1 Key Metric for Square Investors to Focus On

If you're anything like me, you've noticed more and more local businesses set up for you to pay using Square (NYSE: SQ). From barbershops to food trucks, Square's simple interface is becoming ubiquitous for mom-and-pop outlets. By and large, these small businesses are Square's core customer. But the company's customer mix is changing rapidly: It's trending toward larger sellers. Much of square's eye-popping valuation of eight times sales is resting on the company's ability to accelerate this shift. Investors who believe in Square's potential will need to follow the company's upmarket growth. Here's the metric you should pay the most attention to.

Why Square is obsessed with this metric

At its core, Square is a middleman that enables a seller's customers -- like you and me -- to seamlessly pay for goods and services. As such, Square's lifeblood is made up of transactions -- to the tune of 35 per second around the world. These transactions are referred to as Gross Payment Volume (in USD), or GPV for short. Square's leadership is obsessed with GPV, and for good reason. Square keeps a small percentage of every transaction, so a sliver of each gross payment translates to revenue, which translates to receivables and cash. Cash can then be reinvested in the business to acquire new customers, and so on and so forth. Being in the business of digitizing payments, this cycle happens quickly for square. Software makes it highly scalable, too, which is why revenue has grown by 46% on average over the last three years. Revenue growth is paramount, of course, but it all starts with GPV growth. That's why Square mentioned "GPV" 36 different times in its most recent 10-K annual filing with the SEC. And during the upcoming Feb. 27 earnings announcement, you'll want to pay attention to what CEO Jack Dorsey has to say about this metric. Savvy investors, however, will go one level deeper, dissecting the GPV further to understand how rapidly Square is swimming upmarket to capture bigger and bigger fish.

The secret to Square's future growth

Square's GPV grew from $6.5 billion payments in 2012 to $49.7 billion in 2016, representing a tremendous 664% increase. (Through the first three quarters of 2017, GPV was $47.4 billion.) More importantly, the mix of GPV has begun to tilt from heavily concentrated in small sellers (Square's core customer) to a much more balanced picture across small and large sellers. At a high level, Square categorizes its sellers (customers) in two buckets to distinguish between small and large:

  • Small sellers with less than $125K of annualized GPV.
  • Large sellers with more than $125K of annualized GPV. (In this large-sellers bucket, it also talks about "midmarket sellers" that generate more than $500,000 in annualized GPV.)

With that in mind, here's a chart that illustrates three key things that have been under way since 2012:1. Overall GPV growth from $6.5 billion to $49.7 billion. 2. Large seller GPV jumped from $1.2 billion to $20.9 billion.3. Large sellers as a percentage of GPV jumped from 19% to 42%.

What investors must understand about Square

Why does this matter? The balanced revenue mix is attractive because it diversifies away some of the risk from small businesses that could prove most vulnerable in an economic downturn. More importantly, however, it allows Square to swim upstream and pursue a bigger market opportunity.

For context, Square cites a U.S. Census report from 2012 that juxtaposes "micro" businesses in the U.S. against the two upmarket categories of "small & medium-sized businesses" and "mid market businesses":

A $451 billion market in "micro" businesses is nothing to sneeze at, but it pales in comparison to the $4.8 trillion market in larger sellers (noted as Square's "additional area of focus"). Likewise, the services that Square can offer to bigger businesses are often more profitable. Larger sellers are more likely to opt-in to premium product lines like subscription and service-based sales. For example, sales from subscription services translated to gross margins of 66%in 2016, which is nearly double the 35% gross margins from transaction-based revenue. This margin gap has been consistent since Square IPO'd in 2014. Large sellers hold the key to bigger margins and, ultimately, to making this company profitable. Without continued success in this area, Square's stock price acceleration of more than 190% in the last year is unjustified. For investors, the percentage of payment volume from large sellers will be the most important metric to watch in the company's upcoming earnings announcement.

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Isaac Pino, CPA has no position in any of the stocks mentioned. The Motley Fool owns shares of Square. The Motley Fool has a disclosure policy.