Introduction: Square's main businesses
Square Inc. (SQ, Financial) is a fintech company mainly composed of a seller and a digital wallet business, among other minor ones (the company is also in the bitcoin trading arena, but even if revenues are significant, margins are still quite low). The company recently announced it will rename itself as "Block."
The seller business is traditionally linked to the name Square, as this is the name of its iconic square-shaped card reader. The idea of a new credit card reader emerged from a discussion founders Jack Dorsey and Tim McKelvey had on payment processing, and specifically when the latter couldn't sell one of his glass faucets as he was not able to accept credit cards.
Since then, Square has built a powerful network of consumers and merchants, and was even able to fend off the attacks of Amazon (AMZN, Financial), thanks to its full-stack merchant solutions, which make everything from transactions to taxes to invoices for small and medium-sized businesses really simple, and consequently successful.
The seller ecosystem as it is, does not, in my opinion, necessarily associated with network effects as it is heavily skewed toward sellers, who enjoy reduced take rates from card processors and simplicity of use, while consumers, apart from the attractiveness of a nicely designed dongle, are not necessarily attracted to Square's ecosystem compared to another payment methodology; after all, they can continue to use their credit cards or other payment methods. As we'll see later, Square figured out how to solve this issue to create a real network effect.
The Cash App business was originally started as a digital peer-to-peer payments solution. Teenagers first began to use the app to share restaurant payments, which lead to a rapid adoption, especially thanks to the app's "social" approach. This created, over time, a real network effect as every time someone wanted to send you money through Cash App, downloading the app and starting to use it felt very natural. The app now has more than 70 million annual transacting active customers (practically doubling from the end of 2020). Over time, Cash App added, among others, the spending and investing features in order to attract more users. This is important as (mostly young) underbanked people can use the app in place of a legacy bank account.
The next logical step was integrating the app with with the seller ecosystem, which allows consumers visiting their favorite shops to pay with their Cash App account. This is creating stronger network effects since it provides both sellers and consumers with very good reasons to use the merged ecosystem.
What is not so evident but meaningful is that sellers will pay about 3% to 4% of the transaction just to let Square move the money from the consumer Cash App account to the seller account. This means that money, from Square's perspective, is not going anywhere: still, they will actually earn a fee on it. Can you imagine the return on investment of such a business once (and if) it is widely adopted?
The Afterpay deal
On Aug. 1, Square announced it will acquire Australian fintech company Afterpay (AFTPY, Financial) in an all-stock deal. Afterpay shareholders will receive 0.375 shares of Square for each share they hold.
Afterpay is part of the buy now pay later (BNPL) system. BNPL companies allow consumers to pay their bill in several installments at zero interest. Not only does this system give consumers the possibility to postpone (or better, dilute) the payment, but it also has additional advantages compared to a credit card processor like Visa (V, Financial) or Mastercard (MA, Financial).
Apart from the zero interest advantage, the plan duration is typically greater than one month (so longer than a credit card payment cycle), and the consumer does not need his credit score to be checked in order for the payment to be approved.
Moreover, BNPL users don't pay compound interest if they miss payments, only late fees, which are usually capped at a fixed amount, so the user already knows ahead of time the maximum loss he can incur.
This business model can look dangerous for the seller because of the credit risk, but remember that it works with small sums and consumers having to pay back a small sum are more likely, on average, to repay their loans. Moreover, Afterpay prevents consumers with a pending (or missing) payment from accessing other deals, so the issue tends to correct by itself. The model allows Afterpay to basically reuse the same capital and consumers to use their Afterpay option multiple times a year.
Specifically, Afterpay is based on a payment plan which lasts six weeks (a 25% initial payment and three 25% installments every two weeks). Available consumer credit is set to around $2,000 and late fees are fixed at $5 to $10 and capped at 25% of the purchase price.
Afterpay is already a leader in Australia, the U.K. and the U.S. One of its competitive advantages is the fact it is a consumer brand aggregator since a big chunk of its transactions start directly on their website or mobile app and not only on the seller's website as with any other BNPL company.
Competition in the BNPL arena is fierce, with both Paypal (PYPL, Financial) and the European leader Klarna already offering similar options and pure-play company Affirm (AFRM, Financial) targeting new users with its strategy of signing deals with big retailers.
Square-Afterpay integration
Let's now look at the advantages both Square and Afterpay will gain once they merge.
The first obvious advantage is the integration of Afterpay into the seller ecosystem. Customers will have an additional payment option, both in-person and online, leading to a stronger ecosystem and to more sellers willing to join in order to have the chance to offer BNPL, which is in high demand.
The second is the integration of Afterpay with Cash App. In this case, current Afterpay consumers will be able to pay their installments using an additional option (that is, using their Cash App balance), while current Cash App users will be able to use the BNPL option and handle it directly from their account (no credit card needed, smaller charges).
What Square is actually doing, thanks to the recent integration of the seller ecosystem with Cash App, is placing Afterpay right in the middle, in the hope that paying with Cash App (either online or in-person) and using BNPL will become something natural for customers. They have, in my opinion, a very good chance of success.
Conclusions
The Square Seller and Cash App businesses' integration created powerful network effects by connecting sellers and consumers in a way that makes paying easier.
The next step was trying (at least partially) to get rid of traditional card processors by offering something special to the consumer. A buy now pay later feature is exactly what consumers are looking for. Afterpay's integration into Square's businesses produce clear advantages both for sellers and consumers, helping to add more motivated users and, consequently, reinforcing the network effects.
The company appears to be richly valued (even after the recent selloff), mainly because research and development as well as investments in sales and marketing are still high (and growing), but once network compounding effects reach scale, customer acquisition costs will decrease and Square's investors will reap the benefits of top-class profitability.
