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ABSTRACT

In this report, I present a unique


short thesis on the common stock
of a popular mobile payment
service provider - Square Inc. I
believe the downside risks to
Square are significant and deserve
more attention. My analysis
suggests that Squares stock has
over 80% downside based on a
current market capitalization of $6.1
billion (and stock price of $17.4).
This thesis is a contrarian one as
most of the analyst community is
extremely bullish on the company.
As several components of my
thesis have not been discussed by
analysts or the research community
A short thesis on a popular mobile at large, I believe the perspective is
payment service provider additive to the current information
set available to investors on
Squares business prospects.
Accordingly, I recommend a short
position against Squares common
stock to profit from its potential
future decline.
Abdullah Sheikh
February 25, 2017

If your business model relies on your customer being uninformed, you better have a good
marketing strategy. Jeff Bezos, Founder and CEO of Amazon.com Inc.

Square (pricing) is higher than Willie Nelson on the weekend.- Senior Sales Manager,
Credit Card Processing Solutions, National Bankcard.

Copyright 2017 Abdullah Sheikh 1


Contents______________________________________________________________

Chapter 1: Executive Summary Page 3

Chapter 2: Introduction to Square Inc. Page 24

Chapter 3: Reasons for Squares rapid growth Page 43

Chapter 4: Squares competitive landscape Page 52

Chapter 5: Management and analyst view of Squares business prospects Page 77

Chapter 6: Short thesis on Square Page 86

Chapter 7: Modeling dynamics of Squares business Page 163

Chapter 8: Valuation of Squares common stock Page 186

Square Magstripe Reader, Contactless + Chip Reader and Stand

Source: November 2016 Investor Presentation

Copyright 2017 Abdullah Sheikh 2


Chapter 1: Executive Summary
Square a mobile payment service provider, that also offers financial and marketing
services is severely overvalued. With a market capitalization of $6.3 billion, the
market is pricing in high margin revenue growth over an extended period. Sell side
analysts are largely bullish on this company with a greenfield growth opportunity.

I believe Square is likely to underwhelm investors in a significant way on both the


revenue and margin front over the coming years for the following reasons:

1. Squares customer base is fundamentally unattractive: While most


merchant acquirers seek financially strong and commercially thriving customers,
Square targets exactly the opposite; desperate micro-merchants looking for a quick
and easy payment processing solution with low up-front cost. Square attempts to
onboard as many of these financially disadvantaged micro-merchants as possible to
its overpriced payment processing platform with free or highly subsidized debit and
credit card readers in the hope that a few successful micro-merchants will justify
the acquisition costs of the millions of unsuccessful others. This strategy has
worked to-date due to a first mover-advantage in micro-merchant payment
processing and a conducive economic environment. Squares anomalously high
transaction margins of over 1% and its string of surprisingly strong results over the
last five quarters can be explained by these dual tailwinds.

Exhibit 1: Square has outperformed analysts expectations over the last five
quarters due to dual tailwinds of micro-merchant acquisitions and GPV growth
400 10.00%

350 9.00%
8.00%
300
REVENUES ($ MILLIONS)

7.00%
250 6.00% SURPRISE
200 5.00%

150 4.00%
3.00%
100
2.00%
50 1.00%
0 0.00%
Q4 2016 Q3 2016 Q2 2016 Q1 2016 Q4 2015

Actual Adjusted Revenue ($ million) Consensus Adjusted Revenue ($ million)


Surprise (%)

Copyright 2017 Abdullah Sheikh 3


Exhibit 1: Square has outperformed analysts expectations over the last five
quarters due to dual tailwinds of micro-merchant acquisitions and GPV growth
Period ending Actual Adjusted Consensus Surprise (%)
Revenue ($ Adjusted
million) Revenue ($
million)
Q4 2016 191.9 187.7 +2.2%
Q3 2016 177.8 172.9 +2.8%
Q2 2016 170.8 159.4 +7.2%
Q1 2016 146.2 134.6 +8.6%
Q4 2015 374.4 344.7 +8.6%
Source: Bloomberg, Author calculations

However, the hyperbolic growth Square has experienced over the last eight years is
not sustainable. Square needs a constant influx of new micro-merchants to
replenish its existing cohort of older micro-merchants, close to 70% of whom are at
risk of leaving the platform at some point during their respectively business
lifecycles.

Exhibit 2: Most of Squares nearly three million customers are low


contributors to total GPV with a risk of falling out of the ecosystem
# of customers

High risk
customers

High risk customers

Contribution to GPV
Source: Author illustration

The underlying dynamics of Squares business are ugly, characterized by an


expensive mobile payment processing solution, a customer base with median card
sales of just over $400 a month, high levels of merchant and GPV attrition
reaching 40% and 15% in a normal year, respectively and potential recessionary
merchant and GPV attrition rates, exceeding 50% and 30%, respectively. This
dynamic will significantly dampen Squares Return on Invested Capital, compared to
other payment service providers, such as PayPal and Heartland Payment Systems,
who cater to a higher quality customer base.

Copyright 2017 Abdullah Sheikh 4


Exhibit 3: Probability estimates of a hypothetical Square micro-merchant
business outcome in any given year

Measure Estimate
Probability of Staying with Square Given Business Success 7%
Probability of Staying with Square Given Business Muddles 54%
Probability of Leaving Square 39%
Source: Author estimates

2. Analysts comparing Square to PayPal or First Data are comparing


apples and oranges; Square has more in common with Fitbit and
GoPro: As a micro-merchant aggregator, Squares overpriced and commoditized
product caters to a sub-prime customer base, has high transaction expenses, no
moat, no network effects, no vertical integration, suffers from extreme competition
and has almost zero switching costs. This contrasts with PayPals payment
processing platform that caters to a prime customer base, has a monopolistic
presence as the internets preeminent online wallet, a funding mix that frequently
results in 100% margin transactions and high switching costs due to network effects
developed from engaging both buyers and sellers.

