Square stock had a strong run up in 2020 with year to date
returns of 247.84%, and currently it is trading at a price to
sales ratio of 14, and price to earnings ratio of 310. Such nose bleed
valuations implies that high growth expectations has been baked into the stock
and investors are betting on the company to deliver stellar growth.

When I added Square

When the news of the discovery of Covid 19 vaccine broke,
there has been a slow rotation of ‘work from home’ stocks to ‘back to office’
stocks and I took the opportunity nibble some Square shares with the hope to
increase my position as it drops further. Unfortunately, the dip was short
lived, and currently Square is just $18.7 away from its all time high of $241.58. After doing
some research, I decided to add a few more shares near its high as I believe
there is still plenty of growth remaining.

History of Square

Square’s root can be traced back to 2009 when James Mckelvey
who run a studio business faced a dilemma on whether to accept credit cards.
Accepting credit cards would mean profit margin gets eaten up by the credit
card fees, whereas not accepting it would mean losing its customers who only
has credit cards at the point of purchase. He then got in touch with his
friend, Jack Dorsey to build a device to accept credit card payments in the
form square shape reader which can be plugged into a headphone jack. After it
was invented, the duo approached Cheri Mims, owner of Lilybelle Flowers who
just lost a sale from a customer who could only pay by credit card. Back then, banks
were reluctant to work with small shop owners to setup credit card terminal due to insufficient credit
worthiness. She was initially sceptical
at first but decided to give it a try and the rest is now history. 

Square then began shipping many readers to small business
owners for free and their business grew from all the transaction fees it
collected. In Oct 2015, Square filed an IPO to be listed in the stock exchange.

As Square became widely adopted, they launched Square stand,
which replaces the need for a cash register and a range of accounting software.
It is sleek, stylish and easy to set up which also attracted mid to larger size
companies to use its services.

While on its way to build a payment ecosystem, Square
launched Square capital, where they partner with financial institutions to
financing to small business seller which solved many of the pain points
merchants faced. Back then the business startups could not get access to
capital from traditional banks due to lack of customer basic and lack of
management. They have to turn to their family members for funding. In Square
Capital, they access the loan size without using traditional credit scores, but
artificial intelligence based on real time revenue and the number of swipes on
square terminal. In turn, the merchants pay back their loans by the average
daily card swipes.

Cash App

To go beyond serving business needs, Square launched its
digital wallet called Cash App, which is a peer to peer payment service to
compete with fintech companies like Paypal’s Venmo, GPay and Apple Pay. The app
enables consumers to make payment via their mobile devices and transfer funds
to their friends and family, via email.

In Singapore’s
context it is very similar to Grab Pay app, DBS’s PayLah and Singtel’s
Dash.  If seller and consumer can
transact via Cash App, Square earns money from both parties: by charging 2.75%
per transaction to business and a fee when consumers use credit card on Cash
App.

Square’s four sources of Revenue Stream

Square classifies its revenue into four categories: (1)
Transaction Based Revenue (2) Subscription and services based revenue (3)
Hardware Revenue and (4) Bitcoin Revenue. Effective from June 2020, Square
further split its sales to 2 components: Seller app and buyer App to
reflect two big ecosystem which it serves.

(1) Transaction Based Revenue

This is where most of the Square’s revenue comes from and
it’s the bread and butter of Square’s business. Square basically collects a fee when there is a transaction:

Sellers App

i. Sidecar payments using Square’s terminal. The standard
processing fee is (2.6%+$0.10)

ii. Apps such as virtual terminal/Square Register/invoices 

iii. Square for Retail/ Square Appointment (2.5% to 2.6% +10
cents) processing fee below 10 staff calendars as well as other 3^rd party
apps (charges vary)

Cash App

Square collects a fee when topping up Square’s debit card using credit card and cash for business. The
latter is essentially a business version of cash app, where users can set up a
business account using their cash app to collect payments and Square earns a
fee from the transactions.

https://www.fundera.com/blog/square-cash-for-business

(2) Subscription and Services (SaaS
model where square collects a subscription fee for using its software)

Seller App

i. Apps such as Square for Retail &
Appointments/ Square Team Management
Team management allows the employer to track the team members working hours
using timecards

ii. Flexible loans repayment and instalment

iii. Square instant transfer and square card

iv. Website hosting services- Weebly which they
acquired in 2018

Cash App

i. Cashcard Interchanges and boost Rewards- a
discount programme attached to cash card and gives discounts to various
retailers. It’s quite similar to shop back Go but this programme is only
available to Square’s Cashcard. Find out more here: https://www.youtube.com/watch?v=JWrA1PSbXYo

(3) Hardware Revenue

Sellers App

i. This segment’s profit is still in the red as
their focus is to attract more new and bigger sellers to use Square Terminal
and Register. Hence, they have been lowering their price to increase the
adoption rate of their hardware which translate to more transaction and
subscription revenue.

