Square's Marketing Expense Is Exploding

One thing that stood out on Square's (NYSE: SQ) second quarter earnings report from earlier this month is the surge in sales and marketing spend. The line item grew to nearly $60 million last quarter, up about 50% year over year and 20% sequentially.

The growth spurt in marketing spend could be a sign that Square is facing intense competition. The increase outpaced revenue growth, which climbed 26% (41% on an adjusted basis). That's despite Square boasting of its marketing advantage over competitors since it's in direct contact with its merchants nearly every day.

Here's what Square's management had to say about the growth in marketing expense in the second quarter.

What sparked the surge in marketing

Square CFO Sarah Friar says the reason for the explosion in marketing spend is that it's ready to scale some of the newer products it's released over the last year. "We do a lot of iteration in a market when we release something new," she told analysts on the second quarter earnings call. "And then once we feel like we've hit the point where it's scalable, we will then put some real oomph behind it."

But revenue growth from its subscription and services business -- the segment that includes those new products -- didn't change from the first quarter to the second quarter.

What's more likely driving the growth in marketing spend is Square's expansion to the U.K. and Australia. Unlike in the United States, Square wasn't exactly early to the market in either country, and as such has to spend more on marketing to catch up with the competition.

The payback period is still the same

The most important metric Square pays attention to when it comes to its marketing spend is its payback period. That's the average amount of time it takes for Square to recoup its marketing spend for each new merchant it brings on board. At its investor day earlier this year it said it's seeing a consistent payback period of 3 to 4 quarters when you account for its growing portfolio of services. Most of that still comes from payments.

Friar says that payback period remained the same for the products it decided to put more "oomph" behind. Of course, there's no guarantee that will stay the same as it scales, and it's hard to gauge payback period on marketing spend after just a few months or weeks. Investors will have to wait a couple quarters to see if Square's marketing spend is paying off.

Square doesn't have much of a choice

Square faces intense competitive pressure from companies like PayPal (NASDAQ: PYPL) and Shopify (NYSE: SHOP). Both are moving into Square's core market of in-store credit card processing, and Square is likewise moving into online payments. Each competitor also offers small business loans akin to Square Capital -- arguably Square's most successful secondary product.

While Square holds an advantage in marketing its other services to its current merchants, it doesn't hold any competitive advantage to attract those merchants in the first place. Likewise, its competitors hold the same advantage in marketing secondary services to their current merchants, and it's worth noting PayPal has quite a head start on Square.

PayPal also has a head start on Square with in-store payments in Europe. As do several other European-centric payments solution providers. As such, it has to spend heavily in order to attract merchants in its new markets, and that could eventually cause its payback period to decline.

To offset that trend, Square may be able to rely on its growing portfolio of new services to improve retention rates and increase lifetime customer value. It's doing a good job of that in the United States, but it's too early to tell how it's doing in the U.K. and Australia.

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