Copyright 2017 Abdullah Sheikh 5


Exhibit 4: PayPal has structurally higher transaction profit margins than
Square
PayPal Square

3.50%
2.94%
3.00%
2.65%
2.50%

1.92%
2.00%
1.70%

1.50%
0.95% 1.01%
1.00%

0.50%

0.00%

Metric PayPal Square


Take-rate 2.65% 2.94%
Expense rate 0.95% 1.92%
Profit margin 1.70% 1.01%
Source: Square and PayPal Q3 2016 earnings, Author calculations

Exhibit 5: Squares small ticket size results in high structural transaction


expenses as illustrated by three different Visa programs
SQUARE TRANSACTION COST AS % OF $15 SALE

Visa CPS / Retail Credit 2.49%

Visa CPS / Small Ticket Credit 2.23%

Visa Reg. Debit 1.83%

0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00%

Copyright 2017 Abdullah Sheikh 6


Exhibit 6: Squares small ticket size results in very high transaction expenses
as illustrated by three different Visa programs
Fee Visa Reg. Debit Visa CPS / Visa CPS /
Small Ticket Retail Credit
Credit

Interchange fee 0.05% + $0.22 1.65% + $0.04 1.51% + $0.10


Assessment fee 0.13% + $0.02 0.13% + $0.02 0.13% + $0.02
Processing fee 0.05% 0.05% 0.05%

Total transaction 0.23% + $0.24 1.83% + $0.06 1.69% + $0.12


cost
Transaction cost as 1.83% 2.23% 2.49%
% of $15 sale

Source: Visa, Author calculations

Square also stands in contrast to First Data a vertically integrated merchant


acquirer and payment processor that earns abnormal profits due to low customer
acquisition and payment processing costs.

Square has more in common with Fitbit and GoPro pioneers in the connected
fitness and action camera markets, respectively that severely undershot lofty
analyst projections because of the effects of brutal price competition in a
commoditized low-barriers-to-entry business.

Exhibit 7: Squares industry and business shares significant similarities to


Fitbit and GroPro
Key attribute Square Fitbit GoPro

Pioneers in niche markets


Run by growth focused charismatic
CEOs
Low barriers to entry products, with few
network effects and low switching costs
Claim differentiation on brand appeal
and ecosystem vs. no-frills alternatives
and other established players offering
similar products
High R&D expenses relative to revenues
signifying short product cycles

Source: Author research

Copyright 2017 Abdullah Sheikh 7


3. Extreme competition from ISOs/MSRs and traditional merchant
acquirers will limit Squares growth and margins: A look at the micro-
merchant mobile payment service provider landscape shows a bewildering number
of Square competitors offering cheaper no-frills alternatives or similar polished
products. Notable no-frills competitor Electronic Merchant Systems offers EMS+,
a service with a flat all-inclusive rate of 2.25% per swipe compared to Squares
2.75% - and a free card reader.

Exhibit 8: EMS+ offers a cheaper no-frills version of Square


Attribute Square EMS+

Swiped Rate 2.75% 2.25%


Keyed-in Rate 3.5% + $0.15 3.5% + $0.15
Monthly fee
Early termination fee
Annual fee
Monthly minimum
Setup fee
Free magstripe card reader
Free app
Ecosystem (Invoicing,
Inventory management,
receipts etc.)

Source: Author calculations, toptenreviews.com

Products with similar, and sometimes superior pricing, hardware and software to
Square, include Spark Pay by Capital One, QuickBooks GoPayment by Intuit,
PayPal Here by PayPal, Clover by First Data, and Pay Anywhere.

Copyright 2017 Abdullah Sheikh 8


Exhibit 9: Highly-rated mobile payment service providers as ranked by
toptenreviews.com

Source: http://www.toptenreviews.com/business/payment-processing/best-mobile-credit-card-processing/

Traditional merchant account providers, which includes many Independent Sales


Organizations (ISOs) and Member Service Providers (MSRs), now also offer mobile
processing rates that make Squares rates look higher than Willie Nelson on a
weekend. First Datas Clover has been gaining market share with over 500,000
devices shipped and 16% market share amongst its SMB clients establishing a
strong presence in a Square target market.

Exhibit 10: Clovers mobile payment service offering is gaining traction


amongst merchants

Source: First Data investor presentation

There are also several new entrants. Chase Paymentech will soon be releasing a
micro-merchant mobile payment processing solution with flat rates lower than
Squares. Shopify has recently introduced a suite of POS products competing for
micro- and small businesses. Verifone will soon be launching Carbon, a payment

Copyright 2017 Abdullah Sheikh 9


terminal with a POS platform in a single device. Poynt 5 and Poynt Smart Terminal
are new open-architecture POS competitors to Square.

Exhibit 11: Poynt Smart Terminal will soon be a Square competitor

Source: https://poynt.com/

4. Square is over-earning; Gross margins will come down due to


lower take-rates and stubbornly high transaction costs: Squares
outsized gross margins are likely to come down substantially over time as it
experiences pressure on take-rates from extreme competition and its efforts to move
upmarket to merchants with higher GPV, all the while experiencing stubbornly high
transaction costs, particularly high interchange and assessment fees. Analysts are
extremely sanguine on these key drivers of Squares profitability forecasting
stability far into the future despite several warning signs. PayPals decline in take-
rates and transaction margins over the last few years provides us with empirical
evidence and a historical precedent, while Heartlands transaction profit margin a full
fifty percent below Squares show us the real-world challenges of merchant
acquirers moving up-market.

Copyright 2017 Abdullah Sheikh 10


Exhibit 12: GPV, take rates and transaction profit margins are inversely
correlated, as PayPals experience shows
Quarterly GPV Take rate Transaction profit margin

110 3.30%

3.10%
100
2.90%
GPV in USD millions

90 2.70%

2.50%

Rate
80
2.30%

70 2.10%

1.90%
60
1.70%

50 1.50%

Metric 3/31/2014 6/30/2014 9/30/2014 12/31/2014 9/30/2014 6/30/2016 9/30/2016 12/31/2016


Quarterly
GPV 53.676 56.736 58.184 66.039 58.184 86.208 87.403 99.4
Take-rate 3.11% 3.02% 3.01% 2.98% 3.01% 2.69% 2.65% 2.63
Transaction
profit 2.15% 2.09% 2.09% 2.08% 2.09% 1.75% 1.70% 1.67%
Source: https://investor.paypal-corp.com/, Author calculations

Exhibit 13: Squares transaction profit margins are double Heartlands due to a
focus on financially disadvantaged micro-merchants
1.20%

1.00%

0.80%
Transaction margin

0.60%

0.40%

0.20%

0.00%
Square Heartland Payment Systems

Copyright 2017 Abdullah Sheikh 11


Exhibit 13: Squares transaction profit margins are double Heartlands due to a
focus on financially disadvantaged micro-merchants
Metric Square Heartland Payment
Systems

Take rate 2.93% 2.30%


Expense rate 1.92% 1.80%
Transaction profit margin 1.01% 0.50%

Source: Heartland 10K, Square Q3 Shareholder letter

Interchange and assessment fees, which comprise over 80% of the cost of a typical
transaction, are highly persistent as evidence from a Federal Reserve study over the
last six years shows. In the card processing food chain, card networks like Visa
and MasterCard call the shots. Square does not have the influence to maintain its
high pricing structure or retain its successful clients.

