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Square’s Growth Still Justifies Its Premium Valuation

By Leo Sun - Mar 4, 2020 at 11:30AM

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Investors should look beyond the next few quarters to understand the fintech darling’s true growth potential.

Square (SQ 3.97%) is a divisive stock for the bulls and bears. The bulls are impressed by the online payment company's robust revenue growth and expanding ecosystem, but the bears warn of its competitive threats, lack of consistent profits, and high valuation.

Square's stock is certainly expensive at 86 times its adjusted earnings forecast for 2020. But if we take a closer look at Square's core business, we'll notice that its growth still justifies its premium valuation for five simple reasons.

Square Register.

Image source: Square.

1. Robust growth in payments and revenue

Square's gross payment volume (GPV), or the value of all payments processed on its platform, consistently grew by more than 25% annually over the past year. Its revenue growth also remained comfortably above 40%.

YOY growth

Q4 2018

Q1 2019

Q2 2019

Q3 2019

Q4 2019

GPV

28%

27%

25%

25%

25%

Revenue

51%

43%

44%

44%

41%

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

Square expects that momentum to continue with 33% revenue growth in 2020, after excluding the sale of its food delivery platform Caviar.

2. Improving profitabiity

Square expects its non-GAAP EPS, which excludes certain one-time charges, to rise 13%-18% in 2020. On a GAAP basis, Square generated a profit of $375 million in 2019, compared to a loss of $38 million in 2018.

However, most of that profit came from a $373 million gain from its sale of Caviar in the fourth quarter. Excluding that gain, and factoring in its losses in the previous three quarters, Square would have remained unprofitable.

However, Square's decision to sell Caviar, the elimination of its "adjusted revenue" metric, and its expectation for a "modest" increase in stock-based compensation expenses in 2020 all suggest that it's gradually tightening up its GAAP numbers.

3. An expanding ecosystem of higher margin services

Square attributed its robust growth in the fourth quarter to the expansion of its subscription and services ecosystem, which generated 78% annual revenue growth (excluding the sale of Caviar) and accounted for 21% of its top line. This segment, which includes the Cash App, Square Capital, and various subscription services for merchants, also boosted its gross margin sequentially and annually:

Subscription and services

Q4 2018*

Q1 2019*

Q2 2019

Q3 2019

Q4 2019**

YOY revenue growth

144%

126%

87%

68%

78%

Percentage of Square's revenue

21%

23%

21%

22%

20%

Gross margin

72.9%

72.3%

76.1%

77.1%

85.3%

YOY = Year-over-year. Source: Square quarterly earnings reports. *Including Zesty and Weebly acquisitions. **Excluding Caviar.

The growth of this higher-margin business could eventually offset the lower margins at its core payment business, which retains a cut of each transaction, and its hardware business, which sells its payment devices at losses to tether merchants to its ecosystem.

4. The growth of Square Cash

Square's Cash App, its peer-to-peer payments app for consumers, surpassed PayPal's (PYPL 2.23%) Venmo in U.S. downloads last year, according to App Annie. The Cash App grew its revenue and gross profit 147% and 104% year-over-year, respectively, in the fourth quarter.

A customer pays for a coffee with a mobile app.

Image source: Getty Images.

Its monthly active customers rose 60% annually to 24 million in December, while App Annie named Cash the top "breakout" finance app in the U.S. in 2019.

For the full year, the Cash App's revenue grew 157% to $1.11 billion as its gross profit surged 135% to $458 million, accounting for 24% of Square's revenue and gross profits. Square capitalized on that momentum by adding bitcoin purchases and free stock trades -- two features which Venmo sorely lacks.

5. Long-term industry tailwinds

Grand View Research estimates that the global digital payments market will grow at a compound annual growth rate (CAGR) of 17.6% between 2019 and 2025 into a $132.5 billion market.

Based on those bullish industry estimates, analysts expect Square's annual earnings to grow at an average rate of 38% over the next five years. Investors should always take long-term growth forecasts with a grain of salt, but that forecast gives Square a surprising reasonable 5-year PEG ratio of 2.3. PayPal, which is projected to generate 19% earnings growth over the next five years, has a PEG ratio of 2.1.

In other words, Square's stock looks pricey relative to its near-term growth, but it's cheap relative to its long-term growth potential. If Square continues to lock in merchants with cheap hardware, expand its higher-margin services, and transform Cash into a full-blown fintech platform, it could certainly hit those targets.

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