Goldman Sachs is a high quality cheap stock...

Goldman Sachs is not a company that needs an introduction.  Here is a description:

"The Goldman Sachs Group, Inc. is an investment banking, securities and investment management company that provides a range of financial services to corporations, financial institutions, governments and individuals. The Company operates in four business segments: Investment Banking, Institutional Client Services, Investing & Lending, and Investment Management. The Investment Banking segment consists of financial advisory and underwriting. The Institutional Client Services segment makes markets and facilitates client transactions in fixed income, equity, currency and commodity products. The investing and lending activities, which are typically longer-term, include its investing and relationship lending activities across various asset classes, primarily debt securities and loans, public and private equity securities, infrastructure and real estate. The Investment Management segment provides investment and wealth advisory services. As of December 2016, it had offices in over 30 countries."

Goldman announced quarterly results last night and the stock sold off based on tepid growth in various business lines.  Short term disappointment really.  That's not what this note is about.  I have no idea what the short term holds for the global economy or Goldman Sachs.  My goal is to discuss the quality of Goldman's earnings, and also the low multiple it currently trades at.  I'm going to argue it deserves a higher multiple.

Let's look at how Goldman Sachs has done over the last few years.  From the 10K: 

2016: $30.6 billion in revenues, $10.3 billion pre-tax net earnings
2015: $33.8 billion in revenues, $8.8 billion pre-tax net earnings
2014: $34.5 billion in revenues, $12.4 billion pre-tax net earnings

There are a lot of moving parts underlying this, as Goldman Sachs is a big diversified business.  Granted it is a financial services company and all its business lines are correlated to economic activity to a great extent, it still is the life blood of the global economy through its various business lines.  Goldman Sachs is a brokerage and partakes - in a similar spirit to Visa and MasterCard - in a large swathe of economic activity.  Anyone who has been investing for any significant period of time will tell you that you do not generate pre-tax net income margins of 35% without offering a very valuable service.  These margins are very juicy in the world of investing.  Any investor will take note.

Let's quickly look at what this high quality business is valued at right now: $90 billion.  So last year, GS did $7.3 billion of net income after tax.  Analysts are projecting 2017 E at $7.9 billion.  So 11X NTM EPS.  Is that cheap?  The answer is complicated.  I believe so.  I think 15X is more fair, since I believe Goldman is likely to continue to compound bottom line EPS nicely over the next few years.  Of course, this relies on steady economic growth, and an acceleration would be even better, but economic growth is largely unpredictable, so there is very little point in discussing it.

Back to the P/E multiple.

P/E multiples don't mean anything.  Stocks can trade at 1000X NTM EPS (e.g. Netflix, Amazon at one point historically) or 2X NTM EPS (e.g. Valeant, Endo currently).  What is required is that the P/E multiple is paired with a deeper understanding of the underlying dynamics of the business.  This means we have to understand the moat around the business, sustainability of earnings, the cost of capital, competition, potential cyclicality, potential for technological disruption etc.

Ben Graham has a great quote on this front: "You don’t have to know a man’s exact weight to know that he’s fat.”
Amazon and Netflix are valuable enterprises.  Are they worth $400 billion or $60 billion respectively?  I have no clue.  But they are valuable, given the service they provide, the durability of their moat, and their customer focus.  Valeant and Endo are debt laden enterprises that offer ordinary products at prices that arguably are inflated.  (To be sure, Valeant does own Bausch & Lomb, which is a high quality consumer products company).  But neither Valeant nor Endo are particularly valuable, apart from the once popular carry trade both were able to implement thanks to a conducive drug price environment.  You don't have to know a man's exact weight to know that he's fat.

Back to Goldman Sachs.  Goldman Sachs is a high quality company.  While it is not a bank, Goldman does have leverage due to the financial intermediary and balance sheet heavy nature of its business.  This is not a capital light business by any means.  While this is not ideal (since leverage almost always results in some crisis at some point in the life of a business), the core operations are a necessary evil for the modern economy to operate.  Obama really captured the essence of Goldman Sachs' business during the  annual White House Correspondents Dinner

“All of the jokes here tonight are brought to you by our friends at Goldman Sachs,” Mr. Obama said, referring to the SEC allegations. “So you don’t have to worry — they make money whether you laugh or not.”
And that is important. 

