One of the secrets to Square Inc's (SQ -1.92%) success has been its remarkable ability to develop an ecosystem for small and medium-sized businesses that extends far beyond mere payment-processing capabilities. That ecosystem hinges in part on industry-specific solutions, like Square for Retail, an app that retailers can download and start using within minutes for a monthly fee. Another platform tailored for a specific industry is Caviar, a food-delivery and mobile order-ahead platform to which restaurants can subscribe. However, the most successful of Square's additional services is probably Square Capital, the platform through which Square offers its clients small-business loans.
The latest attempt by Square to expand its ecosystem builds upon the earlier success of Square Capital. Earlier this month, The Wall Street Journal reported (link requires subscription) that Square would soon apply for a bank charter in Utah for a new unit, Square Financial Services, that would offer loans to small and medium-sized businesses. As fellow Fool John Maxfield explains, if Square's request is approved, the new unit will not be a bank but, rather, an industrial loan company.
The importance of this distinction to investors is twofold:
- It will allow Square Financial Services to act as the functional equivalent of a bank, allowing the division to receive deposits and make loans all while being FDIC insured.
- It does not subject the rest of Square Inc to the strict banking regulations that its newly formed banking division will face.
Since the financial crisis, the market has not acted kindly toward companies that have taken on credit risks. Normally, I would not want a high-flying financial technology company that I had an investment in, with heady growth numbers and a nosebleed valuation, to take on this type of risk. Even if the loan default risks never materialize, the move runs the very real risk of the market assigning the company a much-lower valuation multiple. Yet, in this particular case, I find the action to be the next logical step in Square's progression from a payment-processing company to a unique one-stop shop for meeting nearly all of a small business's needs.
Here are three reasons, in particular, why I believe Square is not taking on excessive credit risk and that its expansions into business banking if approved, will be another wildly successful move for the company and its investors.
1. The past success of Square Capital
Square Capital has seen a huge amount of success since being introduced, proving it is fulfilling an unmet need in today's marketplace. In its most recently reported quarter, Square loaned $318 million through Square Capital, a 68% increase year over year. That money was spread out over more than 49,000 business loans for an average loan size of about $6,500.
2. Square's reliance on data and algorithms to mitigate credit risks
In the recent Deutsche Bank 2017 Technology Conference, CFO Sarah Friar reiterated that Square's loan loss rates were "approximately 4%," a rate that Square has historically maintained through Square Capital. What makes this remarkable is that it is far below the national average loan loss rate for business loans. In fact, according to WAIN Street's Business Default Index, typical business loans default at about twice that rate.
In the latest conference call, Friar credited this remarkable success to the company's reliance on software algorithms and the transaction data that Square has on its merchants. She stated:
So Square was born using, at the time, what we call, software algorithms. Now we talk about machine learning and even deep learning. We have clearly moved on that continuum, and those models help us to really manage the risk prudently. And the models get better and better as the cohorts mature and we get more and more data on that. So no change to the core business on loss rates.
3. A better pay-back model
Finally, Square's pay-back system ensures that borrowers cannot ignore the loans for months at a time if business lags, and avoids a situation in which a debt would battle priority with other pressing bills. That's because borrowers pay back during the normal routine of operation: As a company uses Square's payment-processing services, an extra, pre-determined percentage is taken out of each transaction made through the hardware until the loan is paid off.
Take it to the bank
The success of Square Capital proves that Square is meeting an unfulfilled need in today's marketplace through these small, but necessary, loans to fledgling businesses. Square's heavy use of data to determine who qualifies for these loans and how much to lend reduces the risk of permanent loss of capital via dicey loans. The fact that these loans are automatically paid back to Square through the normal operations of a business further enhances the likelihood that these loans will be repaid and not lost in an avalanche of bills and debts of a struggling business.
I believe these signs all point to Square's banking adventures seeing a fair amount of success. In the company's second-quarter shareholder letter, management stated that businesses accepting loans through Square Capital's platform "often" pay for other services offered by Square. In other words, a business-loan division would have the potential to make Square's ecosystem that much stickier for its clients. With all these positives, it's hard to see how this move might fail. While I would never be so bold as to predict a stock's short-term movements, I believe long-term investors will be richly rewarded for seeing Square's bank endeavors through.