Exhibit 14: Interchange fees are likely to remain stubbornly high as illustrated
by their persistence over the last six years
1.60%
Interchange fee as % of average transaction

1.40%

1.20%

1.00%
value

0.80%

0.60%

0.40%

0.20%

0.00%
2009 2011 2012 2013 2014 2015

Dual-message Single-message All Networks

Source: https://www.federalreserve.gov/paymentsystems/regii-average-interchange-fee.htm

5. Square has a limited Target Addressable Market in the U.S. and


internationally: Squares over-bullish management team has misled the analyst
community on the potential size of their TAM in the U.S., by repeatedly citing
success with large sellers and U.S. card transaction volume of $10 trillion. The
reality is that 99%+ of Squares customers, by number, are financially disadvantaged
micro-merchants, with only a handful of SME customers. Squares prospects with
large companies are extremely limited. For a business processing debit and credit

Copyright 2017 Abdullah Sheikh 12


card transactions with an average ticket size of $9 and monthly GPV greater than
$7,700, leaving Square for a merchant account becomes economically preferable,
due to special Visa/MasterCard small ticket rates. For businesses with higher
average ticket sizes, the volume threshold is significantly lower due to the cap on
debit card rates imposed by the Durbin Amendment. For example, for a merchant
with an average ticket size of $30, the monthly GPV threshold to leave Square for a
merchant account falls to $4,400.
Exhibit 15: Ratio of Squares cost to merchant account Squares pricing is
unfavorable compared to a merchant account for any significant volume
and/or large ticket size
Ticket size
Volume $ 3 $ 6 $ 9 $ 12 $ 15 $ 18 $ 21 $ 24 $ 27 $ 30 $ 33 $ 36 $ 39 $ 42 $ 45 $ 48 $ 51 $ 54 $ 57 $ 60 $ 63
$ 200 0.11 0.11 0.11 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12
$ 700 0.26 0.31 0.33 0.34 0.34 0.34 0.34 0.35 0.35 0.35 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.37 0.37 0.37 0.37
$ 1,200 0.35 0.43 0.47 0.49 0.51 0.49 0.51 0.52 0.52 0.53 0.54 0.54 0.55 0.55 0.55 0.55 0.56 0.56 0.56 0.56 0.56
$ 1,700 0.40 0.52 0.58 0.61 0.63 0.61 0.63 0.65 0.66 0.67 0.68 0.69 0.69 0.70 0.70 0.71 0.71 0.72 0.72 0.72 0.72
$ 2,200 0.44 0.59 0.66 0.70 0.73 0.70 0.73 0.75 0.77 0.78 0.79 0.80 0.81 0.82 0.83 0.83 0.84 0.84 0.85 0.85 0.86
$ 2,700 0.47 0.64 0.72 0.78 0.81 0.78 0.81 0.83 0.85 0.87 0.89 0.90 0.91 0.92 0.93 0.94 0.94 0.95 0.96 0.96 0.97
$ 3,200 0.49 0.68 0.78 0.84 0.88 0.83 0.87 0.90 0.93 0.95 0.97 0.98 0.99 1.01 1.02 1.03 1.03 1.04 1.05 1.05 1.06
$ 3,700 0.51 0.71 0.82 0.89 0.93 0.88 0.93 0.96 0.99 1.01 1.03 1.05 1.07 1.08 1.09 1.10 1.11 1.12 1.13 1.14 1.14
$ 4,200 0.52 0.74 0.85 0.93 0.98 0.93 0.97 1.01 1.04 1.07 1.09 1.11 1.13 1.14 1.16 1.17 1.18 1.19 1.20 1.21 1.21
$ 4,700 0.53 0.76 0.88 0.96 1.02 0.96 1.01 1.05 1.09 1.12 1.14 1.16 1.18 1.20 1.21 1.23 1.24 1.25 1.26 1.27 1.28
$ 5,200 0.54 0.78 0.91 1.00 1.06 0.99 1.05 1.09 1.13 1.16 1.18 1.21 1.23 1.25 1.26 1.28 1.29 1.30 1.31 1.32 1.33
$ 5,700 0.55 0.79 0.93 1.02 1.09 1.02 1.08 1.12 1.16 1.19 1.22 1.25 1.27 1.29 1.31 1.32 1.34 1.35 1.36 1.37 1.38
$ 6,200 0.55 0.81 0.95 1.05 1.11 1.04 1.10 1.15 1.19 1.23 1.26 1.28 1.31 1.33 1.35 1.36 1.38 1.39 1.40 1.41 1.42
$ 6,700 0.56 0.82 0.97 1.07 1.14 1.07 1.13 1.18 1.22 1.26 1.29 1.32 1.34 1.36 1.38 1.40 1.41 1.43 1.44 1.45 1.46
$ 7,200 0.57 0.83 0.99 1.09 1.16 1.09 1.15 1.20 1.25 1.28 1.32 1.35 1.37 1.39 1.41 1.43 1.45 1.46 1.48 1.49 1.50
$ 7,700 0.57 0.84 1.00 1.11 1.18 1.10 1.17 1.22 1.27 1.31 1.34 1.37 1.40 1.42 1.44 1.46 1.48 1.49 1.51 1.52 1.53
$ 8,200 0.57 0.85 1.01 1.12 1.20 1.12 1.19 1.24 1.29 1.33 1.37 1.40 1.42 1.45 1.47 1.49 1.51 1.52 1.54 1.55 1.56
$ 8,700 0.58 0.86 1.03 1.14 1.21 1.13 1.20 1.26 1.31 1.35 1.39 1.42 1.45 1.47 1.49 1.51 1.53 1.55 1.56 1.58 1.59
$ 9,200 0.58 0.87 1.04 1.15 1.23 1.14 1.22 1.28 1.33 1.37 1.41 1.44 1.47 1.49 1.52 1.54 1.56 1.57 1.59 1.60 1.62
$ 9,700 0.58 0.87 1.05 1.16 1.24 1.16 1.23 1.29 1.34 1.39 1.42 1.46 1.49 1.51 1.54 1.56 1.58 1.60 1.61 1.63 1.64
$ 10,200 0.59 0.88 1.05 1.17 1.25 1.17 1.24 1.30 1.36 1.40 1.44 1.47 1.51 1.53 1.56 1.58 1.60 1.62 1.63 1.65 1.66
Source: Author calculations

