used these terminals in 44 stores in US.

Shake Shack partnered with Fuzz to use the Square Reader SDK to power a self-service kiosk. (Photo: Business Wire)


2. 
Investing and cryptocurrency Trading

On the buyers side of the app, management has commented that Cash App’s indicator of success is determined by its volume of direct deposits. Users who uses direct deposit to cash app tends to carry higher balances and uses more of their platform which is part of their monetization strategy.

While commissions earned from Cryptocurrency and investing isn’t significant, it allows users to invest their surplus funds in their CashApp without the money leaving the platform. As Square has demonstrated history of innovation and will continue to innovate with rolling out new solutions, it creates multiple monetization opportunities with the funds that users kept in the Cash App.

In case if you are wondering how much it could potentially grow, Cash App currently only penetrated less than 2% of the $60b opportunity. That excludes the opportunity to expend to overseas market and new products to penetrate into new markets.





3. Further monetizing Cash App

This is perhaps the most significant growth driver for Square moving forward and will probably overtake the buyers app in terms of revenue and profit.

https://www.businessofapps.com/data/cash-app-statistics/

Although Cash App started in 2013, its growth showed no signs of stopping. During the Pandemic year in 2020, its Monthly Active Users surged to 30mil users, representing 62% YoY growth since 2017. Coupled with its P2P functionality, this further creates a network effect which attracts more new users and keep them engaged in the platform.

Once these users introduced into this ecosystem, they can be exposed to its features that helped to drive its revenue, such as its Cash Card facilities which Squares takes a cut from buyer and seller Ecosystem. With its proven ability to innovate and the improved product adoption, it can continue to a powerful growth driver considering that it has a huge TAM and the largely untapped global market.

Hence investors should pay attention to Cash Apps Annual Revenue per MAU, which is $30 in 2019 up from $15 in 2017.



Valuation

I will be doing Square valuation using discounted Cashflow method by projecting its unlevered Free Cash Flow and discounting it to present at a rate of 7%.

Firstly, I will breakdown Revenue generated from two segments: Cash App and Sellers App to derive their respective gross profit and then combine the gross profits to calculate and project Unlevered Free Cash Flow.

I will be excluding Bitcoin Revenue for two reasons. First it is unmeaningful with Gross Profit Margin (GP Margin) of 1-2% and it's derived from the total sale of bitcoin to customers. Management too believed in deducting bitcoin Revenue to better reflect actual company performance. Secondly including Bitcoin Revenue will affect the overall computation of GP Margin. Its GP Margins Nine months ended 2019 and 2020 is 75.99% and 80.79% and hence will be using margin of 80% in this calculation.

Step 1. Projecting Cash App's Gross Profit for 10 Years



Step 2. Projecting Seller's App Gross Profit for 10 Years



Step 3. Determine OPEX as a Percentage of Revenue

In order to determine operating expenses, I will exclude P&L Segement of Caviar which was sold to Doordash. It was a loss making business. Square's financial statement only includes breakdown P&L of Caviar for two years 2018 and 2019.

P&L Inc. Caviar ex Bitcoin





P&L of Caviar


P&L Ex Caviar Ex Bitcoin


Opex as a % of Revenue remained at 43% and 44% for 2018 and 2019 respectively which suggests that Caviar's P&L has minimal impact on the overal P&L. In addition, we can infer from the chart that Opex as a % of Revenue is trending donwards and hovering at 40%.






I will be using 45% from 2021 to 2025 and 35% from 2026 onwards for Opex as a % of Revenue to project Unlevered Free Cash Flow.

Step 4. Determining Investments in Working Capital

I used Seeking Alpha to obtain its values for Trade Receivables, Inventory and Accounts Payable and determine, DSO, DIO and DPO and Net Trading Cycle. Next, I take the average of DSO, DIO and DPO and Net Trading Cycle of the past five years to project the next ten years Net Trade Cycle and hence Investments in Working Capital.



Step 5. Determining Capex as a % of Revenue


Since 2015, Capex as a % of Revenue is hovering at about 1.5-2% of Revenue hence I will assume Capex as 2% of Revenue from 2021 to 2025 and 1% from 2026 onwards.

Step 6. Depreciation as a % of Revenue



Depreciation has been growing steadily but decreasing as a % of Revenue. To be on the conservative side, I will assume Depreciation to be 2% of Revenue throughout.

Step 7. Combining Cash App and Seller App


Summing it all up gives USD454.35, potential upside of  (454.35-222.88)/222.88* 100% = 103.85%. Despite having more than 2X upside, the next 10 years free cashflow is not really contributing to its present value and adding the fact that tax increase in Biden's administration could potentially drive down the intrinsic value of the stock. To expect a 100% upside, one has to assume that Square will continue to grow and stay relevant beyond 10 years.

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3 comments:

  1. man this is a very strong analysis. thanks for doing this.

    ReplyDelete
  2. Hello
    I Read your article about Why Square has potential 100% upside. Thanks for sharing such amazing information, and I hope you will share some more info about Cash App. You wrote really very well, I really like your blog and information provided by you. I appreciate your work. I will share this Information to other peoples also.
    Thanks

    ReplyDelete