Square (NYSE:SQ) is a young, newly public company that allows small and medium-sized businesses to make credit card transactions. In the past year since its IPO, Square has grown tremendously -- but the company is not yet net income positive, and several significant risks are keeping the stock away from must-buy lists.

In this week's Industry Focus: Tech, Fool.com analysts Dylan Lewis and Sarah Priestley take a deep dive into Square, and how long-term investors should approach it. Find out how the company makes its money, what to check for meaningful growth, the most important risks the company might face in the next decade, and much more.

A full transcript follows the video.

This podcast was recorded on Aug. 19, 2016.

Dylan Lewis: This episode of Industry Focus is brought to you by Casper, an online retailer of premium mattresses for a fraction of the price. Because everyone deserves a great night's sleep, get $50 off any mattress purchase by visiting Casper.com/fool and enter the promo code FOOL.

Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, August 19, and we're diving deep into the payments company, SquareI'm your host, Dylan Lewis, and I'm joined in the studio by Sarah Priestley, one of Fool.com's tech editor/analysts. Sarah, how's it going?

Sarah Priestley: It's good, thank you so much for having me again.

Lewis: Again, yeah. Last time you were on the show, we did a deep dive into Match.com.

Priestley: We did. It got a fairly warm reception, I think.

Lewis: David Gardner loved it, he tweeted it out, he was psyched about it. That's always are really good stamp of approval. So, you're quickly becoming Fool.com's deep-dive resident expert.

Priestley: Ooh, I would be very nervous to put that title on myself.

Lewis: I'm happy to bestow it. So, we were planning out this episode, and we were a little nervous that Monday's Financials show might have stolen our thunder a little bit. They did a little survey of the payments landscape. And on that episode, Kristine Harjes, subbing in for Gaby Lapera, and Jay Jenkins, they talked about payments, and on the episode, Jay said "Square is a technology company first, that just happens, I think, to be in the financial technology space." Darn right, Jay!

Priestley: Put your hands up.

Lewis: We don't normally get territorial at Fool.com, but we're not going to stand for people in financials grabbing our companies.

Priestley: Absolutely right.

Lewis: So we have to do Square proud with this deep dive.

Priestley: We do, indeed.

Lewis: Let's hop right into it. What is some of the background here with Square? How did they come to be? What was the inspiration?

Priestley: It's actually pretty interesting. They were founded in 2009 by Jack Dorsey, who everyone will know as one of the co-founders of Twitter. He funded it with Jim McKelvey, who was, at the time, I'm not sure if this was his job or if he was dabbling in it as a hobby, but he became a glass blower. And he lost a sale to a prospective customer because he couldn't accept credit cards. So, they came away from that and they thought, "This has to affect millions of other small businesses in the same way that it's affected us," and they wanted a solution for that. And that's exactly what they've created.

They developed Square, a payment service provider. They basically facilitate small businesses to accept credit card and card payments. They IPO-ed last year, and raised around $275 million.

Lewis: I think one of the coolest things with the early stages of Square is Jack Dorsey published this manifesto basically explaining all of the reasons things could possibly go poorly for Square, and the idea could flop.

Priestley: Yeah, he was absolutely on the defensive. And I kind of like that. He came out with this "140 reasons why Square will fail." And every single one of those reasons, he had a rebuttal for. I think you'll find, and I think this is a thread for him, too, in a lot of his communications about the company, he is very defensive. He's always on his guard. And that's kind of the way he has had to be with some of these businesses that he's started.

Lewis: He owns over 20% of shares right now.

Priestley: He does, he owns 24% of the class B shares.

Lewis: So, what does Square do exactly?

Priestley: As I said, they're a payment service provider. What this means is they're a facilitator. They give you either a dongle that you can put on your phone to swipe or dip a card. There's a contactless reader for $49. There's a stand for $100. And after that, you can accept credit card payments, and they take a 2.75% cut for doing that service. So, it's a flat rate charge.

Lewis: And then, there's a slightly different rate if it's not through and through as credit card, and typed in manually instead.

