November 25, 2016 - 2:57pm EST by
2016 2017
Price: 12.75 EPS 0 0
Shares Out. (in M): 166 P/E 0 0
Market Cap (in $M): 4,500 P/FCF 0 0
Net Debt (in $M): -513 EBIT 0 0
TEV (in $M): 3,987 TEV/EBIT 0 0

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  • Payment services


Square (SQ) has carved a great niche for itself as a micro merchants’ payment processor, because of its
cheap cost of acquisition, low fraud rate, differentiated technology, customer service and vertically
integrated offering. We think it can continue to grow revenue at a 20% CAGR for the next 10 years
expanding EBITDA margins mid to high single digits per year normalizing at 40%+ in 2026 resulting in
the stock being close to a double in the next 3 years. We believe that the Company hit an inflection point
over the last couple of quarters that essentially disproves the short thesis. It has a largely open-ended
growth opportunity and has started showing solid operating leverage. While competition has increased, it
has sustainable competitive advantages that are not appreciated. Because it was first to market serving
micro merchants, it has a technical lead and superior brand recognition, which effectively means that it
can pay less to Google and other marketing channels for the same amount of new business. The company
has only started making money and looks expensive on near term earnings, but a largely fixed cost
structure means that it is likely to expand margins rapidly. It trades a large discount to comps on revenue
Historically, these small customers were not highly profitable for acquirers, but SQ has been able to
successfully acquire these customers with payback period of just 12-15 months, because of its low
customer acquisition cost and fraud rate. Over 12% of the float is sold short and only about half of the sell
side analysts that cover the stock rate it as a buy. The short thesis on SQ has been mainly centered on
SQ’s inability to grow after a certain point because of its limited TAM, failure to expand with bigger
merchants, and higher competition resulting in disappointing operating leverage. So far this year SQ has
proved shorts wrong by growing sales from larger merchants and expanding margins. As merchants grow
they continue to stay with SQ as they appreciate the company’s technology, customer service,
comprehensive / vertically integrated offering, loyalty program and ease of use to drive productivity and
growth in their business. We acknowledge that SQ will encounter dilution from stock compensation, and
factor that in our valuation. Below we debunk the short thesis in detail.
SQ talks about its TAM of 30mm small businesses out of which only 10mm accepts cards. We agree with
bears that not all of these 20mm businesses will eventually move to cards as some will use ACH and
other alternatives, but with international expansion (TAM expands to 125mm if you include worldwide
small businesses), market share gains and potentially winning medium size merchants, SQ should still be
able to get to around 8mm customers in the next 10 years vs. 2.5mm customers it serves today. The
mobile card swipe was a big hit, but SQ gained traction by carving a niche among micro merchants which
were being ignored by traditional merchant acquirers. The big acquires were unable to cost effectively
move into the micro merchant channel as high cost of acquisition and fraud rate didn’t justify the return.
However, SQ shortened the onboarding process from 3-5 days to 5 minutes through its technology, drove
sales through its brand and self-serve model, and drove its cost of onboarding to $14 vs. $90 to $238 per
merchant for a traditional acquirer. SQ invested in data analysis and understood its merchant’s risk well
enough to drive payback period to just 12-15 months on just payments revenue without any ancillary
sales. SQ’s unique all-in-one system allows sellers to begin accepting EMV chip-enabled cards in a
matter of minutes. Integrated hardware, software, and payment processing put SQ in a unique position to
make the checkout process faster. In September, SQ rolled out an update to its contactless and chip reader
that improved average EMV transaction speed by 25% to 4.2 seconds from 5.7 seconds, compared to
reported industry averages of 8 to 13 seconds. It has one of the best engineering teams in the payments
industry led by an ex-Apple executive. 70% of cards processed on Square are now EMV enabled, where 
Verifone and other companies are still struggling with their readers. SQ’s flat transparent prices are not
far from its competitors when one includes all the hidden fees they charge.
