Square (SQ) is a fintech company founded in 2009 which provides credit card payment processing solutions. It has a commerce ecosystem consisting of point-of-sale software and hardware that helps sellers with payment and point-of-sale solutions.
With year-to-date gains of about 9%, SQ stock has underperformed the market this year and now faces some key challenges. I am bearish on Square. (See Analysts' Top Stocks on TipRanks).
I consider it overpriced, and I expect operating expenses to further add pressure on profitability. At the same time, I expect that its capital expenditures to serve global expansion will harm free cash flow.
Business News
Square has been very busy supporting and expanding its business operations. Among notable business news, Square and TikTok partnered up to help businesses expand their reach online.
The company also launched in France, Spain (Early Access Program), enhanced customer experience with the launch of its Square Register in Canada, and plans to acquire Afterpay (AFTPF), which is a global "buy now, pay later" (BNPL) platform.
This global expansion of Square, though, comes at a cost. It is not logical to expect this fintech company, which considers itself to be a "software, payments and hardware solution for businesses of all sizes," to expand and establish a dominant position in digital payment services without challenges, risks, and problems.
Square has built its business model based on its active Cash App, not ignoring the fact that synergies and economies of scale can strengthen its growth across multiple levels.
Square announced that the acquisition of Afterpay "aims to enable the companies to better deliver compelling financial products and services that expand access to more consumers and drive incremental revenue for merchants of all sizes."
Among the key benefits mentioned from this business deal were the enhancement of both the Seller and Cash App ecosystems, added value, differentiation, and Afterpay's potential scale due to the direct benefit from Square's large and growing customer base.
Square, however, recognized the risk of a modest decrease in adjusted EBITDA margins expected in the first year after the transaction completes. This transaction is estimated to be worth $29 billion and will be paid in all stock. It's expected to close during the first quarter of 2022.
Mixed Q3 2021 Results: Cash App Growth Is Slowing, Earnings and Revenue Missed
Square's adjusted earnings came in at 37 cents per share, higher than the 34 cents in the year-earlier period. It's best to compare the same quarter's financial performance to get a more accurate trend analysis. The estimate for EPS was 38 cents.
Net revenue increased 27% to $3.84 billion, partly attributed to Square offering cryptocurrency services. Analysts had predicted a revenue figure of $4.39 billion.
Gross payment volume (GPV) from merchant customers rose 43% to $45.4 billion compared to estimates of $45.6 billion.
Cash App's Q3 gross profit was $512 million, down 6% from the previous quarter. In the third quarter of 2021, net income attributable to common stockholders was $0.1 million, a considerable decline compared to $37 million reported in Q3 2020. Square reported that it recognized a loss of $7 million during the third quarter that was driven primarily by the revaluation of equity investments.
What about liquidity and cash positions? Square ended the third quarter of 2021 with $7.4 billion in available liquidity, with $6.9 billion in cash, cash equivalents, restricted cash, and investments in marketable debt securities.
Square has a debt-to-equity ratio of 182%, which is considered high. There are two major problems I see about SQ stock.
Fundamentals: Increased Operating Costs, Stock Dilution
In its Q3 2021 earnings report, Square cited that "operating expenses were $1.11 billion in the third quarter of 2021, up 49% year over year, and non-GAAP operating expenses were $906 million, up 47% year over year." Sales & marketing expenses and general & administrative expenses all increased substantially. Its efforts to expand globally come at a cost, putting pressure on profitability.
Square has repeatedly engaged in stock dilution for the past five years to raise capital and fund its operations and business plans. For 2020, the sale of common stock brought $162 million in cash as part of financing activities. The valuation does not seem attractive based on key financial metrics.
Valuation: Relatively Rich
On a relative valuation, SQ stock is expensive based on its P/E ratio of over 200x compared to the U.S. IT industry average of 36.3x. Its price-to-book ratio of 36.3x is also much higher than the industry average of 5.2x.
Investors are now paying a significant premium to buy shares of Square, given its high growth prospects. The forecasted annual earnings growth in the next one to three years is 43.5%.
Wall Street’s Take
Square has an analyst consensus rating of Moderate Buy, based on 16 Buys, four Holds, and one Sell rating. The average Square price target of $306.20 implies 29.7% upside potential.
Disclosure: At the time of publication, Stavros Georgiadis, CFA did not have a position in any of the securities mentioned in this article.
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