How Square Quietly Inches Closer to Profitability, Continuously Surpassing Expectations

Square was started in 2009 to enable businesses to accept card payments, an important capability that was previously inaccessible to many businesses. Since then, Square has continued to expand its product offerings to match the needs of its customers and now operates a cohesive commerce ecosystem that combines sophisticated software with affordable hardware to enable sellers to turn mobile and computing devices into powerful payments and point-of-sale solutions.

A little over a month has passed since Square, Inc. released their most recent 10-Q, and investors were pleasantly surprised to see that the company surpassed market earnings estimates yet again. While Square failed to generate Net Income in the first quarter of 2017, its losses were much narrower than expected as the company continues to experience significant revenue growth that is outpacing the growth rate of its expenses. For the first quarter, Square reported a loss per share of $0.04, beating the Zack’s Consensus Estimate of $0.17. This encouraging earnings release fared well for Square’s stock price as it has increased by 18% since the announcement. This better-than-expected financial performance for the quarter can be attributed to several factors.

Growing business segments

Square made a name for itself by offering an ingenuitive tool that allowed small business owners to facilitate debit and credit card transactions using their smartphones and collect valuable transaction data previously unavailable to them. In addition to continuing to grow this transaction-based line of business, Square has kept innovating new products and services aimed at bringing big business capabilities to those who would otherwise lack the means to attain them.

At the end of Q1 2017, the management provided an update on its food delivery service Caviar, which now includes a pickup option with Q1 orders more than doubling year over year; Square management sees Caviar as being an important part of reaching the full-service restaurant industry and providing new solutions to business owners.

As will be discussed later, revenue growth from subscription and services was a big factor in Square beating market earnings expectations. A large part of this was attributable to Square Capital, which grew 64% year over year and facilitated over 40,000 business loans totaling $251 million.

A second contributor to subscription and services was Instant Deposits. The feature allows merchants and P2P users to receive deposits up to $2,500 paying a 1% fee to Square. The company has already seen a growing demand for instant deposits and predicts it will continue to have a positive impact on the margins of its subscriptions and services segment.

Each of these new product and service offerings is helping Square reach new and untapped market segments as it continues to build market share and push to become the premier name in small business financial and data solutions.

Expanding revenue

Total net revenue for Q1 2017 increased by $82.3 million or 22% compared to Q1 2016. This increase in total net revenue for the quarter was primarily driven by an increase in transaction-based revenue from Q1 2017 by $103.0 million – or 34% – compared to Q1 2016. This increase in transaction-based revenue was attributable to growth in Gross Payment Volume (GPV) processed in Q1 2017 of 33% compared to Q1 2016, some of which came from growth in processed sales volumes from Square’s existing sellers, and the rest of which comes from new businesses using Square’s services.

One notable aspect of revenue missing from the newest quarterly earnings is transaction-based earnings from Starbucks. During the fourth quarter of 2016, Starbucks completed its previously announced transition to another payment solution provider, resulting in a $38.8 million decrease in revenue. Accordingly, no future transaction-based revenues are to be expected from Starbucks.

Subscription and services-based revenue for Q1 2017 increased by $25.3 million or 106% compared to the Q1 2016. As previously mentioned, this increase was primarily driven by continued growth and expansion of Square Capital, Caviar, and Instant Deposit, which were the largest contributors to subscription and services-based revenue. Subscription and services-based revenue contributed 11% of total net revenue in Q1 2017, compared to 6% in Q1 2016, signaling an increased prominence of such revenue as the aforementioned business segments continue to gain traction.

Hardware revenue for Q1 2017 decreased by $7.2 million – or 44% – compared to Q1 2016. This is due to a sharp increase in Square’s shipments of its contactless chip readers driven by the fulfillment of many of its backlogged preorders of the technology from its launch in Q4 2015. However, this also resulted in a decrease in hardware expenses over the same time frame of $14.1 million or 53%.

Well-managed costs of revenue

Square’s total cost of revenue for Q1 2017 increased by $19.1 million – or 7% – compared to Q1 2016.

The transaction-based costs of revenue increased by $63.5 million – or 33% – in Q1 2017 compared to Q1 2016. This percentage growth almost exactly matches the 34% growth in year-over-year transaction-based revenue previously discussed which indicates a steady and healthy gross profit margin for this business segment going forward.

The only other major change in expenses occurred because of the discontinuation of transaction-based services with Starbucks. This decreased Square’s cost of revenue for Q1 2017 by $36.6 million as compared to Q1 2016.

Reduction of other operating expenses

Total operating expenses for Q1 2017 decreased by $19.9 million compared to Q1 2016, however this decrease is misleading; in Q1 2016, Square incurred a non-recurring $50 million legal expense associated with a court case against Robert E. Morley. Removing this legal expense from the book resulted in most of Square’s decrease in operating expenses. This factor must be considered when analyzing this quarter’s results because this expense is not going to occur again and is not reflective of the company’s operations.

The company also increased its sales and marketing expenses by $11.4 Million or 30% as it continues to focus on developing market share, specifically its Square Cash peer-to-peer transfer service.

Adjusted EBITDA analysis

As a more telling measure of its ongoing financial performance, Square also reports its Adjusted EBITDA as a non-GAAP compliant financial measure that can be used as a supplement to its financial statements. Adjusted EBITDA does not include any Starbucks transaction-based revenues or expenses, share-based compensation expense, or litigation settlement expenses to better capture the financial results from the firm's ongoing operations. In Q1 2016, Square recorded an Adjusted EBITDA loss of $9 million, but in Q1 2017 it recorded a gain of $27 million. This metric makes it more clear that, after taking away all non-operational and non-recurring revenues and expenses, Square is moving in the right direction towards profitability.

Profitability analysis

For Q1 2017, Square reported a net loss of $15.09 million, which may seem bad in a vacuum but is rather favorable when compared to Square’s Q1 2016 net loss of $96.75 million. It is clear to see that Square is quietly inching closer to overall profitability as it expands its product offerings, strengthens its margins, and continues to gain market share.

Square’s gross margin for Q1 2017 was 37.6%, up from 29% in Q1 2016. When analyzed along with the observed increases in revenue, it’s clear that Square is becoming better at managing the costs associated with generating its revenue. As it continues to capture market share and generate more transaction-based revenue, Square’s healthy gross margin puts the company in good shape to operate at a profit.

In Q1 2016, Square had a Return on Equity (ROE) of -25.51% – meaning that for every dollar of equity financing used, the company generated a net loss of $0.25. In Q1 2017, the company reported an ROE of -2.40%, showing an improvement in the metric. This is an important measure for a company like Square because it is financed almost entirely with equity (as opposed to debt), so its ability to generate profits – or narrower losses – from equity financing tells a lot about its success. Additionally, Square has continued to increase its equity financing over time (~$52 million in new equity financing from year-end 2016 to the end of Q1 2017), so an improvement in its ROE signals that Square is improving its profitability as it expands its operations.

Summary of findings

Upon first glance of Square’s earnings reports, an investor might have trouble understanding why yet another reported loss from the company was met with such market optimism. However, after comparing the results to previous periods and market expectations, the rationale of investors should become much clearer. Square is making big moves towards profitability and has been successful in its continued expansion efforts into being a one-stop provider for small business financial needs. Only future earnings reports will tell us for sure how Square will be able to grow from here, but things are definitely looking good for the company going forward.