Square will continue to move upmarket. GPV from larger sellers (merchant with >$125k in annualized
GPV), grew 55% year over year last quarter, representing 43% of the GPV in the third quarter of 2016 vs
37% a year before. SQ continues to grow GPV from the larger sellers and maintains overall transaction
revenue margin for several reasons. First, as demonstrated by positive dollar-based retention across its
entire seller base, many sellers grow when they join Square. Second, larger sellers switch to Square for
the benefits of its entire ecosystem, including fully featured point of sale software and capabilities such as
APIs (Build with Square), mobility of hardware, and customer service. In fact, SQ believes that leading
with its unique capabilities and brandnot priceis what drives larger sellers to select Square. For
example, some merchants are turned off with their processors when point of sale system doesn’t
communicate well with other business systems. This lack of integration creates “two sets of everything”
and requires enormous amounts of time to reconcile. SQ also offers great customer engagement tools to
attract more customers and offers loans for working capital. Since larger sellers tend to have more
complex needs, SQ made changes to its website onboarding process to allow sellers to self-identify their
sales volume, industry, and other characteristics. Based on these inputs, it can determine when it is
appropriate to allow a seller to self-onboard, or when to dedicate a sales representative to provide more
details on the breadth and flexibility of its solutions. It also fulfills needs of sellers who want flexibility in
their business solutions. For example, enabling integrations with third-party apps keeps sellers on SQ’s
system, even as they become larger sellers. In March of this year, SQ launched Build with Square, a
developer platform (APIs) that provides sellers with the ability to build and operate a fully customized
point of sale while processing payments with Square. This flexibility is especially important to larger
sellers, who tend to have more sophisticated needs. Approximately half of its E-commerce API and
Register API GPV currently comes from its larger sellers. This will allow SQ to have industry specific
specialized software tools and integrated payments to gain market share from even bigger acquirers down
the road.
SQ has grown EBITDA margins for the last 3 quarters at a healthy pace. It has 9% EBITDA margins
now. Prior to the last two quarters, many believed that it would never be profitable. As SQ gains scale, we
think it will expand margins mid to high single digits normalizing at 40% in the next 10 years. We think
that is a conservative assumption as we shrink the take rate considerably and assume low single digit
margin expansion in the tail years. SQ’s take rate and transaction margins have remained stable for the
last 3 quarters even though the mix of large merchants has increased and many competitors have
emerged. Again, we attribute SQ gaining market share to differentiated technology, ease of use and its
vertically integrated payments systems which drives productivity and growth for the client. The rest of the
peers offerings are fairly commoditized competing on price, whereas SQ customers are even willing to
pay slightly higher price in order to get a superior product.
We also think Q4 guide is very conservative. Management has raised 2016 adj. EBITDA guidance for the
last three consecutive quarters, more than doubling expectations since 4Q15. 4Q16 midpoint of the
guidance assumes only 3% sequential revenue growth even though it is the seasonally strongest quarter.
For example, in 4Q15 Square adjusted revenue grew 14% sequentially. Even though the Street is
modeling slightly higher revenue than the guidance, we think SQ will report even higher revenue than the
Street in Q4.
We also think that SQ doesn’t have much of an acquisition premium built in its share price. In 2013,
Vantiv paid $1.65 billion for Mercury (best in class high growth ISO (Independent Sales Organization))
for 7x net Revenue. Square trades at 4.5x 2017 revenue. We think a big acquirer could acquire SQ just
for the technology and brand recognition.

We expect a risk adjusted 3 years IRR on the investment of +20%. The risk/ reward is very attractive with
an only -20% downside vs 90% upside in the next 3 years. We arrive at this valuation by discounting
back 2026 normalized EPS to 2020. In the base case, we assume 8mm customers, 20% revenue CAGR
and 40% EBITDA margins with a share count of 484mm by 2026. In the bull case, we assume 9.5mm
customers, 26% revenue CAGR and 45% EBITDA margins with a share count of 488mm by 2026. In the
bear case, we assume just 5mm customers, 14% revenue CAGR and 25% EBITDA margins with a share
count of 400mm by 2026. The resulting EPS and valuation is listed in the table below for the scenarios
mentioned above:
Key Risks:
1. Pricing pressure/ growth slowdown
    a. Higher competition resulting in a lower take rate and adds
    b. Square unable to pass higher cost of transactions hurting its margins
2. Inability to expand margins
     a. Slowdown in growth failed to monetize the benefit of operating leverage from the fixed
         cost. New products failed to materialize
     b. Higher fraud rate: Square unable to collect the chargebacks or refunds from the seller’s
           i. Since October 2015, businesses that cannot process EMV chip cards are held
              financially responsible for certain fraudulent transactions conducted using chip-
             enabled cards
     c. Credit risk: Weak economic conditions could result in charge-offs for Square Capital, and
         it would increase the risk of Square Capital merchants and reduce investor appetite to
         fund loans. This would force Square to hold loans on its own balance sheet and
         dramatically increase transaction losses as a percent of GPV (currently 0.1%)
     d. Rise in cost of acquisition
          i. SQ needs to spend more money on Google search and other advertising channels
             to attract incremental clients
