2016 was a rocky year for Square Inc (NYSE:SQ), to say the least. At times, the market couldn't tell whether the company was making a turn toward profitability or falling down a rabbit hole of losses it may never emerge from.
Amid the market turmoil, Square made some solid moves that expand its capabilities for customers and will help grow revenue organically -- and there's evidence the plan is working.
How Square is building out its business
Many investors focus on the results of a business like Square from quarter to quarter. But if the business is going to be successful, it will have to become an indispensable tool for owners to operate their small- and medium-sized businesses. It can't just be a payment processor that takes Visa Inc and Mastercard Inc. It has to be a platform that businesses can build on, where transactions from big credit card companies will be just one capability. 2016 was a big step in that direction.
Square improved its dashboard, invoice, and payroll offerings, to name a few. Seeing how a business is doing in real time is something that's long been difficult for small-business owners to have. With the dashboard offering these capabilities, Square is moving beyond merely processing payments and into value-added services that make running a business easier. And if Square makes running a business easy, it will draw more customers to the platform, increasing payment volume.
Integration with dozens of third-party apps like Xero, Weebly, TouchBistro, and Vend help to advance the overall ease of using Square as a platform as well. Partnerships like this make it easy to go from taking payments to paying employees, taxes, and tracking profits without a lot of manual work.
On top of providing easy payment solutions and integration with other offerings, Square Capital is bringing small loans to businesses. This is another way Square is making it easier to run a small business and the data Square can capture through payments allows them to understand businesses better than many lenders could. The average loan was only about $6,000 in the third quarter, so the individual risks are small, allowing Square to aggregate risk, and loans grew 70% in the most recent quarter. Again, this is a product add-on that makes working with Square attractive for small businesses.
Evidence the strategy is working
Building out back-office capabilities that help small businesses is the foundation on which Square can drive growth, and evidence the strategy is working will come from increasing payment volume. In the third quarter, gross payment volume increased 39% to $13.2 billion as more customers adopted the platform.
Not only are small businesses liking the Square platform, but medium-sized businesses are a growing customer base as well. Gross payment volume from customers with over $500,000 in annualized payment volume increased from 8% a year ago to 14% last quarter. This shows Square moving up the ladder in customer size, which should help grow revenue long term.
The future of Square
Square is showing progress in building out the platform that will make running a small business easy, and in 2017, I think it will continue to expand. It could potentially buy some of its preferred partners to build out capabilities or do it in-house.
One thing to watch will be how it uses its position in the market to squeeze out costs, mainly from processing cards like Visa and Mastercard. Paying card companies and banks that process payments are the company's single biggest cost. In the third quarter, transaction revenue of 2.93% of gross payment volume led to just 1.01% in transaction profit. Most of the difference goes to these third parties.
Square is combating this by building out more information about customers and increasing the capabilities of peer-to-peer platform Square Cash. In time, Square Cash could begin processing payments directly from a consumer's bank account to the seller, even using Apple's Apple Pay or Alphabet's Android Pay, potentially lowering Square's transaction costs. Bank fees for bank transfers (ACH) can sometimes be free, so there's incentive for Square to use them more and more, cutting out the expensive Visa and Mastercard platforms.
Square Cash may be a small business today, but given its value to customers, it could eventually become a key cog in Square's business. That's something I'll be watching in 2017 to build on the success of the last year.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Travis Hoium owns shares of Apple, Mastercard, and Visa. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, Mastercard, 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 has a disclosure policy.