In this report, we present a unique short thesis on the common stock of a very popular payment service provider - Square Inc. (henceforth, just Square). We believe we are contrarians on Square as several components of our thesis have not been discussed by analysts or the research community at large. Hence, we believe our perspective is additive to the current information set available to investors on Square’s business prospects and has not been fully priced by the market. Accordingly, we believe the downside risks to Square’s common stock at current valuations are significant and deserve more attention. We believe Square has close to 80% downside based on a current market capitalization of $5.5 billion (and stock price of $15). Accordingly, we recommend investors establish a short position against Square common stock to profit from its decline.
Key operating, financial metrics on Square Inc. (NYSE:SQ)
LTM 9/2016 Revenues: $1,631 million
LTM 9/2016 Gross Profits: $518.6 million
LTM 9/2016 EBITDA: $112.8 million
LTM 9/2016 Net income: $-$201.5MM
LTM 9/2016 Free Cash Flow: $40.3 million
Shares Outstanding: 343.9 million
Share Price (1/9/2016): $15.06
Market Capitalization (1/9/2016): $5,303.2 million
Cash & Cash Equivalents (9/30/2016): $514.3 million
Debt (9/30/2016): $1.3 million
Approximate Enterprise Value: $4,790.2 million
Analyst opinion on Square Inc.
Analyst Consensus Price Target: $15
Analyst Buy / Sell / Hold recommendations: 17 / 12 / 0
Price / (2017/18/19E Consensus Earnings): 170X, 55X, 35X
EV / (2017/18/19E Consensus Revenues): 5.4X, 4.3X, 3.5X
EV / (2017/18/19E Consensus EBITDA): 57X, 29X, 16.9X
Short interest statistics (as at 1/11/16)
Short interest: 19.1 million
Total float: 156.5 million
Short interest ratio: 3.3
Markit Short Interest Score: 1
S3 Blacklight Market Composite Rate: 0.31%
Short thesis on Square Inc. (NYSE:SQ)
Square - a payment processing company, that also offers financial and marketing services - is severely overvalued. With a market cap of $5.5 billion, the market is forecasting high margin annual revenue growth of 25%+ over an extended period of time i.e. a decade or more. Consensus is largely bullish on this company with a so-called “open-ended” growth opportunity. We believe consensus, guided by management and by Square’s recent quarterly results, is overly optimistic about the long term business prospects of this business given the realities of Square’s business model and rapidly developing competitive landscape.
In summary, Square’s business model in many significant ways resembles a “Ponzi” that needs a constant influx of new small business owners to replenish its existing cohort of older business owners, close to 80% of whom will eventually leave the platform due to the success OR failure of their businesses over time. This “Ponzi” dynamic is being supported by Square’s financing arm, Square Capital, which makes small business loans to otherwise unviable business enterprises. These small businesses are then required to rely on Square’s overpriced payment processing services to support their fledgling businesses. The rapid growth Square has experience since inception in 2009 is not sustainable and has primarily been a function of large small business growth fueled by government supported economic growth initiatives such as the JOBS Act and several quantitative easing programs. Square’s rapid growth from a financially disadvantaged group (i.e. small business owners) is characteristic of the beginning phases of a “Ponzi” type business.
We believe, over time, this “Ponzi” dynamic will inevitable rear its ugly head due to increased “churn” rates that are not yet apparent due to a conducive environment for small businesses, from rising price competition on its overpriced commoditized payment processing platform and, if not sooner, from an economic slowdown, which would lead to large drops in its customer base and profitability, due to rising small business failures. Any one or all these events, or the recognition of their high probability by the financial markets, should lead to a revaluation down of Square’s lofty stock price, which currently trades at a consensus 2018 and 2019 Price-to-Earnings ratio of 55 and 35, respectively.
