The Potential Dilemma in Square Moving "Upmarket"

By Markets Fool.com

Image Source: Square.com.

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Give even a cursory glance to Square's (NYSE: SQ) recent earnings call transcript and you can't fail to notice the phrase "upmarket." What Square meansby moving upmarket is expanding its service to customers with annual GPV (gross payment volume) between $125,000 and $500,000 and even above $500,000.While this will provide Square with a more stable and lucrative customer base, investors will want to watch how much Square has to spend to work its way into this segment of the market.

Why go upmarket?

This is a sensible move by Square as pushing upmarket will mean signing up more larger and traditionally more stable businesses. Though Square sees transaction income as being a hook to upsell customers to many of the company's numerous other offerings -- such as Payroll (which manages employees' remuneration for a monthly fee), Capital (which arranges loans), and Appointments (which offers online booking and scheduling services) -- transactions still make up the bulk of Square's revenue, 76% to be precise.

Of that 76% of income, in the most recent quarter, 58% came from businesses that bring in under $125,000 in annual GPV, meaning that although Square's customer portfolio has improved over the past couple of years, with more coming from larger businesses, the bulk of the company's revenue still comes from smaller businesses with less than $125,000 in GPV.

Image Source: Square's Q2 Filings

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Some of this maturing customer mix can be attributed to organic growth of Square's existing vendor pool. When those who use Square's products grow their business, it's good for that business and good for Square. Some growth can also be attributed to acquiring new customers with higher annual GPV. Though the customer mix is improving, growth has been slow. As the graph above demonstrates, last quarter the company grew the $125K-$500K segment by 2 percentage points (from 26% in Q2 2015, to 28% in Q2 2016) and the over $500,000 segment by 3 percentage points (from 11% in Q2 2015, to 14% in Q2 2016).

Square's target market has traditionally been small businesses. Jack Dorsey and Jim McKelvey founded Square as they noticed, firsthand, that this underserved group of merchants had no easy, inexpensive way to accept card payments. They then set out to serve this niche.

Square has proven very effective in this sector. At the time of the IPO, toward the end of 2015, it had over 2 million customers (Square hasn't released its number of customers since) and 50% of those customers came to Square without the need for marketing. In just one year, it has grown transaction revenue (the cut from customers' sales) by 40% from $259,864 in June 2015 to $364,864 in June 2016, demonstrating impressive growth.

The problem with this area of the market is that it is notoriously volatile. The often-used metric to quash any entrepreneur's dreams is that 80% of small business go bankrupt within five years. The rationale behind Square's move to court bigger businesses is that they are much more stable and can weather economic downturns far better than small companies and start-ups.

This can be seen in the average default rate on small business loans (SBL). Square Capital -- which facilitates loans by analyzing data from Square's customers and pairing them with external investors -- is particularly attractive to financiers because it boasts a 4% default rate. The average default rate in August of this year for business loans outside Square was around 8.7%. In 2009, in the wake of the Great Recession, this went up to 12%.

Does Square offer big business a compelling product?

It makes sense that Square start targeting big commerce, but can it scale up? Well, CEO Dorsey believes so. In the company's second-quarter earnings call, he commented on the "best-in-class hardware" Square has to offer -- the company's contactless (NFC) reader shaving transaction time to a tenth of a second. In the second-quarter shareholder letter, Dorsey and CFO Sarah Friar highlighted why Square is attractive to "upmarket" companies:

Our success with larger sellers is due to multiple factors. First, larger sellers join Square because of our products' differentiated ease of use. ... Second, we have focused on bringing payments together with additional services into one cohesive ecosystem. ...Third, larger sellers benefit from fast access to capital, whether it's next-day settlement of funds, Instant Deposit, or Square Capital loans

It's clear that the company identifies the cohesive suite of extra products it offers as scalable and a unique differentiator. Square Capital is where the real opportunity is. Larger loans to larger companies means better returns, and hopefully lower default rates, meaning potentially lower risk and higher reward for investors.

Square Capital is currently housed under "software and data product revenue" in the company's financial filings. As you can see from the chart below, the 7% contribution to total revenue in the second quarter is dwarfed by transaction revenue, however that segment is up 130%. It is worth bearing in mind that Square only began offering Square Capital in earnest in the first quarter of this year and in just a short amount of time it is making a dent in the revenue mix. Given more time, software and data revenue will continue to grow and act as a higher-margin boost than transaction revenue.

Revenue Breakdown

Q2 2016 Revenue ($) Q2 2016 Percentage Contribution Q2 2015 Revenue ($) Q2 2015 Percentage Contribution

Transaction Revenue

364,864

90%

259,864

94.1%

Software and Data Product Revenue

29,717

7.3%

12,928

4.6%

Hardware Revenue

11,085

2.7%

3,591

1.3%

Data Source: Square's 10-Q. Percentage contribution to total revenue excludes Starbucks transactions.

Prudent to be cautious

Square's move to serve medium and large businesses is sensible and should be applauded by investors. But there are a couple of caveats.

First, Square needs to be able to do this without shooting the golden goose. Transaction revenue is still the company's bread and butter. What people don't realize is that Square's margins on GPV is razor thin. It takes around 2.75% per swipe (more for manual and online service). MasterCard or Visa, which enable the digital transaction, take around 0.15% from that and the bank who releases the funds takes 2%. Bottom-line: Square gets 0.6% of every transaction. That's tiny!

CFO Sarah Friar commented in the earnings call that Square is not afraid of custom pricing. To play in the big leagues, you've got to offer an incentive. Cutting costs to attract customers is a time-testedmethod and certainly something Square will need to compete on to tempt companies away from legacy equipment and setups. But it doesn't have much to play with and needs to be careful it doesn't give away too much. Need I mention the Starbucks deal?

Secondly, bigger companies are used to being courted by sales and marketing teams. One of the criticisms of Square is that it can be a little faceless. This will not do for established enterprises. Consequently, the company is expanding its sales and marketing team, which is expensive and a continual expense for the company. Sales and marketing teams are absolutely necessary for the company to achieve its goals, but it should be mindful that it doesn't saddle the balance sheet with more expense than is necessary. Last year the company posted a loss of $1.24 billion, up 13% from 2014 and driven in part by expansion of the engineering team. The addition of extra personnel was necessary, but it serves to demonstrate the heavy impact new employees can have on company finances.

Great idea, now just don't mess it up

This decision makes complete sense for Square. It demonstrates the company's maturation and should lay the foundation for future growth -- and crucially, profit.

That being said, the road to hell is paved with good intentions. The company needs to ensure it does not give away too much in pricing or take on too much cost in its crusade to move upmarket. Both custom pricing and sales and marketing expansion are an obligatory by-product of the company's move upstream, but they shouldn't be taken lightly.

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