Exhibit 16: Rising volumes assuming a $9 average ticket size result in Square
becoming uneconomical at GPV of $7,700 a month

Source: Author calculations

Copyright 2017 Abdullah Sheikh 13


Squares business model does not work as well in other developed markets, such as
the U.K., Europe and Australia, and emerging markets, such as China and India. In
the case of the U.K., Europe and Australia, consumer interchange fees are heavily
regulated at very low flat rates between 0.2%-0.3%, so Squares all-inclusive flat
payment processing fee is far less attractive to merchants. In the case of Emerging
Markets, low levels of credit card penetration and prevalence of cash transactions
for micropayments make Squares solutions significantly less attractive. In this
respect, Square also faces regulatory risks that would potentially make its business
model far less appealing for micro-merchants in the U.S. and Canada. A cap on
credit card interchange fees, like debit card swipe fees implemented by the Durbin
Amendment, could be potentially devastating to Square, yet is not a possibility being
considered by analysts.

Exhibit 17: European interchange rates on MasterCard consumer credit cards


are capped at low rates making Squares flat rates less attractive

Source: Global Payments Inc.

Square is also on the wrong side of a powerful technological megatrend towards


digital payments and its hardware gateways risk obsolescence from larger
innovative digitally focused payment solution providers, such as Apple, Google and
PayPal, and even new tokenization technology such as that used by Apple Pay and
Cartwheel Point of Sale. In fact, countries like China are leap-frogging debit and
credit cards to move straight to online payment solutions like Alipay, WeChat
Payment and Baidu Wallet.

6. Analysts are overestimating growth of Square Capital, which will


likely experience a fate similar to other non-bank lenders, like
OnDeck Capital: Squares core payment processing business lacks operating
leverage, so to justify lofty price targets analysts are modeling rapid revenue and
margin growth from upselling of Squares value added services particularly
Square Capital. Square Capital is an unattractive source of funding for all but the
most desperate and financially disadvantaged micro-merchants given APRs in the
region of 16%-28%. In addition to larger merchants, Square Capital also presents

Copyright 2017 Abdullah Sheikh 14


an economically inferior solution for successful micro-merchants compared to
alternatives. SBA working capital loans targeted at profitable and growing micro-
merchants have APRs a full 6% to 18% lower than Square Capital.

Exhibit 18: SBA micro- and small loan programs offer more compelling
alternatives to Square Capital for successful micro-merchants
Max Loan Maximum interest
Program Amount Use of proceeds Maturity rates Who qualifies Benefits to Borrowers
Purchase machinery & equipment, Direct loans from nonprofit
fixtures, leasehold improvements; Negotiable with Must be a for profit intermediary lenders; Fixed-rate
finance increased receivables; working Shortest term intermediary. Subject to business & meet SBA financing; Very small loan
Non-7(a) capital. Cannot be used to repay possible, not to either 7.75 or 8.5% above size standards; show amounts; Technical assistance
Loans $50,000 existing debt. exceed 6 years intermediary cost of funds. good character, credit, available
May be used for revolving lines of Revolving Lines of Loans $50,000 or less; management, and Fast turnaround, Streamlined
credit (up to 7 year maturity) or for a Credit including prime+ 6.5%; Loans over ability to repay. Must process; Easy-to-use line of
SBAExpress $350,000 term loan (same as 7(a)). term out period.
Depends on $50,000;
Loans prime
less than + 4.5%$0 -
7 years: be an eligible type of credit
ability to repay. $25,000, Prime + 4.25% business. Prepayment
Term Loan. Expansion/ renovation; new Generally, $25,001 - $50,000, P + penalty for loans with
construction, purchase land or working capital & 3.25% Over $50,000, Prime maturities of 15 years
buildings; purchase equipment, machinery & + 2.25%; Loans 7 years or or more if prepaid Long-term financing; Improved
fixtures, lease-hold improvements; equipment (not to longer: 0 - $25,000, Prime + during first 3 years. (5% cash flow; Fixed maturity; No
working capital; refinance debt for exceed life of 4.75% $25,001 - $50,000 P year 1, 3% year 2 and balloons; No prepayment penalty
7(a) Small compelling reasons; inventory or equipment) is up + 3.75% Over $50,000, 1% year 3) (under 15 years). Plus
Loans $350,000 starting a business to 10 years; real Prime + 2.75%; Can also streamlined process.
Source: https://www.sba.gov/sites/default/files/files/Loan-Chart-Baltimore-June-2016-Version-A.pdf

Square Capital is an attempt by management to stem the effects of GPV attrition


due to successful micro-merchants leaving Squares overpriced payment processing
platform for a more competitive solution. The decline of other non-bank online loan
providers also reliant on fickle third-party funding sources, like OnDeck Capital,
should serve as a cautionary tale for Square Capital.

Exhibit 19: OnDeck Capital has severely undershot analysts projections due
to its reliance on third-party investors as a source of funding

Source: Bloomberg

Copyright 2017 Abdullah Sheikh 15


7. Micro-merchants have neither the business need nor financial
wherewithal to afford Squares me-too software products:
Squares other value added services consist of me-too software solutions, such
as Square Payroll and Invoice ( la Quickbooks), Employee Management ( la
Zenefits), Cash ( la Venmo), Online Store ( la Shopify) and Appointments ( la
Google Calendar). The median Square customer is a financially disadvantaged
micro-merchant with approximately $400 of card sales that has neither the business
need nor the financial wherewithal to purchase complex accounting, employee
management, email marketing, and loyalty software. Given sales of Squares
software are tied to the number of customers subscribing to it, not GPV volume, it is
highly likely that software sales will undershoot analyst forecasts. Another indicator
of the low demand Squares ancillary software is likely to generate is the lack of any
mention of ecosystem by experts when comparing payment service providers.

