What to expect from Square's first earnings report

March 3, 2016 | by Thomas Yohannan
What to expect from Square's first earnings report

Moving beyond the question of staying private and going public, companies such as Square need to appreciate the responsibility of constant innovation and fiscal responsibility.

Recent stock market volatility has raised plenty of questions surrounding the technology sector's growth with companies such as LinkedIn losing massive value in a matter of hours. Square stock is not all that different in that it soared during its IPO, an act that helped give credibility to innovation, technology, and payments.

But its first earnings report as a public company on March 9 will tell us whether investors believe in the company in this turbulent market. In the face of varying headwinds from not understanding the market to criticisms of direction and leadership, Square is, at least for the moment, able to prove that innovation in payments is possible. The question is, however, for how long?

S-4

Square's S-4 showed the state of a company that may not have the ability to grow, let alone be profitable in the near future.

Square's losses totalled $154 million in 2014, along with a Starbucks partnership that was costly as well ($28 million in 2014). Square's transaction costs-to-revenue breakdown (also called an efficiency ratio) has consistently been more than 60 percent, which is roughly double PayPal's transaction efficiency ratio of 30 percent. It spent $1.2 billion on transaction costs in the first six months of 2015 to process $3.9 billion of payments. This all points to a mountain of fiscal challenges that the company will have to overcome in a world of myopic quarterly results.

The prospectus' premonition that Jack Dorsey's job at Twitter "may at times adversely affect his ability to devote time, attention, and effort to Square" seems to be spot on (even though he takes no money). Twitter's latest leadership turmoil has public markets wondering why a public company would allow Dorsey to venture into a leadership role of another public company. I'm not suggesting that management has failed or is lacking, but it's another challenge that few, if any, companies would be willing to face in today's market.

Finally, depending on the future of fraud, the progression of the stock may show just how bad credit card fraud has become. If you take a look at the “Risk Factors” in the S-4 statement, you can see that Square took a $5.7 million loss to fraud from a single customer! While this does come on the heels of the EMV transition, it helps to expose the security aspects of payments and the potential of fraud to affect public markets.

EMV

The impact of EMV fraud on the stock is that those who bought into Square will likely see their initial investment take a loss on the signal of fraud from EMV. Square's stock has been suffering, and may continue to do so as we move forward with the challenges that face the payments industry. The company's EMV devices just came into the market, but this cost is going to be absorbed by the “small float” offering. On the flip side, Square (and Visa) has a unique relationship with Apple in that the reader will be sold in retail stores. Thus, the success of the reader is buoyed by Apple and vice versa.

In many ways, the EMV shift is an opportunity, not a problem, for Square. For one, they've encouraged their customers to adopt EMV. More importantly, if a business chooses to use non-EMV devices, Square isn't responsible for fraudulent transactions as the merchant takes the risk.

Square has an opportunity to grow in the next year as merchants in the U.S. seek to upgrade their point-of-sale systems to EMV. With Square readers available in Apple's retail stores, this could create a certain synergy that will bring great business to both companies. I expect to see Square to continue to grow in the next year, and I certainly don't think the EMV shift is going to hurt their stock's value

SMB

As a business scales, marketing and accounting systems become more important and that is good news for Square. The company would be wise to use its IPO funds as a way to handle existing scaling challenges and move into other services such as marketing to help drive small businesses forward.

Square has three main lines: a payments or point-of-sale system — a digital cash register that operates on mobile devices, which includes transaction data and analysis; financial services such as payroll and Square Capital (which provides financing to small businesses); and Square Customer Engagement (a software suite that provides customer tracking, marketing, and feedback, among other services).

Square also recently purchase food-delivery app Caviar.

The most important thing an SMB needs to do is reach its customer. SMBs barely operate in the black, so “closing the loop” is an opportunity for Square. Whether Square is able to do so through its many products is still up for discussion. The average SMB deal is around $10,000, so Square should plan to use its ancillary offerings to diversify revenue and accelerate growth for those businesses. However, Square's growing topline numbers hide its weak competitive position and razor-thin margins because, at the end of the day, Square keeps only about 1 percent of all the payments it processes. And that's before operating expenses are accounted for such as well as the sale of its hardware at a loss.

Now that it has to go on the record for its public offering, the company has had to admit where its business really stands. As Square's IPO filing says, "We derive substantially all of our revenue from payments services. Our efforts to expand our product portfolio and market reach may not succeed and may reduce our revenue growth."

Some of this success hinges on whether the merchants sign up fast enough for Square to overcome its losses.

Wall Street

Unfortunately, Wall Street is a double-edged sword. If Square was able to close the loop on the marketing and purchase of goods in the SMB market, then it would have achieved an elusive goal while also possibly becoming profitable. This isn't an easy task.

Companies such as Square in a new market need a five-to-10-year plan to truly build their companies. Wall Street, however, is seeking immediate results. Although profits don't ever seem to match up to what analysts think they should, you still have to perform every quarter. Private ownership is great for any transitional period so that a company can make the changes that need to be made. Square no longer has this freedom from Wall Street.

Everyone loves a big IPO, as the markets go for darlings. The what-have-you-done-for-me-lately mentality will come to technology stocks as IPO paydays with short term gains are followed by quarter-by-quarter scrutiny to keep institutional clients happy. Take a look at Etsy as an example of darlings that fall out of favor. Unfortunately, this type of transactional state is not new to the international scene as the Germans and Japanese laugh at Wall Street for this myopic view of companies. Having a private company insulates peering eyes and enables a company to focus on the future.

With Square's IPO filings showing a net loss of $29.6 million in the second quarter, ballooning to nearly $54 million in the third quarter, the company has many questions to answer while solving perplexing payments and marketing questions under the scrutiny of impatient smart money investors. 


Topics: Contactless / NFC, EMV, Handsets / Devices, POS, Trends / Statistics



Thomas Yohannan
Thomas focuses on the convergence of payments, security & data. Thomas holds a JD from the University of Southern California and an MBA from New York University. www

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