Square (NYSE:SQ) is best known for its cleanly designed, pristine-white payments hardware that's often connected to a tablet or smartphone. Millions of small merchants use Square's payment-processing service every day to accept credit and debit cards from customers, and Square's payments business is booming. Transaction revenue is up 41% in the first half of 2016.
But Square's best product in 2016 is something that most small-business customers never even know about. It's the small-business lending arm of Square, Square Capital. Square Capital offers loans to merchants using Square's payments terminal and business dashboard in exchange for an additional cut of sales from every swipe they make at the register. It's fast, convenient, and simple, and Square extended $342 million in loans during the first half of the year.
Square Capital had a slow start to the beginning of 2016. During the first quarter, it extended $153 million in loans, just 4% more than the previous quarter. Management pointed to trouble signing new investors as a result of challenging credit-market conditions. Square packages its Square Capital loans and sells them to investors.
Square squashed any lingering worries with its second-quarter report. The company grew its total loans 23% sequentially and 123% year over year. The total number of loans has nearly matched 2015 just halfway through the year, and that's after the slow start.
With millions of sellers using Square's hardware, and less than 200,000 receiving loans from Square Capital, management sees a lot of room to run with Square Capital.
What makes it Square's best product
Square Capital provides a couple of big benefits to Square's business. First of all, its small-business loans provide better profit margins than its main payment-processing business. The payment processing segment's gross margin through the first half of the year was just 35%. That's actually lower than its gross margin in 2014 and 2015, when it posted 36% margin.
Square is structured such that it would be extremely difficult for it to improve on that gross margin. That puts a lot of pressure on its operating costs.
Square Capital is lumped in with software and data products, which posted a gross margin of 64% through the first half of the year. That's an improvement from 61% during the first half of 2015. Not only does Square Capital's segment carry a higher gross margin than its main business, it has been able to expand that margin. That will make it easier for Square to turn a profit as Square Capital continues to grow.
Moreover, the overhead costs associated with Square Capital are relatively low. Square spends almost nothing on marketing Square Capital, because it's selling the service into an existing customer base that's in constant contact with its products every day. Square CFO Sarah Friar told analysts on the company's second-quarter earnings call, "Our ability to put a product in front of them and have them take it is quite strong."
The second major benefit to Square is that Square Capital directly supports Square's transaction business. Merchants who receive loans from Square Capital use it to invest in their businesses. If a merchant invests well, that means more customers or more products and more revenue. As Ms. Friar said, "They are actually using that capital to do things to help them grow their business like inventory, equipment, et cetera."
As a result, Square sees the benefit of revenue growth in two areas from just one product. That's a pretty good product, if you ask me.
Can Square Capital continue growing in 2017?
Square Capital is certainly the company's best product of 2016 so far, but will it maintain that title in 2017? Analysts are expecting continued strong growth from the service to drive profitability at Square, but that task only becomes more difficult as Square penetrates more of its merchants and its base grows larger.
Square is experimenting with offering loans to merchants who don't use Square hardware. Square loses several key advantages when it moves beyond its core customer base, though, and investors should pay attention to any comments from management on the results of those efforts. Operating expenses and default rates might grow as Square tries to keep up with analysts' expectations.
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.