Square – does one good idea make a viable business?

Square (SQ), the San Francisco-based upstart payments processor, is an intriguing company on a number of levels: for one, it’s CEO, Jack Dorsey, invented Twitter, has had numerous profiles appear in respected publications like The New Yorker and Wired, and has even been compared to his erstwhile idol, Steve Jobs. But aside from the ‘Dorsey effect’, Square has been ‘through the ringer’ as a private company and is going public at an interesting time in its corporate evolution. All this piqued my interest so I decided to take a closer look at the company.

Square burst onto the start-up scene in 2010 with a good, or perhaps even great, answer to an unmet need: how could small businesses (often mobile) accept payment by credit card? The original Square dongle – a small white appendage you plug into the headphone jack of an iPhone – immediately took off with small businesses across the US due its combination of form (sleek and sexy), functionality (easy to sign up and use), and cost (original dongles were given away free to build share; processing fees were and are set lower than the comp as well). The visual similarities, along with the innovative yet simple solution to a pressing need, initially drew the Jobs comparisons.

Those comparisons were short-sighted, however, for a few reasons, but mostly because Steve Jobs would never sell a premium product at a discount to market – in fact he was famous for making the best possible product and letting consumers come to his product on his terms. Dorsey, of course, did not have this luxury: payment processing margins are so thin (around 1% net of each transaction, after paying fees to the credit cards, and before provisioning for operating costs) that he could not simply build the coolest product and hope the customer would show up at his door. Instead, he would need to seek out the customer (via loss-leading dongle giveaways), build scale, then hope to up-sell ancillary services (POS systems, invoice/receipt management, tax-related services, credit provision, etc) to build profitability later. Along the way, Square would hope to transition – or at least grow exposure to – much higher-volume enterprise (read: big business) users, since small businesses of course process many fewer transactions, are harder to scale (a new client win counts for relatively little) and are smaller targets for add-on upselling.

Win share with low-value customers, build relevance, transition from low-value to high-value customers once demonstrating a value proposition, then make money – not a bad model, as far as it goes (except perhaps the part about starting with low-value customers). Of course, note that success is dependent not just on growing low-end share but ALSO upon transition the offering up the value chain. The fundamental issue for Square today is that, four years in, it has become painfully clear that no matter how much the small-business segment has been a success, growing share with larger payers has been, all told, a failure – and it is thus extremely unclear whether the model will ever profitably scale. Square’s experience with Starbucks is a telling example.

When Square first announced its deal (2012) to provide POS solutions and process all card transactions at Starbucks’ 7000+ US outlets, it seemed like a massive win. Square was moving beyond small business and into the enterprise; it could push out ancillary products (Square Wallet, etc) to Starbucks users as well as hopefully to Starbucks corporate; and Starbucks even took an equity stake in the company.

But fast forward just three years and Square’s S-1 (pre-IPO) document depicts promising opportunity gone awry. Square cumulatively lost ~$80mm on Starbucks transaction processing alone (ie, not counting the operating expenses to support the business), while Starbucks has opted to move to another payments process from October this year. The problems were various: transaction volumes at Starbucks basically stopped growing this year – implying  consumers simply didn’t care to use the product – while Square was unable to up-sell ancillary products either to Starbucks customers (eg, the failure and eventual shut-down of Square Wallet, a Paypal/Venmo/Google Wallet competitor) or to the company. Subsequently, various articles have suggested Square only won the business back in 2012 by severely under-cutting the then-processor (Bank of America) on price – not exactly a sustainable way to profitably win new business.

The financial implications as reported by Square are also troubling. In the IPO offering docs, Square takes the somewhat aggressive approach of removing all the Starbucks related business from their ‘Adjusted’ revenue and EBITDA metrics. This effectively treats the Starbucks experiment as a discontinued operation, which it is, given the service will stop from October this year. But the adjustment of Square’s financial reporting to remove Starbucks numbers also gives the impression that this experiment – despite being ~15% of Square’s total transaction revenues in 2014 and 1H 2015 – is immaterial to Square’s on-going operations and prospects, which I believe is severely misleading. After all, earlier in the S-1, Square proudly trotted out the below ‘GPV’ (Gross Purchasing Volume, a measure of the $ value of all transactions processed by Square) chart, suggesting a successful transition to larger merchants was an ongoing part of the Square growth story:

Capture

Looking at the financials, it is clear that Starbucks represents most all of the ‘>$500k annualized GPV’ exposure (and likely a good chunk of the ‘$125k-$500k’ range as well), since they accounted for 15% of transaction revenues and at lower-than-average take-rates (thus implying higher % exposure of GPV). As such, the spectacular failure of the Starbuck deal demonstrates both that go-forward Square will be, once again, most entirely a small-business focused payment processor; and that the company cannot make money serving enterprise clients. Both of these deductions suggest serious concerns over the ultimate scalability of the model.

