Square (NYSE:SQ) made a name for itself by developing little credit card readers that hook up to a smartphone or tablet. It made it easy for anyone to accept credit cards, from tutors to food trucks. But now, as Square continues to move into more traditional brick and mortar businesses, it faces intense competition from companies like Intuit (NASDAQ:INTU) and Shopify (NYSE:SHOP).

The switching costs for these new point-of-sale services are relatively low, and Square's pricing isn't always better than that of its competitors. While Square has done a great job bringing new merchants on board, investors need to ask what its competitive advantage is. What's going to allow Square to generate meaningful profits in the face of growing competition?

A person's hand tapping the iPad attached to a Square Stand.

Image source: Square

The square ecosystem

Square may have started as a simple way to process payments that were previously reserved for larger operations, but it's quickly expanding to more software and services for small and medium-sized businesses. In its fourth quarter letter to shareholders, Square said 25% of adjusted revenue came from products launched in 2014 or later.

Some examples of these services include sending and accepting invoice payments, small loans that are automatically paid back through future sales, payroll management software, and a food delivery service. Not only do these additional services generate extra revenue for Square, they provide a way to lock in customers.

"We talk a lot about ecosystem, and what we mean by that is a suite of tools that work together," CEO Jack Dorsey said on Square's second quarter earnings call. "That larger ecosystem helps with retention. It helps a seller make more sales, and it makes us a lot more valuable to every one of our customers."

Once Square is able to get a merchant onboard, it has a direct line to that customer that its competitors don't.

CFO Sarah Friar told analysts, "We have a very unique advantage here in that we can sell to our sellers through their dashboard. We also know that they tend to open the emails they get from Square because those emails are telling them about their business every day. Those are channels that no one else has access to."

She added, "Once someone is taking multiple products, that clearly helps with the retention as well. So, it kind of compounds the overall growth of the model."

It cuts both ways

Square has certainly done a good job building out its ecosystem of services, but it's not the only competitor with ancillary products.

Shopify, for example, also offers small business loans. As it tailors toward e-commerce (an area Square is increasingly interested in), it also offers fulfillment services to help its merchants get products out the door faster and cheaper.

Intuit already has a suite of accounting tools for businesses with software like QuickBooks, TurboTax, and its payroll services. In 2015 it started offering a point-of-sale solution that integrates with its software suite.

Just as Square locks customers in with its additional services, both Shopify and Intuit have their own ecosystems as well. While software and services help with retention, they don't create a real competitive advantage to help Square attract customers over Shopify, Intuit, or any other competitors. As Square starts to saturate the market in the U.S. and comes up against foreign competition abroad, it may require additional marketing expenses to keep growing its customer base.

Last quarter, Square's sales and marketing expenses grew 50%. CFO Sarah Friar said it was an example of the company leaning in on some new products and pushing them to scale. She reiterated that the company still expects to maintain its three-to-four quarter payback period on its marketing expenditures, so investors should expect the marketing to result in continued revenue growth down the line.

But marketing expense growth spurts like the second quarter may become the norm for Square as it works to stay ahead of the competition with new software and services to draw in new customers to its payments platform.

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