3 Simple Reasons to Stick with Square

Shares of Square (SQ -1.97%) tumbled 9% on Nov. 8 after the payment services provider reported its third-quarter earnings. That sell-off was surprising, since its headline numbers easily beat expectations.

Square's adjusted revenue (which excludes transaction-based costs, Bitcoin costs, and deferred revenue adjustments) rose 68% annually to $431 million, beating estimates by $17 million. Its total revenue rose 51% to $882 million, and it generated $20 million in net income (thanks to a $37 million gain from the Eventbrite IPO) -- compared to a loss of $16 million a year earlier.

Image source: Square.

Square's adjusted EBITDA surged 107% to $71 million, and its adjusted EPS rose 86% to $0.13 per share, beating estimates by $0.02. For the fourth quarter, Square expects its adjusted revenue to rise 59% annually (at the midpoint), its adjusted EBITDA to grow 89%, and its adjusted earnings per share to rise 56% to between $0.12 and $0.13 per share.

Square's top-line guidance topped expectations, but its EPS guidance fell short of the consensus estimate of $0.15 per share. That shortfall prompted the sell-off, but I think investors should stick with Square for three simple reasons.

1. Square sandbags its EPS guidance

Square often "sandbags" its guidance, or provides conservative estimates it can easily beat, to temper investors' expectations and prevent analysts from issuing excessively bullish forecasts. Simply take a look at Square's guidance and actual earnings over the past four quarters:

Source: Square quarterly reports. Adjusted EPS.

This pattern is obvious, yet analysts and journalists repeatedly claim that Square's guidance "missed" expectations. Based on that pattern, I think Square's Q4 EPS could actually hit $0.15 per share -- matching analysts' current forecasts -- instead of missing it by $0.02 or $0.03.

2. Square raised its full-year guidance

The minor EPS guidance miss for the fourth quarter, along with a slight deceleration in its transaction-based revenue growth (up 29% annually compared to 30% growth in the second quarter), overshadowed the fact that Square raised its full-year guidance across the board:

Source: Square Q3 report. Year-over-year growth.

The fact that Square tightened up its EPS guidance toward the high range of its previous guidance indicates that its Q4 earnings will likely beat expectations. In fact, Square's full-year EPS guidance -- for $0.45 to $0.46 per share -- suggests that it will generate at least $0.13 to $0.14 in Q4 earnings, instead of its guidance of between $0.12 and $0.13 per share.

3. Its subscription and services unit is still growing

Square started out as a hardware and payments processing company, but it now owns a sprawling ecosystem of cloud-based services for analyzing data, managing customer relationships, tracking inventories, managing payrolls, creating websites, delivering food, and financing small businesses.

Image source: Square.

These platforms enable Square to expand into adjacent markets to challenge other high-growth companies like Shopify (SHOP 0.14%) and GrubHub (GRUB), which are also expanding into one-stop shops for small businesses. Shopify helps companies set up e-commerce platforms and online marketing plans, and GrubHub is expanding its food delivery platform into a payments platform. Square's acquisition of Weebly takes aim at Shopify, while its new Square for Restaurants platform targets GrubHub.

Bundling those services with its payment hardware (just 2% of its generally accepted accounting principles revenues) locks in and boosts its revenues per customer. On the consumer front, Square offers Square Cash, the popular peer-to-peer payments app, and the Cash Card, a physical debit card for the platform's users. Here's how quickly Square's subscription and services revenue grew over the past four quarters:

Source: Square quarterly reports. YOY = Year over year. *117% excluding Weebly/Zesty acquisitions, 165% on an adjusted (non-GAAP) basis.

Guggenheim analyst Jeff Cantwell expects Square's subscription and services revenue to hit $1.02 billion in fiscal 2019 -- which would account for nearly half its adjusted revenues and offset the decelerating growth of its transaction-based revenues.

Why investors should stick with Square

Square's stock isn't for queasy investors, since it's highly volatile and trades at about 100 times forward earnings. The company also faces an uncertain future after the upcoming departure of CFO Sarah Friar, and it isn't consistently profitable on a GAAP basis yet. However, investors who believe in Square's first mover's advantage, its accelerating growth, its ability to expand its ecosystem, and its vision of a cashless future should stick with this stock.