At this point, you are probably wondering why Square hasn’t caught on with enterprise clients or larger consumer-facing businesses (despite the Starbucks debacle). After all – if it is such a hit with smaller businesses, surely the offering has something going for it? But recall that Square’s initial market-share gains were a function of a) unmet needs; b) winning share on price; and c) ease/efficiency of use. Of these three factors, you could argue only in the last instance does Square hold an advantage when it comes to larger enterprises (if you believe Square’s POS interface, and back-end offerings are more efficient than the comp), though even this is debatable. But as for points a) and b): clearly the corporate market is highly competitive (Micros, NCR, First Data, a number of banks, and even the likes of Paypal now are all here), and Square cannot waltz in and offer a solution to an unmet need because, frankly, the need is being met. As for b): the Starbucks disaster clearly demonstrated how competing purely on price for larger-scale business worked neither for Square nor the client. That is not to say it will never work, and Square won’t win any share – but certainly we should deduce that the chances of Square being able to replicate its initial and ongoing success with small businesses amongst larger enterprises – in the face of furious competition with more experienced, cashed-up players – is much, much lower.

Competition is coming to the small business market

The challenges Square appears to be facing vis-a-vis large enterprises are tough enough; but the coming threat to its bread-and-butter business of serving small businesses could be existential. As discussed, Square is winning in small businesses mostly because they were a first mover to an unmet need – but they are no longer the only player in town. Both Paypal and Verifone (amongst others) have already released competing dongles designed for mobile small businesses; others, like Google could soon follow. I will be the first to admit the Paypal and Verifone dongles don’t look very cool but both companies have significantly greater financial resources than Square,  and Paypal especially is on a growth mission to prove its relevance and defend its dominant share in another vertical (P2P payments) by expanding turf. Furthermore it has been an aggressive acquirer of ancillary services like Venmo and Xoom – both far superior offerings to Square’s nascent ‘Square Cash’ money-sending app (and we already mentioned the abject failure of Square Wallet). Suffice to say that the small-business payment processing space, though still likely to grow rapidly, may become much more price competitive going forward.

The other corollary of this trend would be the need for Square to spend much more in advertising dollars to defend or win share – a problem when the business is already having trouble scaling, and advertising dollars were actually cut in 2Q’15 to make incremental operating losses seem less bad (likely to try to juice numbers for the IPO). As Square says in its S-1:

Nearly half of our sellers find us and sign up, rather than us finding them. This is the result of building services that deliver value and that sellers eagerly recommend.

While of course it is great to have a killer product that customers eagerly recommend, sentences like the above read to me as code for increasing marketing spend as the company grows beyond its initial core of early adopters – especially in the face of new and fierce competition. This does not bode well for trying to scale operating margins.

The future of payments is…Apple Pay or die?

I specifically haven’t talked much about where the payments industry is heading, frankly because I am not an industry expert. But even a few very broad strokes suggest a problematic outlook for Square. We already know Square is facing Herculean challenges in entering the large-enterprise space against entrenched, capital-rich competitors. But even looking at changes coming to the point of sale (POS), it is difficult to see how Square can maintain a value proposition in the far future.

Take Apple Pay, for example. At the moment this is basically a function that allows you to swipe your iPhone in front of a NFC (near field communication) terminal at CVS and pay for your groceries (via a link to your debit/credit card, etc) without dipping your card. That is to say, at the moment, the payment architecture (whereby payment processor routes the transaction through the credit card network, receives approval/denial from the issuer, and routes it back) does not change – the consumer simply does not dip the card. This allows room for payment processors, like Square but including the behemoths like First Data, etc, the ability to take a fee for processing the transaction.

But if Apple Pay goes mainstream (as I and many think it will) and the technology improves slightly to allow for ‘phone-to-phone’ NFC payments (this was already speculated a year ago and in my view happens in the near-term), all of a sudden it becomes much more murky for payment processors. Of course, such a move immediately obviates the need for a physical dongle: this immediately puts Square’s main hardware offering (and key network building-block) atop the technology dustbin. As already discussed, since Square is an entirely small-business focused processor, this move alone likely hits them harder than any of its competitors as all of a sudden their core user-base will no longer need their Square dongle and hence a good chunk of their transaction revenue could dry up.