Square popular service caters primarily to the bottom rung of business owners - those with neither the resources nor sophistication to make optimal financial decisions when setting up or growing their businesses. This is fantastic for Square at time of sale as many new business owners love the low upfront cost and convenience of Square’s services. The drawback is that they rarely fully appreciate how expensive Square’s payment processing services actually are (as we will demonstrate below). To be clear, Square does provide new business owners the ability to instantaneously accept credit and debit cards with no training and or messy paperwork. Thanks to this convenience, Square is able to charge these small business owners very high payment processing fees while increasing cross sales of ancillary products in their ecosystem. Small business owners are usually desperate to avoid upfront costs due to limited financial resources as well as complexity due to their particularly skill set of running their usually non-technical core business operations. Square appears to be a no brainer for these under-resourced overly optimistic new business owners.
The reality is that, according our calculations, Square will eventually lose nearly 80% of their existing customer base due to the natural lifecycle of a small business and the commoditized and overpriced nature of their payment processing services. In due course, they will have to replace these lost customers due to “churn” with new ones, which will raise acquisition costs and reduce the company’s return on invested capital.
To understand why this could be the case, consider three eventualities (which, given enough time, cover 100% of business outcomes):
- The business fails: There are no transactions to process and the customer exit’s Square’s ecosystem. (Estimated probability: 50%)
- The business succeeds: Revenues scale and the customer realizes the overpriced nature of Square’s services and transitions to a cheaper and more professional payment processing provider. (Estimated probability: 30%)
- The business muddles along at break even levels: The business does not scale yet the owner continues to operate on Square’s platform as it does not represent their primary source of income. (Estimated probability: 20%)
Given enough time, we estimate that within a five year time period close to 80% of Square’s customers will eventually either go out of business (50%) or, if they are successful, seek a potentially cheaper alternative to the overpriced payment processing platform that Square currently provides (30%). This presents a serious and potentially crippling “churn” problem for Square’s management team.
Luckily for investors, management is fully aware of this “churn” issue and goes to great pains in its conference calls to explain why businesses would want to stay with Square as they scale. Their primary explanation is loyalty to its high quality ecosystem that provides customers with services to assist in the day-to-day management of their business, such as Employee Management, Location Management, Appointments, Payroll, Instant Deposit, Marketing and Loyalty.
While we do not dispute the utility of such services to new small businesses already on Square’s platform, we are very skeptical that this is true for the majority of small businesses that scale. Successful businesses have unique needs and Square’s one size fits all solution (hardware + software) is not the answer for everyone. Many large businesses want to pick different providers for different functions. There are also good reasons to think that larger businesses would also not find complete reliance on Square’s ecosystem to be an advantage, but rather a potential liability.
Our theoretical view is validated by the loss of Starbucks as a Square customer in 2014. Despite being on Square’s “ecosystem” since 2012, Starbucks was unwilling to pay more in processing fees to get access to it. This makes sense.
We believe other successful business, like Starbucks, will reach a similar conclusion once they grow revenues to any significant scale. There are simply better providers of day-to-day business services than Square. Larger organizations need better tools than Square currently provides its small business startups.
It’s worth noting that Square does offer large sellers more competitive payment processing rates to adopt and stay on their platform. This is an implicit acknowledgment that Square’s product competes with the largest payment processors on price, lending credibility to the thesis of its core produce being a commodity and the more limited value of its ecosystem.
The “Ponzi” problem would be difficult enough on its own. However, things are getting significantly more difficult for Square due to certain competitive developments. At its heart, Square’s core payment processing solution displays three undesirable characteristics in an investment:
- Payment processing is a commodity product that, similar to other financial transaction fees such as broker and bank processing fees, faces long term price deflation
- Square has no “moat” as demonstrated by similar, cheaper and in some cases better product offerings (card readers, registers) from a large number of competitors e.g. First Data. We debunk the thesis, in theory and in practice, that argues that their “ecosystem” is in fact their main competitive advantage. R&D is CAPEX for a tech company and is very high for square
- Square has a small Target Addressable Market. In particular, the TAM is significantly lower than what management has “misled” the market to believe, as demonstrated by an analysis of statistics from the Small Business Association. Analysts are also underestimating the secular trend away from physical credit cards, including EMV ((i.e. Europay, Mastercard and Visa) chip cards, and towards pure online solutions.
