Two Key Growth Drivers Square Investors Are Overlooking

By Matthew Cochrane Markets Fool.com

Image source: Square Inc.

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Square Inc (NYSE: SQ) investors certainly had a lot to celebrate when the company recently reported its 2016 fourth-quarter and full-year results. Total net revenue came in at $452 million, a 21% increase year over year. Adjusted net revenue, a much more meaningful metric for the company, came in at $192 million, a whopping 43% increase year over year. Gross payment volume also increased dramatically to $13.7 billion, a 34% gain from the previous year's fourth quarter. This performance powered Square's stock price higher, and the company's shares are now up more than 20% year to date, reaching new all-time highs in the process.

SQ data by YCharts.

Square's subscription and services based revenue segment (formerly called software and data product revenue),which houses the lucrative services Square upsells to its clients, also continues to show explosive growth. Powered by products like Instant Deposit, Square Capital, and Caviar, this segment saw an 81% increase in revenue year over year in 2016's fourth quarter. For the full year, revenue growth in this segment was an even more explosive 123%. Better yet, these services now represent approximately 25% of Square's adjusted revenue.

An increasingly stickier ecosystem

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Not only are Square's services and products it upsells to clients lucrative, but each sale to a merchant makes it harder and harder for that merchant to ever break away from Square's growing ecosystem. In other words, every time Square makes a loan to a small business through Square Capital or sells a restaurant on the need for its delivery service, Caviar, the likelihood of that merchant leaving Square for another payment processor decreases. The same goes for its Instant Deposit, payroll, and invoices services.

CEO Jack Dorsey recognizes Square's growing ecosystem as a key component of the company's strategy moving forward. In his opening comments on the quarter's conference call, he stated:

Today, sellers come to Square for much more than managed payments and hardware. They come for financing, payroll, customer management and even delivery. We've chosen to build these tools as part of one cohesive ecosystem as opposed to a series of singular disconnected services. Whether sellers are in food, retail, or services or have one location or 50, they can pick from a menu of services and get up and running fast with Square. Everything works together seamlessly to help our sellers make smart decisions for their businesses.

Continued innovation

Another encouraging sign for Square shareholders is that the company does not seem to be resting on its laurels. Seemingly every quarter, it announces another innovative feature retailers can incorporate into Square's core platform. In the past, these innovations have ranged from faster EMV processing times to small business loans through Square Capital. This quarter, the company released Square for Retail, its first industry-specific point-of-sale (POS) platform.

As with Square Point of Sale (previously named Square Register), Square for Retail is an app that sellers can download and start using within minutes. Merchants who download and use the app are then charged a monthly subscription fee per device.

Image source: Square Inc

Why would merchants pay more for a payment processing solution like this? According to Square's shareholder letter, the platform "is optimized for retailers, with a search-based user interface and fast bar code scanning, while advanced inventory management supports tens of thousands of items and manages cost of goods sold, purchase orders, and other capabilities that a retail business needs." In the conference call, Dorsey added more color, saying the platform solution will give sellers the ability to "build customer profiles and provide purchasing history" right from the POS terminal.

Undoubtedly, if Square continues to innovate it will gain more customers, retain existing customers, and upsell lucrative products. That seems like a winning combination for investors!

Weighing the risk and reward

Of course, investing in this type of innovation and growth is rarely cheap on Wall Street, and Square is no exception. Management is guiding for adjusted earnings per share of $0.15 to $0.19 for full-year 2017. The high end of that guidance would give Square an adjusted price-to-earnings ratio of about 90 at the end of next year if it shows no increase in stock price from where it is currently trading. That's high!

As with all high-growth, high-valuation types of companies, volatility will almost always be the price of admission.Yet Square has showed a continued ability to innovate in this space, and its growth rates are proof that its offerings are attractive to a host of businesses. If Square sustains its growth rates while it moves quicker than expected into profitability, investors might look back at these prices wistfully in just a couple of years.

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Matthew Cochrane has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.