2 Big Fixes Pushing Square to Profitability

By Markets Fool.com


SOURCE: SQUARE.

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Jack Dorsey manned his second earnings call of the season earlier this month, detailing the results of payments company Square . Results came in above expectations, posting $374 million in net revenue and a $6 million loss in EBITDA. More importantly, the company's outlook for 2016 is strong, and it expects to post positive EBITDA for the year.

There are two major factors that will enable Square to show a profit. First, the company renegotiated its agreement with Starbucks , which has put pressure on gross margin since its inception. Second, the company is expanding its high-margin software and data products.

Let's take a look at each one.

Roasted by Starbucks
Square's deal with Starbucks legitimized the start-up as a payment processor for businesses of all sizes. But the terms of the contract cost Square a lot of money. In 2014, Square lost $28 million in gross profit from transactions at the coffee chain. Last year, it cut its loss to $23 million despite higher transaction revenue at Starbucks.

The company was able to stem its losses after renegotiating its contract with Starbucks last August. The new contract went into effect in October. The results were clear; in the fourth quarter, Square nearly broke even on Starbucks transactions.

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Those costs weren't for naught. As mentioned, the Starbucks deal instantly provided scale for Square and built greater awareness of its product with other businesses. Additionally, Starbucks invested in Square's Series D preferred stock before the company went public, and Starbucks CEO Howard Schultz spent a year on Square's board of directors, lending considerable business knowledge.

While Square has fixed its deal with Starbucks, now charging the chain higher transaction fees, management still expects it to switch to a different payments processor when their contract expires in the third quarter of this year. That would have a negative impact on net revenue, but considering the deal is an earnings loser for Square it would have a net positive on EBITDA.

Expanding its other products
Square's software and data products consist of pretty much anything that isn't payments processing or the hardware it sells to support payments. The two biggest contributors are Square Capital (its financial services division) and Caviar (a restaurant delivery service). The division also includes Instant Deposit and Square Invoices, which were added last year.

The important part about Square's software and data products is that they have significantly higher gross margins than its payment processing business. In 2014, the division generated 75% gross margin. That fell to 61% last year as it expanded into its new new businesses like Square Deposit, which allows merchants to receive funds in their bank account within 24 hours.

Square Capital, Caviar, and Square Invoices are all scalable with very little incremental costs. That means gross margin expansion as more merchants and restaurants come on board. Comparatively, Square's payment processing gross margin is pretty much fixed around 36% no matter how much it scales.

The good news for investors is that software and data products as a percentage of total revenue is rapidly increasing. In 2014, the division accounted for just 1.4% of revenue. Last year, that number grew to 4.6%, and it reached 6% in the fourth quarter. Going forward management expects "good growth" in its software and data products line.

With the continued growth of its high-margin business coupled with the renegotiation and eventual phase out of the Starbucks deal, Square expects to generate EBITDA of $6 million to $12 million in 2016. While the company is still making losses by other measures, the results from last quarter show that it's well on its way to reaching its goals.

The article 2 Big Fixes Pushing Square to Profitability originally appeared on Fool.com.

Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Starbucks. 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.