Most people only know Square (NYSE:SQ) for one or two products: its elegantly designed point-of-sale systems you can find in small coffee shops and boutiques and maybe its Square Cash peer-to-peer payments app. And while its payments business is growing well -- gross payment volume is up 42% through the first nine months of 2016 -- it's one of the company's other products that's driven its recent top-line beats.
Square has been able to continue growing its Square Capital business, recently surpassing $1 billion in total originations since its introduction in 2014. 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. Last quarter, Square extended another $208 million in loans, up 10% sequentially and 70% year over year.
The big reason Square Capital is so important to Square
Square Capital is the biggest part of Square's software and data products segment. The segment also includes its food-delivery business, Caviar, and smaller products like Instant Deposit and Payroll. While Square doesn't separate out Square Capital's financial results, the software and data products segment consistently produces a gross margin of around 65% compared to the 35% gross margin for Square's payments business.
The segment still accounts for just 7% of revenue, but it overshoots its weight in operating income due to its superior margins. It's also growing significantly faster than Square's other operating segments. Through the first nine months of 2016, software and data products revenue increased 149%. Growth accelerated from the second quarter to the third from 130% to 140% despite strong sequential growth last year as well.
Not only does Square Capital have relatively high margins, but it also supports the company's main business. The loans Square provides through Square Capital go directly toward growing the small businesses that use its payments systems. If the money is invested wisely, it should result in an increase in payments volume from the businesses as they grow.
So, Square benefits from a rapidly growing, higher-margin business in Square Capital while its main payments business gets a boost as well. That makes Square Capital its best product.
A strong contender for 2017
Last August, Square opened up Instant Deposit to all of its merchants. Instant Deposit, as the name implies, allows Square users to deposit funds from sales directly into their bank accounts 24 hours a day, seven days a week. The funds post instantly.
Since launching the service, over 200,000 sellers have used it more than 4 million times. Additionally, it's growing faster than other products in the high-margin software and data products segment, although Square wouldn't provide any exact details.
As CFO Sarah Friar noted, "Instant Deposit is definitely a high-margin product," implying that it has even higher margins than Square Capital or Caviar. "Instant Deposit is a real growth driver in that software and data line and becoming material to it" during the company's third-quarter earnings call, she added.
To be sure, Instant Deposit is a small part of a small business segment for Square, but it's a product that has the potential to produce meaningful operating income for Square considering its high margins. That makes it something to watch when Square reports its results next year.
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.