Square (SQ -1.29%) added 12 million new Cash App users in 2020, and those users are turning to the financial Swiss army app a lot. The company is increasingly benefiting from the network effect of its core peer-to-peer payments service as well as the expanding ecosystem of services it offers through Cash App. So not only is it bringing on new users more quickly than ever before, but they are using more features than others and generating more revenue and profits for Square.

"Cohort economics"

One of the topics Square CFO Amrita Ahuja kept coming back to during Square's fourth-quarter earnings call and its letter to shareholders was "cohort economics." A cohort is a group of users who all signed up for a service around the same time. Square broke out both Cash App and Seller cohorts by year in its letter to shareholders.

A rendering of a credit card.

Square's Cash Card. Image source: Square.

Square sees increased gross profit from each of its cohorts every year. For example, the gross profit generated by Cash App users who joined in 2018 was greater in 2020 than it was the year before. Ahuja says the company has seen gross profit retention of more than 130% year over year in each of the last three years for all of its Cash App cohorts. That means users who joined in 2017 generated more than twice as much gross profit in 2020 as they did the year they signed up for the service.

The gross profit generated by users who signed up for Cash App in 2020 was massive. While there are more users in the cohort (12 million), the absolute gross profit generated by new users was substantially larger than any other cohort in its first year. Management didn't break out exact numbers, but it noted "2020 cohorts are pacing ahead of prior cohorts" in terms of payback period for its marketing spend. 

Why did 2020 outperform, and can it keep it up?

There are a couple of reasons the 2020 Cash App cohort produced such strong results.

First of all, the midyear government stimulus led to many new sign-ups and direct deposit users. Square has found direct deposit users are typically more engaged and more profitable than those who haven't used direct deposit in the app: Cash Card users who also have direct deposits into Cash App spend two to three times that of other Cash Card users.

Square saw a sequential decline in gross profit per user in October and November, but it ticked up again in December after a new round of stimulus checks were announced. That benefit could continue through tax season as Square has historically seen a similar response around tax refunds. However, it'll be more difficult for the company to continue growing direct deposit adoption in the latter half of the year.

The second reason is the expanding ecosystem. Square continues to roll out new features in the Cash App, and users are responding well to them. Management said its stock investing feature was the most quickly adopted feature in the company's history. Meanwhile, it saw increased adoption of Bitcoin trading in recent months as the cryptocurrency has run up in price.

The more products Cash App users adopt, the more engaged they become across the suite of services, and the more profitable they become for Square. The company will continue to roll out new features in 2021 and create more ways each service connects with others in the app. Last quarter, for example, the company introduced Boosts on its Cash Card that increased interest in Bitcoin and setting up direct deposits.

Leaning into the success

With the strength of its 2020 cohort, management plans to invest more in growing its user base through sales and marketing. Ahuja said the company will increase operating expenses $800 million to $900 million in 2021. That's an increase from the guidance she provided at the end of the third quarter. About 60% of that spend is earmarked for Cash App.

Importantly, Cash App has a customer acquisition cost of less than $5. With an annualized gross profit per user of $41, that's a massive opportunity for Square to lean in and grow the user base. In its March investor update presentation, the company said Cash App has a $60 billion total addressable market. With just $1.4 billion of revenue (excluding Bitcoin transactions) in 2020, the fintech company has only penetrated about 2% of the market.