Exhibit 20: Squares software products are expensive for the median Square
micro-merchant with $5000 of annual card sales
Square software Annual cost

Payroll subscription $25 + $5 x 3 employees x 12 = $480


Employee Management subscription $5 x 3 employees x 12 = $180
Appointments subscription $50 per month X 12 = $600
Email Marketing subscription $15 per month X 12 = $180
Loyalty subscription $25 per month X 12 = $300
Gift cards purchase $40 per pack X 2 = $80

Total $1,820
Source: www.squareup.com, Author calculations

8. Unattractive industry economics and poor capital allocation


decisions will detract from shareholder returns: Extreme competition
and the fast pace of innovation in mobile hardware and software payment providers
has led to unattractive industry economics with a need for extremely high R&D. In
the twelve months ending September 30, 2016, Square devoted a full $263 million to
product development, or 42% of adjusted revenues of $630 million. Given the lack
of traction Squares me-too software products are likely to have with micro-
merchants, I believe the return on this R&D will be poor.

Copyright 2017 Abdullah Sheikh 16


Exhibit 21: Squares product development spending as % of Adjusted
Revenues has been over 30% over the last nine quarters
60%

50%
R&D as % of Adjusted Revenues

40%

30%

20%

10%

0%
Q4 2016 Q3 2016 Q2 2016 Q1 2016 Q4 2015 Q4 2015 Q4 2015 Q4 2015 Q4 2015
Source: Square Shareholder Letters

Operating in a commoditized yet fast faced industry has led to high levels of capital
expenditures (CAPEX), in the form of regular acquisition spending. For example, to
get in-house access to the latest NFC/EMV technology for payment cards, in 2015
Square acquired Kili Technology a fabless semiconductor company based in
Canada. More recently, Square also bought a software technology related to
network connections for an undisclosed amount. I believe such regular
acquisitions, which highlight the elevated CAPEX needs of this business, will
continue, negatively impacting shareholder returns.

Before focusing more exclusively on the current growth opportunity in micro-


merchant card processing, CEO Jack Dorsey spent significant shareholder
resources developing a failed food delivery business, first organically through
Square Order, then through three acquisitions Caviar in 2014 for $90 million,
Fastbite in 2015 and Main Line Delivery in 2016. The returns on these investments
have so far been poor, as these businesses continue to lose money. A misfit food
delivery business shows a history of poor capital allocation. CEO Jack Dorsey is
stretched thin, as he is also currently the CEO of Twitter, a company desperately
trying to turnaround operations.

Copyright 2017 Abdullah Sheikh 17


Exhibit 22: Square is a prolific issuer of Stock Based Compensation
30.000%

25.000%
SBC AS % OF ADJUSTED REVENUES

20.000%

15.000%

10.000%

5.000%

0.000%
Q4 2016 Q3 2016 Q2 2016 Q1 2016 Q4 2015 Q4 2015 Q4 2015 Q4 2015 Q4 2015
Source: Square shareholder letters, Author calculations

Staying true to its Silicon Valley roots, Square is a prolific issuer of stock for
acquisitions and to employees as compensation, thereby diluting existing and future
shareholders if the practice continues. Over the twelve months ended 12/31/2016,
Square issued $138.8 million of Stock Based Compensation (SBC), primarily to its
engineering, design, and product personnel in product development ($91.4 million).
This comes to 20% of the Companys Adjusted Revenue of $687MM over the same
period. Given what I believe to be Squares limited prospects for profitable growth, I
believe this generous SBC will detract from shareholder value. Using a dilution
adjusted Black-Scholes model, I calculate the negative impact value on equity of
outstanding stock options at the current stock price to be approximately $963.5
million.

Exhibit 23: Squares outstanding options are valued at almost $1 billion, based
on a $17.43 stock price, and represent an overhang on the companys
valuation
Current stock price $17.43
Options Outstanding 86.7 million
Average Strike Price $7.32
Average expiration term 7.4 years
Standard deviation of Square stock 43.5%
Risk free rate 2.4%

Value per option $11.37


Valuation of outstanding options based on $985.5 million
dilution adjusted Black-Scholes
Source: Author calculations

Copyright 2017 Abdullah Sheikh 18


9. The market is being too optimistic; Squares fair value is 80%
below current levels: By valuing Square at $6.1 billion today, the market is
implying a business that will grow revenues at close to 26% over the next ten years
to over $7 billion, generate over $1.4 billion in operating income at margins close to
20% a year and generate ROICs close to 20% a year. This outcome is highly
unlikely in my opinion given the realities of Squares customer base and business
model.

Exhibit 24: Square Combining reverse DCF with a customer dynamics model
shows the markets implied steady state customer and revenue figures
Key metric Market implied steady state

# of customers 19.3 million


Percentage of micro-merchant market 70%
GPV $531 billion
% GPV > $500,000 14.7%
Transaction margin 1.04%

Square Capital origination volume $9.1 billion


Square Capital gain-on-sale + interest $548 million
revenues*
Software subscription revenues $269 million
Instant deposit revenues $48 million
Invoice revenues $48 million
Food delivery revenues $122 million

Subscription and services-based $1,036 million


revenue

Square hardware revenue $402 million

Total revenues $7.0 billion


Operating income $1.4 billion
Operating margin 20%
Return on invested capital 20%
Terminal cost of capital 8%

Source: Author assumptions

Under more realistic conditions, Square will likely see a sharp deceleration in
revenue growth over time as the realities of its fickle and financially disadvantaged
customer base become more apparent.

My estimate of Squares long-term market share of the micro-merchant card


payment processing market is approximately 7 million merchants, with strong

Copyright 2017 Abdullah Sheikh 19


competition from PayPal Here, Clover, QuickBooks GoPayment, Spark Pay, and
Shopify.

