The Most Impressive Number From Square's Second Quarter

Shareholders in Square Inc (NYSE: SQ) have been taken for quite the ride this year. Since the calendar turned, shares are up an amazing 89% and over the past year, the stock price has increased an even more incredible 130%. When the company recently reported its second quarter earnings, shares mildly dipped but there was plenty to like for investors with a long time horizon.

Square reported adjusted revenue of $240 million, a 41% increase year over year, and adjusted EBITDA of $36 million, an increase of $24 million from last year's second quarter. Gross payment volume (GPV), the total amount of all purchases processed by Square, rose to $16.4 billion, a 32% increase year over year. Square's lucrative subscription and services-based revenue, driven primarily by Instant Deposit, Square Capital, and Caviar, increased an amazing 99% year over year to $59 million. All in all, there really wasn't much from Square's quarter to disappoint long term investors.

The one number, however, that stood out above all the others was Square's take rate. Square's take rate is its transaction-based revenue expressed as a percentage of its GPV. This quarter, Square's transaction-based revenue rose to $482 million, a 32% increase year over year. As a percentage of GPV it was 2.94%, giving us the take rate. This is up slightly year over year from 2.93%. Its transaction-based profit, after the credit card networks and banks were given their cuts and fees, was 1.04%, flat from the previous year.

Why that's so impressive

Over time, Square has found itself with larger clients for its payment processing services. In 2015's second quarter, the percentage of Square's GPV coming from large businesses (as defined by those with GPV greater than $500,000) was 11%. In this year's second quarter, that number had jumped to 19%. Over the same time period, the payment volume coming from small businesses (those with GPV of less than $125,000) had dropped from 63% to 54%.

There are plenty of positive reasons for Square to pursue these businesses. After all, larger businesses will supply Square with greater payment volume from steadier streams of revenue. They also might provide a more fertile ground for some of Square's add-on services like data analytics, payroll, and other software-powered sale solutions. However, larger businesses also have the ability to negotiate lower transaction fees with payment processing companies.

Square is not immune to this pricing pressure. For instance, when potential customers click on Square's home page, they will immediately see the option to choose the size of their business. For those with sales under $250,000 per year, they are immediately shown the standard 2.75% per processed transaction fee. Customers with larger businesses, however, are asked to call for customized pricing options.

With these inherent headwinds, one would expect Square's take rate to show signs of pressure but, thus far, it has resisted.

How Square keeps its take rate so high

The primary driver of Square's take rate and its margins against pricing pressure seems to be the extra services Square is able to upsell its clients. In the company's second quarter conference call transcript, provided by S&P Capital IQ, CFO Sarah Friar answered a question on this very subject:

Investors are hip to be Square

Square's clients obviously see real value in the added services that Square offers; otherwise they wouldn't be willing to give a higher percentage of their sales to their payment processing service. This makes it evident that Square is becoming much more than a payment processing company whose primary service is largely commoditized.

These services are creating a business ecosystem for Square that is proving to be quite sticky. The products and services that Square can sell its clients at a premium not only drive growth and stabilize margins, they also make it extremely difficult for Square's customers to leave for another payment processor. While Square still sells for quite the premium price-to-earnings multiple, if it can continue to drive growth while keeping its take rate buoyant, investors might still have quite the ways to go over the coming quarters and years.

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Matthew Cochrane owns shares of Square. The Motley Fool owns shares of Square. The Motley Fool has a disclosure policy.