One of the most troubling parts of Square's (NYSE:SQ) first-quarter earnings report was the meager growth in Square Capital, the company's financing arm. The company pointed to a challenging credit environment for the business but said that it added two new investors at the end of April and that demand remained strong from customers. The second-quarter results confirmed those statements, and it looks like Square Capital is back on track.
The reason that's so important for Square investors is that Square Capital remains the largest potential earnings growth driver for the company. With the shift to loans from cash advances, Square is holding on to some of the paper to show its customers that it has skin in the game.
Importantly, it has more potential to profit as it scales compared to its main payments business but can help grow the payments business at the same time. The gross margin on Square's Software and Services business, of which Square Capital is the largest part, was 66% last quarter. That compares with 36% for its transaction revenue.
Here's what investors need to know about Square Capital.
Square Capital extended $189 million in loans during the second quarter, up 123% year over year and 23% sequentially. While Square says its loan volume tripled in the first quarter, it increased only 4% sequentially. The acceleration in sequential growth is encouraging, but more important is the potential for Square to continue accelerating its growth through the rest of the year.
The company added five new investors to the program during the second quarter to which it sells the majority of its loans for an upfront fee and an ongoing service charge. That was the bottleneck in the first quarter.
CFO Sarah Friar told analysts on the company's earnings call, "We feel like we have a lot of capacity, from an actual dollar perspective." In the letter to shareholders, management added, "We continue to have a strong continued pipeline of interested investors."
Adding more investors to offload loans to will be the key to Square Capital's growth. It appears there's already a large and growing demand for the product.
With gross payment volume growing at a high and steady clip (up 42% year over year), that represents fresh opportunities for Square to proactively offer loans. Additionally, the growth in large businesses using Square provides larger and safer opportunities for Square Capital. Last quarter, 14% of sellers had gross payment volumes over $500,000, up from 11% a year ago and 7% in 2014.
Driving its main business
While the expansion of Square's main payment-processing business represents a growth opportunity for Square Capital, just as important, if not more so, is that Square Capital's growth represents an opportunity to increase the payments business.
The entire idea behind taking out a business loan is to grow the business. In that way, Square stands to benefit from both the loan and the growth in the business' sales. On the earnings call, Friar noted: "We can actually see in our data that our sellers do grow when they pick Square Capital. ... They are actually using that capital to do things to help them grow their business, like inventory, equipment, etc."
Friar wouldn't provide exact numbers to quantify the impact Square Capital loans have on its sellers, but her comments indicate a non-negligible impact. That will help to continue growing its payments business even as competitors move into the space.
Another benefit is that uptake of Square Capital increases the stickiness of the company's other products. The idea behind Square and its competitors is that the start-up costs are very low. That means switching costs are very low. Adding products like Capital or its payroll service help reduce churn and open the door for Square to sell vendors other products.
Not only is Square Capital a high-margin business in itself; it helps improve the other aspects of Square's business as well. That's why the acceleration in growth was so important for investors to see, and why the comments from management make it even more encouraging.
Adam Levy has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.