Square filed its S-1 several weeks ago and is now in the middle of its IPO road show process. There’s been ample coverage in the popular press of course highlighting everything from the company’s revenue growth, lack of profitability, and the well-publicized fact that founder/CEO Jack Dorsey is also CEO of Twitter so would theoretically be running two public companies simultaneously.

This past Friday Square also filed an initial pricing range of $11-13/sh which would give them an enterprise value less than their last round of financing ($6B post-money).  A bunch of articles came out saying that Square had “priced” their IPO below last round and this was something terrible ranging from the bursting of a tech bubble to the coming of the apocalypse.  This was clickbait at best or bad journalism at worst.  Anyone who’s familiar with the IPO process knows that companies state an “initial” range as they begin their road show.  Based on demand from potential investors this may get revised, upwards or downwards, multiple times.  In the days before a stock starts trading the underwriters take orders from potential buyers, and then a final exact per share price (not a range) is set for the IPO… this is referred to as the “pricing”.  We will not know the final price of Square’s IPO for another week or two (or more)… it may be higher or lower or equivalent to the last round.  I’ll address potential valuation further down the post here.

But all this is just the surface… I wanted to dive deeper into the business itself, having worked in payments and invested in other payments startups. I don’t really have a dog in this hunt… I am not a shareholder of Square and have never been involved in the company. I do have friends and former PayPal colleagues who are or have been senior execs or investors in Square, but I feel pretty comfortable in my ability to make a balanced analysis here.

I’ll try to cover a bunch of different areas in detail, as Square’s filing provides pretty rich data, so this will be a very long read. I’ll broadly frame things with the lens of these three questions:

What does Square’s fundamental business look like today?
How good or bad is it as a payments business?
How might one think about the value of Square relative to other payments companies?

For those who just want the TLDR… based on my analysis, Square is a very good business. It has grown remarkably, has favorable gross margins and customer acquisition payback, and a clear path to profitability. Unfortunately the fact that the company raised capital in private markets at a healthy valuation ($6B) and the uncertainty about having a CEO who’s attention is divided between two public companies obscures this story.

So let’s start with What Square’s Business Looks Like Today:
As we all know, Square helps small offline (e.g. physical world) merchants process credit card payments. Square really democratized “card present” (e.g. swipe transactions) payments for very small merchants who historically did not accept credit cards because of the cost and complexity of dealing with traditional payment solutions (expensive terminals, confusing fee structures, etc). Small businesses like food trucks or farmers market stands, home contractors, taxi drivers, etc typically didn’t accept credit cards 5–10 years ago.  While their “larger” merchants are growing as a % of the total base, today about two-thirds of Square’s merchants process <$125K in annual payments.  In this regard Square really is analogous to PayPal… prior to PayPal very small online merchants (eBay sellers, small websites, etc) had a hard time accepting credit cards and PayPal democratized these “card not present” transactions. Square has done the same for small physical merchants.

Revenue Composition
Fees on payments account for 95% of Square’s revenue. A small portion (4%) comes from other “software and data products” which is mostly the Square Cash product, which gives businesses faster access to their credit card funds (essentially a very short term receivable loan). The other tiny portion (1%) comes from sales of hardware, like the tablet stands and POS like cash drawers that some businesses use to process Square payments.

Square typically charges a 2.75% on its payments, so revenue scales linearly with payment volume. I’ve created my own Google spreadsheet which shows gross payment volume (GPV), revenue, cost of revenue, gross margins, etc both figures directly from the S-1 and my own calculations on top of that. It’s easiest to refer to that to get the details, but at a high level Square is roughly at a $1B annual gross revenue level today (excludes Starbucks deal – see next).

Starbucks Deal
Square formed a high profile partnership with Starbucks in late 2012 to process their credit & debit card transactions. This included accepting Square Wallet (Square’s consumer payment app) at Starbucks location and processing the transactions that went through Starbucks’s conventional POS terminals. Howard Schultz joined Square’s board as well, though he left the board just over a year later. Square and Starbucks are now winding down this partnership.

From a raw economics standpoint, the Starbucks partnership represents a bad deal for Square. Square loses money on every transaction (-23% gross margin in 1H 2015), and since the deal’s inception Square has incurred over $70M in cumulative losses on processing Starbucks transactions. So while some have pointed out that Square will lose roughly 11% of their gross revenue as the Starbucks deal ends and Starbucks transitions to a different payment processor, it’s actually good for Square to get out of this business.  Negative gross margins are bad, as lots of folks have pointed out.

So was the Starbucks deal worth it? The raw ROI is obviously vastly negative, but it’s tough to assess whether the brand halo, publicity, and other intangible benefits paid off. Undoubtedly some small businesses who became Square customers were comforted by the affiliation… if it’s good enough for Starbucks’s billions in payments it must be good enough for me. It raised Square’s profile with competitors and the card networks (Visa/MC/Amex) relatively early in the company’s life. So on balance I’m not sure it was a crazy deal to do, but clearly it’s not a partnership that is worth continuing. Getting out of the deal is a good thing, not a bad thing for Square.

