Why Investors Should Stop Worrying About Square's Guidance

Square's (SQ 5.04%) stock recently tumbled after the payment service provider posted its first-quarter earnings. The headline numbers initially looked solid: Its adjusted revenue rose 59% annually to $489 million, clearing estimates by $9 million. Its non-GAAP EPS rose 83% to $0.11, also beating expectations by three cents.

But Square's guidance spooked the bulls. For the second quarter it expects its adjusted revenue to rise 42%-44%, compared to expectations for 44% growth. It expects its adjusted EPS to come in between $0.14 and $0.16, which would represent 8%-23% growth. Analysts had expected $0.18 per share.

Image source: Getty Images.

However, investors should realize that Square usually "sandbags" its guidance with conservative numbers, which lowers expectations and enables it to easily beat estimates next time.

How Square sandbags its guidance

Square's habit of sandbagging its guidance is easy to track. Here's how Square's guidance compared to its actual earnings over the past year:

Source: Square quarterly reports.

If Square really expected a significant slowdown, it would have reduced its full-year guidance. However, Square actually reiterated its full-year adjusted EPS forecast of $0.74-$0.78, while raising its full-year adjusted revenue guidance from $2.22-$2.25 billion to $2.22-$2.28 billion -- which suggests that its "soft" second-quarter guidance is all smoke and mirrors.

Keep your eye on the ball

Instead of focusing on Square's guidance game, investors should focus on the company's core growth engines.

Square's GPV (gross payment volume), or the value of all transactions processed on its platform, rose 27% annually to $22.6 billion during the first quarter. 51% of that total now comes from "large" sellers, which generate over $125,000 in annualized GPV, versus 47% a year ago. For comparison, Square's larger rival PayPal (PYPL 1.96%) posted 22% year-over-year growth in its payment volume last quarter.

Square's subscription and services revenue rose 126% annually to $219 million, or 23% of its net revenue, marking the segment's fourth straight quarter of triple-digit growth:

YOY = Year-over-year. Source: Square quarterly reports.

This indicates that Square's expanding services ecosystem -- which includes its Cash App, Caviar food delivery service, Zesty catering platform, Square Capital, Instant Deposit for sellers, its e-commerce services platform Weebly, and industry-specific bundles like Square for Restaurants and Square for Retail -- is locking in more shoppers and merchants.

Square Register. Image source: Square.

During its conference call, Square stated that the payment volumes on its consumer-facing Cash App had risen 2.5 times annually. Its closest rival, PayPal's Venmo, posted 73% annual growth in payment volumes last quarter. Square Capital, which provides financing for businesses, reported a 50% increase in loans.

Square's smaller hardware business also continues to grow, thanks to its introduction of Square Terminal and a new Square Reader for contactless and chip-based payments. The segment's revenue grew 26% annually to $18 million during the quarter, indicating that it's still disrupting the market for traditional POS (point of sale) systems.

But mind the pitfalls...

I own shares of Square, and I think it's still a great long-term play on a cashless society. However, investors should be wary of three issues.

First, it isn't profitable in GAAP terms. By that metric, which includes stock-based compensation expenses and other one-time charges, its net loss widened from $24 million to $38 million between the first quarters of 2018 and 2019.

Second, the expansion of Square's subscription and services ecosystem requires the acquisition of smaller companies and the development of new features. That's why its non-GAAP operating expenses surged 54% annually during the first quarter.

Lastly, Square's stock isn't cheap. Square expects its adjusted EPS to rise about 62% this year, but the stock trades at over 90 times that earnings estimate. For comparison, PayPal expects 23% adjusted earnings growth this year, and its stock trades at roughly 36 times that estimate.

The bottom line

Square isn't a stock for queasy investors, but it still has plenty of upside potential. Investors should ignore its sandbagged guidance and focus on its GPV growth and the expansion of its subscription and services ecosystem instead.