Exhibit 25: Estimate of steady state market share of the micro-merchant card
payment processing market
30%

25%
25%

20%

15% 15% 15%


15%

10%
10%

5% 5%
5%
3% 3% 3% 3%

0%

# of customers in
Company Percentage millions

Square 25% 6.88


PayPal Here 15% 4.13
Clover 15% 4.13
QuickBooks GoPayment 10% 2.75
Spark Pay by Capital One 5% 1.38
Shopify 5% 1.38
Chase Paymentech 2.5% 0.69
Pay Anywhere 2.5% 0.69
Verifone Carbon 2.5% 0.69
Poynt 2.5% 0.69
Others* 15% 4.13

Total 100% 27.50


* Others include "no-frills" solutions like EMS+ and Cartwheel Point of Sale, ISOs/MSRs like Flagship ROAMpay, National Bankcard and
CreditCard Processing.com. Author estimates.

Copyright 2017 Abdullah Sheikh 20


Exhibit 26: Projected Square revenues split between transaction, software and hardware revenues over the next
20 years
$2,500 18.00%

16.00%

$2,000
14.00%

12.00%

Revenue Growth Rate


$1,500
Sales (millions)

10.00%

8.00%
$1,000

6.00%

4.00%
$500

2.00%

$- 0.00%
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036
Subscription and services-based revenue (millions) $153 $177 $204 $232 $263 $293 $324 $357 $392 $430 $456 $472 $483 $490 $496 $501 $506 $510 $515 $519
Square hardware (millions) $53.83$62.92$72.20$81.58$91.03$100.5$110.0$119.5$129.0$138.5$141.5$143.1$144.1$144.6$144.9$145.0$145.1$145.2$145.2$145.2
Transaction revenues (millions) $602 $695 $787 $875 $957 $1,033$1,101$1,162$1,216$1,314$1,388$1,430$1,453$1,466$1,473$1,478$1,480$1,481$1,482$1,482
Revenue Growth Rate 16.41%15.67%13.63%11.82%10.25%8.79% 7.68% 6.76% 5.98% 8.33% 5.51% 2.99% 1.70% 1.01% 0.64% 0.44% 0.33% 0.27% 0.24% 0.23%

Source: Author calculations

Copyright 2017 Abdullah Sheikh 21


In a steady state, I believe Square will generate revenues of just over $2 billion, GAAP
operating margins of 15%, Return on Invested Capital of 10%, with transaction margins
close to 0.77% on a GPV of $171 billion. This compares to PayPals revenues of $6.4
billion, GAAP operating margins of 20%, Return on Invested Capital of 9%, with
transaction margins of 1.80% on a GPV of $354 billion.

Exhibit 27: Assumptions underlying DCF modeling


Key metric Steady state assumption PayPal TTM 2016

# of customers 6.9 million 197 million


GPV $171 billion $354 billion
% GPV > $500,000 14.6% N/A
Transaction margin 0.77% 1.80%

Transaction revenues $1.3 billion $6.4 billion

Square Capital Origination $3 billion $8.4 billion**


volume
Square Capital gain-on-sale + $173 million N/A
interest revenues
Software subscription revenues $85 million N/A
Instant Deposit revenues $17 million N/A
Invoices revenues $43 million N/A
Food delivery revenues $112 million N/A

Total subscription and $500 million $1.352 billion


services-based revenues

Square hardware revenue $138 million N/A

Total revenues $2.1 billion $6.4 billion

GAAP operating income $315 million $1.59 billion


Non-GAAP operating income $420 million $2.17 billion
GAAP operating margin 15% 20.5%
Non-GAAP operating margin 20% 28%
Return on invested capital 10% 8.8%
Initial Cost of Capital 10% N/A
Terminal Cost of Capital 8% N/A

Source: Author calculations

I estimate a fair value of Squares stock at $2.1 per share, which is roughly 90% below
current market levels.

Copyright 2017 Abdullah Sheikh 22


Exhibit 28: Discounted Cash Flow modeling of Squares stock
$20

$18

$16

$14

$12

$10

$8

$6

$4

$2

$0
Current price Estimated value per share

Terminal cash flow (in millions) $172.09


Terminal cost of capital 8.00%
Terminal value (in millions) $3,071.05
Present Value of Terminal value (in
millions) $1,236.74
Present Value of Cash Flow over next 10
years (in millions) $91.24
Sum of Present Values (in millions) $1,327.98
Value of operating assets (in millions) $1,327.98
- Debt (in millions) $96.06
+ Cash (in millions) $514.30
Value of equity (in millions) $1,746.22
- Value of options (in millions) $985.45
Value of equity in common stock (in
millions) $760.77
Number of shares (in millions) 366.59
Estimated value per share $2.1

Source: Author calculations

Copyright 2017 Abdullah Sheikh 23


Chapter 2: Introduction to Square Inc.
This chapter introduces Squares business and is divided into the following sections:

1) Overview of Squares business


2) Squares ecosystem of hardware and software products
3) Management and key shareholder information on Square Inc.

1) Overview of Squares business


Square is a Payment Service Provider (PSP).

At its core, Square provides a service that allows micro-merchants with low volumes of
debit and credit card sales to obtain the benefits only a separate merchant account
could otherwise have provided. Square is not a payment service processor like
First Data, Bank of America, Chase Paymentech, Vantiv or Wells Fargo Merchant
Services.

Square is in fact an Independent Sales Organization (ISO) and Member Service


Representative (MSR) like PayPal and Global Payments. ISOs and MSRs look to
acquire merchants through independent sales efforts and direct their payment
processing through larger payment processors such as Chase Paymentech and Wells
Fargo Merchant Services. ISOs and MSRs are not payment processors, card networks
or issuing banks but simply third-party intermediaries that look to acquire merchants
through independent sales and marketing efforts.

Square provides hardware and software to merchants that enable them to accept debit
and credit card payments. The card readers and stands attach to smartphones and
tablets, providing a business with a point of sale solution. As the Exhibit below shows
examples of Squares card readers, contactless and chip readers and stands. These
Square readers and stands are now a familiar a sight to many people purchasing items
from micro-merchants. The term Square has becoming synonymous with any dongle
used to accept payment cards using a smartphone or tablet.