Goldman makes money as long as the economy functions.  It makes more money as the economy grows.  11X for a company earning 35% pre-tax margins is too cheap in my opinion.  Granted we could see an economic slowdown, or muddling growth, and in that case Goldman Sachs' stock will fall, just like almost every other company.  But if you look at Goldman's business, it is a high quality service oriented one.  Goldman is also buying back stock at these prices, so that's a nice return of capital at a low multiple.

So maybe Goldman Sachs doesn't deserve a 24X multiple like Visa.  But it does deserve a better multiple than 10-11X, especially since if we do see rising rates and a faster growing economy, EPS will compound very nicely over the next few years. 

J. Jill - an apparel retailer with upside...

With all the doom and gloom surrounding the apparel sector - particularly, brick and mortar retailers - it might seem odd to be bullish on a women's apparel company.  But that is what I am going to do in this note.  I believe women's retailer J. Jill has upside.  First, a description of the company:

"J.Jill, Inc. (J.Jill) operates as a specialty retailer in the women’s apparel industry. J.Jill is a women’s apparel brand focused on customer in the 40-65 age segment. The Company operates an integrated omni-channel platform that is diversified across its retail stores, Website and catalogs. It operates in the retail and direct channels segment. Its direct channel consists of its Website and catalog orders. As of January 28, 2017, it operated 275 stores in 43 states. The Company also offers a range of footwear and accessories, including scarves, jewelry and hosiery. Its products are marketed under the J.Jill brand name and sold through its direct and retail channels. It offers two sub-brands as extensions of its brand aesthetic: Pure Jill and Wearever. Its Website provides customers with access to the J.Jill product offering and features content, including updates on new collections and guidance on how to wear and wardrobe its styles."

J. Jill is not a fast growing retailer that will take over the world.  Revenue growth over the last year was a meek (perhaps reasonable) 13.7%.  Consensus pegs revenue growth over the next year at 9.9%, and 8.8% the following year.  The big positive here is that it is a retailer with a laser sharp focus on profitability.  Here's the key detail:

J.Jill focuses on females in the 40-65 age group.  Their customer base has some very desirable characteristics.  As they described in their S1: "Our customer is 40-65 years old, is college educated and has an annual household income that exceeds $150,000.  She engages across both our direct and retail channels and is highly loyal, as evidenced by the fact that approximately 70% of our gross sales is pro forma 2015 came from customers that has been shopping with J. Jill for at least five years."

In their 10K, J.Jill describes why they are different:

1) Distinct, well recognized brand
2) Industry leading Omni-channel business
3) Data-centric approach that drives consistent profitability and mitigates risk
4) Affluent and loyal customer base
5) Customer-focused product assortment
6) Highly experienced leadership team, delivering superior results

J.Jill currently has 275 stores in 43 states.  They project that they could potentially increase their store base by about a 100 over the long run.  But this is not the reason you want to invest in this company.  The reason you want to invest is because this retailer has good economics, which will grow EPS nicely over the next decade or so - if business holds up.  The latter is always a consideration in fashion retailer, so that will have a big influence on shareholder returns too.

And business is holding up well.  Company comparable sales were up 11.2% over 2016. 
J. Jill was taken private and recently IPO'd.  It is saddled with $267 million of debt, so as they pay down these obligations, value should accrue to equity holders.  In addition, there may even be share repurchases in the future, if all goes to plan. 

The stock currently trades for 14X NTM EPS, which seems reasonable but not excessively cheap.  However, with steady profitable growth (through SSS growth and opening new stores), J. Jill might be able to compound the bottom line at 20% for some time going forward - given favorable economics. 

