The company we review in this report has tremendous long-term price appreciation potential—thanks to its ongoing high growth trajectory, its large total addressable market and its reasonable valuation. The pandemic accelerated one half of its business, and now the other half is expected to accelerate thanks to re-openings. This one doesn’t pay a dividend, and the growth can be lumpy, but over the long term the company has a clear path to dramatic share price gains. In this report, we review the health of the business, growth opportunities, valuation, risks, and conclude with our opinion on investing.

Overview: Square (SQ)

Square Inc. (SQ) is a financial services and digital payments company. The company provides tools to merchants (or sellers) to help them to manage and grow their business. On the consumer (or buyer) side, Square offers tools to individuals to help them send, receive and manage their money. The company has two reportable segments: Seller Ecosystem and Cash App Ecosystem.

Seller Ecosystem: consists of 30 distinct products and services available to sellers to help them manage their business. Square monetizes these products through a combination of transaction, subscription, and service fees. Its primary offering is the Point of Sale solution which allows seller to accept payments in person via swipe, dip, or tap of a card, or online via Square Invoices, Square Virtual Terminal, or the seller’s website. For Q1 2021, Square processed $33.1 billion of seller Gross Payment Volume (GPV).

Cash App Ecosystem: provides financial tools for individuals to store, send, receive, spend and invest money. It also offers Cash Card, a Visa prepaid card that is linked to the balance stored in Cash App. Customers can also use Cash App to invest their funds in US stocks and exchange-traded funds (ETFs) or buy and sell Bitcoin. As of the end of 2020, Cash App had ~36 million monthly active customers.

Square has built an ecosystem of both seller and consumer products and services, expanding well beyond payments. The company’s full-service offerings makes it easier for sellers to implement compared to installing systems from multiple vendors. The multiple offerings beyond payments increases engagement and improves retention.

Square has seen rapid growth since it started operations. Revenue has increased at a CAGR of more than 50% during 2016-2020. Gross profit has followed a similar trend increasing at nearly 50% CAGR during the same period (2016- 2020) as shown in the figures below.

Cash App – Key Growth Driver

The Cash App has been a major beneficiary of pandemic-driven social distancing. Cash App segment received significant inflows over the past year as many users deposited their stimulus checks in their Cash App wallet and spent it on online purchases as well as investing in bitcoin and stocks. The company noted that inflows in March 2021 rose ~55% compared to February 2021 as customers brought more funds driven primarily by an increase in government disbursements. Gross profit at Square’s Cash App more than doubled during Q1 2021, reaching $495 million. This marked the first time that Cash App’s gross profit exceeded gross profit at Square’s seller segment which stood at $468 million.

Cash App Gross Profit Exceeds Seller Gross Profit for the First Time

Cash App products saw strong engagement during Q1. Cash Card reached more than 10 million monthly active users in Q1. Specifically in March 2021, nearly 7 million Cash Card customers transacted on a weekly basis on average, nearly double versus last year.

Management noted the same during its Q121 earnings call:

“we saw increased engagement across our ecosystem, with customers transacting more on each cash app product year over year. Monthly actives in the first quarter transacted an average of 18 times per month across the ecosystem, with March reaching an all-time high for transactions per customer. Cash card is a strong example of a product that has driven engagement, both for spend on the card itself, as well as in the broader ecosystem.”

Higher engagement is leading to increase in spend as well. In the first quarter of 2021, spend through Cash Card was up ~2.5x compared to the prior year and the majority of weekly actives transacted multiple times per week.

Bitcoin is increasingly becoming an important part of Cash App. Cash App generated $3.51 billion of bitcoin revenue and $75 million of bitcoin gross profit during the first quarter of 2021, each up ~11x year over year.

While Cash App may see a slowdown in growth in Q2 due to tough comps (as the government disbursements began in April 2020), it will continue to remain a key driver for growth going forward.

Seller Ecosystem Recovery Well Underway

The re-opening of the US economy bodes well for the Seller ecosystem. As physical stores including restaurants, salons (for example) reopen, Square should see higher demand for its Seller Ecosystem offerings. The company also noted that it is seeing improvement in GPV retention rates. In April 2021, GPV from existing cohorts was nearly back to 2019 levels.

Further, Seller delivered strong gross profit growth year over year in April 2021. Seller GPV was up 144% year over year in April. The company noted that it saw continued strength in GPV from its online channels as well as an improvement in in-person activity, which benefited from regional re-openings.

Large addressable market

The company’s addressable markets are large and growing. The seller ecosystem in the US is ~$85+ billion opportunity currently and is expanding further with new products and use cases as well as expansion in new markets. The company expects this to increase to in excess of $100 billion in the medium term.

The Cash App ecosystem represents ~$60 billion opportunity in the US currently with multiple vectors for future growth. SQ has <3% penetration in the seller ecosystem and <3% in the Cash App, leaving significant runway for growth.

Valuation:

SQ is currently trading at a multiple of 5.3x EV to FY21 Sales, which is quite reasonable in our view. As a comparative, PayPal which is its closest peer is trading at 13.0x FY 2021 sales. We believe there is potential for the stock price to rise from multiple expansion and through the solid growth outlook for the company. Square offers an attractive risk/reward opportunity for new investors with a long-term horizon.

Risks:

Pricing Pressure: Square faces pricing pressures from competitors which may offer lower prices to sellers for similar services. This could force the company to alter its pricing to sellers and could reduce gross profit. In addition, sellers may demand more favorable pricing amid competitive pressures which could further reduce its margins.

Competition: The company faces intense competition in both its segments. Many competitors have great financial resources and larger customer base. If the competitive intensity further increases, it may result in SQ losing its market share which could adversely impact its growth.

Conclusion:

Square is an attractive way to play the digital payments space. The company is targeting two large total addressable markets with total opportunity in excess of $150 billion (versus annual sales of $13 billon over the last 12months). While the company is likely to face deceleration in growth in the near-term as government stimulus fades, we still believe SQ’s investments in marketing, new products, and geographic expansion should help offset the near-term headwinds and sustain the momentum. The secular shift to digital payments continues to be the company's key growth driver. If you appreciate significant long-term price appreciation, Square’s potential is attractive, and the shares are worth considering for investment.

Note: We currently own shares of SQ within our Disciplined Growth portfolio.

Digital Payments Company: Attractive Growth and Value