Is Square Playing Its Best Hand?

Square Capital is proving to be very successful for Square (SQ -4.53%), and analysts are starting to take notice. In the company's most recent earnings call, an analyst asked CFO Sarah Friar if the company would consider extending Square Capital outside of the company's customer base. Motley Fool analysts Dylan Lewis and Sarah Priestley discuss the potential pitfalls of such a move and other challenges the company faces in this clip from Industry Focus: Technology.

A full transcript follows the video.

This podcast was recorded on Aug. 19, 2016.

Dylan Lewis: One of the other things that I think is a little interesting, and a potential business risk for them, is looking at their Square Capital business. They've talked a little bit about getting outside of Square (SQ -4.53%) vendors. We praise the beautiful system that that is, where they're offering loans, they have incredible granularity into what a seller is doing prior to offering that loan, and they're able to immediately take their cut to make loan repayments, which is fantastic. If they start moving outside of that ecosystem and offering loans to people that are not on the selling platform, I wonder how strong that loan advantage is, and what default rates might look like.

Sarah Priestley: I absolutely agree with you. I think that they may be playing their best hand, almost, with doing this. [Square CFO] Sarah Friar was asked the question, would they look outside of Square's ecosystem to offer loans, and she said that they could use the "muscle," she described it, of their business, which is the scientific data-analysis side, and apply that to different data sets, to accidental data sets.

The reason I think this is dangerous for the company is the fact that Square's key advantage, as you touched on, is the fact that you can't game that system. They are inherently linked to those customers, and they know exactly how much money they're getting, they know when they're getting it. You can't hide from that. And that enables them to very, very well-target the customers with the appropriate amount of loan. And they're automatically receiving their payments back. Investors love that. When you're going to a different company to receive this data, whether it be through Intuit (INTU -1.45%) or Upserve, which is a restaurant company that they work with, yes, they are getting data, I'm sure they're very good at analyzing data -- but is that data going to be the granularity that they want? And are they better underwriters than banks that have been doing this for a number of years? I'm not sure that we'll know that. But there is a market for micro-loans, absolutely.

But my main issue with it is that there is a ton of demand within their current customer base.

Lewis: And they might be better-served meeting those people first, and then worrying about getting outside of the core customer group they have.

Priestley: Yeah. And that's what Sarah Friar may have been alluding to with that. At some point in the future, they may offer this out, but right now, they need to focus on their own customer base.

Lewis: Looking at the business, I think a couple other risks that are worth noting: there's a bit of a hardware risk. I think they've been nimble in approaching it, and smart. But to a certain extent, Square is, a little, subject to the whims of the smartphone and tablet manufacturers. There have been rumors that Apple might ditch the headphone jack and its phones. That could take the old dongles that some people are operating on and turn them into bricks, if they ever decide to upgrade the devices they're working on. So, they would have to either roll out new ones, which, Square has been nice about providing free dongles to a lot of their sellers, or you'd have to see sellers port over to the paid NFC ones that they're also offering. I think that's another thing to keep in mind. They seem to have been ahead of that. But anytime you're relying on another platform -- as they do in so many different ways, with credit card processors, with device manufacturers, everything -- that's something you have to be mindful of.

Another thing that I think is worth noting is the space in specifically mobile payments is becoming increasingly competitive. Before the show, we were talking about how I'm not so much worried about the credit card companies. Visa actually has a stake in Square. But you look at PayPal (PYPL -1.67%) and their Venmo line, right now they're a peer-to-peer payment primarily. But you see in the conference calls, they're interested in getting into the merchant side of things. And I worry that it might be a little bit tougher for Square to lock down some of these merchant agreements.

Priestley: Absolutely. I think PayPal kind of has that heritage, too. Square, I do feel, has competitive advantage as a first mover with this, and what I think really gives them the edge is the full suite of offerings. They talk about their ecosystem. Their ecosystem is pretty sticky when you get inside it. If you're using all of these apps and invoicing, payroll, all those kinds of things, every single day, I think, as your business grows, you will continue to use them. So, yes, absolutely, the space is becoming increasingly crowded. That's something that Square is going to have to be aware of.

Lewis: I think they've done a very good job of learning from, not necessarily payment companies, but other platform companies out there in building out an ecosystem, making it very sticky, and incredibly useful and valuable to the sellers that are on it. If you have an all-in-one suite option where you can get your payments taken care of, you can get financing as you need it to make new inventory orders, can get some help, maybe, on the employee side and managing hours, timesheets, things like that. That's pretty compelling for a small business.

Priestley: It is, and I think, I keep saying this when we talk about it, but I feel like they're targeting a very underserved group. I think small business owners historically have really had to fend for themselves with a lot of these things, and they haven't had access to the high-scale, high-technology analytics that they're now getting. That is going to give the company a lot more credibility when they're going to customers, or if they're going for a bank loan, a larger bank loan, for example. So, I do think that this is adding a lot of value to their customers. I think that's their competitive advantage.

Lewis: And just a testament to the small business market, you look at what's going on with Facebook (META -2.28%) and a lot of their advertising. They have put a huge emphasis -- they talk about it in pretty much every conference call -- on the hyper-local and very targeted small business advertisements. This is obviously a big market. You don't think of Square and Facebook necessarily being on the same plane, with Square being a $4 billion company and Facebook being a hundreds of billions of dollars in market cap, but there's clearly a compelling market there that they're both trying to meet. It's a testament to the value that's available there.