Better Buy: Square Inc. vs. PayPal Holdings Inc.

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Now that the dust has settled on PayPal Holdings Inc.'sspinoff from parent eBay in July, and Square Inc.'sinitial public offering in November, it's appropriate to peek in on how these organizations are faring. More pointedly, the time is ripe to take a position on which company is the better buy for your portfolio.

As for stock price performance, both tech innovators are cumulatively in the red since their respective 2015 debuts. PayPal has lost nearly 7% since its July 20 spinoff, and Square is down over 27% since its Nov. 19 IPO pricing.

Let's begin by reviewing key financial and performance metrics for each company, using the first quarter of 2016 as a basis for comparison:

Source: PayPal and Square Q1 2016 SEC filings.
*Gross transaction volume measures the total dollar amount of transactions processed by each company. Revenue is earned as a percentage fee on each processed transaction. PayPal refers to gross transaction volume as "total payment volume"; Square refers to it as "gross payment volume."

The preceding table indicates how PayPal and Square are at different junctures of similar journeys.In the first quarter of this year, PayPal processed roughly eight times the transaction volume of Square. Although PayPal is expanding revenue at an extremely fast rate, growing 19% year over year, Square, as the smaller and younger company, is exhibiting blistering expansion -- growing more than 51% in Q1 2016.

These metrics are supported by the underlying company narratives. PayPal, which was founded in 1998 and acquired by eBay in 2002, re-entered the stock market last year as a mature technology company. The organization has diversified its revenue stream from its long-standing iteration as a checkout button on web pages to evolve into a broad-based payments platform that generates revenue on both the merchant and customer sides of transaction processing. Other examples of diversification include entry into the international remittances market through its Xoom subsidiary, and development of the extremely popular social-payments app Venmo.

Square was founded in 2009, "to enable anyone with a mobile device to accept card payments, anywhere, anytime." While the Square card reader has functioned as the primary engine of the company's growth, Square is also beginning to widen its revenue base. This is illustrated by its purchase of restaurant delivery service Caviar and the launch of a successful program to extend loans to merchants, labeled Square Capital. Still, the company derives about 90% of total revenue from credit card transaction processing.

Margins are an important differentiator

In the technology industry, being a mature corporation isn't exactly a hip attribute, but age is often accompanied by profits, which PayPal delivers to its shareholders in abundance. The company's 16.3% operating margin is in stark contrast to Square's 25%-plus operating loss in the first quarter of the year.

To keep an apples-to-apples comparison, however, investors may want to back out a $50 million accrual Square made during the quarter in anticipation of settling an intellectual-property dispute. Removing this one-time item reduces the operating loss margin to 12.4%, which is an improvement over the prior year quarter, when Square booked an operating loss margin of 18.5%.

In the third quarter of this year, Square's revenue from initial booster Starbucks Corporation will terminate, leading to some top-line deceleration. But Square is growing so quickly that the impact won't be anywhere near fatal. In Q1 2016, Starbucks transactions accounted for only 9% of total Square revenue. Now that's a large customer, to be sure, but consider that in the same period last year, Starbucks transaction costs exceeded revenue. Moreover, even after renegotiating pricing, Square managed only $2 million in gross profit on its $39 million in Starbucks revenue this quarter. Thus, the actual earnings impact may be flat to slightly positive when the Starbucks relationship expires.

Square hopes to fill the Starbucks gap via revenue from what it calls "larger sellers" -- that is, sellers with more than $125,000 in annualized gross transaction volume. This group of sellers is notable for growing faster than the overall business. In Q1 2016, gross transaction volume from larger sellers increased more than 70% over the comparable 2015 quarter.

Cash flow and valuation

As I've written previously

"In line with our strategy to drive growth, we focus on the generation of free cash flow. ... We consider free cash flow to be a key performance measure that provides useful information to management and investors about the amount of operating cash flow generated by the business after the purchases of property and equipment, which can then be used to, among other things, invest in our business, make strategic acquisitions, and return cash to shareholders."

As the table earlier in this article reveals, PayPal is a free cash flow monster, converting almost $0.25 of every revenue dollar to free cash flow. Square? Currently, it doesn't have the margins in its business to provide positive operating cash flow, let alone free cash flow. This resulted in a negative cash flow of more than $0.06 per dollar of revenue in Q1 2016.

If Square doesn't generate profits, or positive cash flow, how can we compare the company's valuation to that of PayPal's? One way is to understand what the market pays for each company as a multiple of sales. On a trailing-12-month basis, Square trades at 2.27 times sales, versus 4.73 for PayPal.

This type of differential may appeal to some Square advocates, for it suggests a bit of undervaluation relative to PayPal, which may increase if the company begins to book profits.

In the final analysis, while Square is extending its reach, it's still highly concentrated in the credit card processing business, and this makes it more vulnerable to competitive threats.PayPal has created a stable business that continues to scale up swiftly, despite threats from a raft of competitors in the banking and tech industries, and it's producing solid financial returns for its shareholders.

Do keep an eye on Square in 2016, and into 2017, for improving profitablity and diversification trends. But while both companies represent intriguing opportunities in the payments space, at present, PayPal represents the better buy.

The article Better Buy: Square Inc. vs. PayPal Holdings Inc.

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