If potential investors in Square Inc (NYSE:SQ) were to simply look at the numbers from the company's latest quarterly earnings report, they couldn't help but come away impressed. Adjusted revenue increased to $204 million, a 39% increase year over year. Gross payment volume increased to $13.6 billion, a 33% increase year over year. Adjusted EBITDA for the quarter was $27 million with a 13% margin, compared to last year's $9 million loss and negative 6% margin.
This earnings report comes on the heels of previous great quarters, and the stock price is starting to reflect Square's growing business momentum. After the spike following the company's blowout first quarter, shares are up an amazing 45% year to date. Since hitting its low last summer, the stock price has gone up over 100%.
Naturally, this heady growth comes at a high price. Square's management is guiding for 2017 full-year adjusted EPS to be $0.16 to $0.20. This means that even if shares don't rise from now until the end of the year, they would sport a price-to-earnings ratio of just under 100. And that's based on adjusted earnings at the high end of the company's own guidance.
Yet despite the shares' lofty valuation and meteoric rise over the past 12 months, I don't think the stock is done going up. Why? While there are several reasons to be bullish, the three that stand out the most are new international opportunities, an impressive transaction revenue margin that refuses to go down, and a continued ability to innovate around traditional problems facing the payment processing industry.
Square enters the U.K.
This quarter, Square entered the U.K. market; this follows the company's debut in Australia, Canada, and Japan. The U.K. was chosen as the next market to enter because the country seems to be a perfect fit for Square and the services it offers the small and medium-sized business (SMB) market.
According to Square's first-quarter shareholder letter, the United Kingdom features a "thriving entrepreneurial scene." The country's 5.5 million SMBs generated 1.8 trillion pounds in 2016, nearly half of the U.K.'s private-sector revenue. While 70% of the country's consumers would prefer to pay by card, less than half of the market's SMBs accept card payments.
Better yet, Square is not entering the United Kingdom's market with just its point-of-sale solutions, but with most of its suite of products as well, including the company's lucrative subscription- and services-based revenue category (previously called software and data product). In the quarterly conference call, CEO Jack Dorsey said:
...one of the things that ... we're really proud of is our ability to launch multiple products in the market. Traditionally, we have only focused on payments and point- of-sale, and this really speaks to how good we're getting at internal platform and moving much faster to launch [a] fuller suite of products within market ... And everything that we've learned from launching Canada, Japan, Australia and now the U.K. is going into this launch, and we're going to work really hard to make it successful. But one of the biggest things that we were able to do this time was really launch with an ecosystem instead of launch with a part.
Square's buoyant take rate
Perhaps one of Square's most impressive feats is keeping its take rate so high. "Take rate" is industry-speak for Square's transaction-based revenue as a percentage of its gross payment volume (GPV). This quarter, Square's take rate was 2.96%, up from 2.92% in the year-ago quarter.
That Square has managed to inch up its take rate while increasing the size of the average business it services is quite remarkable. Indeed, this was previously one of my chief concerns regarding Square. Larger businesses, while offering some advantages like higher payments volume, generally can negotiate lower take rates than smaller businesses. In the first quarter of 2015, large businesses, defined as businesses that contribute more than $500,000 in annual GPV, contributed 9% of Square's overall GPV. Fast forward two years and these businesses contributed to 15% of Square's GPV.
In this quarter's shareholder letter, Square management stated it had been able to maintain its take rate because companies recognize the value of Square's ecosystem, which now includes services and products like invoice and inventory management, data analytics, Square Capital, and instant deposit.
Square's continued innovation
Square has shown a remarkable ability to innovate, eliminating several points of friction for the payments industry in the process. In the past, this innovation has led to faster EMV processing times as well as the development of Square Capital, a hugely successful small-business loan platform. Last quarter, the company introduced Square for Retail, a platform optimized for retailers' needs that can be downloaded and used within minutes.
This quarter, Square faced a particularly thorny problem in at least one of the new international markets it was entering. In Austalia, the generally accepted security standard for accepting credit cards is "chip and PIN." The "chip" is the EMV chip now embedded in most of our credit cards, which offers a higher standard of security than the traditional magnetic stripe on the back. The "PIN" is because Australian customers must enter a four-digit PIN to authorize purchases.
In the past, payment processing companies have traditionally produced extra hardware, namely numerical keypads, to enable this type of transaction. But in this quarter's shareholder letter, Square's management described how the company tackled the problem:
We built a new, secure way to enter PINs into the Square app on a mobile device, eliminating the need for expensive hardware PIN pads and making card acceptance more accessible. Also, our solution is quick and easy to update because it is software based, ensuring that our sellers always have access to the latest technology. We are working alongside industry partners to evolve standards for this new mobile PIN acceptance capability, which is the first of its kind for payments.
This continued innovation offered by Square has now led to key selling points for its platforms, lucrative new services, and cheap software solutions for traditionally expensive hardware problems. Not bad!
Why I bought shares
It is for the above reasons that I decided to take a position in the company after it reported first-quarter earnings. Because volatility is usually the price of admission for high-growth, highly valued stocks, I have kept my position relatively small...for now. In the quarters and years ahead, I plan on adding to the position, hopefully taking advantage of dips along the way.
While the stock has raced up this year, I believe it could still have a great deal more to run in the years ahead. Indeed, if Square continues innovating its way around pain points embedded within the industry, entering ripe international markets, and maintaining its margins, investors might be wistfully looking back at these prices in the years ahead.
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