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Morningstar | Square Sees Top-Line Growth in 1Q, but No Bottom-Line Improvement

Square continued to achieve impressive growth in the first quarter, but it’s still struggling to translate this growth into better profitability. We will maintain our $49 fair value estimate and narrow moat rating.

Square continues to grow at a very fast rate, with adjusted revenue up 49% year over year. The business is transitioning as the company builds out more ancillary products, with transaction-based revenue up a relatively modest 26% and subscription and service-based revenue up 97%, excluding acquisitions. To monetize its niche, we think Square needs to both move upmarket and develop a sufficient suite of ancillary services. The strong subscription and service growth supports the idea that Square can achieve the latter, and the ongoing gross payment volume shift toward larger sellers provides comfort that Square can move past its initial micro-merchant niche. In the first quarter, 52% of gross payment volume came from sellers with more than $125,000 in annual volume compared with 47% last year.

Cash App continues to make good progress, with volume up 2.5 times over the past year and the company seeing growth in both users and number of transactions per user. However, we don’t doubt the near-term growth prospects for Cash App. Our concerns about Cash App center more on the platform’s long-term viability once the peer-to-peer area becomes less nascent and network effects start to kick in and consolidate the space. We continue to believe that Square’s relatively late entry into the space and the existing consumer customer bases at Venmo (PayPal) and Zelle (the banks) leaves it as the most poorly positioned among the leading platforms from a long-term perspective. As such, we think the future of this business hinges on how many platforms ultimately remain viable, and we continue to believe Cash App could prove to be a distraction from more achievable growth opportunities closely related to the core acquiring business.

While Square’s top-line performance remains impressive, the company needs to show at some point that its scalability can lead to major improvements in profitability. Evidence for this was somewhat lacking in the quarter. The company’s adjusted EBITDA margin did improve slightly to 12.6% from 11.7% last year. However, we’re skeptical of this metric given that it excludes line items that we consider real costs, such as stock compensation. The GAAP operating loss and net loss both actually widened a bit year-over-year. We appreciate the fact that the company is investing to maintain its heady growth, but the company’s inability to achieve strong margin improvement supports our view that Square’s margins might ultimately be somewhat constrained given the relative lack of volume in its small business niche and that the current market price is overly optimistic about the company’s long-term profitability potential.