Square's (NYSE:SQ) third-quarter earnings report beat expectations on both the top and bottom lines. Its fourth-quarter revenue outlook was also better than expected, but management's expectations for just $0.05 to $0.06 in adjusted earnings per share (EPS) disappointed investors. The analyst consensus for next quarter is $0.06 per share, and considering Square's run-up in price this year, anything less will be a big disappointment.
But the weaker EPS implies Square is finding new places to invest. At the beginning of the year, CFO Sarah Friar told analysts to expect mid-single-digit adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) margin expansion. The company then proceeded to expand margins much faster.
For the third quarter, Square managed a 7 percentage-point improvement in EBITDA margin over last year. Next quarter's 13% EBITDA margin forecast would be a 3 percentage-point contraction but implies full-year EBITDA margin expansion of about 7 percentage points. That's a number closer to what Friar said investors should expect at the beginning of the year and nothing for investors to sneeze at.
Square could grow earnings more quickly
Square has been outperforming on the top line, which resulted in growing profitability during the first half of the year. Even though Square once again exceeded expectations in the third quarter, the company is focused on creating new hardware, expanding existing hardware to new markets, unveiling new subscription services, growing Square Capital with new partners and a potential banking license, and more.
Friar points out that these investments have helped produce impressive top-line results. Expanding the ecosystem and providing new products for merchants makes them less likely to leave for a competitor. To that end, she told analysts, "It doesn't make sense to hold back on investments when you see the ROI [return on investment] that we see," during the third-quarter earnings call.
CEO Jack Dorsey later explained the company's philosophy behind its product expansion. It looks to identify the most critical need for its customers and then works to create a solution that's best in class. That's led to some excellent products following its flagship credit card reader -- Square Capital, Instant Deposits, and Payroll are just a few. He couldn't provide any hints as to what Square might be investing in now, though.
Fending off the competition
It's important to note the disappointing margin guidance isn't necessarily the result of increased competition. Intuit recently announced QuickBooks Capital, which will work similarly to Square Capital. It will use AI to analyze QuickBooks users' businesses and similar ones to make lending decisions.
Square, with its access to merchant transactions, is able to make lending decisions using a similar process, as are Shopify and PayPal. Indeed, Square Capital loan originations declined slightly on a sequential basis, but Friar says that has more to do with one-off events (hurricanes) than competition.
More importantly, the best way for Square to compete with a growing number of competitors in its space is to offer more services and target new markets. Square has no other competitive advantage besides its ability to create a bigger, better, and stickier ecosystem of fintech products.
Competition is something Square has been managing for years. Intuit, Shopify, and PayPal all have in-store credit card processing services, but Square has managed to remain the leader nonetheless.
As long as Square's ongoing investments continue to produce strong revenue growth, investors should be cheering instead of jeering management's decision to reign in margin expansion. Friar reiterated her expectations for mid-single-digit adjusted EBITDA margin expansion for the next few years.
Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Intuit, PayPal Holdings, and Shopify. The Motley Fool owns shares of Square. The Motley Fool has a disclosure policy.