          ii. SQ needs to invest in sales distribution channel if its traditional marketing effort
              doesn’t work
3. Share dilution: The Company has options, RSUs, and warrants it pays out to employees as a part
of the stock compensation plan. The fully diluted share count including exercised options is
significantly higher than reported share count. Exercise of options could create an additional 37-
125m shares depending upon the share price. We assume 100mm dilution by 2026
4. Economy slow down and deflation
5. Competition: Square faces tough competition from both new entrants and more traditional players
with larger customer bases and financial resources, who could offer more favorable pricing by
cross-selling processing with other services they offer
     a. US competition: ShopKeep, Revel, HarborTouch, Clover (First Data), LevelUp, PayPal
         Here, Poynt
     b. International: iZettle (Swedenbased), SumUp (UKbased), Payleven (UK-based),
         WorldPay Zinc, PayPal Here
6. Regulatory risk
     a. Interchange cap
     b. Inquiry from CFPB or other authorities on Square Capital rates
7. Key man risk: Jack Dorsey
     a. Potential conflict with Twitter
8. Change in operating system and hardware from Apple IOS, Google Android and MSFT windows
limiting SQ use or pushing customers to switch to another vendor
9. Technology and security risk
    a. Hacking
    b. Network downtime
10. Dual share class limiting voting rights for Class A shareholders
    a. Class B has 92% of the voting power
Business overview (content mostly from 10k and an initiation report from Credit Suisse)
Square provides payment acceptance, processing and other services to small businesses. The company has
roughly two million small merchant customers (i.e., “sellers”). While the largest merchants generate
annual sales of up to $20 million, roughly half of these sellers generate annual sales below $125k. Square
also provides payment acceptance hardware and other software solutions including data, customer
management and business operations products. It also provides cash advance and loans to business
customers. There are about 30 million small businesses as defined by the U.S Census, and about 10
million of them accept cards today giving SQ a lot of runway even at the micro level. There are about
500,000 new businesses created in the United States on a monthly basis, which is a good growth engine
for SQ as new businesses are more likely to adopt the new technology.
The mobile card swipe was a big hit, but SQ gained traction by carving a niche among micro merchants
which were being ignored by traditional merchant acquirers. The big acquires were unable to cost
effectively move into the micro merchant channel as high cost of acquisition and fraud rate didn’t justify
the return. However, SQ shortened the onboarding process from 3-5 days to 5 minutes through its
technology, drove sales through its brand and drove its cost of onboarding to $14 vs. $90 to $238 per
merchant for the traditional acquirers resulting in only 4-5 quarters payback period. The chart below
shows how SQ simplifies the payment process for merchants:
 Source: Credit Suisse
This chart above shows how SQ has been able to grow the large merchants mix.
Transaction revenue (75% of total revenue): Transaction revenue consists of fees charged to merchant
customers for processing consumer credit/debit card payments. Square charges a basic flat fee of 2.75%
for each payment transactions (larger clients can negotiate different rates). For transactions where the card
is not swiped, but the card number is manually keyed in (as with phone orders) Square charges 3.5% +
$0.15 per transaction. Revenue generated from processing fees represents the “take rate” on processed
transaction volume. Square’s take rate is about 2.95%.
Hardware Revenue (5% of total revenue): Hardware revenues includes sales of Square Stand, Square
Readers for EMV chip cards and NFC, and other third-party peripherals including cash drawers, receipt
printers, and barcode scanners, all of which can be integrated with Square Stand to provide a
comprehensive POS solution. Square sells its Stand and Reader devices directly to merchants through its
website and via other electronics vendors including Apple, Staples, Best Buy, Amazon, etc. (over 35,000
retail locations). The Square Stand is an iPad docking station, where merchants can run Square Register
apps and accept mag-stripe card payments. It also connects to the contactless chip and EMV card reader.
The stand sells for $99 and the reader sells for $49 with available $1/week financing for 60 weeks. SQ has
been benefiting from EMV conversion, the tailwind which should go away next year. It has the fastest
speed in the industry (See chart below). SQ doesn’t make any profit on the hardware.
Software and Data Products Revenue (20% of total revenue): Software and data products revenue
primarily consist of Square Capital and Caviar (restaurant food delivery service), with other revenue
generated from various other software services. Caviar is a food delivery app that generates service fees
from restaurants and delivery fees from consumers. Square acquired the company in August 2014 for a
reported $90m. Other software services generate ratable use fees from various services including: gift
cards, square appointments, scheduled and instant deposits, customer engagement, employee
management, payroll and other apps sold through the marketplace. Instant deposit is likely one of the
larger components of other software services and one of the most profitable. This enables merchants to
instantly receive sales proceeds through a debit reversal charge at a cost of 1% of the transaction volume.
Square Capital: Square Capital provides loans to square’s merchant-base. Square Capital began in May
2014 and in 2015 the company advanced $400 million (about 1% of payment volume) through 70,000
merchant cash advances an average of about $5,700 per advance (management has sized average loans
at $6,000-$10,000). Typical loan-sizes are about 10% of a seller’s GPV, have a nine-month duration, and
carry an average fee of 10-14% paid over the life of the loan with no other fees, interest or penalties.
