Should Investors Fret Over Square's $1 Billion Debt Offering?

Square's (SQ 0.71%) stock recently dipped after the online payments company announced an offering of $1 billion in 0.125% convertible senior notes due in 2025. The notes will be sold in a private placement to qualified institutional buyers, and initial buyers will gain a 30-day option to purchase an additional $150 million in notes to cover over-allotments. The notes can be converted to cash, to shares of Square's Class A common stock, or a combination of both.

After deducting the initial purchasers' discount and estimated offering expenses, Square expects to generate $984.9 million in net proceeds (or $1.13 billion if the over-allotment is fully exercised) from the sale. It plans to spend $49.7 million of the proceeds on transaction costs, and the rest for "general corporate purposes."

It isn't surprising to see Square take on more debt since it's still aggressively expanding. However, Square also reduced its first-quarter and full-year guidance to reflect those costs -- so should investors be concerned?

Image source: Square.

Gauging the impact on Square's bottom line

Square's guidance cuts weren't massive, but they came just a week after Square posted its original forecasts.

Data source: Square press release.

Those reductions reflect Square's anticipated interest expenses, and the revised full-year forecast cuts its adjusted EPS growth rate from a range of 13% to 18% to a range of 10% to 15%. That's still a decent growth rate, but at $75 a share, Square's stock trades at more than 80 times that estimate.

Tracking Square's long-term debt

Square's long-term debt rose 4% annually to $938.8 million last quarter. Its debt has consistently risen since its IPO in late 2015 and was exacerbated by the expansion of its financing arm, Square Capital, which provides loans to businesses.

Source: YCharts.

That translates to a debt-to-equity ratio of 1.7, meaning Square has $1.70 in debt for every dollar of equity. By comparison, larger rival PayPal (PYPL 0.59%) finished last quarter with a debt-to-equity ratio of 2.0. However, Square's new offering will more than double its long-term debt and likely give it a higher debt-to-equity ratio than PayPal by the end of 2020.

Yet Square isn't biting off more than it can chew. Its cash and equivalents surged 80% annually to $1.05 billion last quarter, partly due to proceeds from Eventbrite's (EB -1.86%) IPO and its sale of Caviar to DoorDash, and it expects its cash flow to grow on a "sustained" basis throughout 2020.

Where will Square spend that cash?

Square sells its payment terminals at a loss to tether more merchants to its ecosystem. Therefore, it needs to expand its higher-margin subscription and services ecosystem, which grew its revenue 78% annually last quarter (excluding its sale of Caviar) and accounted for a fifth of its top line, to boost its profit.

Data source: Square quarterly earnings reports. YOY = year over year. *Including Zesty and Weebly acquisitions. **Excluding Caviar.

The subscription and service unit's core growth engines include the Cash App, Square Capital, and other subscription services for merchants.

Square is gradually expanding Cash App, which surpassed PayPal's Venmo in U.S. downloads last year, into a fintech platform with bitcoin purchases and free stock trades. Launching new services and expanding the app's user base, which grew 60% annually to 24 million monthly active customers in December, requires a lot of fresh capital.

Square Capital facilitated $671 million in loan origination last quarter, representing 42% growth from a year earlier, with a loss rate of less than 4%. The expansion of that business, which tethers more merchants to Square's services, also requires Square to keep spare cash on hand.

Lastly, Square could need additional cash to buy smaller companies and widen its moat against PayPal, Adyen, and other rivals in the growing digital payments market.

Should investors be concerned about Square's debt?

Square offered similar debt offerings of $400 million in 2017 and $750 million in 2018. Those offerings financed the expansion of its business and helped it grow its revenue by 30% in 2017, 49% in 2018, and 43% in 2019. Its stock has rallied more than 350% over the past three years.

In short, Square's debt offering is a calculated move aimed at expanding its ecosystem. It will throttle its short-term earnings growth, but it could generate long-term returns for patient investors as it locks in more merchants and consumers.