Quantcast

Will Wall Street’s Double Edge Sword Cut up Square?

 

4265381864_8a4d7b5bb3_b

Moving beyond the question of staying private and going public, companies such as Square need to appreciate the responsibility of constant innovation and fiscal responsibility. The recent stock market volatility has raised plenty of questions around the growth of the technology sector. It’s been especially hard in technology with companies such as LinkedIn losing massive value in the matter of hours. Square’s stock (NYSE:SQ) is not dissimilar in that it went soaring during its IPO, which helped lend credence to innovation, technology, and payments. Its first earnings report as a public company on March 9 will tell us whether investors believe in the company in this turbulent market. In the face of varying headwinds from not understanding the market to criticisms of direction and leadership, Square is, at least for the moment, able to prove that innovation in payments is possible but the questions is for how long?

S-4

Square’s S-4 showed the state of a company that may not have the ability to grow let alone be profitable in the near future. Its losses amounted to $154 million in 2014 along with a Starbucks partnership that was costly as well ($28 million in 2014). Square transaction costs-to-revenue breakdown (also called an efficiency ratio) has consistently been more than 60 percent which is roughly double PayPal’s transaction efficiency ratio of 30 percent: It spent $1.2 billion on transaction costs in the first six months of 2015 to process $3.9 billion of payments. This all points to a mountain of fiscal challenges that the company will have to overcome in a world of myopic quarterly results.

The prospectus’ premonition that Jack Dorsey’s job at Twitter “may at times adversely affect his ability to devote time, attention, and effort to Square” seems to be spot on (even though he takes no money). Twitter’s latest leadership turmoil has public markets wondering why a public company would allow Dorsey to venture into a leadership role of another public company. I’m not suggesting that management has failed nor is it lacking but it’s another challenge that few, if any, companies would be willing to face in today’s market.

Finally, depending on the future of fraud, the progression of the stock may show just how bad credit card fraud has become. If you take a look at the “Risk Factors” in the S-4 Statement, you can see that Square took a $5.7 million loss to fraud from a single customer! While this does come on the heels of the introduction of EMV, it helps to expose the security aspects of payments and the potential of fraud to effect public markets.

EMV

The impact of EMV fraud on the stock is that those who bought into the stock will likely see their initial investment take a loss on the signal of fraud from EMV. Its stock has been suffering and may continue to do so as we move forward with the challenges that face the payments industry. EMV terminal chip readers for Square just came on to the market, but this cost is going to be absorbed by the “small float” offering. On the flip side, Square (and Visa) has a unique relationship with Apple in that the reader will be sold in retail stores so the success of the reader is buoyed by Apple and vice versa.

In many ways, the EMV shift is an opportunity, not a problem, for Square. For one, they’ve been very on top of encouraging their customers to adopt EMV. More importantly, if a business chooses to use non-EMV swipes, Square isn’t liable: the business is. And if someone commits fraud on an EMV card, that still comes back to the credit card company. Square offers its customers protection between ordering their EMV reader and its arrival at their store, but other than that, at no point does Square assume liability for credit card fraud.

However, because of the EMV shift, businesses across the country are switching their cash registers and POS systems. With the Square reader tied to Apple retail stores, this could mean a certain synergy that will bring great business towards both companies in the mobile payments arena. With millions of business owners replacing their card readers anyway, Square has an opening to convince them to upgrade their whole POS. I would expect to see Square continue to grow in the next year, and I certainly don’t think the EMV shift is going to hurt the value of their stock.

SMB

As a business scales, marketing and accounting systems become more important which is good news for Square. Square would be prudent in using the IPO funds as a method to handle existing scaling challenges and move into other services such as marketing to help drive small businesses forward. Square has three main lines: a payments or point-of-sale system — a digital cash register that operates on mobile devices which includes transaction data and analysis; financial services such as payroll and Square Capital (which provides financing to small businesses) and Square Customer Engagement (a software suite that provides customer tracking, marketing, and feedback, among other services). With the purchase of the food-delivery app Caviar, restaurant clients can scale as well.

The most important thing an SMB needs to do is reach its customer. SMB’s barely operate in the black so “closing the loop” is the opportunity for Square. Whether Square is able to do so through its many products is still up for discussion. The average SMB deal is around $10K so the plan for Square should be to use its product extensions – financial services and marketing services – to diversify revenue and accelerate growth. However, Square’s growing topline numbers hide its weak competitive position and razor-thin margins because, at the end of the day, Square keeps only about 1 percent of all the payments it processes. And that’s before operating expenses are accounted for – such as well as the sale of its hardware at a loss.

Now that it has to go on the record for its public offering, the company has had to admit where its business really stands. As Square’s IPO filing says, “We derive substantially all of our revenue from payments services. Our efforts to expand our product portfolio and market reach may not succeed and may reduce our revenue growth.” Some of this success hinges on whether the merchants sign up fast enough for the network to overcome its losses.

Wall Street

Unfortunately, Wall Street is a double-edged sword. If Square were able to close the loop on the marketing and purchase of goods in the SMB market, then it would have achieved an elusive goal while, possibly, also becoming profitable. This isn’t an easy task. Companies, such as Square, in new markets need 5-10 year plans to truly build out their companies. However, Wall Street doesn’t care about horizon as much as good news in the form of significant profit. Although, profits don’t ever seem to match up to what analysts think they should, you still have to perform every quarter. Private ownership is great for any transitional period so that a company can make the changes that need to be made instead of getting hammered by institutional shareholders. Square no longer has this freedom from Wall Street.

Everyone loves a big IPO as the markets go for darlings. The “‘what have you done for me lately” mentality will come to technology company stocks as IPO paydays with short term gains are followed by quarter-by-quarter scrutiny to keep institutional clients happy. Take a look at Etsy as an example of darlings that fall out of favor. Unfortunately, this type of transactional state is not new to the international scene as the Germans and Japanese laugh at Wall Street for this myopic view of companies. Having a private company insulates peering eyes and allows a company to focus on a horizon of 5 and 10 years. With Square’s IPO filings show a net loss of $29.6 million in the second quarter, ballooning to nearly $54 million in the third quarter, the company has many questions to answer while solving perplexing payments and marketing questions under the scrutiny of impatient smart money investors.


 

Image credit: CC by Daniel R. Blume

About the author: Thomas Yohannan

Thomas currently does business development for Cisco Security. Previously, he headed major partnerships at Cvent and worked at a variety of startups. As a lawyer, Thomas worked for Goldman Sachs, UBS Investment Bank and the Falconwood Corporation [parent co. to AOL MovieFone] focusing on law, licensing, M&A and private asset transactions.

You are seconds away from signing up for the hottest list in New York Tech!

Join the millions and keep up with the stories shaping entrepreneurship. Sign up today.