Priestley: Yeah, it's higher, I think it's something like over 3% plus $0.30 per transaction.

Lewis: One of the things that I've noticed is that they're very clear in that they are not a credit card processor. They are a payment facilitator, they are an aggregator, but they draw that line pretty hard.

Priestley: They absolutely do. When we look more into the different aspects of the business, you can see why they do that. They have so many more product offerings. They talk about employee management. So, for $5 per employee per month, they'll do time cards, tip reconciliation, all those kind of things. They offer invoices. So when you're working business-to-business, you can send invoices through Square, and they take a cut of that. They offer appointments, online store, so you can easily setup your payments online. Payroll they'll run for $25 a month. Email marketing. There's a whole plethora of offerings for small companies. That's how they see themselves. They want to be a central part of your business. And they do deliver on that.

Lewis: And I think that's how most people probably encounter Square, through a local business, whether it be a food truck, a small retail operation, a pop-up store, maybe a farmers market, something like that. You look at the breakdown of their customers, just over 20% of them in retail, 18% of them are food-related, 16% in services, then you see a lot of other ones in contract work, repair work, hair and beauty. So, a lot of businesses that might have very small operations, a couple people in the business, or just an entrepreneur running things on their own. A lot of what they do is very oriented toward empowering those small businesses.

Priestley: Yeah. And I think Jack Dorsey, if you look at his background, his parents are both very entrepreneurial. I think that's formed a lot of his view to these things. They offer products that I think really do help small businesses. If you look at instant deposit, you can pay extra and you can guarantee that the money you receive from your customer will be in your account either instantly or the next business day. That's very helpful for a business that's struggling with cash flow issues.

Other things like Square Capital that they built from what was merchant cash advances, in the first quarter of 2016, they developed that into loans. These are all very value-added opportunities for businesses.

Lewis: Yeah. A lot of what they do, and some of the different products that they offer companies, are targeted toward getting cash in their hands faster, or providing capital so that they can expand marketing budgets or maybe add to their inventory orders or do anything to help grow their business and build it out a little bit.

I think, one of the interesting things with them, to go back to this idea of them not being a processor, is that they lean quite heavily on the existing payment infrastructure for how they operate. And you see that in the breakdown of how much they take on a lot of the transactions that they process.

Priestley: Absolutely. They take 2.75% cut of every amount that you receive. At first glance, that seems like quite a lot. But actually, 0.15% of that is taken from MasterCard or Visa, and they enable the transaction tap and they do the ...

Lewis: The actual processing.

Priestley: ...the actual processing, yeah. And 2% is taken from the bank that releases the funds. So, they're left with 0.6%.

Lewis: Which is razor-thin as a margin.

Priestley: It's tiny, yeah. It really is. We'll probably talk about this later, but it really shows, the transaction processing for them is really their entry point into the market to offer all these great other services that they do.

Lewis: We started talking a little bit about some of the different product offerings that they have. Most people encounter Square, they're at a farmers market or some local store or something like that, and they see something they want to buy, and they have the merchant with a dongle in an iPhone or an iPad or some sort of other tablet device, and they just get built like that, the same way they would at point-of-sale. That's how most people encounter it. 

The reality is, on the seller side, there's a pretty robust offering that Square has been building out. I think they've been forced to do that because the margin business on payment facilitating just really isn't all that great. You touched a little bit on Square Capital before. Do you want to dive into that a little bit more, and some of the benefits that it offers to sellers?

Priestley: Absolutely. I think Square Capital indicates a unique insight into the small business world. Just a bit of background on this: it's very difficult for small businesses to acquire loans. Usually, you have to have been in operation for two years, have about $250,000 on your revenue, and also have collateral, usually a house, to secure the loan. This doesn't require you to have that. And the brilliant thing behind it is that Square has access to a huge amount of sales data. They're processing every single one of your transactions. That means they can see if you have slow periods, what your good days are, what your bad days are, what your drum beat is like. And they use all this data to offer you a loan that they know you will be able to repay. The repayment of that is usually 10% to 11% that's taken from the gross payment value daily from that customer.