It's worth going long here IMO at $13.6 per share and a market cap of $600MM.  This could provide a decent, albeit not spectacular return, over the next few years...

Trivago is a risky stock...

"Trivago NV is a company based in the Netherlands that operates an online hotel search platform. The platform allows users to search for, compare and book hotels. It gathers information from various third parties' platforms and provides information about the hotel, pictures, ratings, reviews and filters, such as price, location and extra options. The Company offers access to approximately 1.3 million hotels in over 190 countries via more than 50 localized websites and applications in various languages. The Company also offers marketing tools and services to hotels and hotel chains, as well as to online travel agencies and advertisers, among others. Its principal executive offices are located in Germany."

We have all seen commercials where the Trivago guy tells us how he can help us find a good hotel deal.  And that is a great idea; we all want super low rates on hotels and that is why Airbnb has been such a winner.  Priceline is the online aggregator of great deals for hotels, air flights, so its a nice concept. 

Except, the problem with Trivago is that it aggregates data from aggregators.  For example, hotels.com aggregates the best hotel deals from around the world.  Trivago then sends you to hotels.com to book a room.  In other words, Trivago is an unnecessary layer between the hotel and booking site.  And it generates hits through aggressive advertising. 

Over 2016, Trivago spent $730 million on advertising!  And it generated a total of $754 million of revenues.  I don't see how this is a great business model and why this company should be valued at $2.9 billion!

Granted they are growing rapidly.  And I think the bullish thesis is that - at some point - brand awareness kicks in and Trivago becomes the Google of Hotels.  The only problem is that Google is the Google of Hotels!  And if not Google, then certainly hotels.com or bookings.com. 

I think there are too many problems with Trivago's business model for it to be a long term success.  The ROICs for this business are going to be low, and margins are going to be even lower.  I thin Trivago is expensive!

TWNK has upside

"Hostess is one of the largest packaged food companies focused on developing, manufacturing, marketing, selling and distributing fresh baked sweet goods in the United States. The brand’s history dates back to 1919, when the Hostess CupCake was introduced to the public, followed by Twinkies® in 1930. Today, Hostess produces a variety of new and classic treats including Ding Dongs®, Ho Hos®, Donettes® and Fruit Pies, in addition to Twinkies® and CupCakes."

Hostess released their quarterly and annual results on March 14, 2017.  Pro-forma Full Year 2016 Net Revenues increased by 17.2% to $728 million.  The company has guided to $781 million of revenues for 2017, and adjusted EBITDA of $235 million.  The company has net debt of $972 million. 

A few key points:

1) Hostess has introduced new products, which has driven growth to the tune of 15%.  Organic growth is a good thing, and suggests they are gaining traction with consumers.  They introduced Suzy Q's and Hostess Sweet Shop Brownies. 
2) Acquisition suggests management has an eye towards generating shareholder value through smart acquisitions. Superior Cake products is an example, albeit gross margins are a little lower than the sweet baked goods segment at 30%.
3) Guidance suggests that gross margins will come in at 45% suggesting a premium product that consumers are willing to pay a little extra for due to the brand.  EBITDA margins of 30% are very healthy.  Combined with low debt costs of 5% (based on proforma interest payments), there is a very good chance Hostess will be able to pay down debt, thereby accruing value to equity holders. 
4) The stable margin and high free cash flow generation of the business is conducive to leverage.  While the multiple is not dirt cheap (EV of 3.1b over EBITDA of $235 million, implying 13X), there is a good chance management will be able to compound shareholder value here.
5) Hostess could become an acquisition target for a larger packaged food company looking to acquire a solid brand with durable margins and growth potential. 
6) The business is not CAPEX intensive and operating expenses (including marketing) are reasonable.

Negatives:

1) Healthy living is in, while fatty foods are out.  I think this will likely put a cap on Hostess' ability to grow the business, but it is small and nimble enough right now for this not to weigh heavily on their ability to generate profitable growth. 

