How Much Lower Can Square Inc. Shares Go?

By Markets Fool.com

Shares of Square have declined nearly 30% since the beginning of the year, and currently hover just above its IPO price of $9. The online payments processor has been battered by lackluster sales growth, non-existent profitability, and a lockup expiration in mid-May. CEO Jack Dorsey's ability to simultaneously lead Square and Twitter has also been repeatedly questioned. Should investors consider Square a contrarian buy, or could it fall far below its IPO price like Twitter?

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Square Register. Image source: Square.

What's wrong with Square?

Square is basically David to PayPal's Goliath in the payments processing market. Square has a presence in just four markets -- the United States, Canada, Japan, and Australia. PayPal is accepted in over 200 markets. Square's total payment volume (TPV) rose45% annually to $10.3 billion last quarter, while PayPal's TPV grew 31% to $81 billion (in constant currency terms) last quarter.

Much of Square's past growth was fueled by a partnership with Starbucks , which granted the coffee giant an undisclosed discount on payment fees. Square won't renew that partnership when it expires later this year, because it actually lost $56 million on that lopsided deal over the past three years. Square's total revenue rose 51% to $379.3 million last quarter, but its adjusted revenue (which excludes Starbucks) rose 64% to $146 million.

Square's core business runs on paper thin margins. It charges 2.75% per card swipe or paid invoice, 2.9% plus $0.30 for online store transactions, and 3.5% plus $0.15 per manually entered transaction. But after subtracting other expenses, Square only retains about 1% of each payment. That's why Square broke up with Starbucks, and why it's never posted a GAAP-adjusted profit.

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Getting lost in the shuffle

Back when Square was founded in 2009, its card-swiping dongle for smartphones and low-cost point-of-sale stations for tablets seemingly streamlined payments for small businesses. About 84% of its revenue comes from transaction fees, and the rest comes from lending, cash advances, and digital services like receipts and accounting.

But over the past few years, PayPal duplicated many of its POS features, and the mobile payments market has become crowded with big new players like Apple and Facebook . Apple Pay pivoted the whole market toward NFC payments, whichprompted Square to launch an NFC Reader. Square partnered with Snapchat to add social-based peer-to-peer payments in 2014, but PayPal's Venmo and Facebook Messenger now sport similar features.

Apple Pay. Image source: Apple.

Being the underdog in this crowded market could be rough on Square, which doesn't have much room to raise sales and marketing expenses. PayPal can use economies of scale to lower its expenses, while Facebook, Apple, and other tech giants could intentionally take losses on their mobile payments efforts to expand their ecosystems.

But don't overlook the catalysts

Square might look like it's stuck between a rock and hard place, but investors shouldn't overlook the catalysts that could cause the stock to rebound. If Jack Dorsey resigns from Twitter to become Square's full time leader, the stock would likely rally.

Plenty of companies could also benefit from buying Square, which has an enterprise value of just $2.7 billion. Back in 2014, Apple and Alphabet's Google were reportedly interested inbuying the company. The launch of Apple Pay makes that acquisition now seem unlikely, but Google could still make a bid to fix its fragmented mobile payments ecosystem on Android. Microsoft , which lacks a meaningful presence in mobile payments, could also buy Square to enter the market without a dominant mobile OS.

Lastly, Square stock isn't terribly expensive. It trades at just 2.2 times trailing sales, which is much lower than PayPal's P/S ratio of 4.5. That should limit its downside potential and cause the stock to rise on any positive headlines.

So is it safe to buy Square?

I personally wouldn't buy Square as a long-term investment, since it's stuck in a highly competitive market which is increasingly dominated by big ecosystem players. Its lack of profits, its 4% decline after its lockup expiration in May, and its lack of open market insider purchases over the past year raise additional red flags. Therefore, I'd avoid Square until it can improve its profitability and widen its moat against formidable giants like PayPal, Apple, and Facebook.

The article How Much Lower Can Square Inc. Shares Go? originally appeared on Fool.com.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, Facebook, PayPal Holdings, Starbucks, and Twitter. The Motley Fool owns shares of Microsoft and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. 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.