by Saamia khan
Up until late last year, Square (SQ) enjoyed massive growth in its share price in 2018; reaching a peak of nearly $100/share in late September, its share price quickly plummeted nearly 50% to $51/share by late December. Square’s mobile payment processing apps, credit card readers, small business organizational tools, and even a children’s book (My First Bitcoin and the Legend of Satoshi Nakimoto) among other products have made Square a company to put on the watchlist. Small businesses like coffee shops, restaurants, and hair salons have been swift to adopt Square’s recognizable white stands that turn iPads into payment processors. While this share price volatility coincided with an overall market downturn, and is typical of an early stage growth stock, I would argue that Square’s current share price of $66/share is overvalued. Depending on the economy’s health in the medium term, shares could decline to as low as $40/share.
Square hopes to become a one-stop-shop for small businesses by creating an entire financial ecosystem. In pursuit of this goal, the company has rolled out an array of innovative hardware and software products to help facilitate small business operations. Its original product, the Square Reader allows businesses to accept credit card payments on the go. Used concurrently with the Square Dashboard app, owners can track and compare real-time sales data. Square Appointments combines the payment system with easy access to managing bookings and clients. Square has even started to dabble in high-end food delivery services with the acquisition of the startup, Caviar. The theory goes that if a business adopts even one of Square’s products, it is likely to try others as well. Square hopes to increase its online presence, and to this end, it has acquired the website creation company, Weebly.
Within the past few quarters, Square started offering loans to small businesses, coining the name Square Capital. In the last year, they have seen a 34% increase in loan volume. More recently, Square has applied to become a licensed bank, allowing the company to have greater autonomy with loaning while also allowing them to take deposits. Jacqueline Reses, the would be chairman of the bank said in a statement, “Square Capital is uniquely positioned to build a bridge between the financial system and the underserved, creating access for small businesses to both capital and the economy.” In giving out loans, Square may be doing a favor to small businesses that generally have trouble financing their operations through other means. For Square however, this spells trouble should these loans perform poorly; according to the U.S. Small Business Administration (SBA), only about 50% of small businesses survive longer than five years, and more than 1 in 6 SBA-backed loans went into default between 2006 and 2015. In loaning funds primarily to small businesses, Square exposes itself to an unparalleled risk.
Evidently, Square has created a detailed organizational plan aimed at small businesses with its hardware and software products and loans. However, what’s concerning lies in the fact that Square is starting to look a lot more like a bank than a tech company. Traditionally, the market is willing to pay a higher multiple of earnings for tech companies. Square’s current valuation may reflect this sentiment. And although revenue has increased through each quarter of 2018, earnings have only just edged into positive territory in the third quarter. This points to the fact that Square’s share price may currently be overvalued.
The company’s success relies heavily on booming sales in the small business industry. Not only is this a somewhat worrying business model in the face of a looming recession (economists forecast a 25% probability of a recession within one year), with a Beta of 4.25, the company is especially vulnerable to market swings— Square’s share price has dropped almost 50% since its peak in late September 2018— coinciding with an overall weak S&P 500 performance. Moreover, Square’s dependency on small businesses may result in problems in the future. Conventional wisdom says that during a recession, consumer spending decreases. Although this consumer spending drop affects all businesses, smaller companies bear a greater brunt. Figure above illustrates small businesses identifying poor sales as the “Single Most Important Problem Associated with Weak Economic Conditions.” During the most recent recession, employment decreased by 10.4% for businesses with less than fifty employees, while all other businesses saw a 7.5% decrease, a significant difference (Figure below). Although small businesses do have more flexibility in laying off workers, recessions evidently seem to accentuate small business operation difficulties, coupled with evidence of higher rates of bankruptcy. Given that Square derives much of its revenue from small businesses, a drop in consumer spending may result in unpaid loans and simply a smaller volume of sales, signaling decreasing profits for Square.
When Jack Dorsey and Jim McKelvey founded Square in 2009, its idea for an on-the-go credit card processing service aimed at small businesses was fairly novel. However, competition since then has increased. PayPal, Intuit, Capital One, and Shopify all offer quite similar products in terms of basic credit card readers. To the average small business, it is not expensive to switch credit card readers to a cheaper alternative. If a small business is not already integrated with the rest of Square’s apps like Square Dashboard and Square Appointments, there is little incentive to stick to Square if the costs are greater. To this end however, Square has tried to distinguish itself, rolling out a number of supplements to its main credit card processing terminal. Future quarters will reveal whether or not Square’s push to retain clients has proven to be a success.
Square’s focus on a niche sector of commerce— doing business with micro-merchants— may end up exposing the company to great uncertainty. Expanding its base to larger businesses may help alleviate some of this business cycle dependent risk. If Square can continue finding ways to distinguish itself from competitors, this may pay off in the long run. Nevertheless, with a view of a potential recession in the medium term, SQ is a sell.