Over time, we believe there are three catalysts that will lead investors to recognize a significantly lower value of Square’s business in the public markets:
- The “Ponzi” nature of the business model will become apparent as “churn” rates increase. Notably, Square does not disclose churn rates at present, but we believe the analyst community will demand more transparency as time goes by and revenue growth and earnings underwhelm consensus estimates.
- Pricing pressure on Square’s core payment processing solution will accelerate and revenue growth estimates will come down due to a realization of a lower TAM
- An economic slowdown will lead to large drops in its customer base and profitability due to an increase in small business failures, thereby leading to a revaluation of its share price. The impact of an economic slowdown on the business will be exacerbated by loss of revenue and potential credit losses from Square’s small business lending arm, Square Capital, which makes business loans. To the extent that Square is unable to securitize any loans due to a freezing of credit markets (and is forced to hold such loans on its balance sheet), an economic downturn would pose an even greater risk.
We believe Square is more fairly valued closer to $1 billion than the current $5.5 billion valuation. Thus, we believe the stock has significant downside from current levels. If our thesis is correct, Jack Dorsey - currently Square’s and Twitter’s charismatic and dynamo CEO - will have his hands full over the next few years.
In this report, dividend into six sections, we delve into each of our key conclusions to justify a bearish stance on Square Inc. The report is structured into the following sections:
Section 1: Background on Square’s business
Section 2: Competitive landscape in the payment processing industry
Section 3: Comparing Square’s Dashboard, Reader, Register, Square Capital to competitor products
Section 4: Analysis of Square’s Target Addressable Market
Section 5: Consensus views from the Street (and why it’s wrong)
Section 6: Our fair valuation of Square using a discount cash flow model
1) Background on Square’s business
- Tailwinds to Square's business
Data supporting new business formation due to positive economic growth
Percentage new businesses that succeed or fail
- Ancillary products such as Square Capital
- Food delivery app
- Payroll services
- Quikbooks?
- Invoices, analystics, appointments
For the most part, even Jack Dorsey doesn’t think much of Caviar, as he has been looking to sell it unsuccessfully albeit for the last few years. Given a jewel is unlikely to be on top of a CEO’s sell list, we do not think Caviar will be a big driver of value for Square in the future.
Hardware revenue is a money loser
Adjusted net revenues which nets out Starbucks revenues, 20-25% long term growth
R&D expenses are 16% - big
Sales & Marketing expenses - 10%
Transaction take rate
Total take rate
Costs per transaction? What is the mark up?
Split of businesses using Square?
Square is also on the wrong side of technological innovation. Mostly moving away from phycial cards. Consider example of PMTS and other industry player commentary.
Failure rate of small businesses
Small business failure rates vary depending on where the statistics are coming from, but Carroll said that generally 50 to 70 percent fail within the first 18 months.
Square Capital facilitates this PONZI by offering credit to businesses that might otherwise be in existence. In many ways, this resembles the controversy around Patient Assistance programs in the pharmaceutical industry. Or chartitable donations to the American Kidney Fund to transition people on to commercial healthcare plans that might not have otherwise been able to. Square Capital is ultimately not a long term sustainable business since its target market has very high losses. LOOK AT YIELDS ON SECURITIZED DEBT OF SQUARE CAPITAL LOANS. LOW INTEREST RATE ENVIRONMENT.
