How Square Successfully Serves Substantial Sellers

Even though the company's shares dropped about 10% the following day, Square Inc (SQ -0.49%) continued to show accelerating revenue and earnings growth when it released its quarterly earnings earlier this month. In the payment processing company's third quarter, adjusted revenue rose to $431 million, a 68% increase year over year, while adjusted EBITDA rose to $71 million, an even more unbelievable 107% increase year over year.

This strong top- and bottom-line growth was primarily driven by two factors. First, the company saw a 29% increase in gross payment volume (GPV), the total amount of the transactions originating from a Square point-of-sale (POS) or app. The strong payment volume growth led to Square realizing $655.4 million in transaction-based revenue, almost 75% of its total net revenue. The second factor was the explosive growth of its subscription and services-based revenue category, which saw revenue rise to $141 million, or a 117% increase over last year's third-quarter total after adjusting for acquisitions. This category's growth was once again fueled by services such as Instant Deposit, Square Capital, Caviar, and its Cash Card.

Data source: Square Inc. YOY = year over year.

In the company's shareholder letter and in the conference call immediately following its earnings release, Square's management didn't take too much time dwelling on its dynamite numbers. Instead, management breezed by these numbers to explain what it was doing today to appeal to more sellers -- and bigger sellers -- than ever before.

Square has released several new hardware products in the past year, including the Square Register (pictured) and the Square Terminal, to appeal to more larger businesses than it traditionally serves. Image source: Square Inc.

Square's sales pitch

At the end of the day, Square's success hinges on its ability to sell to sellers. Without growing its merchant base, the company cannot offer its ecosystem of payments and business tools to retailers and grow its payment volume and revenue in the process. In his opening remarks on the conference call, CEO Jack Dorsey said:

[O]ur purpose is to empower people into the economy, enable them to participate in a way that they haven't been able to in the past. The way we do this is by focusing most of our efforts on helping sellers make a sale and, ideally, helping them make more sales. One of the things that we have done extremely well is increasing the access to sellers in the first place. A number of sellers and individuals could not even participate, could not get on the financial networks, and therefore could not participate in the economy.

Dorsey believes Square is empowering more businesses than ever after releasing three new products in recent months: Square Terminal, Square Reader SDK, and Square Installments. Let's take a closer look at how all three are enticing more merchants than ever before to enter Square's growing ecosystem.

Square Terminal, an elegant alternative

Square Terminal is an alternative to the clunky black boxes used everywhere to accept credit cards. The Terminal's design is elegant and features a 5.5" touchscreen, making what management believes is a perfect fit for crowded counter tops of many businesses. More than that, though, it can accept card payments via tapping, dipping, or swiping, and even print receipts. It automatically updates its software, and the interface is cloud-based, making it easy to use right out of the box.

Square first made it easy for small merchants to accept card payments by designing a dongle that sellers could plug into their smartphone or tablet. The need for the Square Terminal became apparent when Square encountered resistance from some merchants who did not wish to use their personal devices for sales. Management believes the demand for this device will be extremely high and cited that there were currently two million stand-alone card acceptance devices in the United States.

Square Reader SDK, for a customizable selling experience

The Square Reader SDK (SDK stands for software development kit) allows sellers to customize their point-of-sale and checkout experiences with only a few lines of simple computer coding. This is especially valuable for industries that do not have a specific point-of-sale solution designed for them. For instance, in Square's shareholder letter, the company highlighted one such use in the healthcare industry:

DrChrono is a platform that helps health-care professionals manage electronic health records (EHR), medical billing, and revenue. In the past, practice groups using DrChrono would have to manually input in-person payments. Now, with Square Reader SDK, when a medical practitioner accepts an in-person payment with Square hardware, the transaction data is automatically linked with the patient's profile in DrChrono. This can save medical practitioners valuable time, improve accuracy, and create a more complete patient record.

Another example Dorsey called out in the conference call was Shake Shack Inc (SHAK -0.56%), which is using Square's SDK for self-serving kiosks in its restaurant locations. These kiosks reduce the amount of time diners wait in line, allowing "Shake Shack to sell more burgers and ... see more customers."

Square Installments, enabling sellers to make that big sale

Square Installments might be Square's most second-guessed move because it will initially expose the company to some credit liability risk. This feature allows sellers to give their customers the option to break up large purchases into several monthly payments. It comes at no risk for the merchant, which immediately receives the money for the sale from Square. Square instead facilitates a short-term loan with the consumer online, who will be approved in real time. As this business segment grows, CFO Sarah Friar said the company would seek third-party investors interested in becoming the lender, in the same way Square does for business loans through Square Capital, ensuring there is little credit risk exposure to the company's balance sheet.

Square believes this will greatly help some of its businesses, especially in specific industries, to grow. Citing just one example in its shareholder letter, a custom car body parts maker has increased sales by 20% since it started using Installments.

Large sellers equal faster growth

Square believes these products will help it appeal to more businesses, especially larger businesses above its normal target range. This quarter, businesses with annualized payment volume over $500,000 represented 24% of Square's customer base; that's up from 16% in 2016's third quarter, a big increase in just two years. Even better is that many of these large sellers -- more than 40%! -- started off as microsellers (defined as merchants with less than $125,000 in annualized payment volume) on Square's platform. With Square's help, these sellers are growing from small to large merchants, and as these sellers grow, Square also grows!

While Square believes there is still a huge opportunity to reach microsellers, large sellers offer a faster avenue to growth. This quarter alone, gross payment volume from large sellers grew 42%, much faster than the overall growth rate of 29%. These products -- Square Terminal, Square Reader SDK, and Square Installments -- should only increase the company's opportunity to grow among this base of larger-sized clients. With revenue already accelerating for six straight quarters, investors might want to take advantage of this dip in price by considering Square's shares for their own portfolio. With this kind of growth, the price might not be down for long.