Now, Square doesn't fund these loans, that's important thing. They're basically a facilitator. They take all this data, they analyze it, look at it scientifically, and see who is prospective for the loan. And then they pair those with investors. And what this has resulted in is a really good averaged default rate of 4%.

Lewis: That's incredible.

Priestley: It is, yeah. In 2014, for small businesses, the average default rate was around 7%. Understandably, this has grown hugely for them. In the second quarter of 2016, they extended $189 million, which was up 23% sequentially, 123% year over year. That's an explosion of growth. They added five investors in the last quarter. And it makes sense from an investor's point of view. This is a pretty safe loan in a very unsafe territory traditionally.

Lewis: Yeah. And those are the two metrics that you want to key in on to see the success of this segment. The amount that's extended continuing to rise, and the people that are interested on the financing side continuing to rise, then, adding new investors. That's a proof of concept in a stamp of validation that investors are seeing the ROI and they're not getting stuck with bad loans that they're offering out.

To give you a sense of why this is so valuable for Square, the sellers that use their platform, you look at their customer mix, and most of them fall into that small business loan category.

Priestley: They do. They're definitely improving the mix. If you look at the past quarter, second quarter of 2016, 58% of their customers were under $125,000 annual gross GPV.

Lewis: Which is gross payment volume. That's basically the total amount that they're processing via Square.

Priestley: Yeah. 28% were between $125,000 and $500,000. Then, only 14% were above $500,000. That mix has drastically improved from where it was in 2014, when there was only 7% above $500,000. Understandably, and if you even glance at either of the past two earnings calls, you'll see the term "up market" thrown about many times. What they mean by moving up market is that they want to access more of these higher-earning companies.

Lewis: Yeah, and we're going to touch on that a little bit in the second half of the show. Before we do, this episode of Industry Focus is brought to you by Casper. Casper is revolutionizing the mattress industry by cutting the cost of dealing with resellers and show rooms, and passing that savings directly onto the customer. Casper's mattress in an obsessively engineered mattress at a very fair price. You can buy it easily online, and it's completely risk-free. The company offers free delivery and painless returns within a 100-day period. Best part -- you don't even have to lie down in a show room. Get a Casper twin mattress for $500 or a king size mattress for $950. Compared to what I've seen shopping around, that's actually a pretty great deal. You can even save an additional $50 toward a mattress purchase by going to Casper.com/fool and entering the promo code FOOL. That's Casper.com/fool and the promo code FOOL. Terms and conditions apply.

So, Sarah, we talked about some of the various business segments within Square and what they do as a business. Why don't we dive in to some of the financials and some of the numbers here on the second half of the show? What do things look like for 2016? We're halfway through, what are they projecting out for the year?

Priestley: 2016, total net revenue is expected to be about $1.63 to $1.67 billion. They actually raised that guidance fairly recently. The gross margin is meant to be around 31%, which is a 2% improvement.

Lewis: And I think one of the things that's important to note here is, when they say net revenue, that's their top line. It's not a margin number. It's referring to the net revenue they take from the payments they're facilitating that the loans they're offering, and all of these various things. That's something that you'll commonly see with payment processing companies or companies that are in the payments space. I don't want you to be confused by that net revenue tag. That is still the top-line number.

Priestley: Absolutely, yeah. We talked previously about that razor-thin margin. It looks pretty different on a growth level. They also raised that adjusted revenue guidance and adjusted EBITDA guidance. If you don't mind, I'm just going to spend one minute talking about adjusted.

Lewis: And, EBITDA: earnings before interest, taxes, depreciation and amortization, just for anyone who needs that clarified.

Priestley: Adjusted revenue for this company specifically, they exclude Starbucks transactions. They made an arrangement with Starbucks a few years ago that turned out to be not very successful. They lost money on the transactions. So, they've backed those out. And, the transaction costs Square to pay to banks. That's adjusted revenue. Adjusted EBITDA takes out taxes and depreciation, as you'd expect, but they also remove stock-based compensation and the Starbucks transactions. And that does impact the figures quite substantially.