Management team
Morley initially sued Square (sq, -1.00%) and its co-founders Jack Dorsey and James McKelvey in early 2014, alleging patent infringement and breach of fiduciary duty. The college professor claims that he, Dorsey, and McKelvey worked together in 2009 to figure out how to accept credit card payments through a mobile phone. Morley then alleged that he actually invented the hardware device that Square went on to use as its credit card reader. Dorsey and McKelvey then took that information and created Square, according to Morley, and cut him out of any ownership stake of the company.
2) Competitive landscape in Square’s key payment processing industry
- Comparisons to paypal, Apple Pay, Android Pay
- Square's vs. competitors
- fees comparison, services offered
- for core and ancillary products
- Reviews of Square's app
- is there a moat?
- client experience including starbucks
Analysis of Square Capital
Section 3: Comparing Square Dashboard, Reader and Register to competitor products
R&D is CAPEX for a tech company and is very high for square at 17% of revenues
3) Analysis of Square’s Target Addressable Market
- how many new business owners can Square have at any one time
- Management guidance on TAM
- why this is a Ponzi scheme
- Ponzi scheme targeting financially disadvantaged group
- There is also a secular trend away from using physical credit cards, including EMV cards
4) Consensus views on stock from the Street (and why it’s wrong)
file:///C:/Users/Abz/Downloads/Square-2016-Q3-Shareholder-Letter.pdf
The bullish thesis.
While it is true that existing customers use Square’s ancillary services, the question is if their services would be desirable for an independent third party - NOT currently on their platform.
“Square currently cites a 4-5 quarter payback period for a quarterly cohort of sellers to generate transaction profit that surpasses the sales and marketing spend in the quarter of acquisition. Based on the strong retention rates, as the business scales, there should be potential for leverage.”
Needham & Company writes on the decline in “take rate”:
“The other piece of the transaction revenue formula, transaction take rate, has been in moderate decline in recent years, though the pace and magnitude is not of great concern, particularly when the overall top line is supplemented by other types of revenue.”
This conclusion is misguided. The reality is that Square is offering larger customers a discounted payment processing fee if they stick with the platform. While ultimately this is a good, it also illustrates how customers have a real aversion to paying higher rates for a “bundled” service.
Needham writes:
“We see potential for Square to reach 35% EBITDA margins LT, consistent with other scaled payments, processing and software businesses.”
Transaction Take Rate 3.33%, which is very high and represents and anomalous margin with history.
What will happen to fees charged by banks and credit card companies?
Management is very generous with SBC: $142.5MM in CY2016, $165MM estimated in CY2017 and $206.4MM estimated in CY2018.
BTIG states:
“The ongoing mix shift provides confirmation that SQ can continue to grow rapidly with larger firms even as it faces more competition in that segment than it does in pursuing growth from the micro-businesses on which it had initially focused. The change in mix toward larger businesses also demonstrates that the company can win business from such firms by pitching all of the benefits of its “ecosystems” rather than competing on price.”
This would be a huge negative development for the company and an acknowledgement of the current high and unsustainable nature of gross margins (currently in excess of 50%).
Needham has a similar opinion:
“We note that while margin pressure does persist, we believe that Square is less dependent on discounting due to the value add from its cohesive, easy to use platform, particularly given that the bulk of payment volume still comes from sellers with less than $125K in annualized GPV.”
5) Our fair valuation of Square using a dividend discount model
to grow at anywhere near the projected growth rates given its Target Addressable Market is not as large as it has led investors to believe. In a more negative scenario, as its core payment processing platform faces competition and price erosion, it will face the dual effects of revenue and margin headwinds, leading to underperformance on both consensus revenue estimates and margin targets.
Cavier - a food delivery app - Jack Dorsey has been trying to sell but to no success. Acquired for $90 million.
This dynamic puts Square in a very unfortunate position of cutting price if they would like to retain their successful clients. However, this is a race to the bottom, given the significant differences in price between Square’s payment processing services and the larger players. For Square, the optimal outcome is for a client to muddle along, neither growing nor going out of business.
due to the “Ponzi” nature of its business model and several better and more competitive products currently hitting the payment processing market.