Copyright 2017 Abdullah Sheikh 24


Exhibit: Squares hardware card readers

Source: Company investor presentation

Squares software handles the backend of the transaction, making sure accounts
square up between the merchant, the card company, the bank, and the consumer. In
laymans terms, as the Exhibit below shows, Square connects the merchants customer
to the acquiring processor, who then ensures the card networks and banks efficiently
process the transaction.

Exhibit: As a micro-merchant aggregator, Square connects customers with the


acquiring processor

Source: American Express, Author illustration.

Square derives most of its revenues from directing the payment processing activity of its
micro-merchants to Chase Paymentech and Wells Fargo Merchant Services its two
acquiring processors.

Squares profits from providing payment processing services comes from taking
a flat fee from the merchant for each card transaction it processes and paying

Copyright 2017 Abdullah Sheikh 25


financial intermediaries such as acquiring processors, card networks and
acquiring banks a fee for ensuring the transaction is processed.

The transaction fees that Square pays financial intermediaries vary depending on the
type and venue of card transaction (debit/credit, reward, consumer/business,
retail/restaurant etc.) Squares transaction profit has been in the region of 1% of Gross
Payment Volume (take rate of 2.93% less transaction cost of 1.92%), as a slide from
their investor presentation shows.

Exhibit: Squares revenues are mainly derived from taking a percentage of GPV,
while its costs are incurred by paying financial intermediaries

Source: Investor presentation

Squares transaction costs on each card payment processed comprises of four different
fees:

1) Third party payment processing fees it pays to Chase Paymentech and Wells
Fargo Merchant Services (typically around 0.05%-0.2% per transaction)
2) Interchange fees set by payment card networks and paid by the merchant to the
customers issuing bank (varies depending on card type, card brand, processing
method, and transaction amount, but typically between 0.5% and 1.7%)
3) Assessment fees paid to payment card networks, such as Visa and MasterCard
(typically 0.12% - 0.13%)
4) Bank settlement fees (vary depending on the nature transaction)

Exhibit: Squares transaction costs comprise of paying third party processors,


interchange fees, assessment fees and bank settlement fees

Copyright 2017 Abdullah Sheikh 26


Interchange fees are typically the largest component Squares cost. Interchange is the
fee paid between banks for the acceptance of card based transactions. It is
usually a fee that a merchant's bank (the "acquiring bank") pays a customer's
bank (the "issuing bank").

Interchange fees are set by debit and credit networks, such as Discover, MasterCard
and Visa, and aim to encourage issuance of a brand of card (e.g. use of Chase
Sapphire Preferred, a Visa signature card, leads to fees for Chase as an issuing bank).
Interchange fees for rewards credit cards are typically higher than those for traditional
cards because banks use the interchange fee to help subsidize the cost of the rewards
program. The exhibit below shows a list of U.S. debit and credit card networks.

Exhibit: Examples of U.S. debit and credit card networks


Debit card networks
Discover NetWorks
MasterCard NYCE
Visa PULSE
ACCEL SHAZAM
AFFN STAR
ATH ACCEL
Credit Union 24 AFFN
Interlink ATH
Jeanie Credit Union 24
Maestro

Credit card networks


Visa
MasterCard
Discover
American Express
Source: Federal Reserve

Copyright 2017 Abdullah Sheikh 27


Interchange fees have been the subject of some controversy for some years, in
the U.S. and around the world, with many merchants arguing against them due to
the direct cost while payment card networks argue for their indirect benefits. It is
important to note that while debit and credit card networks set interchange fees, the
actual fee itself goes to the issuing bank, not payment card network. This distinction is
important in the cases of Visa and MasterCard, although less so for Discover and
American Express, as the latter two are both issuers of the cards bearing their logos
and processors of the payments made with them.

The large card payment networks now publish1 their interchange rates on various
branded card types, regions, transaction type and point of sale. The exhibit below
shows a handful of Visa interchange fees for a few different kinds of cards.

Exhibit: Visa interchange fees for a range of debit and credit cards
Interchange Category Interchange Fee

Retail Debit Regulated 0.05% + $0.21


Retail Debit unregulated 0.95% + $0.20
Visa CPS/Retail 1.51% + $0.10
Card Not Present Debit 1.60% + $0.15
Rewards I 1.65% + $0.10
Retail Key Entry 1.80% + $0.10
Business Card - Retail 2.20% + $0.10
Signature Preferred 2.10% + $0.10
Corporate Card - Retail 2.10% + $0.10

Source: https://www.cardfellow.com/tiered-pricing-merchant-account-services/

2) Squares ecosystem of hardware and software products


As part of its payment processing services, Square also provides a suite of hardware
and software services to micro-merchants. Square offers its micro-merchants a
cohesive ecosystem as the exhibit below shows.

1
MasterCard, Visa, American Express and Discover interchange fees can be found at the following
locations: http://www.MasterCard.com/us/merchant/pdf/MasterCard_Interchange_Rates_and_Criteria.pdf
https://usa.visa.com/dam/VCOM/download/merchants/Visa-USA-Interchange-Reimbursement-Fees-2015-April-
18.pdf

Copyright 2017 Abdullah Sheikh 28


Exhibit: Squares ecosystem

Source: Company investor presentation

Below we delve into each one of Squares product offering to merchants.

Financial Services: Square Capital and Square Payroll


Payments and POS: Point of Sale, Hardware, Analytics, Employee Management,
Instant Deposit, Cash, Invoices, Appointments, Online Store and Build with Square
Marketing Services: Customer Engagement and Caviar

Financial Services Square Capital

Square provides merchants with working capital loans. A working capital loan is a loan
that has the purpose of financing the everyday operations of a company. Working
capital loans are not used to buy long-term assets or investments and are instead used
to cover accounts payable and wages. Companies that have high seasonality or cyclical
sales cycles usually rely on working capital loans to help with periods of reduced
business activity.

Square Capitals working capital loans are paid back with receipts from future debit and
credit card receivables. The term of the loan is 18-months; however, merchants have
the option of paying them back sooner. Square has moved away from giving merchant
cash advances which are not loans per federal law to making loans though Celtic
Bank, selling these loans to third-party investors. In both cases, repayments are
financed through future credit and debit card receivables.

