2016 has been tough for Square (SQ -0.38%) investors. Shares of the payments processing company have shed more than 26% of their value since the start of the year. In May, Square shares tumbled after the company turned in its first-quarter earnings report. Although Square's revenue rose more than many analysts had anticipated, the company also posted a wider-than-expected loss.
But the double-digit decline that befell shareholders in the wake of that report may have been fueled, largely, by the anemic growth of one of Square's most crucial initiatives: Square Capital. On a sequential basis, Square saw the dollar amount of the loans extended to its small business partners rise only 4%.
Although there's much more to Square then Square Capital, it serves as the backbone of an important business segment, its software and data products. For investors, the revenue those products generate may be Square's single most crucial metric.
Facilitating credit card transactions
Square's core business centers around credit card transactions. Square offers sellers, primarily small business owners, an easy way to accept credit cards. Obviously, there are many alternatives to Square's mobile readers, but they're often expensive and cumbersome, making them impractical for all but the largest businesses. Before Square, businesses without sufficiently large revenues were mostly unable to accept anything but cash payments.
Square's gross payment volume is often regarded as a key metric for its business. It quantifies the amount of transactions that Square's partners are conducting using its credit card readers, and it generates the bulk of Square's revenue. Square takes a cut -- about 2.92% on average -- of each transaction its readers facilitate. In the first quarter, Square generated $300 million of revenue this way.
Square isn't profitable, but management believes it will be profitable at some point in the future, and that it can achieve profitability just on the basis of its core payments processing. It takes about one year for a given Square user to generate enough transaction revenue for Square to break even, but after that, those users become sources of earnings for the company.
Building an ecosystem of software and services
But Square's real potential may lie not with its gross payment volume, but with the budding network of software and services that it offers to its merchant partners. The nature of Square's business means it has an intimate relationship with millions of small business owners -- a relationship it can use to build an ecosystem of profitable products.
Square has several services that it offers to small businesses, including Square Capital, Caviar, Instant Deposit, Employee Management, and Customer Engagement. All of these services attempt to solve problems many small business owners face: Caviar is for restaurants that want to offer delivery, while Instant Deposit makes it easy for Square's partners to transfer money around.
It's hard to say just how lucrative these services could eventually be. Almost all of them are in their infancy, along with Square's core business. Historically, however, enterprise software has offered attractive margins, and Square benefits from advantages other players in the space don't have. Square has almost no customer acquisition costs -- about half its sellers find it, rather than the other way around, and once they're using Square's readers, it's easy to offer them additional services -- and it collects vital data on the health of its partners, namely the amount of sales a given business is actually doing.
Square breaks out the revenue its software and services generate. Last quarter, they combined for $24 million worth of sales. That represented a modest 16.4% of Square's adjusted quarterly revenue, but software and data product sales rose a stunning 197% on an annual basis. If Square can continue to introduce useful new products and expand its base of sellers, that strong growth could continue in the quarters ahead.
"...we're now layering on new software and data products," said Square CFO Sarah Friar on the company's March earnings call, "that continues to add to our ability to cross sell, upsell, and see the operating leverage that you're seeing."
Square's been a disappointment for shareholders since it began trading late last year, but a strong software and services business could help it reward investors in the months and years ahead.