To summarize, management and consensus is severely overestimating Square’s revenue and earning potential and this has lead to an unreasonably high market valuation.
If things weren’t difficult enough,
payment processing platform to replenish the stock of business owners that have either exited due to a failed business or exited due to a successful business that can afford a cheaper payment processing platform. Curtly put, Square is a business that loses its customer under two ceventually loses its customer -
As Buffett has said, "Pessimism is the friend of the long term investor, euphoria the enemy." We believe investors in Square are experiencing a few fleeting moments of euphoria that in hindsight will become more obvious.
If Square wants to maintain its existing number of customers, it is in the unfortunate position of having to replace existing customers exiting its ecosystem due to business failure or success (i.e. churn).
In our opinion, Square is going to severely underwhelm investors on revenues and margin over the next decade. We believe that the stock should re-rate lower over time to better reflect significantly worse business prospects than are currently priced in, with a target market capitalization closer to $1-1.5 billion (70%-80% below current levels of $5.5 billion). We believe this lower market capitalization would better reflect Square’s actual revenue and profitability potential over the next decade.
“Morley initially sued Square (sq, -1.00%) and its co-founders Jack Dorsey and James McKelvey in early 2014, alleging patent infringement and breach of fiduciary duty. The college professor claims that he, Dorsey, and McKelvey worked together in 2009 to figure out how to accept credit card payments through a mobile phone. Morley then alleged that he actually invented the hardware device that Square went on to use as its credit card reader. Dorsey and McKelvey then took that information and created Square, according to Morley, and cut him out of any ownership stake of the company.”
It seems like Square is trying to be evFor this to be true, Square would have to either:
a) offer a similar bundled product at a lower cost or
b) a superior product at a similar cost to the unbundled products
/
an established business would pay higher payment processing fees just to get on the ecosystem. It doesn’t make economic sense, given Square’s entire product suite is priced at a premium to competitors given their smaller scale.
developments “on-the-ground.” At a minimum,
Specific to the short thesis,
Background on Square Inc.
A brief description of the business from the Company’s 10-K:
Square, Inc. enables payment processing, and also offers financial and marketing services. The Company provides sellers various tools to start, run, manage and grow their businesses. It serves sellers of all sizes, ranging from a single vendor at a farmers' market to multinational businesses. It serves as a payment service provider, acting as the touch point for the seller to the rest of the payment chain. Square Register is a point of sale (POS) software application for iPhone operating software (iOS) and Android, and is available to sellers across the world. Square Reader for magnetic stripe cards plugs into the standard headset jack of a mobile device, enabling swiped transactions. Square Customer Engagement helps sellers analyze and understand their businesses, engage their buyers in ongoing conversations, and promote their offerings through e-mail marketing. Caviar offers a food delivery service to help restaurants reach new customers.
Summary
Square Inc. (henceforth, just Square) has grown revenues rapidly since its founding in 2009 by Jack Dorsey and Jim McKelvey. The success of Square has come primarily from tapping into a previously unaddressed payment processing market of small merchants, by providing access to convenient solutions for a small and transparent flat percentage fee per transaction (plus a small flat charge per unit transacted). Square Reader and Register (and other ancillary software service offerings) have provided many small merchants with a turnkey and easy to use solution - a hardware and software package that allows small businesses to focus on business, rather than dealing with bank tellers and/or tedious bookkeeping items.
For good reasons, this has proven to be very attractive amongst small merchants, who typically detest accounting and finance. Square’s success and growth is undeniable. In 2017, the company is expected to generate $682.6 million of revenues, with gross margins of nearly 50%. 2017 expects to bring 30% Year Over Year growth, with Gross Margins expanding to 54.6% and EBITDA margins expanding to 9.4%. Consensus calls for top line annualized growth over the next four years of 24%, with EBITDA margins expanding to 25.5% in 2020 and EPS of nearly $0.62 per share. Analysts are largely bullish on the stock with 17 buys / 12 holds / 0 sells. Consensus largely views the opportunity as open ended, particularly with the recent quarterly financial beats over the last three quarters. With the recent rally in the stock, the current price of $15.4 compares reasonably to average price target of $15.
