Why Did Visa Take Such a Big Stake in Square?

By Markets Fool.com

Visa is such a force in the world of finance that it can apparently lift a peer stock by mere association. That's what happened last month when the company disclosed that it holds -- on paper, anyway -- a potential stake of around 10% in payments processor Square .

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IMAGE SOURCE: SQUARE

Square's stock, which had been in a slump since the company's IPO last November, got a nice jolt from the news.

Since then the chronically unprofitable company's stock has stayed on the up, somehow (there hasn't been much fundamental news of note lately). It's risen to nearly the closing price on IPO day. The apparent hope when the ascent began was that Visa was grabbing an anchor stake, perhaps as a springboard to an acquisition.

But owners of either stock shouldn't get too excited/worried about a potential tie-up, in my opinion. Here's why.

Plan B
Visa owns just under 4.2 million shares of Square's class B common stock, which are convertible to class A shares (i.e., the stock that's publicly traded). But it's not like the credit card giant picked up this stake recently -- it was purchased back in 2011.

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By the terms of an agreement inked between the two companies when the investment was made, a maximum of 3.5 million shares and change may be converted to Class As.

True, this would give Visa in the neighborhood of a 10% stake in Square... but only if its other class B shareholders don't exercise their right to convert. That's a very big "if," as there are another 300 million or so class B shares, and their investors would surely be eager to morph those into A shares if Visa were to do so.

The credit card giant has been fairly quiet about why it invested in Square, perhaps that's why some investors' hopes have been lifted on this latest news.

However, nothing it has said implies that it is eager to own the company, or even become a major shareholder. "We believe that Square helps to drive acceptance of payment cards in a segment that has been historically underserved," a Visa spokesman said at the time of the purchase.

In other words, Square's solutions boost the payment volume flowing to Visa.

As the operator of a so-called "open-loop" system -- i.e., it acts only as a processor of transactions, not as the entity actually extending the credit, asAmerican Expressor Discover Financial Servicesdo -- the name of the game for Visa is volume.

Why? Because in contrast to American Express and Discover, Visa doesn't have the revenue streams of card fees and interest on credit provided. As basically a payments middleman, it depends on the amount of purchases made by card holders.

So I fervently believe that Visa took that Square stake in order to enhance the reputation of the then-early stage company, and give it a better chance to succeed. This, in turn, provided another channel from which the company could draw revenue without getting directly involved in managing or otherwise participating in another processing business.

It was an opportunistic and low-risk move for Visa, and it apparently worked. But investors shouldn't consider it to be much more than that. They certainly shouldn't think it means Visa wants to get more deeply involved in Square.

The landscape may change if Square reports eye-popping numbers when it posts its Q4 and fiscal 2015 on Wednesday. The consensus analyst estimate is for yet another loss (of $0.13 per share), so a deep change in the fundamentals -- say, a sudden lurch into the black -- is unlikely.

The article Why Did Visa Take Such a Big Stake in Square? originally appeared on Fool.com.

Eric Volkman has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Visa, and recommends American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.