Square's (NYSE:SQ) Cash App has been on a tear this year. The company's peer-to-peer payments app generated adjusted revenue of $159 million in the third quarter, more than a quarter of the company's total. Still, it's the company's merchant services business that's producing all of its profits.

Management said its seller business is on target to produce an adjusted EBITDA margin of 30% for 2019. Applying that margin to its third-quarter results suggests the Cash App business produced only a small adjusted EBITDA loss last quarter. But with increasing scale and positive revenue retention, the digital payments app should move from a drag on EBITDA to a contributor as soon as next year.

A person holding a smartphone displaying Cash App.

Image source: Square.

A similar path as the seller business

In Square's letter to shareholders, management points out the company's seller business went from an adjusted EBITDA margin of about negative 9% in 2015 to an expected margin of 30% this year. CFO Amrita Ahuja says Cash App shares similar dynamics with the seller business that should enable comparable margin expansion.

First of all, it has low customer acquisition costs thanks to the network effect. Square faces a challenge from PayPal's Venmo, but it's increasingly common for people to use both apps. Square's app downloads have outpaced PayPal's for a long time now as its user growth compounds due to the network effect.

Square's also leveraging its seller ecosystem and its payroll product to push more users to download Cash App. Employers using Square's payroll may be able to pay their employees faster if they download Cash App. That's an advantage Venmo can't compete with.

Second, Square has developed a strong ability to cross-sell its users on other features of Cash App than what originally brought them into the ecosystem. If a user downloads Cash App for easy access to bitcoin trading, for example, they're twice as likely to also use Cash Card, according to management.

The company recently redesigned Cash App to make it easier to access all of the features available in the app. It also recently added stock trading to the service, and it plans to keep adding more features in the future. As a result, average revenue per customer keeps increasing.

The growing ecosystem of services in Cash App also leads to strong customer retention. Instead of using the app to send a payment to a friend one time and ditching it, users keep coming back again and again.

As a result of low customer acquisition costs, increasing average revenue per user, and strong user retention, Cash App is seeing faster and faster payback on its investments in the product. "We've been able to increase Cash margins each of the last three years, and we would expect to do the same in 2020," Ahuja said on Square's third-quarter earnings call.

Reinvesting for growth

As Cash App moves from a drag on earnings to a profit generator, investors may see an increase in spending to bring new features to the app and other marketing efforts to draw in users. The company is currently exhibiting a similar strategy with the growth of its seller ecosystem, which Ahuja says has become too efficient at attracting merchants

With the long-term potential for high revenue per user, Square has a lot to gain from spending now to attract users, especially as Venmo works to retain its users and copy features from Cash App. Management says the new free stock trading feature in Cash App is more about bringing new users to the app. "We really view this product set to be an engagement driver for us as we mentioned earlier, to help build out the network, and to help bring discoverability and daily utility to the app that enable growth for other revenue streams within the app," Ahuja said. By comparison, Square takes a small spread on bitcoin trading.

Square took a similar approach with Boosts, the instant cash-back rebates offered for using Cash Card. It funded the cash back out of its marketing budget, but it's slowly turning the feature into a source of revenue. It could eventually monetize stock trading down the line with additional features.

In the meantime, the company will invest in features like investing and other bank-like services in order to grow. It'll give users a reason to choose Cash App over competitors like Venmo. And while that could slow down its margin expansion, it's already at a point where it's no longer a significant drag on profits.

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