Sellers repay the loan by having Square withhold a fixed percentage of daily processing volume, which is
recognized as revenue. Square funds the majority of loans by selling the future receivables to third-
parties. For these loans, Square generates revenue by charging an upfront fee based on a percentage
of the loan amount and ongoing servicing fees. According to management, Square is able to sell most of
its loans within a day of issuance, minimizing direct exposure to loan performance and keeping loans off
its balance sheet. In recent quarters, Square has kept around $50m in loans on its own balance sheet
Payment processing overview:
Processing payment card transactions requires multiple participants including payment service providers,
acquiring processors, card networks, and issuing banks. Within this landscape, Square serves as a
payment service provider, acting as the touch point for the seller to the rest of the payment chain. The
definitions and graphic below outline this payment chain and the typical flow of a Square payment
transaction, along with the types of fees typically paid and received at each stage.
Payment Service Provider (PSP): Provider of the payment services that holds the direct
relationship with the seller and facilitates the rest of the payment transaction on behalf of the
seller. A PSP is also the merchant of record for the transaction. The merchant of record is liable
for the settlement of transactions processed.
Acquiring Processor: Provider of the back-end technology that facilitates the flow of payment
information through the Card Networks to the Issuing Bank. SQ agreements with acquiring
processors typically have terms of two to four years.
Card Networks (e.g. Visa, MasterCard): Provider of the infrastructure for card payment
information to flow from the Acquiring Bank to the Acquiring Processor.
Issuing Bank: The financial institution that issues the Buyer’s payment card.
Acquiring Bank: The financial institution associated with the Acquiring Processor.
1. Once the Buyer is ready to make a purchase, the Seller inputs the transaction into the Square
point-of sale (POS) and presents the Buyer with the amount owed.
2. The Buyer pays for the transaction by swiping or dipping their payment card, or by tapping
their NFC-enabled mobile device on the Square Reader or Square Stand, which captures the
Buyer’s account information.
3. The Square POS sends the payment transaction information to Square, which acts as the
Payment Service Provider (PSP).
4. Square passes the payment transaction information to the Acquiring Processor via an internet
connection. Square pays a small fixed fee per transaction to the Acquiring Processor.
5.The Acquiring Processor routes the payment transaction to the appropriate Card Network
affiliated with the Buyer’s card such as Visa, Mastercard, Discover, or American Express.
Square pays a variety of fees to the Card Network, the most significant of which are
assessment fees that are typically less than 0.15% of the transaction amount.
6. The Acquiring Processor then routes the payment transaction through the Card Network to
the Issuing Bank, which authorizes or declines the payment transaction for the Buyer’s
payment card.
7. Upon authorization, the Issuing Bank sends a notification back through the Card Network to
the Square POS to inform the Seller that the transaction has been successfully authorized.
8. The Square POS sends a digital receipt for the transaction to the Buyer, enabling a persistent
communication channel between the Seller and the Buyer. For example, this is how the Buyer
can send feedback to the Seller about the service provided.
9. The Issuing Bank then triggers a disbursement of funds to the Acquiring Bank through the
Card Network for the transaction amount. Square will ultimately pay the Issuing Bank an
interchange fee as a percentage of the amount of the transaction plus a fixed fee per
transaction, which together average between 1.5% to 2.0% of the transaction amount.
However, this percentage can vary significantly based on the card type, transaction type, and
transaction size.
10. Square transfers the funds to the Seller’s bank account, net of the fee charged by Square
(typically 2.75% of payment volume for card present transactions or 3.5% of payment
volume plus $0.15 per transaction for card not present transactions). Square provides sellers
with fast access to funds, typically settling with them by the next business day after the date
of the transaction via Automated Clearing House (ACH) transfers, or the same day via its
Instant Deposit service for an additional fee. Square pays a very small fee for each ACH
11. The funds are settled from the Acquiring Bank to Square, typically in one to two business
days after the date of the transaction.
12. At the end of the month, the Issuing Bank sends a statement to the Buyer showing their
monthly charges. The statement includes a reference to Square as the merchant of record on
the billing statement as a prefix to the Seller name (denoted as SQ).
Source: SQ 10k


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Catalysts / Path to Value Realization:
Upside in stock will come from:
1. Earnings beat: Guide for Q4 is very conservative. Q4 is seasonally the strongest quarter and guide
for Q4 suggest only 3% sequential growth. The company has historically grown revenue mid-
teens sequentially in Q4.
2. Low attrition and growth among big merchants proving short sellers wrong that Square has a
differentiated offering
3. International expansion
4. Upside option: Incremental growth from the new products and future market share gains.
Accretive acquisitions
5. Possible takeover by larger payments player.
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