Shares of Square (NYSE:SQ) recently tumbled after the payment services provider posted its first-quarter earnings. Total revenue rose 51% annually to $933 million, as adjusted revenue -- which excludes transaction-based costs, bitcoin costs, and a deferred revenue adjustment -- climbed 64% to $464 million and exceeded expectations by about $11 million. Gross payment volume (GPV), or the value of all transactions on its platform, jumped 28% annually to $28 billion.
Square's reported net loss widened from $16 million a year ago to $28 million, but adjusted EBITDA nearly doubled to $81 million. Adjusted earnings per share increased from $0.08 a year ago to $0.14, which beat expectations by a penny.
Square expects adjusted revenue to rise 55% annually at the midpoint for the first quarter, which, though in line with analyst expectations, would mark its slowest growth rate in four quarters. It expects adjusted EBITDA to go up 36% at the midpoint, and for adjusted EPS to come in between $0.06 to $0.08 -- compared to $0.06 a year earlier. That EPS guidance missed the consensus forecast of $0.12.
For the year, Square forecasts adjusted revenue to get a 41% boost at the midpoint, which should meet expectations. It anticipates that adjusted EPS will improve 61%, clearing the consensus forecast for 49% growth. Those headline numbers look solid, but two key issues spooked the bulls.
Weaker-than-expected EPS forecast
Square attributed its weaker-than-expected adjusted EPS forecast for the first quarter to two main factors. First, it noted that the first quarter is "typically" its slowest in terms of sequential revenue growth due to seasonality. Second, it expects operating expenses to rise as it invests in more "growth opportunities."
That statement isn't surprising, since Square is aggressively expanding its ecosystem with cloud-based services for analyzing business data, managing customer relationships, tracking inventories, maintaining payrolls, designing websites, delivering food, and financing small businesses. It's also tethering more mainstream consumers to its ecosystem with its Cash App, which more than doubled monthly active customers year over year to 15 million in December. All these moves widen Square's moat against fintech rivals like PayPal (NASDAQ:PYPL) and Zelle.
Meanwhile, investors should recall that Square traditionally "sandbags" its guidance, meaning that it tempers expectations with numbers that it can easily beat. Simply compare its guidance to its actual earnings growth over the past year:
That guidance often disappoints analysts, but sets Square up for an easy earnings beat the following quarter. We should also note that its full-year adjusted EPS forecast still topped expectations -- so it either expects an earnings beat during the first quarter or stronger earnings growth for the rest of the year.
Slowing revenue growth
At $74, Square trades at nearly 100 times this year's adjusted earnings. Investors were willing to pay such a high premium for the stock because its growth was accelerating. PayPal, by comparison, trades at about 34 times this year's earnings.
However, Square's revenue growth is gradually decelerating, and its operating expenses (up 52% annually by both GAAP and non-GAAP metrics during the quarter) could keep climbing and eventually outpace the growth of its adjusted revenue.
Square keeps investing that cash into the expansion of its fintech ecosystem, which locks in customers and boosts its subscription and services revenue. The bulls often claim that Square's subscription and services revenue will keep rising and account for a larger percentage of total revenue.
However, the growth of that unit (excluding the acquisitions of Weebly and Zesty) decelerated during the third and fourth quarters:
|Metric||Q4 2017||Q1 2018||Q2 2018||Q3 2018||Q4 2018|
|Subscription and services revenue||$79 million||$97 million||$134 million||$172 million||$194 million|
|Percentage of GAAP revenue||13%||15%||16%||19%||15%|
If we include Weebly and Zesty, Square's subscription and services revenue rose 127% in the third quarter and 144% in the fourth quarter. That's not bad, but it indicates that Square needs to keep making acquisitions or launching new services to boost its top-line growth.
Why I'm sticking with Square
I'm a Square investor, and I don't plan to sell my shares anytime soon. Its near-term growth might be lumpy, but it's still a growing company with plenty of irons in the fire. Therefore, investors should focus on the long-term growth potential of Square's payment services instead of fretting over its guidance or the costs of expanding its ecosystem.