Square Inc. (SQ, Financial) has been a favorite of growth investors within the financial technology space over the last couple of years. The electronic payment solutions provider for small businesses has seen its share price multiply more than seven times since being listed at the end of 2015.
The management team has also been actively diversifying its services to include data analytics, loans and inventory management solutions. In addition, its subscription-based model has been growing at a rapid rate, driving investor optimism. The recent fall in the stock price, however, has started raising some questions in regard to the company’s future.
The unreal growth story
The price chart clearly illustrates the stock’s crazy growth story as it has grown by more than 400% despite the recent correction. The growth frenzy suddenly reversed a couple of months ago, when the U.S. indexes began to fall. The decline was expected to stop if the company released good results for the third quarter. Square delivered 51% top-line growth in the third quarter as compared to 48% in the second quarter. Despite these numbers, Square’s shares fell about 10% the day after results were released. The big question being asked by potential investors is if this is a good entry point for the stock.
Too much diversification away from the core business?
Square witnessed a drop in gross payment volume, which is a major negative given that the company’s revenue is largely dependent on the transaction fees it charges to businesses. The management team is in the process of shifting toward a subscription and services-based revenue model, which is driving the optimism as it more than doubled in the recent quarter.
The recent acquisitions of Zesty and Weebly have significantly contributed to the company's revenue growth numbers. Organic growth is good, but the fact management is moving away from its core payment business toward other areas such as loans, catering and website building is not a very good sign. Prima facie, this diversification has limited synergies and is not seen as a positive sign for the company. The recent exit of Chief Financial Officer Sarah Friar is another red flag. It will be interesting to see how management handles the new business lines and whether it is able to maintain revenue and earnings growth.
The fundamentals are not as strong
When analyzing Square's key ratios on GuruFocus, we realized that the fundamentals are not so strong after all. The company has had a posted continued losses over the years and while the net loss as a percentage of revenue has declined, the operating margin continues to be -1.56% with a return on equity of -2.86%. This margin improvement is a result of rapid revenue growth. The company's three-year revenue growth rate has been as high as 25% with an earnings before, interest, taxes, depreciation and amortization growth rate of 54.1%.
None of these facts, however, are sufficient enough to justify a forward price-earnings ratio of 99.01, which is phenomenally high despite the recent fall. Shares of Square are trading at 25.66 times book value and the enterprise value-to-revenue ratio has been as high as 9.54. These unjustifiably high multiples appear to be why the revenue growth in the third quarter could not stop the stock from crashing.Ă‚
Conclusion
Square is a classic example of a high-beta stock that has minted money for those growth investors who entered around the IPO and held tight. However, the company is not in the same situation today as it was two years ago. The management is diversifying across businesses with limited synergies and moving away from the core payment business that was driving it forward. The resignation of the CFO also increases the level of uncertainty.
It is possible that the company’s subscription business will continue growing at a double-digit or even triple-digit rate. This would not necessarily be sufficient for the stock to keep going up given Square is already trading at almost 10 times revenue and almost 100 times forward earnings. Given the current level of uncertainty surrounding the stock, it would not be prudent to enter at current levels. Potential investors should keep an eye on the management’s announcements and upcoming initiatives and have more clarity before entering the stock for the long term.
Disclosure: No positions.Ă‚
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