Square’s potential and its challenges

on October 15, 2015

Payment company Square made its S-1 filing with the SEC public yesterday and the document provides the first insight into the company’s financials beyond the occasional comment from executives. As usual, there’s tons of data in the filing and it will take some time for observers to parse all the contents. But there are some interesting tidbits throughout the filing and I’m going to share some of what I’ve found so far.

The core financials are typical for a fast-growing startup

The basic financial metrics for Square are typical for a fast-growing startup – that is, revenue is growing rapidly but the company is losing money in the continued pursuit of that growth and scale. Below are revenues (broken down by source) and margins for Square for the last seven quarters (it hasn’t reported results for Q3 3015 yet):

Square revenuesSquare margins

As you can see, revenues are growing nicely, but everything from adjusted EBITDA margin down to net margins has been negative for Square’s entire history. Only Adjusted EBITDA margins have ventured into positive territory, in Q2 this year. However, the trend is upward, which bodes well in general terms.

The underlying business model of the payments industry is challenging

However, one of the biggest challenge Square faces is the underlying business model of the industry it is operating in are pretty challenging. Square basically takes a percentage cut of every transaction that runs through its system (2.75% for card-present transactions, and 3.5% plus 15 cents for every card-not-present transaction), which averages out at a very consistent 3% in total. So far, so good. However, around 65% of that transaction revenue then gets paid to a variety of other parties. The largest chunk goes to interchange fees paid to card issuers and smaller amounts going to payment card networks, third party payment processors and others. That means Square’s cut of each transaction is 35% of 3%, or around 1% of the transaction value. From that, it has to cover all its costs, including the cost of subsidizing hardware (it’s always given its mobile Reader product away for free and makes a loss on its Stand Reader product), and all its operating expenses including development of future products, all its salary and overhead costs, and so on. And as the average size of its customers’ transaction volumes grow, it’s having to discount its fees below those standard fees I cited earlier. All of which means it’s stuck within a pretty narrow range of margins for its core product and there’s not much left over to cover its overhead costs, hence its ongoing negative margins.

This is somewhat par for the course for a fast-growing startup, in that achieving scale often solves the problem of profitability over time, as revenue from existing customers begins to outweigh the costs of acquiring new customers. The good news is new customers pay off their cost of acquisition within 4-5 quarters and revenue from these existing customers is growing at around 110% year on year. But, unlike many software startups, Square’s incremental cost to serve these customers isn’t close to zero – in fact, as we’ve already seen, it’s about 65% of revenue. So even though its customer acquisition costs are relatively low, its cost to serve these customers on an ongoing basis is high.

New parts of the business are promising

Partly because of all this and partly because being in the business of processing millions of payments provides lots of data, Square is beginning to diversify its offerings, which should help provide new opportunities to drive margins. Square has two major new business streams: software as a service and data products. Its SaaS offerings include Square Appointments and Square Customer Engagement, while its major data product today is Square Capital, which uses data on transaction volumes to proactively offer customers loans which get paid back through a cut of transaction revenue. Square also has its Caviar food delivery business, which takes a % of the total food order price as a fee. These new business lines are small in the context of Square’s overall business today – about 4% of its revenues combined in Q2, but they’ve grown rapidly from under 1% in early 2014, and show real promise. Even better, they’re subject to much more favorable economics (more like traditional SaaS or finance businesses) than the core payments business. And all of them will be driven by the rapidly growing total transaction volume Square is driving ($29 billion in the last four quarters). To the extent Square can keep these businesses growing, it should be able to help drive better margins over time.

Another thing that will help Square significantly over the next few quarters is the end of its relationship with Starbucks, which has had dramatically worse financials than its other transactions. No doubt Starbucks was helpful in boosting Square’s scale and giving it a marquee customer when the deal was signed in 2012 – Starbucks accounted for around a quarter of total transactions in early 2013 – but the deal has been horribly unprofitable and Square says in the S-1 that it’s not looking to renew it. The gross margin on Square Starbucks transactions have been minus 20-25%, while the gross margin on all other transactions has been positive at around 35%. The sooner Starbucks transitions to alternative payment providers, the better it will be for Square’s profitability.

Some other tidbits

I garnered a few other interesting tidbits from looking through the S-1 filing. First off, Square shares some interesting one-off data points about the scale of its business, which provide insights when taken together. In 2014, Square processed 446 million payments for a total gross payment volume (GPV) of $23.8 billion. Take those two numbers together and you get roughly $53 as an average transaction amount, which is higher than I was expecting, given I most often see Square terminals in casual dining restaurants where I’m spending much less than that. However, only 15% of Square’s GPV is actually food-related, and it’s got a pretty diverse base of customers at this point, well beyond restaurants and other small businesses. That same set of 446 million payments was processed against 144 million payment cards, which makes for an average of 3.1 payments per card, suggesting a significant number of repeat users. Combining these numbers with Square’s 3% average cut on transactions, and Square generates an average of $1.60 in revenue (and about 50 cents in gross profit) per transaction. And by the way, those 144 million payment cards represent around 1 in 5 active payment cards in the US (which accounts for the vast majority of Square’s business today, though it also operates in Canada and Japan).

What these numbers show is Square is getting a small slice of the total payments market in the US today, but it’s still managing to have a fairly significant impact and influence – hitting one fifth of all payment cards during a single year is impressive and it’s growing fast. Square sees the liability shift and the associated move to EMV and NFC terminals as a significant opportunity in the next few months and hopes to drive significant growth as a result. The big question is still whether it can do all this while also improving its margins, which will depend as heavily on its ability to drive new businesses as on its core payments segment.