Better Buy: Square Inc. vs. Visa

Square (SQ 0.13%) and Visa (V +0.38%) have delivered big gains to shareholders as digital forms of payment gradually replace cash and checks. But there's still a massive growth opportunity for these electronic payment providers, considering that consumers globally spent $17 trillion with cash and checks last year.  

Let's look at Square and Visa to find out which is the better buy for investors today.

Image source: Getty Images.

A digital payments ecosystem with huge growth potential

Square offers a range of products and services that remove a lot of the hassle for small businesses to get set up and accept payments. Square's basic strategy begins with selling point-of-sale card readers to merchants, which Square sells at a loss. But these hardware devices only make up a small percentage of revenue. The vast majority of Square's revenue is derived from transaction fees when someone completes payment at a store that uses Square's point-of-sale system.

Data source: Square. Amounts in billions. TTM = Trailing 12-month.

However, Square is becoming much more than a transaction processor. While transaction-based revenue has grown 30% year over year through the second quarter of 2018 compared to the previous year's period, the company's fastest growing sales category is subscriptions and services, which grew more than 100%.  

Square is building a complete ecosystem of services for both merchants and individuals. It has one of the most popular peer-to-peer payment apps with its Cash App. Other services include Caviar (a food ordering and delivery service), web hosting, and a suite of software tools the company offers for a subscription fee. 

All of this creates a sticky ecosystem for merchants. Once they are set up with point-of-sale capabilities using Square's hardware, they might adopt Square's payroll and invoice management software, or take out a business loan from Square Capital. This creates a lock-in effect with merchants, giving Square a competitive advantage.

Square's breadth of service offerings requires a great deal of investment up front, which is why Square hasn't generated a profit, although it did generate positive free cash flow of $73 million over the last year. Square also has more cash than debt on its balance sheet, so the company is in solid financial standing, despite the lack of reported profit so far. 

Management estimates its global addressable market to be $350 billion, which is enormous compared with its trailing 12-month revenue of $2.7 billion and explains why management is choosing to reinvest in the business instead of reporting a profit right now.

A pure payment processor with big margins

Visa is one of the most recognized brands with 3.283 billion cards around the world. The stock has delivered incredible returns of 810% over the last 10 years. Over that time, revenue grew 193% and non-GAAP earnings per share soared 519%, as a result of expanding margins and share repurchases. 

What many investors might not realize is that Visa is purely a payment processor. It doesn't issue cards and it doesn't take on risk by offering loans. It's simply a credit card transaction processor, and that has made Visa tremendously profitable, as you can see in this table. 

Data source: Visa. Amounts in billions. TTM = Trailing 12-month. Visa's fiscal year ends in September.

Visa generated a mind-boggling operating margin of 66% last year. It's able to earn a high margin for two key reasons.

First, its VisaNet network can handle more than 65,000 transactions per second. That's not easy to duplicate. Second, Visa is one of the most trusted brands in the world. It has spent decades building the technological capabilities for secure, fast, and efficient transaction processing. That's not easy to duplicate, either.

Visa's wide competitive moat is why digital payment leaders like PayPal Holdings, Square, and Apple's own digital payment service (Apple Pay) have partnered with Visa instead of trying to compete.  

In 2014, after introducing iPhone 6 and Apple Pay, Charlie Rose asked Apple CEO Tim Cook in an interview why not disrupt the payments industry and go around credit cards? 

Cook's response: "People love their credit cards."

It's an impossible task to displace credit card brands when a company like Visa has the technological infrastructure and over 3 billion cards in people's wallets around the world.

The difference between Square and Visa

Investors might be wondering if Square is coming after Visa. Even though Square serves as a transaction processor, it doesn't compete with Visa. Each company has its role in the transaction processing chain, which involves several entities to process, approve, and finalize a transaction.

Here's where Square and Visa fit in that process: When someone buys something using Square's point-of-sale checkout system, Square passes on that transaction information to other entities for processing. Square actually pays a fee to card networks like Visa to process payments. 

Think of Visa as a tollbooth operator between Square and the cardholder's issuing bank. Once a buyer's transaction has been approved and completed by the issuing bank, Square collects a transaction fee from the merchant. 

Which is the better buy?

I like both companies and would be comfortable owning both for the long haul. Square is growing much faster and therefore trades at a much higher forward P/E multiple, as you can see in this table. 

Data source: Yahoo Finance. 

Analysts expect Square to grow earnings 54% per year over the next five years. Because of Square's huge growth opportunity, I wouldn't be afraid of paying a high P/E for the shares. But given the rapid rise in the stock price recently, it might be best to wait for a pullback before jumping on board.

In the meantime, Visa offers plenty of growth potential that should deliver good returns to investors over the long term. Analysts expect Visa to grow earnings 19% per year over the next five years. 

Comparing both stocks' P/E multiples relative to growth expectations, Visa trades at a much lower PEG ratio than Square. Visa also pays a small dividend yield of 0.56%, which might appeal to investors who like the combination of income and growth.

With the caveat that I wouldn't blame readers if they decided to ignore my choice and go with Square, I believe Visa is the better buy.