A Foray Into Square’s Finances: What Should Investors Look Out for?

Square's (SQ -1.12%) finances indicate solid foundations for just its third quarter as a public company. In this clip from Industry Focus: Technology, Fool.com analysts Dylan Lewis and Sarah Priestley talk about what investors will be watching and why trying to capture big business comes with some risks for this young tech company.

A full transcript follows the video.

This podcast was recorded on Aug. 19, 2016.

Dylan Lewis: 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 into 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?

Sarah 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.