Revenue Growth
Square has grown revenue rapidly for a 6 year old startup, but like most startups that achieve significant scale, top line growth is now slowing. It’s the age old challenge that as you get bigger and bigger it’s hard to keep growing at extraordinary pace. Square grew revenue >170% YoY in 2013, then 54% YoY in 2014, and is on pace to grow about 32% YoY here in 2015. I’ll compare Square to similar payments businesses below but just for reference Facebook top line growth was 58% YoY in 2014 and on pace for 22% in 2015 (FB is >10x larger and more mature business).

With a baseline understanding of Square, we can turn to How Good or Bad of a Payments Business is Square?

So we know Square has decent growth in GPV and thus revenue. We know the Starbucks volume is significantly unprofitable but what about the core business serving small merchants? What are customer acquisition costs like? How much revenue does each merchant drive? All of these are worth looking at in order to assess how good of a payments business Square is.

Gross Margins / Net Revenue
Again if you refer to the Google spreadsheet I created, you can see the gross margins by product line and by year. Bottom line is that the core payment’s business has been 35–37% gross margin over recent years. This is pretty darn good for a payments processor like Square and is better than I expected. See below for a comparison of how this GM stacks up with PayPal and others.

It’s important to note that “net revenue” is calculated inconsistently for payments companies. I always look at payment companies as having gross revenue of the transaction fees they charge merchants or consumers, costs for processing those transactions, and then net revenue is the difference of those two figures. So if Square collects a 2.75% fee from a merchant but pays ~2% in fees to process that card transaction (interchange, network fees, etc), their net revenue would only amount to 0.75% of the total transaction.  FWIW further into the S-1, Square calculates an “adjusted revenue” figure which is basically net revenue from core payments business (e.g. excluding Starbucks deal).

I consider net revenue and gross profit to be equivalent for most payments businesses. This is akin to the product gross profit of an e-commerce company… if Amazon sells a widget for $1 and the cost of goods is $0.60, obviously there’s 40% product gross margin. You’d add in shipping, fulfillment costs, and such to get to a final contribution margin for an e-tailer. With Square there are other costs like fraud which they report below the line in operating expenses rather than as a cost of revenue.

Fraud
Most press coverage of Square honed in on a disclosure in the risk factors section of S-1, where they described a single fraud loss of >$5M attributable to one merchant. The risk factors section is basically where you describe all the worst case scenarios for your company now to mitigate the risk of litigious shareholders if the stock price goes down after the offering. If you actually dig into the data you see that overall fraud is pretty low… it’s been roughly 0.1% of GPV, though it has ticked up slightly here in the first half of 2015.  It’s possible to defraud a processor like Square, even with a magnetic stripe “swiped” payment, but the model is harder to defraud in scalable ways.

Per Merchant Unit Economics
We don’t have a detailed breakdown of merchants by time cohort and payment volume (Square undoubtedly tracks this internally).  There’s a long tail of merchants who almost never transact even though they have a Square account, but Square reports over 2 million merchants that do 5+ payments per year and these merchants account for 97% of GPV.  So the average square merchant processes something like $13K per year in volume, which translates to roughly $150 in gross profit per year.  That’s the averages… the bigger merchants probably account for a disproportionate amount of Square’s total dollar volume.

But while the S-1 doesn’t have a specific section on per merchant unit economics, there is a good bit of information interspersed throughout the filing which enables us to draw some conclusions.

• Nearly 1/2 of Square’s sellers (Square’s best estimate) find them organically or through word of mouth, rather than paid sales & marketing
• On a blended basis (paid + unpaid), Square’s payback period for new merchant acquisition is “four to five” quarters
• Square has negative revenue churn… even accounting for merchants who churn or go out of business, Square generates 10% more total net revenue each year from those they retain.  This has held true for every quarterly cohort since 2010.

Bottom line is that Square appears to have profitable customer acquisition and excellent retention, especially considering the inherent churn typically associated with serving SMBs.

I think Square is well positioned to continue capturing increasing market share among offline merchant payments.  Lots of existing businesses have adopted Square as the best/only option for them to accept credit cards.  Also anecdotally it seems that every new restaurant or coffee shop I visit starts with Square as their POS / payments option, so I think Square is making a real dent in the POS world with newly formed businesses.

Profitability
Revenue is good, gross profit is better, but there’s a reason they call net profit the bottom line. More precisely double entry P&L accounting and listing profit below the bottom line of a ledger originated first… we then started using “bottom line” in common parlance to mean “that which matters” or the outcome of something.    

Square is currently unprofitable no matter how you measure it… GAAP net profit, EBITDA, adjusted EBITDA, or operating cashflow.  Obviously a late stage startup going public is better positioned if they’re profitable on at least one of these measures.  So then we must ask ourselves how likely Square is to achieve profitability and how soon will it happen?