But taking this one step further, it is not a huge leap to think that Apple – already possessing many hundreds of millions of customer accounts and having built its own physical ‘network’ through the dispersion of hundreds of millions of iPhones-cum-payment terminals – will just become a payment processor itself. This puts the entire payment processing industry in Apple’s headlamps – not the place you generally want to be, given their resources and track record. (As an aside: the credit card companies, who provide value because they can price the credit risk of their customers, probably have more survivability in this scenario, but will still probably see price pressure from such a development).

Other issues – fraud costs a function of under-investment?

This is all pretty scary stuff, and we haven’t even gotten to the pricing of the shares! Actually, since the price hasn’t been set, I will skip an in-depth analysis of the ‘right’ valuation for Square and suffice by saying that a very high multiple of revenues (maybe 9-10x, assuming it comes at a premium to the $6bn valuation achieved in the last private financing round late last year) for a high-growth yet high-loss, high-cash burn, minimally-scaling business with demonstrated failure beyond its unprofitable core market and existential threats probably just a couple of years out, is fairly crazy. The only thing this IPO will do is make Paypal (PYPL) look exceedingly cheap at ~4x sales, low double digit EBITDA multiples for a much-better positioned company (already fully scaled and dominant in its core vertical) churning out 20% operating margins and 20% top line growth today.

What is actually more interesting is a couple of line items in the S-1 that may not be noticed by many but I think could be important: namely, “Transaction and advance losses“, as well as net capex spend in recent years. “Transaction and advance losses” is a line in operating expenses that the company describes as:

We are exposed to transaction losses due to chargebacks as a result of fraud or uncollectibility. Examples of transaction losses include chargebacks for unauthorized credit card use and inability to collect on disputes between buyers and sellers over the delivery of goods or services…For the year ended December 31, 2014, our transaction and advance losses accounted for approximately 0.1% of GPV.

These losses have been small in % GPV terms as the company chooses to emphasize – but when reflected as a % of either gross (ie, before paying fees to credit cards, banks) or net transaction revenues, these losses are concerning (4.6% of gross, and 15.7% of net transaction revenues, respectively, in 1H 2015).

Clearly 16% of your net transaction revenue – when gross margins (even excluding Starbucks) are only ~35% – is highly problematic. And thinking about it another way – on a gross basis, this scale of fraud-related loss – around 5% – is strange given this is roughly what American Express provisions for credit losses – but Square is of course not a credit provider, it is just processing the transactions. To have this level of fraud-related losses hit them is fairly inexplicable and I think speaks to under-investment in necessary fraud-prevention software, human support, fail-safe transaction oversight, etc – itself a function of how capital-poor the company has been for much of the last couple of years. There could also be a corollary to Square’s ease-of-use business model: the company promises transactions clear for merchants in 24 hours, which limits the window in which they can catch potentially fraudulent transactions and thus save themselves from these kinds of losses.

This brings me to Square’s capex, or rather lack of it. Square has spent a pitifully low amount on capex in recent years: just $29mm in 2014, and only $20mm in 1H 2015. This equates to 3-4% of revenues, while direct competitors like Paypal are spending 8-10% of revenues (on a much larger revenue base) and of course behemoths like Apple, Google, have limitless resources. It is just really tough to see how Square can even attempt to keep up with the Joneses at this level of capex intensity. Simply put – they won’t.

Why IPO now?

All this leads back to the most important question: why IPO now? There have been persistent sale rumors regarding Square in the last year or so – apparently they were going to be sold to Apple for $3bn last December, though Dorsey turned that down and instead Apple focused on Apple Pay, while Square did another funding round at $6bn implied. Retrospectively, that move is looking more and more to me like Dorsey won the battle but lost the war.

Frankly, the company as currently constituted – one good idea and great product, a number of product failures and unproven new ventures, highly cash consumptive, large market opportunity but increasing competition and existential threats around the corner, and very limited cash resources – would fit much better within the fold of a larger, cashed-up organization like an Apple or a Google than fighting on its own in the unforgiving public markets (my guess is this is what happens down the line, assuming they maintain relevance). Which of course begs the question, ‘Why IPO?’, and the pertinent answer is most likely ‘dumb money’ – that is to say, strategic acquirers had no interest in paying nosebleed valuations but the unknowing public presumably will (but not you, dear reader!).

It will be interesting to see how Square prices and trades: the IPO market has been quite tough, given recent volatility (First Data repriced their IPO and it traded poorly), and Square will be a ‘pie in the sky’ speculative offering. But even if it defies the gloomy backdrop and trades well, this is another hot tech IPO that, like so many others (Etsy, Groupon, etc) is more likely to end in tears. Caveat emptor.

Disclosure: no positions (but may go long PYPL short Square post-IPO)

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