A Quick Assessment of Square's Valuation

Here are some comments on Square's valuation, which will also serve to point out its valuation drivers.

Square ("SQ") reports two segments (not in its 10K/Qs but in shareholder letters and earnings calls): 1) Seller ecosystem, 2) Cash App ecosystem.

Seller ecosystem has ~30% adjusted EBITDA margin for 2019 (Note this is provided by management and they express it as percentage of Adjusted Revenue, which is a much smaller denominator than GAAP revenue because the adjusted version excludes transaction-based costs.)

Cash App ecosystem’s EBITDA margin was not disclosed, but apparently it is much lower EBITDA margin. In the 3Q19 call, an analyst asked:

“thanks for the EBITDA margin disclosure on seller, how quickly you can scale the Cash App margins? And can that ultimately approach the margins you're seeing on seller? That is Cash App versus seller.”

To which management answered:

“...we're continuing to invest aggressively into both our Cash App ecosystem as well as our seller ecosystem, and we think we're in the early days there in terms of customer acquisition and in terms of the product road map. So we'd expect to continue to see strong and growing contributions from Cash app going forward.

With respect to margins, just quickly, we see attributes in the cash business that are very similar to what we see in the seller business in terms of efficient customer acquisition, in terms of retaining customers over the long term and in terms of positive revenue retention. And because of that, we've been able to increase cash margins each of the last 3 years, and we'd expect to do the same in 2020. So over the long term, we see a very positive trajectory there as well."

So Cash App has lower EBITDA margins. But this segment has also been growing revenue at over 100% yoy, far outpacing Square’s overall growth rate in the 30%-40% range.

Thus we can infer that the growth of Cash App must have been weighing on Square’s overall profitability.

Cash App actually enjoys high gross margins (~75% vs ~40% for the Seller ecosystem), but somehow it ends with lower EBITDA margin. This is consistent with my guess that most of the discretionary/fixed cost investments in recent years have been in Cash App.

The big question is where does Cash App’s margin end up? I believe that, at scale, Cash App's EBITDA margin should equal or exceed those of Seller ecosystem. Those much higher gross margins matter, and eventually the R&D costs will be toned down while SG&A will be spread out through a larger base.

If the above is true, here are some basic numbers we can run:

• Adjusted Revenue will be about $2.2-2.3bn for 2019. Let’s say it grows ~25%-30% CAGR for next 5 years. 
• That’s about $6.9bn-$8.3bn of adjusted revenue for 2024. At 30% EBITDA margin that’s $2bn-$2.5bn of adjusted EBITDA
• SQ’s stock at $69/share, or $29b-$30bn mkt cap/enterprise value
• So this is trading at ~12x-15x 2024 adj EBITDA

This sounds ok. It’s a lot worse if we consider that these are adjusted EBITDA with huge stock based comp add backs. Another way to say this is that valuation is higher than it looks because of share count dilution overtime.

So far it would seem that Square’s stock is fully valued.

But at least we now know what SQ has to do. It has to maintain the growth trajectory in its Seller ecosystem (by defending against competitors like Clover). It has to continue growing Cash App by introducing new products and monetization opportunities, while maintaining a path to higher margins through operating leverage (i.e. stay out of ruinous competitive spending sprees).


Competitor PayPal (and its Venmo)

What really surprised me is the fact that Cash App actually makes more than Venmo. Cash App has run rate revenue of over $600mm, while Venmo only about $400mm.

Venmo is a competitor app owned by PayPal and much more popular than Cash App (At least in my experience, no one in my social circle uses Cash App, but may use Venmo). Venmo had $27bn of Total Payment Volume (TPV) for 3Q19, or an annual run rate of over $100bn. To put this in context, Square’s entire GPV for 2019 (most of it from its more established Seller ecosystem and not Cash App) will be just over $100bn!

So how is it that Cash App makes more money? The answer is here:

Main revenue drivers for both are 1) fees on instant deposits and 2) rev share on interchange from Cash Card / Venmo Card. SQ offered 1) for years and started charging 1% fee in 2016, 2) launched same year so more mature. Venmo started both in summer 2018, so still ramping

— CORE Dental DDS (@CoreDentalDDS) November 30, 2019

Now that should get you excited about Paypal. Imagine what happens to its stock when Venmo monetize like Cash App does!

Venmo currently contributes 16% of Paypal’s TPV, but only 2% of revenue. Not only that, Venmo grows faster than core Paypal so Venmo's share of total TPV will be increasing. Put two and two together, it sounds like Paypal's profitability is about to go through the roof.

So we failed to develop a bull thesis for SQ, but we may have ended up with one for PayPal!