Shares of payments processor Square (NYSE:SQ) were on fire in 2016, 2017 and for most of 2018 – a stretch in which Square stock rose from $10 to $100. But, Square has gone in the other direction over the past year, dropping from a $100 high in early October 2018, to $60 today.
Why the sudden and sharp reversal in SQ stock? A few reasons. First, Square’s growth trajectory is slowing as the company is more aggressively rubbing elbows with competitors. Second, the margin expansion narrative has similarly slowed as Square has had to invest more in order to sustain big top-line growth. Third, investors have called into question the valuation on SQ stock, which at $100, was far too rich for its own good.
Net-net, a combination of slowing business momentum and valuation friction has ultimately caused Square stock to crash.
But, there’s reason to believe that the worst of this crash is over. Specifically, there are two big reasons to believe that Square stock is ready to rebound.
First, Square stock is as cheap as it has been in several years, and at levels which imply that it is undervalued relative to its long term growth potential. Second, a new pricing change implies that next quarter’s guide could actually be better-than-expected, a refreshing and welcome change from a stretch of light guides recently.
In other words, relative undervaluation and a strong holiday quarter guide could provide the necessary fuel to drive a strong rebound rally in SQ stock over the next few months.
Square Stock Is Undervalued
In the big picture, Square is undervalued relative to its long term potential.
There are four big ideas here. First, Square is in the right space. The secular non-cash-transaction pivot will provide a multi-year tailwind for Square’s growth trajectory.
Second, Square is the right company in the right space. Square’s track record of innovation over the past several years is impressive – new card readers, HR services, a peer-to-peer payments app, so on and so forth – and so long as the company keeps innovating and adding to its payments ecosystem, the company will continue to be an attractive payment facilitator option for merchants and retailers of all sizes.
Third, this space is huge. Global retail sales measured nearly $24 trillion last year. Square’s GPV measured less than $85 billion, so about 0.35% of the addressable market. Thus, while competition is a risk, the addressable market and opportunity are so large that Square has more than enough space to grow before competition kills the growth narrative.
Fourth, margins are roaring higher. Sure, they aren’t rising by several hundred basis points per year anymore. But, margins are still expanding by 90-plus basis points each year, and so long as revenues keep rising by 20%-plus, that’s enough growth to drive marked opex leverage.
Big picture? Square is still a very important, very rapidly growing player in the secular growth alt payments market. The math underlying that logic supports SQ stock at a $75 price tag today.
Upside Holiday Will Provide a Boost
On the heels of a 40% decline over the past year, SQ stock needs an upside catalyst to reinvigorate investor enthusiasm, breathe life back into shares, and spark a rebound.
That upside catalyst could come in the form of a strong holiday quarter guide in the Q3 earnings print.
Here’s the backdrop. Square just changed its pricing scheme from a 2.75% take rate on each transaction to a 2.6% take rate on each transaction, plus a 10 cents flat fee per transaction. Simple algebra shows that for transactions under roughly $67, Square makes more money under the new pricing scheme. The average transaction size throughout all of retail hovers right around $50. For that average $50 transaction size, Square’s revenues get a ~2% boost per transaction from the new pricing scheme.
The pricing scheme change will come into effect on Nov. 1. Thus, it will impact Q4 revenues. Given the above math, it should impact Q4 revenues positively, meaning that the Q4 guide should actually come in better-than-expected.
That’s a big deal. The slide in SQ stock started a year ago. Over that past year, Square has reported four earnings reports, all four of which have had light guides. If next quarter’s print breaks this weak guidance streak, then that could reinvigorate investor enthusiasm, breathe life back into shares, and spark a rebound in SQ stock.
Bottom Line on Square Stock
I think Square stock looks really good here. The long term fundamentals remain robust, and recent weakness is just noise in the big picture which has left shares attractively undervalued.
As such, I think the best strategy here is to continue to accumulate on weakness, wait for that catalyst to turn the tide, and let the stock roar higher in the long run.
As of this writing, Luke Lango was long SQ.