Square Subscribes to Success

When Square Inc (SQ -4.53%) reported its fourth-quarter results in late February, shareholders had plenty of reasons to cheer. The company's adjusted revenue grew to $283 million, a 47% increase year over year, and adjusted EBITDA rose to $41 million, a 38% increase year over year. Driven by an increase in large sellers, gross payment volume increased to $17.9 billion, good for 31% growth. Here's a look at the company's incredible growth numbers this quarter.

Data source: Square Inc.

Just a few years ago, Square started with a mission to empower small merchants by enabling them to accept card payments. After reviewing the company's conference call, transcribed by S&P Global Market Intelligence, it is evident that the mission remains the same, even if the means of doing so have changed. While accepting card payments via a dongle attached to a smartphone has largely become commoditized, Square continues to empower smaller merchants by offering them products and services that, until recently, were largely unavailable to small retailers. These tools range from payroll and business loans to mobile ordering-ahead services for small restaurants.

The best part for shareholders? It's no longer just small businesses that are being attracted to Square's holistic ecosystem. Gross payment volume from large sellers (defined as sellers with more than $125,000 in annual gross payment volume) grew 44% year over year and now comprises more than 47% of total payment volume.

Square's subscription and services-based revenue rose to $79 million, an incredible 96% increase year over year.

A subscription for success

The products and services are accounted for in Square's subscription and services-based revenue segment. Because Square continues to innovate and add new features, it's getting harder to keep track of everything under the subscription and services-based revenue umbrella. Nevertheless, quarter after quarter, three products are consistently called out for producing the majority of this segment's revenue: Instant Deposit, Caviar, and Square Capital.

Instant Deposit is a platform that sellers can use to have money instantly deposited into their bank accounts upon completion of a sale. This process normally takes a few days, and for small merchants, this lag can cause a serious cash crunch. Square charges 1% for each of these expedited deposits, which is essentially a highly guaranteed loan that Square makes over a few days. During the conference call, CFO Sarah Friar stated that Instant Deposit processed over $2 billion in the third quarter.

Square first acquired Caviar in 2014 as a food delivery service. When I first started following the company, I was skeptical of how this type of business could be integrated into a payment processing company. I was wrong. In March 2017, Square launched Caviar Pickup, a platform that enables prospective diners to place their order ahead either online or via Caviar's app. Friar called Caviar a "real highlight" for the company in 2017 because of the pickup feature, which ensures that anytime the customer is hungry, there are options. The pickup feature also lets far more restaurants participate on the platform than the pure delivery service did.

Square Capital is a business loan platform for the company's vendors. In the fourth quarter, Square Capital approved and processed 47,000 business loans totaling $305 million, up 23% year over year. That makes for an average loan size of about $6,500, a small amount often overlooked by banks giving out loans to their customers. Using the data it has on its sellers, Square has also historically kept its loan losses under the national average on business loans. The platform has now facilitated $2.5 billion in loans since its launch.

The gateway drug

Besides being incredibly lucrative, each of the new services makes Square's ecosystem a little bit stickier, making it harder for companies to leave Square's services because they have come to depend on the company for so much. These new products also act as something of a gateway drug for Square's customers. Once they start subscribing to one of Square's services, it becomes harder to resist the entire ecosystem. During the company's conference call, Friar said:

If you look at some of our newer products like Loyalty, like retail Point of Sale, like Payroll, they're actually acting as a new door to Square, too. So, what we see is net new sellers coming in perhaps using one of those products first. And then our goal is how do we ultimately upsell them back into Payroll and Point of Sale. And it has to be because there's utility, because when they are using payments and point of sale, we can make something like Payroll easier for them because we're already doing Employee Management. So absolutely, we see a lot of these virtuous cycles being created. And thus, the ecosystem continues to grow.

One example Friar used was that 60% of customers who used the Square Appointments platform also subscribed to another Square service.

Hip to be Square

How fast is Square's subscription and services-based revenue segment growing? In the fourth quarter, the segment contributed $79 million to the company's top line, an incredible 96% increase year over year. With this type of explosive growth, it is no surprise that the products launched since 2014 comprised 36% of adjusted revenue this quarter, up from 25% in 2016's fourth quarter.

Square still comes at a nosebleed valuation. Based on the midpoint of its forward adjusted EPS guidance, the company trades at a P/E ratio of over 100! But the company is not focused on earnings right now. Rather, it continues to reinvest in its business so that it can continue to grow and introduce new innovative products and services. If these platforms continue to perform for the company as those introduced since 2014 have -- leading more customers into Square's sticky ecosystem -- then this investment in the company's growth should be well worth it for investors.