Square's CFO Isn't Focused on EBITDA Margin

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Square (NYSE: SQ) CFO Sarah Friar told investors last year that she expects the company to produce mid-single-digit EBITDA margin expansion over the next few years, eventually achieving EBITDA margin between 35% and 40%. And the guidance Friar provided investors at the beginning of the year suggested margin expansion on that level.

But as Square outperformed that forecast on the top line through the first half of the year, Friar didn't provide any guidance for improved EBITDA results. The most recent outlook calls for adjusted EBITDA margin around 16% -- 3 percentage points lower than the guidance given at the start of the year.

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But Friar is more focused on showing a certain level of profitability -- whether that comes from higher margins or higher revenue doesn't matter at this point. In fact, the latter may be preferable for investors.

Showing the potential of Square

Square showed great profit growth last year as it outperformed expectations on the top line. The company is clearly capable of producing significant EBITDA margin expansion based on the results from the first half of last year.

But Friar actually expressed disappointment in those results. "I don't think 700 basis points of margin expansion, when you're growing at the rate that we're doing on the top line, really makes sense," she said at an investors conference earlier this year.

Growing the top line is ultimately more valuable for Square long term, but that requires investing excess profits in new products and services. At some point, finding new areas of investment becomes more difficult, but until it reaches that point, Square should take advantage of opportunity it can find in the market. It's exactly what investors want to see in a growth company -- sacrificing margins today for higher long-term profit potential.

To that end, however, Friar is still showing absolute growth in EBITDA. Her full-year guidance for EBITDA has remained the same -- $240 million to $250 million -- over the last six months. It's simply outperformance on the top line driving the decline in forecast margin.

Square's showing it can invest in new products and growth without sacrificing profits. That indicates that its core products are producing higher margins to offset the losses it's taking in the early stages of new products and expansion.

So what is Square investing in?

Square outlined three priorities for 2018 at the start of the year: omnichannel, financial services, and international.

Square is investing in omnichannel through things like its acquisition of Weebly, the expansion of Caviar with the acquisition of Zesty, and the rollout of a software development kit for its core payment processing service. These investments should lead to greater expansion of Square's usage across the web.

Weebly offers merchants the chance to start their online presence with a direct relationship with Square, even if they're not yet selling anything online. The software development kit opens the opportunity for new online integrations. And the expansion of Caviar and integration with Zesty and Square for Restaurants provides more opportunities to sell services to restaurants.

The core of Square's financial services business has been Square Capital, which provides Square merchants with cash advances and collects interest and principal payments with each card swipe. Square has taken steps to partner with other companies with unique data to expand the reach of Square Capital. It's also investing heavily in financial services through its Cash App and its linked debit card Cash Card. The investments are paying off, with Square calling out interchange fees from Cash Card as a key revenue driver in the second quarter.

Internationally, Square continues to improve its presence in the U.K. through brand advertising, and after striking deals with major payments networks in Canada and Japan, it's starting to gain more traction. Square's main focus in international markets is improving brand awareness and increasing its net promoter score, a measure of customer satisfaction, which will eventually allow it to grow primarily via word of mouth. That's currently its main source of new customers in the U.S. market.

Square has a lot of opportunities to continue investing. It still has a lot of room to expand its omnichannel offering to restaurants, services, and storefronts. It's also just getting started with the Cash Card and consumer financial services. On top of that, it's only in a handful of international markets. Square could also expand into more areas, with advertising showing a lot of potential for the company. As long as Square is showing strong absolute EBITDA growth, investors should be happy to see a long list of investments on Square's plate.

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Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Square. The Motley Fool has the following options: short January 2019 $80 calls on Square. The Motley Fool has a disclosure policy.