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The Most Important Number in Square's 2018 Guidance

Overhead view of a Square mobile reader, dashboard on a laptop, and a notebook.

Along with its fourth-quarter letter to shareholders, Square (NYSE: SQ) gave investors some guidance for both the first quarter and the full year of 2018. It included the standard revenue and EPS expectations that investors typically pay the most attention to, but there's another number that's very important for Square investors to look at throughout the year.

Square expects adjusted EBITDA margin of 19% for the full year. That's a 5-percentage-point expansion from 2017, and it is right in line with CFO Sarah Friar's guidance last year for margin expansion in the mid-single digits.

Investors should pay close attention to EBITDA margin as it shows how well Square is investing in growth. Square continually points to the massive addressable market for its services, but it can't penetrate that market without spending more on its products and marketing. To that end, the mid-single digit margin expansion cadence offers a balance of investing for growth and showing leverage in the business.

Overhead view of a Square mobile reader, dashboard on a laptop, and a notebook.

Image source: Square

When less margin expansion is better

Square came in at the high end of Friar's mid-single digit margin expansion guidance in 2017, producing adjusted EBITDA margin 7 percentage points higher than 2016.

"I don't think 700 basis points of margin expansion, when you're growing at the rate that we're doing on the top line, really makes sense," Friar said at a recent investors conference.

Friar would rather have been investing the excess cash in order to produce more top-line growth in the long term. The problem she ran into was that Square grew adjusted revenue so much last year that the investments couldn't keep up . Talk about a good problem to have.

Friar's guidance for mid-single digit margin expansion is really just a guardrail to ensure Square invests responsibly and doesn't deteriorate margin just to grow. "At the pace that we're growing, where we still see a payback period of three to four quarters with positive dollar-based retention, we should be in investment mode," she noted.

As long as those trends remain the same, investors should be hoping for less margin expansion rather than more. Revenue growth will follow, and the bottom line will take care of itself in the long run as long as Square remains disciplined with its investments.

To that end, Square is actually expecting a lower adjusted EBITDA margin in the first quarter this year compared to last year as it invests heavily at the start of the year in marketing and development. Investors should see those efforts pay off with strong adjusted revenue and adjusted EBITDA growth throughout the rest of the year.

What exactly is Square investing in?

Square outlined its top three investment priorities for 2018 in its fourth-quarter earnings call: international markets, omnichannel, and financial services.

In international markets, Square is going to invest in marketing, particularly in Canada and Australia. It recently struck a deal with Interac in Canada, which handles 50% of card payments in the country. With that addition, Square has a much more compelling story to tell merchants, and it should be able to see a stronger return on its marketing spend in the country.

In Australia, Square is now offering Square Stand, which would give it a larger presence in its merchant's stores. It's focused on pushing the Square Stand into more merchant's storefronts, which could pay off by increasing its already dominant net promoter score of 80 in the country. Additionally, the Square Stand can act as a marketing tool unto itself with its iconic design.

In omnichannel, Square is focused on developing new products to help grow sales online through chat or however customers connect with businesses. But it's also being smart about how it invests in marketing those products. Friar noted the company has studied which products result in customers taking on additional Square products in the future, and it will put more marketing behind those products, increasing revenue growth in the long run.

With financial services, Square has lots of room to expand Square Capital, its small business lending arm. It can increase the size of its average loan, which currently sits at just $6,000. It also had success partnering with other companies that can furnish data needed to make better loan decisions, and it plans to do more of those in 2018. Finally, Square is planning to expand into consumer installment loans based on its merchant data, as well as customer data from Cash App. In order to do all of those, however, Square needs to invest in data scientists to ensure it's not taking on too much risk.

The accelerating revenue growth trend could derail everything

Square has had four straight quarters of accelerating revenue growth. Friar expects that streak to end, although she still expects a year-over-year acceleration in the first quarter with 44% adjusted revenue growth. She expects that number to fall to 34% for the full year.

But positive dollar-based retention means that every older cohort is still producing more revenue this year than it did last year. Add some big catalysts for customer growth with Square's investments in the first quarter, and Square could outperform again in 2018. If it does, that adjusted EBITDA margin could start creeping up more than 5 percentage points. That's certainly not the worst thing in the world, but long-term investors should hope for both the outperformance and stable margin expansion.

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Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of Square. The Motley Fool has a disclosure policy .

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

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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