The current valuation of $5b is being supported by a string of positive short term revenue and earnings beats, a very bullish (and misleading) management team and a compliant analyst community.
Core elements of the short thesis are:
- Square core product is a commodity facing ASP pressures and has no moat
Square’s core offering - payment processing - is a commodity product that faces long term secular pressures on ASPs (similar to broker, bank and credit card processing fees) as improved technology and increased competition from larger players such as Vantiv and First Data aggressively try to capture market share. ASPs declines are almost guaranteed given that underlying bank and credit card processing fees are declining, which constitute a cost for payment processing providers.
- Client experience does not square with Square’s claims of their ecosystem being a competitive advantage
Given its front and backend technology can (and has already been) replicated by several new and existing market players in the payment processing space. Square claims its product is superior because it offers a complete ecosystem (hardware + software). However, almost every payment processing product offers similar features. In this report, we compare Square’s product to its main competitors from First Data and Vantiv. In fact, we believe Square offers an inferior product.
- Using data from the Small Business Association, we can challenge management’s claims of their attractiveness to so called “large sellers.” In reality, Sqaure’s Total Addressable Market (TAM) is a fraction of what they claim.
Management has severely misguided the market on their Total Addressable Market (TAM), which is a fraction of what they claim. Simultaneously, management has convinced the analyst community that Square’s opportunity is larger than it actually is by segmenting their operating results in an unrepresentative way. By categorizing larger sellers as those with revenues greater than $125,000 (which is a very low bar if data from the Small Business Association is to be believed), Square is “proving” the shorts wrong by growing these so-called large sellers. In reality, these are not large sellers at all. According to the SBA, firms with 1-4 employees generate sales averaging about $387,000, which according to Square would make these firms “large sellers.” In reality, the ultimate large seller and now a former Square client - Starbucks - tested their “ecosystem” and did not believe it was worthwhile paying a higher price to use it. This is noteworthy because Square management believes this to be their core competitive advantage with “large sellers.”
The opportunity to short Square Inc. exists because management has created hype around the TAM and done this by “demonstrating” growth amongst customers with revenues above $125,000. I think this segmentation is misleading, as $125,000 is hardly an objective threshold for a large merchant (considering that most of these businesses would not even qualify as microcaps).
- At best,
There are a few pieces of damning evidence that illustrate the lack of scale of Square Inc.’s business model.
in part, due to the hype created by management around success with larger merchants.
What makes Square a particularly attractive short is that unlike its larger competitors
with a limited Total Addressable Market (TAM)
is on the wrong side of a long term trend towards a compression in payment processing fees.
Management is trying one in which price plays a big role when selecting payment processing providers.
“We continue to grow GPV from larger sellers and maintain overall transaction revenue margin for several reasons. First, as demonstrated by positive dollar-based retention across our entire seller base, many sellers grow when they join Square. Second, larger sellers switch to Square for the benefits of our entire ecosystem, including fullyfeatured point of sale software and capabilities such as APIs (Build with Square), mobility of hardware, and customer service. In fact, we believe leading with our unique capabilities and brand—not price—is what drives larger sellers to select Square.”
Firms with…
|
Average Annual Receipts
|
1-4 employees
|
$387,000
|
5-9 employees
|
$1,080,000
|
10-19 employees
|
$2,164,000
|
20-99 employees
|
$7,124,000
|
100-499 employees
|
$40,775,000
|
- Core product has no moat and can easily be replicated and will face margin pressure in the future. The ecosystem is not the competitive advantage they claim.
- TAM is lower than what management is indicating and their characterization of their large sellers is misleading.
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