Square (NYSE:SQ) sold its food delivery platform Caviar to DoorDash for $410 million last year. That marked a significant gain from its purchase price of $44 million five years earlier and streamlined its business by exiting the saturated food delivery market.

That's why it was surprising when Square recently integrated a new on-demand delivery tool for restaurants and retailers in its payment hardware. But instead of hiring couriers itself, as it did with Caviar, Square will redirect the orders to its delivery partners.

Square's first delivery partner is Postmates, and it plans to add more partners in the near future. Let's see how this new feature could strengthen Square's ecosystem.

A woman receives a food delivery from a courier.

Image source: Getty Images.

Escaping a low-margin cutthroat market

The third-party delivery market has notoriously low margins due to the costs of maintaining the platform, paying couriers acceptable wages, the limits of passing costs onto consumers, and cutthroat competition.

DoorDash controlled 44% of the U.S. food delivery market in May, according to Second Measure, but it still isn't profitable. Grubhub, which controlled 23% of the market, was once profitable, but it racked up losses in recent quarters and recently agreed to merge with its European counterpart Just Eat Takeaway to stay competitive.

Uber Eats ranked third with a 22% share, followed by Postmates' 8% share. Neither platform has ever turned a profit. Caviar, which lagged far behind those market leaders before its sale to DoorDash, was also likely a money pit for Square.

Adopting a simpler, higher-margin strategy

This time around, Square will let other companies do the heavy lifting as it generates its standard payment processing fees for each order and a flat fee of $1.50 per on-demand delivery.

Square claims merchants can pass the fees "entirely to the buyer or offer custom delivery promotions" and "save a significant amount on per-order costs" when "applied across hundreds of delivery orders each month." Its delivery partners will charge and retain the additional fees based on distance and other factors.

Square will waive all its dispatch fees, as well as all processing fees for on-demand orders for up to $50,000 in sales, until July 1. That promotion marks an extension of the waived fees, additional pickup services, and broader financing options Square offered its merchants throughout the COVID-19 crisis.

Many third-party platforms retain customer data from orders instead of passing it on to merchants. However, Square's on-delivery platform will retain the customer data for merchants in its Square Customer Directory, which can be tethered to its marketing and loyalty tools to bolster customer relationships. It will also complement Square's existing curbside pickup, shipping, and local seller delivery options.

Another piece of Square's sticky services ecosystem

Square generates most of its revenue from payment processing fees, but its subscription and services unit -- which generates over a fifth of its revenue -- is rapidly growing with expanding gross margins:

Subscription and Services Revenue

Q1 2019*

Q2 2019

Q3 2019

Q4 2019**

Q1 2020**

Growth (YOY)

97%

87%

68%

78%

72%

% of Square's Revenue

23%

21%

22%

20%

21%

Gross Margin

72%

76%

77%

85%

86%

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

Square generated most of the segment's revenue from its Cash App, Square Capital lending arm, and other seller subscription services last quarter. Adding new on-delivery services to that ecosystem should complement that growth.

The key takeaways

Square's second act in on-demand deliveries is a smart extension of its broader digital ecosystem. It won't move the needle for Square right away, but it will likely lock in more merchants and enable it to profit from the third-party delivery market without a first-party platform.

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