This 1 Metric Suggests That Square Stock Can Keep Winning

On Nov. 4, financial technology company Square (SQ 5.04%) reported financial results for the third quarter of 2021. But prior to Q3 results, Fool contributors Jon Quast, Jason Hall, and Danny Vena talked about things they like about the company in this video from Motley Fool Backstage Pass, recorded on Nov. 1.

In the video, Jon mentioned Square's gross-profit growth, a metric he likes when trying to find market-beating investments. And Q3 results showed the continuation of the strong gross-profit trend he was looking at. Here's why Jon likes to watch gross profit and some other things these contributors are watching with Square.

Jon Quast: Square. This is a company very similar to PayPal in the sense that it is a financial technology company, it's providing payment processing services. This is a company that I actually was able to buy, like I foreshadowed, last year during the coronavirus crash, if we want to call it that, up almost 400% for me. I bought it in March of 2020 and created my first position, and I never added to it, to my shame.

One of the things that I like about Square here, and I just want to highlight a different thing here, is to understand that it has two main sides of this company, what they call ecosystems. On one side you have the consumer side called the Cash App ecosystem, and on the other side you have the Merchant ecosystem, which they call the Seller ecosystem.

Looking here at gross profit. One of the things to look for in companies that can beat the market is do they have a history of strong gross-profit growth, and can they continue that gross-profit growth in the future? Typically, that is a good indicator that the business is trending in the right direction.

If you look at the Cash App side of the business, this is quarter two of 2020, the height of the pandemic, 167% year-over-year growth. As we were going more and more cashless in the early days of the pandemic, you saw this Cash App really take off with user adoption, incredible revenue growth, and as a result, gross-profit growth. But what's been interesting here, you can fast-forward to the most recent quarter, we're lapping those coronavirus gains, still growing, 94% growth from the previous year, so that Cash App side of the business really, really taking off.

On the seller side, it's really important, what Square provides to many small and medium-sized businesses. Yes, brick-and-mortar was by and large close during 2020, but what they were able to do is provide services to these businesses that helped them pivot, helped them get their websites up and running, helped them understand how to manage inventory and convert over to omni-channel. As a result, this gross profit on the seller side of the business didn't take that big of a hit in the second quarter of last year. Held on to a lot of business, and most recent quarter here, 85% year-over-year growth. We see the gross profit growing on both sides of the business.

As I look at Square going forward, one of the reasons that I ranked it below PayPal is I don't really like their strategy as much as PayPal. For example, when it came to buy now, pay later, PayPal went the build route. Square went the buy route, and it was a big buy, $29 billion. Twenty-nine billion all stock for after pay. Could that be a good acquisition? Absolutely, it could. I really felt though that Square headed in their capability to build this out themselves for much cheaper, but I'm not in charge, we'll see how it plays out.

They sometimes take weird bets. Right now betting big on a company called Tidal, creating this whole brand new ecosystem based around music and arts. I'm not really sure about that, I don't really get it. However, I will point out that Square has this knack of doing things that other companies aren't doing and having it work out tremendously. One of those areas would be Bitcoin. They allow Bitcoin transactions free to the user. Basically, they're making zero on this. They just want to facilitate the bitcoin transactions, which seems ridiculous. Why would you as a business provide something for free? Well, as it turns out, it's likely one of the main reasons that Cash App is gaining so much of its users. It's almost like free advertising. It's a place that you can go if you want to do Bitcoin and dollars, you could go to Cash App. It's really turned into something of a user acquisition product for them.

You know what, they've been a little bit unconventional in the past and had it work out really well. Perhaps this Tidal acquisition is one of those things that is really going to stun a lot of people in a couple years looking back.

Jason Hall: I want to point out customer acquisition for financial institutions. Square is now bankrupt, they have a bank charter. Well, if you think about most traditional banks, the customer acquisition costs can be in the hundreds and hundreds of dollars, sometimes more. Some banks push close to $1,000. When you can drive that customer acquisition cost down, that is enormous.

There's another thing, guys, like Starbucks Rewards program, where you load your card, you give Starbucks the money before you buy the product from them. A lot of times with Cash App and PayPal's Venmo, you leave the money there, you leave it sitting there. Guess who has your money? It's like float. There's a lot of value to having that capital on their books at the time, so it gives them a lot of financial flexibility and how they manage their own expenses and raise capital. There's more value to providing that free thing than just the on-boarding.

Danny Vena: Now, I did want to throw one caveat out there because this is one thing that gave me pause, and don't get me wrong, I'm a happy Square shareholder. But one of the things that I saw was that, and it was in one of the recent quarters, that was the fact that the growth in the Cash App was primarily driven by the cryptocurrency transactions.

I think cryptocurrency could end up being big. I own a small amount of cryptocurrency myself. But I think Square hitched its wagon early onto the cryptocurrency boom. As a result, if cryptocurrency adoption does not go the way we think it could go, then you could see a big tail-off in Square's growth because it gets a piece of every cryptocurrency transaction when somebody buy or sell a cryptocurrency. That's just something I think investors should be aware of.

Hall: Jack didn't just hitch the wagon, he went and bought another wagon and hitched that to the wagon that was hitched to the wagon.

A bit of an interesting guy. I want to point this out, this is something for a lot of people with Square. Jack Dorsey is the CEO. They view it as a negative because with Twitter and having divided interest in managing two big companies. He is also a bit of an odd guy, but as Henry Ford said, "If I had to listen to what people said they wanted, I'd be making buggy whips." We need people that can see the world in a different way for these innovative companies. I think Jack Dorsey is a really important part of the story for Square.