Hertz at $1.45b market cap: Rental Car Business Model has upside

The issue here is gas prices. Low gas prices have reduced demand for compact and mid-size cars, which has resulted in a sharp decline in used car values. But apart from the initial hit, Hertz should be able to purchase these cars at a lower price going forward, so the hit might be a one time item.

Hertz can recover from here and the upside might be substantial. The business model is a solid one for four reasons:

a) Interest expenses are low due to fleet debt being securitized by vehicles
b) Higher depreciation expenses typically result in high car rental rates (pass through to customer)
c) Supply is rational due to there being only two big players in the market
d) Fleet can be scaled up and down and mix can be changed to influence rental rates thereby improving Adjusted Corp. EBITDA even at lower revenue levels

e) 70-75% of operating costs are variable, which means that "time" can get Hertz through difficult time

At the current price, the Enterprise Value is less than $4.55 billion. LTM Adj. Corp. EBITDA was $553 million, which puts Hertz trading at less than 8X, under pretty poor conditions. Of course the leverage here is very high and there are debt covenants, so a zero is not out of the question. But given the business model and current condition of banks / travel, bankruptcy is not on the cards, although we may see a few covenant breaches if used car prices continue to plummet.

Sunrun isn't a great business, but it might have a good run if residential solar sales accelerate...

First a business description:

"Sunrun Inc. (Sunrun) is engaged in the design, development, installation, sale, ownership and maintenance of residential solar energy systems (Projects) in the United States. The Company is engaged in providing solar energy services and products to its customers. Sunrun has over 111,000 customers across 15 states, as well as the District of Columbia. Sunrun sells directly to consumers over the phone, Web and retail stores, as well as through a network of certified partners. It offers various plans and services, such as Pay as you go and Purchase your system. Its Pay as you go offers plans, such as BrightSave Monthly and BrightSave Prepaid. Sunrun's BrightSave Monthly plan comes with both product and workmanship warranty, as well as protection against future utility rate hikes. Users can lock in over 20 years of electricity with Sunrun's BrightSave Prepaid solar lease plan. With Sunrun's BrightBuy, users can purchase the entire solar system."

There are a couple of issues with this business model. First this is a debt financed business, and inevitably during a solar downturn, these guys will go bust.

They have $640MM of non-recourse debt, and $244MM of recourse debt.

Their recourse debt has interest of 4% to 5.75%. While this may not seem high, they are at the mercy of their bankers to keep them solvent. If the banks pull the plug on funding, this business has no ability to payback debt and will go insolvent like SunEdison.

The non-recourse debt includes term loans from banks and securitized solar asset backed notes. The interest on these is better, but again Sunrun relies on banks for their funding.

Their total debt is $900MM, which is not an insignificant amount.

Now granted they claim they have $1 billion of net earning assets. By a crude measure, they should be trading at $1 billion EV. If you take their current market cap of $524MM PLUS $244MM of recourse debt MINUS unrestricted cash of $206MM PLUS Minority Interests of $389MM, gives you EV of $951MM. So the market has it about right at the current price.

What I would say is that this is not a good business. They have no moat and using fickle third party funding sources to finance a highly cyclical commoditized business is NOT recipe for success. I wouldn't get too excited here, but there is obviously scope for them to "make hay while the sun shines."

Treat the stock as such .

Short thesis on Square Inc. (NYSE:SQ) (1/10/2016)

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):

1. The business fails: There are no transactions to process and the customer exit’s Square’s ecosystem.  (Estimated probability: 50%)
2. 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%)  
3. 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:

1. 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
2. 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
3. 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:

1. 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.
2. 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
3. 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

http://redwoodinternet.com/about-interchange.php

https://www.burlingtonbankcard.com/home/articles/charitable-donations-interchange-plus-vs-paypal-cost-comparison/

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

 

http://quickbooks.intuit.com/r/revenue/how-does-your-revenue-stack-up-to-other-small-businesses/

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:

1. 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.  

2. 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.

3. 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).  

4. 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

1. 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.
2. TAM is lower than what management is indicating and their characterization of their large sellers is misleading.