Why This Analyst Is Wrong About Square

By Adam Levy Markets Fool.com

One of the many numbers Square (NYSE: SQ) likes to highlight in its quarterly letter to shareholders is its "payback period." That's the amount of time it takes for Square to recoup its marketing and sales spending for its average merchant. Square has consistently reported a payback period of four to five quarters.

Continue Reading Below

But Raymond James analyst Wayne Johnson points to a key factor that may be keeping that number so low. "Management estimates that roughly 50% of Square's users join the platform without being touched by direct marketing spend," he wrote in a note. The payback period for those merchants is effectively nothing. Therefore, the payback period for the merchants that actually responded to Square's sales and marketing efforts is closer to eight to ten quarters.

As a result, Square faces a big risk if people stop coming to it directly to sign up, according to Johnson.

Image source: Square.

What happens if Square's aggregate payback period rises?

During Square's fourth-quarter earnings call, CFO Sarah Friar told analysts, "As long as we continue to see a strong ROI, or that four- to five-quarter payback period, we will want to continue to press on investing there, particularly around some of the newer products." In other words, it's willing to give up profits today for the growth of its top line.

Continue Reading Below

But if Square starts to see its payback period elongate, it has an important decision to make. Does it continue to drive revenue growth through marketing spend at the expense of profits, or does it focus more on the bottom line? "The company may have to accelerate investment in additional sales and marketing efforts or, to maintain overall payback periods, pull back such investments, which could potentially slow merchant adoption and/or revenue growth," Johnson writes.

The flaw with Johnson's reasoning

Johnson assumes that Square's marketing efforts don't result in self-selecting customers. Sure, some of Square's advertising efforts -- direct mail, search advertising -- are very targeted and easily attributed to sign ups. But Square also engages in brand advertising, as Friar pointed out on the company's fourth-quarter earnings call. It sponsors events, works with retailers on promotions, and is even exploring television commercials. That brand advertising is much more difficult to measure the impact of, but it's still accounted for in Square's payback period.

Additionally, every new customer Square brings on through its direct marketing acts as a brand ambassador for Square, in a sense. "Sellers tell sellers about Square and that is how they come onto the platform, that remains a really strong flywheel for us," Friar said. Moreover, consumers start seeing Square hardware everywhere, so when they or someone they know needs a simple point-of-sale solution, the first thing they think of is Square. That influences them to self-select Square.

So, while 50% of merchants may come to Square instead of the other way around, that doesn't mean Square's payback period is misrepresenting the true customer acquisition costs. Johnson even specifically notes that those 50% weren't touched by "direct marketing," not Square marketing in general.

Real reasons why the payback period could increase

That's not to say Square doesn't face a risk of longer payback periods in the future. There are a couple big reasons why that could happen.

First, Square may start to saturate the markets in which it operates. That's a long way off, even in the United States. Square's also expanding to new geographic markets, giving it a ton of space to attract new merchants to its platform. If, however, the company does start facing market saturation down the road, it will naturally have an impact on its ability to attract new customers.

The second, and much more pressing factor, is competition. Square continues to face meaningful competition from companies like PayPal (NASDAQ: PYPL), which launched PayPal Here in 2012. Since PayPal has much deeper pockets than Square, it's been able to push the product and the advantages of working with its more established payments platform.

PayPal has also been able to expand to other markets more quickly than Square. Square just launched in the U.K., but PayPal Here has been there since 2013. Square will also face more regional competition as it looks to expand internationally. All of that competition could push Square's customer acquisition costs higher, negatively impacting its payback period.

While investors shouldn't expect a slowdown in Square's payback period, if it does slow down in the future, it'll be important to listen to management's reasons why. It'll also be important to understand how management expects to deal with the situation -- will it continue to push for revenue growth, or will it start to cut back and let more revenue fall to the bottom line?

10 stocks we like better than Square
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and Square wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of February 6, 2017

Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends PayPal Holdings. The Motley Fool has a disclosure policy.