Square Bouncing Back

by Raymond Pucci 0

Square appears to be getting back on its feet after some disappointing results earlier this year. According to the following article, recent performance across its payments and other services are looking positive.

There was a lot to like about Square’s (NYSE: SQ) third-quarter earnings report. It beat analysts’ expectations on both the top and bottom lines, and all of its various verticals are firing on all cylinders. One factor that might get overlooked, however, is the huge potential for margin expansion over the next few years. That will come not only from the growth of higher margin products, but also from the decline of loss-leading products such as its hardware as a percentage of revenue. CFO Sarah Friar expects steady margin improvement every year for the foreseeable future.

Square has seen an uptick in hardware sales this year that’s outstripping growth in payment volume. That’s due to the new requirement to support EMV payments with a chip reader. Hardware sales are up 254% through the first nine months of 2016, and it’s taken a loss of $21 million on those sales. Square’s introduction of its contactless and chip reader hardware will lapse in December, so investors should expect the growth in hardware sales to slow down significantly next year.

During Square’s earnings call, Friar told analysts it takes four to five quarters for Square to break even on its hardware sales by monetizing them through payments. That number has remained consistent, according to Friar. As long as Square can retain its customers at a reasonable rate — and there’s no reason to think it can’t — its hardware sales present a huge point of operating leverage. While it takes a little over a year for a new seller to become profitable for Square, the operating profit on those customers after the first year grows significantly since the hardware is already in place.

The EMV transition has been a major boost for Square—from both a hardware and software perspective. Mobile payment systems are key for small and medium businesses that Square should be able to ride for a while. Meanwhile Square Capital may have some upside with the expected rise in interest rates provided they do not get locked in to long term loan contracts. Interesting that Square is venturing into the restaurant delivery business—heavily competitive especially with Amazon and Uber expanding in this market.

Overview by Raymond Pucci, Associate Director, Research Services at Mercator Advisory Group

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