Square (NYSE:SQ) posted stellar fourth-quarter results at the end of February, beating analysts' expectations on both the top and bottom lines. Management also provided guidance for the first quarter and the full year 2017.
Overall, Square expects to generate between $880 million and $900 million in adjusted revenue, producing adjusted EBITDA of $100 million to $110 million in 2017. At least two analysts think that guidance is too conservative: Nomura Instinet's Dan Dolev and Conan Leon think Square could produce adjusted EBITDA at least 10% above the high end of Square's guidance.
While Square may have produced very strong results in the second half of the year, management is going to manage margin and focus on growth. Investors shouldn't expect any upside to Square's guidance to come from margin expansion beyond what management expects. If it's going to top expectations, it'll have to come from significantly stronger revenue growth.
Managing margin expansion
Square managed to generate significant margin expansion in the second half of 2016. Adjusted EBITDA margin expanded 19 percentage points in the third quarter and 20 percentage points in the fourth quarter. But CFO Sarah Friar says investors shouldn't expect that trend to continue this year.
"I would expect something more like mid-single-digit margin improvement in 2017," she told analysts on the third-quarter earnings call. "We think that's probably the right balance of being able to invest to grow against showing you that we're going to grow prudently and show leverage where we can."
Square's guidance for 11.8% adjusted EBITDA margin is perfectly in line with those comments. Square posted a margin of 6.5% last year. For Square to meet Nomura Instinet's expectations, it would have to post a margin around 13.4% (assuming Square meets the top end of its adjusted revenue guidance).
Investing in top-line growth
Square is still rapidly growing its customer base. Gross payment volume increased 34% year over year in the fourth quarter, and management believes there's still a lot of room to continue increasing that number. As such, it will continue to invest in growing the top line.
"As long as we continue to see a strong ROI, or that four- to five-quarter payback period, we will want to continue to press on investing [in sales and marketing]," Friar told analyst on the fourth-quarter earnings call.
In other words, Square has complete control over how much leverage it exercises, with sales and marketing being the biggest variable cost. Management sees a lot of room to improve both market penetration and the number of products its merchants take. That should keep the sales team busy throughout 2017, and keep margins in line with management's expectations.
It could, however, produce revenue growth beyond expectations if extremely successful. Square's guidance represents a 30% increase in adjusted revenue. For reference, adjusted revenue grew 52% in 2016. While that's a significant slowdown, it's in line with the current trend Square is experiencing. In order for Square to produce adjusted EBITDA in line with Nomura Instinet's expectations at a 12% margin, it would have to generate adjusted revenue growth of 47%. It's unlikely to outperform that drastically.
Not a bad thing
Square's guidance might be somewhat conservative, but it seems the analysts at Nomura Instinet are overly bullish on Square's potential profits in the near term. That's not a bad thing, though. Investors should want management to provide a very realistic outlook for what to expect in the future.
In fact, if Friar's guidance to use her mid-single-digit margin improvement expectations as a "cadence for the next several years" proves true, Square will be producing an adjusted EBITDA margin between 25% and 30% by 2020. That's exactly what Nomura Instinet's analysts expect.
It's better to play the long-term game than try to make a few extra bucks today. That's exactly what Square's management is doing.