(4) Bitcoin Revenue

Buyers App

Growth Drivers

1.Moving Up-Market

One of the ways to grow its business is by having more new
sellers adopting its services which then translates to more transaction and
Saas Revenues. And the chart below shows that is not only able to increase its
clientele but also improves the gross profit per seller. Management has
commented that it is due to the newer customers acquired continued to be in the
upper segment, i.e. mid market and above.

Gross Profit per seller went up 2.3X in 2 years!

I have touched on earlier on how Square had their humble
start in serving micro merchants and it continues to be their bread and butter.
They are currently expanding to serve the mid-market.

While there are more micro markets seller than the remaining sellers combined, the
combined SMB and Mid-Market adds up to $5.5 trillion, which is 12.3X of the
current market they are currently serving.

One of the key drivers that allows Square to capture larger
merchants is through its Open API which essentially means allowing more
technically sophisticated customers to write their own point of sales system
using Square Reader SDK to meet their exact needs and specifications.

For instance, Shake Shack has partnered with Fuzz to build a
self-service kiosk where customers can order and make payment own their own
using Square Reader SDK to build a customer, in-person checkout experience.
Similarly, Joe and Juice adopted Square Reader SDK and integrated with Square
stand to build a customized checkout flow for customers buying coffee.
Currently they used these terminals in 44 stores in US.

Shake Shack partnered with Fuzz to use the Square Reader SDK to power a self-service kiosk. (Photo: Business Wire)

2. Investing and cryptocurrency Trading

On the buyers side of the app, management has commented that
Cash App’s indicator of success is determined by its volume of direct deposits.
Users who uses direct deposit to cash app tends to carry higher balances and
uses more of their platform which is part of their monetization strategy.

While commissions earned from Cryptocurrency and investing
isn’t significant, it allows users to invest their surplus funds in their
CashApp without the money leaving the platform. As Square has demonstrated
history of innovation and will continue to innovate with rolling out new
solutions, it creates multiple monetization opportunities with the funds that
users kept in the Cash App.

In case if you are wondering how much it could potentially
grow, Cash App currently only penetrated less than 2% of the $60b opportunity. That excludes the opportunity to expend to overseas market and new products to penetrate into new markets.

3. Further monetizing Cash App

This is perhaps the most significant growth driver for
Square moving forward and will probably overtake the buyers app in terms of
revenue and profit.

https://www.businessofapps.com/data/cash-app-statistics/

Although Cash App started in 2013, its growth showed no
signs of stopping. During the Pandemic year in 2020, its Monthly Active Users
surged to 30mil users, representing 62% YoY growth since 2017. Coupled with its
P2P functionality, this further creates a network effect which attracts more
new users and keep them engaged in the platform.

Once these users introduced into this ecosystem, they can be
exposed to its features that helped to drive its revenue, such as its Cash Card
facilities which Squares takes a cut from buyer and seller Ecosystem. With its proven
ability to innovate and the improved product adoption, it can continue to a
powerful growth driver considering that it has a huge TAM and the largely
untapped global market.

Hence investors should pay attention to Cash Apps Annual
Revenue per MAU, which is $30 in 2019 up from $15 in 2017.

Valuation

I will be doing Square valuation using discounted Cashflow
method by projecting its unlevered Free Cash Flow and discounting it to present
at a rate of 7%.

Firstly, I will breakdown Revenue generated from two
segments: Cash App and Sellers App to derive their respective gross profit and
then combine the gross profits to calculate and project Unlevered Free Cash
Flow.

I will be excluding Bitcoin Revenue for two reasons. First
it is unmeaningful with Gross Profit Margin (GP Margin) of 1-2% and it’s derived from the total sale of
bitcoin to customers. Management too believed in deducting bitcoin Revenue to
better reflect actual company performance. Secondly including Bitcoin Revenue
will affect the overall computation of GP Margin. Its GP Margins Nine months
ended 2019 and 2020 is 75.99% and 80.79% and hence will be using margin of
80% in this calculation.

Step 1. Projecting Cash App’s Gross Profit for 10 Years

Step 2. Projecting Seller’s App Gross Profit for 10 Years

I will be using 45% from 2021 to 2025 and 35% from 2026 onwards for Opex as a % of Revenue to project Unlevered Free Cash Flow.

Depreciation has been growing steadily but decreasing as a % of Revenue. To be on the conservative side, I will assume Depreciation to be 2% of Revenue throughout.