Square is very nearly breakeven on an adjusted EBITDA and operating cashflow basis.  If you calculate these as margins of the core transaction revenue (e.g. exclude Starbucks which is going away), adjusted EBITDA has gone from -36% in 2012 to -4% for 1H 2015 and operating cashflow has gone from -22% in 2012 to -2% today.  Given the unit economics above (e.g. negative churn on $ basis), if Square stopped spending on sales & marketing their net revenue would still grow modestly (~10% YoY).  So they’re within striking distance of profitability on an adjusted EBITDA and cashflow basis.  GAAP profitability is further out though there are ample examples of startups that go public without a net profit (e.g. Twitter).

So How should we think about Square’s value, both in absolute terms and relative to other payments companies?:
By my estimation, Square is a compelling payments business based on it’s growth, gross margins, merchant unit economics, and near-term profitability potential.

When it comes to valuation, Square will inevitably compared with other payments companies. There’s lots of different kinds of companies in the payments world and they’re pretty different… a full breakdown of these types is beyond the scope of this Square analysis. The short story is that card networks like Visa and MasterCard basically run the underlying rails and set the rules, and take a tiny slice (~10bps) of every transaction on the planet. Processor/acquirers like Vantiv, Total Systems, First Data, Paymentech (a division of JPM Chase), BAMS (a division of Bank of America) all do processing and take on some of the financial risk for merchants they serve.

Square is most akin to PayPal… they both process payments on behalf of merchants, their gross revenue take is comparable (~3%), they both have pretty good margins (more on this below).  Conveniently we have early data on PayPal from when we went public (February 2002) and now again that PayPal has spun out as a standalone public company, separate from eBay.  For reference our original PayPal S-1 is here, the final 10-Q prior to eBay acquisition is here (closed late 2002), and there’s a variety of data from the recent spinout at PayPal’s investor relations page.  

Here’s a quick side by side comparison of Square and PayPal.  There’s more detail in a tab in my Google Spreadsheet:

.                                                          Square                 PayPal

GPV (2015 annualized)                     $32B                    $267B

Revenue (2015 annualized)             $1.0B                    $8.9B

Revenue Growth 2015                          37%                       11%

Txn Gross Margins 2015                      37%                       79%

Adj EBITDA Margin 2015                  -4%                      +15%

Market Cap                                             ???                    $44.3B

PayPal has better transaction gross margins than Square for several reasons… PYPL revenue per transaction is slightly higher, but the biggest driver is that PYPL has far lower cost of funding because they get a large portion of users to pay with bank debit (ACH) or PayPal’s credit product.  When buyers pay with ACH or credit you have very high gross margins compared to when they fund a payment with a credit card.  But given Square is virtually all credit card funded payments, having 37% gross margin is very good.  PayPal’s cost of processing a credit card will generally be higher than Square’s, as PayPal’s transactions are “card not present” without a card swipe and thus carry a higher cost in Visa/MC’s fee structures.

PayPal has roughly double the fraud rate of Square, though both are quite low as a % of GPV.  PayPal is obviously pretty profitable (EBITDA, GAAP net income, etc) whereas Square is not yet profitable.  But PayPal is a more mature business… it’s roughly 8x the size of Square on a GPV basis, but Square is growing >3x faster than PayPal.  Both company’s growth is slowing but if you were to project forward based on current growth rates, Square and PayPal would be equivalent sized in about 10 years.

So given PayPal has a market cap of about $44B, how should we value Square?  Well using PayPal as a comp on a straight multiple of GPV or revenue, Square would be worth between $4.9 – 5.3B.  Square’s lack of profitability hurts, but it’s pretty clear looking at the underlying metrics that they are likely to achieve profitability on an EBITDA or operating cash flow basis in the not too distant future.  As a younger, faster growing company one would typically put a premium multiple on Square relative to PayPal.

I don’t own any shares in Square and don’t have plans to invest in the company at or after the IPO.  If I were trying to value the whole company, I’d probably put a $6-7B value on it.  IMO it’ll continue to grow faster than PayPal for awhile, has pretty good margins and underlying customer metrics, and should achieve profitability soon.  I wouldn’t play a huge premium on the company though given the leadership questions with Jack Dorsey trying to run potentially two public companies.  Elon Musk is CEO of both Tesla and SpaceX, the latter gets plenty of public scrutiny but is still private and given the nature of the rocket business it’s less susceptible to short term pressures anyway (Elon’s board chair but not day to day CEO of SolarCity).

Where does this leave us?  My bottom line is that Square’s a pretty good payments business.  It has some deficiencies like lack of profitability, exiting the Starbucks deal, etc.  But were it not for the current “kill the unicorns” sentiment (which I share partly, in all candor) and the uncertainty about Jack Dorsey as CEO of two public companies, I honestly think the buzz about Square could have been how it just might be the next PayPal.