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3 Reasons to Buy the Post-Earnings Dip of Square Stock

Square (NYSE:) stock plummeted in early August after the payments processor reported better-than-expected second quarter numbers, but disappointed Wall Street with weaker-than-expected third quarter and full-year 2019 guidance.  Wall Street now thinks that Square’s growth is decelerating. Investors freaked out. SQ stock dropped nearly 15% in a day.

Finance stocks: Square (SQ)

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This selloff seems like a gross overreaction to a report which wasn’t all that bad.

The numbers weren’t terrible. In fact, they were pretty good, as the company’s  payment volume jumped 25%, its adjusted revenue surged 46%, its adjusted EBITDA margin increased one percentage point, and its EBITDA soared 54%.

Its guidance wasn’t that bad, either. SQ expects its Q3 revenues and EBITDA to soar 38% and 52%, respectively. Full-year 2019 revenues and EBITDA are expected to rise 43% and 60%, respectively.

Sure, Square’s growth is slowing. But not by much. Payment volume growth has inched lower from 32% in Q2 of 2017 to 25% last quarter. That’s a decline of seven percentage points over eight quarters or less than one point of volume growth deceleration per quarter. Over that same stretch, adjusted revenue growth has actually accelerated, from 41%, to 46%.

Also, its margins are rising rapidly. They should keep quickly increasing, and, in combination with steady, fast-paced revenue growth, they will continue to power even higher profit growth.

The non-cyclical growth story supporting SQ stock remains intact. Consumers globally are still rapidly pivoting towards non-cash payments, and Square’s ecosystem is at the center of this pivot. Over the long-term, this non-cyclical pivot will drive sustained outperformance by Square stock.

Given all of this information, investors should buy the dip of Square stock. SQ stock is on sale right now, and it won’t be on sale for long.

The Non-Cyclical Growth Story Remains Robust

The most important reason to buy the post-earnings dip of Square stock is that its big-picture fundamentals remain exceptionally favorable.

SQ is all about the  pivot to non-cash payments. Over the past several years, consumers globally have increasingly ditched cash in favor of non-cash payment methods, like cards and e-payments. The volume of such non-cash payments has risen at a for the past several years.

SQ helps merchants of all shapes and sizes facilitate these payments. Thus, as non-cash payment volume has grown over the past several years, merchants have increasingly turned towards Square to help them facilitate these payments, and Square’s payment volume has similarly grown quickly.

The pace of this growth is very gradually  slowing now, by about one percentage point per quarter. This slowdown is nothing to write home about. Cash still accounts for in the United States. That means there is still a ton of room for non-cash payments to gain share and grow.

That’s exactly what will happen because non-cash payments are easier and more convenient (and because young consumers really ).

Thus, it seems entirely reasonable to believe that non-cash payment volume will for the foreseeable future.

The fundamentals of SQ stock remain favorable, even though it has competitive concerns on the horizon. These concerns are outweighed by the outlook of Square’s innovations. This company continues to innovate and expand its product portfolio, which should ultimately reduce the number of customers who leave SQ, and increase its market share.

For example, last quarter, SQ  introduced a new product called Orders API, which enables sellers to manage their orders from multiple channels within Square.

Given all of these trends,  the growth outlook underpinning SQ stock remains exceptionally favorable.

Margins Continue to Climb

The second reason to buy the post-earnings dip of Square stock is that its margins continue to  quickly rise, making it clear that the company’s profits will eventually be huge after it has grown significantly

Excluding transaction-based costs and bitcoin costs, Square’s production costs are very small. There are some subscriptions costs and hardware costs,  but those are minimal, Those two costs have amounted to just 17% of the company’s revenue, excluding some items, in 2019. Thus, on an adjusted basis, Square essentially operates at 80%-plus gross margins.

SQ  is spending a great deal on sales, marketing, and product development. But those expenditures are growing its business. Over time, its investment in these areas will drop meaningfully, while its revenue will grow tremendously, meaningfully boosting its profitability.

Indeed, we are already seeing this. On a trailing twelve month basis, Square’s adjusted EBITDA margins have gone from 14% at the end of 2017 to over 16% today, and are expected to reach over 18% by the end of 2019. Thus, SQ is consistently expanding its EBITDA margins by about two percentage points per year.

That trend will continue because most of Square’s costs won’t grow as quickly as its revenues. Consequently, SQ currently has an excellent chance of one day generating high margins, high revenue, and huge profits.

Square Stock Is on Sale

The last reason to buy the post-earnings dip of Square stock is that SQ stock is cheap relative to its long term growth potential.

With around $85 billion in gross payment volume last year, Square had about 0.35% of the . That’s up from 0.23% in 2016 and 0.29% in 2017. Further, if Square maintains a 25% payment volume growth rate throughout 2019, then Square’s share of the global retail sales market will rise to around 0.42% this year.

Thus, from 2016 to 2019, Square has consistently grown its share of the global retail sales pie by roughly 0.06%-0.07% per year. Sure, that growth may slow.

But non-cyclical, positive catalysts in the non-cash payment world — coupled with the sustained, rapid innovation of the Square ecosystem — indicate that the increases of Square’s market share   won’t slow much. Square will likely add roughly 0.05 percentage points to  0.06 percentage points of market share per year going forward.

That will put Square’s share of the global retail sales market at roughly 0.75% by 2025. Assuming the global retail sales pie grows at a historically average 5% rate, then Square’s gross payments volume could amount to over $250 billion by then, representing average growth of roughly 17% growth per year from 2018 to 2023 (versus 25% growth last quarter).

Accounting for out-sized growth in the company’s subscription and software business, Square’s average annual revenue growth should be around 25% (versus 46% last quarter), putting its revenues at nearly $8 billion by 2025.

Assuming its margins continue to increase by two percentage points per year, its EBITDA margins could hit 30% by then, equaling $2.4 billion in adjusted EBITDA by 2025 (up from the average outlook of $410 million this year).

That should produce EPS of at least $4 by 2025. Based on a forward price=earnings multiple of 30, which is average for the payments sector. that equates to a 2024 price target for SQ stock of $120. Discounted back by 10% per year, that works out to a 2019 price target for SQ stock of $75.

The Bottom Line on SQ Stock

Square stock is a non-cyclical winner, and this post-earnings dip is a gross overreaction that is being exaggerated by macro market weakness triggered by a less-dovish-than-expected Fed and a more-aggressive-than-expected trade war. These macro issues won’t stick around. Once they disappear, investors will realize that Square’s strong growth outlook remains intact. Then there will be a flurry of “dip buyers,” and SQ stock will power its way back towards $75.

That’s why I’m buying SQ stock on its current weakness below $70.

As of this writing, Luke Lango was long SQ. 

The post appeared first on InvestorPlace.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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