2 Reasons Square Stock Could Fall

By Markets Fool.com

Image source: Square.

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Shares of Square (NYSE: SQ)have been on a roller-coaster ride this year, falling more than 35% at one point before climbing above a 15% gain earlier this year. Today, shares sit about 10% below where they started this year despite strong second-quarter earnings results.

As a rapidly growing but unprofitable business, Square is bound to be a volatile investment. Investors should be prepared for the company's stock price to move swiftly based on news and its earnings reports.

Here are two things that could cause Square's stock to fall.

1. Square Capital growth slows

Investors already saw what can happen if Square Capital -- Square's small-business loan service -- hits a speed bump in its tremendous growth. During the first quarter, Square had trouble bringing on new investors for Square Capital loans, which limited its ability to extend offers to its merchants. As a result, Square Capital growth slowed to 4% on a sequential basis. Shares of Square fell 12% after that earnings report in part due to those weak results from Square Capital.

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Square Capital bounced back in the second quarter after the company secured new investors for its loans, growing 23% sequentially and 123% year over year. But there's tremendous pressure on the company to continue growing the segment. Not only does Square Capital produce a higher gross margin than Square's main transaction processing business, it helps support its core business as well. Merchants that get loans are generally able to grow revenue because they're investing that money in their businesses.

Square recently formed a partnership with Upserve, which provides business solutions for the restaurant industry similar to Square's dashboard with small businesses. Through the partnership, Square Capital will offer loans to Upserve's merchants. It's unclear if Square will be able to take advantage of the same advantages it benefits from with its own customers -- low marketing expenses, large sets of sales data, etc.

As Square increases its penetration of its existing merchants, it could see margins decline and default rates increase as it looks to keep up with analysts' expectations.

One other factor that could negatively impact the growth of Square Capital is increased scrutiny or heightened regulations on small-business loans.Lending Club (NYSE: LC) came under investigation from the Department of Justice for falsifying documents when selling packages of loans to individual investors. Square Capital operates a similar model but works with a few large investors instead of a bunch of individual investors. The fallout from Lending Club's actions could result in more scrutiny on the small-business loan industry, impacting Square Capital's margins or ability to attract investors.

2. Lack of large merchant growth

In Square's second-quarter letter to shareholders, management highlighted the growth of large merchants using its hardware. The share of payment volume coming from merchants generating over $500,000 in gross payment volume doubled to 14% over the last two years. Last quarter, payment volume from large merchants grew 61% year over year. By comparison, total payment volume increased 42%. (The company defines large merchants as companies generating over $125,000 in gross payment volume per year.)

One advantage of large merchants is that they generally have larger ticket sizes. In fact, an increase in average ticket size is ultimately more important than growth from large sellers, but Square doesn't report that metric. Square can lose money on smaller purchases because its flat 2.75% fee is inclusive of the $0.10 to $0.30 transaction fee normally incurred by businesses paying payment networks.

On a $5 purchase, for example, Square ends up losing money because it only charges $0.14 to the merchant. Wedbush analyst Gil Luria says Square reports a loss on 0.076% of transactions, which is much higher than competing services.

Larger merchants also represent a larger opportunity for Square to sell its ancillary products. A Square Capital loan to a large merchant is likely going to be larger than what Square can offer to a smaller one. Large merchants can also take advantage of services like Square's payroll management software, which doesn't make sense for smaller merchants with just a couple employees.

Square's services are high-margin profit drivers, which will be key to Square reaching analysts' expectations of $0.10 in non-GAAP earnings per share next year. Without continued strength in larger merchants, Square may not be able to reach those expectations.

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Adam Levy has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.