Being a tech company in 2018 isn't the same as it was in 1998. Technology is literally everywhere today and constantly at our fingertips. So, a business that primarily uses or even develops technology isn't necessarily a tech company.
Amazon (NASDAQ:AMZN), for example, might be considered a tech company by many, but its core retail business and most of its ancillary services like shipping, warehousing, or making films and television series certainly aren't technology-centric endeavors.
Square (NYSE:SQ), meanwhile, is in the business of helping merchants accept card payments. That in itself also wouldn't be considered a technology-based industry. Square CFO Sarah Friar begs to differ. "I think of ourselves as a technology company that happens to use payments as one of our business models," she said at an investors' conference in May.
That statement might leave investors with a few questions. What really distinguishes a tech company from a non-tech company? Why should investors consider Square a tech company? And why does it matter?
What's a tech company?
A tech company, by its most basic definition, makes money by selling technology to other companies or consumers.
By that definition, Amazon is (mostly) not a technology company. The only technology it sells is its Amazon Web Services cloud-computing service. It also makes and sells its own electronic devices, which is borderline on the technology company scale, but the inclusion of Alexa, its digital assistant, in those devices pushes it over the edge, in my opinion. For the most part, though, Amazon's business isn't selling technology, and it probably shouldn't be considered a tech company.
So, what does Square sell?
You might think Square sells devices that make it easy to accept card payments. That's technically true, but if you ask management, they might say the company sells a stack of technology that makes sure a merchant never misses a sale. That business is monetized through taking a percentage of each payment and subscription fees.
On top of devices that allow business to accept card payments, Square also provides tools that allow businesses to monitor the health of their business, various software layers that allow merchants to schedule appointments or create customer invoices, and services that allow businesses to manage payroll and inventory.
But what really makes a technology company stand out is its incremental margin. Technology companies typically scale extremely well by replacing marginal expenses (man hours) with fixed costs (equipment or software). As a result, each new user comes with very little additional expenses, and margins expand over time (in a growing business).
What's Square's incremental margin?
Friar claims Square has an incremental margin of greater than 50% for both services monetized by payments and those monetized with subscriptions. That certainly puts it pretty high up on the scale -- and high enough for it to consider itself a technology business.
Still, there's clear room for improvement. PayPal's (NASDAQ:PYPL) incremental margin in 2017 was around 89%, according to CFO John Rainey.
Indeed, PayPal is much more focused on the software layers of accepting payments online, which generally scale much more easily without the need for a physical product. As Square and PayPal converge in their businesses, with Square increasing its presence online and PayPal increasing its presence in stores, investors should expect those incremental margins to start looking more similar.
Why should investors care?
The incremental margin in Square's business provides long-term potential for its overall operating margin. Square is currently reinvesting heavily into its own business to create new products, expand its presence internationally, and grow the business. At some point, Friar will take her foot off the pedal, and investors will see a significant increase in operating margin.
For now, Friar is guiding to mid-single-digit adjusted EBITDA margin expansion per year. Generating bigger expansion than that would mean Square is foregoing market opportunities, or can't deploy its capital fast enough to take advantage of the market. For 2018, Friar is guiding for EBITDA margin of around 17% based on the midpoints of her ranges. That's actually down from her original guidance of around 19%, as the company steps up its investing.
For reference, PayPal produced an operating margin of 21.1% in 2017. Management expects that to climb over the next three to five years as it increases customer count, despite a couple of major headwinds in that period. Square ought to be able to reach a similar level of profitability over the long term as it continues to invest in its products.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Adam Levy owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon, PayPal Holdings, and Square. The Motley Fool has a disclosure policy.