Lewis: So, there's a decent swing between looking at the GAAP and non-GAAP numbers here, and that's something you have to keep in mind with a company like this.

Priestley: Absolutely. But they did raise their adjusted revenue guidance up 6% to $655 [million] to $670 million. Adjusted EBITDA to $18 million to $24 million from previously guided $8 million to $14 million. That's a big jump, there.

Lewis: One of the things that pops out most to me when I look at their numbers year-to-year, 2014 they had a gross margin of just over 26%. In 2016, they're up around 31% now. And that steady march up, we talk about the idea of their bread and butter business, payment facilitation, not being super great for margins. I think you're starting to see the effect of all these other business segments contributing to that margin number.

Priestley: Yeah, you're completely right. The reason for this margin enhancement is basically being driven by the product mix. If you look, transaction right now is about 76% of their income. Software and data, which is what Square Capital falls under, is 18%. And then hardware revenue is 6%. Hardware revenue, as they grow the number of people they supply, this will grow. But what we really want to focus on as investors is software and data. We want to see that become a bigger slice of the pie.

Lewis: Because that's where Capital is nested. They are, of course, on a GAAP basis not net income positive.

Priestley: They are not. That's important to know.

Lewis: Something to keep in mind as you're looking at their numbers. They don't have any debt on the books. They have access to financing, if they're interested in it, but at the moment, they're not levered at all. Which is, for a high-growth company, pretty great to see. That's where you can start to get into trouble, if you need to start making those debt payments and aren't able to because you're so worried about making investments and building out the business. So, that's something to keep in mind there.

Looking at their most recent quarter, what are some of the big numbers that investors should watch moving forward? How are those metrics performing?

Priestley: In the most recent quarter, I would say the things that we need to look out for are the GPV, the gross payment volume. So, it was up 42% year over year, which shows the growth organically of the customer base, but also shows that they're adding customers, too. So it's a mix of those two things.

Net revenue, obviously, we want that to go up, similarly. But the growth in Square Capital is crucially important. We want to see that improve. As I touched on previously, it grew 123% year-over-year. But that needs to be sustained. The slowdown in growth that was experienced in the first quarter actually dipped the share price quite significantly this year.

Lewis: And what about what we're looking at for the rest of 2016? We talked about, that headline number of expected revenue of about $1.5 billion. Anything else to key in on for the business?

Priestley: I think the customer mix, we need to see improving, too, as they move up market. GPV from $125,000-in-revenue-plus companies grew 61% in the quarter. That needs to continue to improve, and the $500,000-plus also needs to improve.

Lewis: We've touched on up market a couple times. It's compelling to have these huge business partnerships, moving into these areas where people are processing over $500,000 per year. But, there's a certain danger that comes with that, too, on the margin side. In conference calls, they've talked a little bit about the idea of custom pricing, and being more lenient when it comes to these big fish. That's fine, but they might get stuck in partnerships where they're not pulling in a very attractive take on those transactions.

Priestley: Absolutely. That's the worry. The other thing is, previously, 50% of the people that use Square have come to them organically, so they haven't had to market. They don't really do much sales. That's a minor criticism of them, that they don't have much of a sales infrastructure for you to go to. Now, they are hiring sales and marketing teams because big companies are going to expect a professional service, custom pricing, and also someone to interface with. This is all added-cost. The way you negate that risk is if it's OK to offer them custom pricing, if the margins are smaller on the transactions, that's OK. But these companies need to be using other services, so, invoicing, payroll, Square Capital. That would make up for that loss.

Lewis: Yeah, the idea of the payments business being the entry point for customers is fine, so long as Square is able to then upsell people to these other products and get them involved in Square Capital, get them involved in some of the employee management stuff that they do. It can be kind of tough for them to grow and stay afloat and be profitable if they're stuck handling payments for people.

Priestley: Absolutely. But it is a crucially important thing for them to do. For the first thing, it recession-proofs them, to a certain degree. You look at their default rate and look at their growth right now, that's great, but it's kind of the rising tide that rises all ships at the minute. The economy is doing well. What happens when we have an economic downturn? There's an often touted statistic that within five years, 80% of small businesses go bust.

Lewis: And that will be amplified in bad economic conditions, right?

Priestley: Absolutely. During the last recession, in around 2008-2009, the average default rate was 12%. That would have devastating effects for Square.

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 talk a little bit about getting outside of Square 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.

Priestley: I absolutely agree with you. I think that they may be playing their best hand, almost, with doing this. Sarah Friar was asked the question, what 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 gain 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 (NASDAQ:INTU) 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 (NASDAQ:PYPL) 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 under-served 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 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. 

As an investor, just trying to contextualize what some of this opportunity might look like, it's kind of tough. On a valuation basis, like we said, Square is not net income positive at the moment. So, we've resorted to looking at P/S to get a sense of where they fit within some of the competitors that they've identified and some of the people we see matching up and being in the same space. You look at their trailing P/S, and they're about 2.7. Meanwhile, PayPal is that a P/S around 4.6, and Intuit is at a P/S of around 6.6. Now, these are far from identical businesses. PayPal and Intuit both posted net income of over $1 billion in the trailing 12 months. That's something to keep in mind there. 

Looking at growth, last quarter, Square posted over 40% year-over-year growth. Intuit was over 20%, and PayPal was around 15%. That gives you some sense of where they sit. I think one of the big things is: re they going to be able to turn on the earnings engine at some point? Right now, they're in a phase that is so growth, growth, growth oriented. Eventually, they're going to have to start making money to prove to investors that they belong at the valuations of some of these other tech payment business type companies. That kind of remains to be seen. 

But, I think, if you look at their market cap right now, and you look at the size of PayPal and Intuit, right now Square is 1/10th the size of PayPal, and 1/7th the size of Intuit. I don't know that they're ever going to reach that size, but I think if they're able to crack that nut, and they reach half that size, that's a 3-5X improvement from where they are right now. There's clearly a large runway there, and I really like the idea of a business that has a symbiotic relationship with the customers. You touched on this one we were doing our prep, but the idea is, if sellers are doing well, they're going to be doing well, and vice versa. And that's always something that you love to see.

Priestley: Yeah. And I think, investors, if you're interested in this company, the things you need to watch are that they're really improving their customer mix, that they're getting those up market customers in, and that they're growing Square Capital, and that they're growing as a company in terms of the transactions that they're handling. Because, you may dismiss that razor-thin margin that they have there, but that's their bread and butter right now, and that's what's going to keep them going.

But I agree with you. I think they have a huge opportunity ahead of them. I love the fact that they have that symbiotic connection with their customers. If they grow, they grow with them.

Lewis: Yeah. I think with that up market pivot, one of the things that I'm most interested in watching, and I'm going to be focusing on for the next couple quarters is, do they add, and do we get some commentary that suggests that those mid-market companies are using them for more than just processing and facilitating transactions? If that happens, then I think you have to be really happy about where the business is going. If not, then you have to worry about the margin profile, and the ability for them to ever really turn on the profit engine. Right?

Priestley: Yes.

Lewis: Anything else before I let you go, Sarah?

Priestley: No, that's great. Thank you.

Lewis: That was an awesome discussion. Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say hey, you can always shoot us an email at IndustryFocus@Fool.com. You can always tweet us @MFIndustryFocus, too. If you're looking for more about stuff, subscribe an iTunes, or you can check out The Fool's family of shows at fool.com/podcasts. 

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Sarah Priestley, I'm Dylan Lewis. Thanks for listening and Fool on!

Dylan Lewis owns shares of Apple. Sarah Priestley has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple, Facebook, Intuit, MasterCard, PayPal Holdings, Starbucks, Twitter, and Visa. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Match Group. 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.