This is an attractive business for Square, since it has intimate knowledge of its micro-
merchants, courtesy of often being their sole card processors. Square only forwards
loans to financially stable micro-merchants that it believes will be able to pay these
loans back. The exhibit below shows a sample of three loan options sourced from
Square Capitals main website.

Copyright 2017 Abdullah Sheikh 29


Exhibit: Three loan options from Square Capital

Source: https://squareup.com/dashboard/capital

Square Capital makes money in two ways: An upfront origination fee and a nominal
recurring service fee. In its Q2 2016 shareholder letter, Square states that loans have a
weighted average fee at origination of 14%. Loans typically have an eighteen-month
duration; however, Square expects the repayments to happen over approximately ten
months. Sellers are obliged to use Squares payment processing platform once they
have taken out a loan.

More recently, Square partnered with Upserve, a startup that offers software and
its own point of sale service to help restaurants manage their businesses, to offer
loans to merchants that do not use Squares hardware or software. Square still
underwrites the loans based on the merchants sales history and the mechanism for
repayment is like that used by Square merchants.

The table below shows a sample terms and annual percentage rates (APR) on a
Square Capital loan.

Copyright 2017 Abdullah Sheikh 30


Exhibit: Sample terms and APR on a Square Capital loan
Loan amount $10,000
Repayment amount (MCA Factor Rate:
12%) $11,300
Expected repayment term (months) 10.0
Maximum repayment term (months) 18.0
Expected monthly payment amount $1,130
Minimum monthly payment amount $628

Annual Percentage Rate (min) 15.8%


Annual Percentage Rate (max) 27.4%
Source: https://squareup.com/capital, Author calculations, * Based on comments section of
https://www.cardpaymentoptions.com/financing/square-capital/

High APRs are characteristic of working capital loans, as they give merchants fast
access to cash and are not collateralized by any underlying assets. Working capital
loans through Square Capital are ideal for micro-merchants with limited ability to
get credit from more mainstream sources due to little or poor personal and / or
business credit.

The exhibit below shows loan origination volume, and the average size of Square
Capital loan, derived by dividing loan origination volume by the total number of loans.

Exhibit: Square Capital origination volume and average loan size


$300 $6.80

$6.60
$250
$6.40
Origination volume (millions)

$200 $6.20

Average loan size


$6.00
$150
$5.80

$100 $5.60

$5.40
$50
$5.20

$0 $5.00
Q4 2016 Q3 2016 Q2 2016 Q1 2016 Q4 2015

Origination volume Size

Full
Q4 Q3 Q2 Q1 Q4 Year Full Year
Metric 2016 2016 2016 2016 2015 2016 2015

Copyright 2017 Abdullah Sheikh 31


Origination
volume
(millions) $248 $208 $189 $153 $150 $798 $400
Average size
of loan $6.20 $5.94 $5.56 $6.65 $6.65* $6.05 $5.71

# of loans 40,000 35,000 34,000 23,000 22,549* 132,000 70,000


Source: Square Shareholder Letters. Author calculations. * Q4 2015 figures are not provided by Square. I derived # of loans in Q4
2015 assuming average loan size similar to Q1 2016.

Financial Services Square Payroll

Square Payroll allows business owners to process payroll for their employees and
handles a business' withholdings, payroll payments, and tax filings. Square Payroll is
available in Alaska, Arizona, California, Florida, Georgia, Illinois, Maryland, North
Carolina, New Hampshire, Nevada, New York, South Dakota, Tennessee, Texas,
Virginia and Wisconsin.

The exhibit below shows Square Payroll from the perspective of a merchant logged into
Square Dashboard. Square Payroll is priced at $25 per month with an extra $5 per
employee.

Exhibit: Square Payroll on Square Dashboard

Source: https://squareup.com/dashboard/payroll

Payments and POS Square Point of Sale

Square Point of Sale is Point of Sale (POS) software. Square Point of Sale combines
payment processing with point-of-sale functionality like itemization and inventory

Copyright 2017 Abdullah Sheikh 32


management. Square offers POS systems customized to the following industries: Food
& Beverage, Restaurants, Coffee Shops, Bakeries, Food Trucks, Retail, Apparel,
Groceries, Beauty Professionals, Salons, Spas, Health & Fitness, Home & Repair
Services, Professional Services, Leisure & Entertainment and Transportation. The
exhibit below shows a sample POS system sourced from Squares website. Square
Point of Sale is free for merchants using Squares payment processing platform.

Exhibit: Square offers a POS software for functionality across different industries

Source: https://squareup.com/pos

Payments and POS Square Hardware

As the exhibit below shows Squares range of hardware options includes Square Stand
for Contactless + Chip at $169, Contactless + Chip Reader at $49, Chip Card
Reader at $29 and a free Magstripe Reader.

Copyright 2017 Abdullah Sheikh 33


Exhibit: Squares hardware options include card readers and POS systems

Source: https://squareup.com/shop/hardware/us/en

Payments and POS Square Analytics

Square Analytics is free business intelligence software. Business intelligence


software helps companies gain perspective on their business operations. It is the
process of transforming unstructured business data into reportable data sets and
visualizing that data into graphs and tables that expose valuable insights. This software
often creates automated reports and dashboards that can be deployed to end users, as
well as non-technical user interfaces for business users to either slice and dice data on
their own or perform ad hoc reporting. As the exhibit below shows a sample report from
Square Analytics. Square Analytics is free for users of Squares payment processing
platform.

Exhibit: Sample Square Analytics report

Copyright 2017 Abdullah Sheikh 34


Source: https://squareup.com/pos/dashboard/analytics

Payments and POS Square Employee Management

Squares employee management software allows merchants to filter reports by


employee, device, or location. It also allows them to see revenue-per-labor-hour
reports, find the most efficient employees and view which employees closed which cash
drawers. Square Employee Management is available for $5 per employee per month.
As the exhibit below illustrates some of the functionality offered by Square Employee
Management.

Exhibit: Creating a new employee profile in Square Employee Management

Source: https://squareup.com/dashboard/employees/permissions/employees/new

Payments and POS Square Instant Deposit

Square Point of Sale allows has embedded functionality called Instant Deposit, that
allows merchants to deposit cash into their linked bank accounts for a 1% fee. There is
a minimum deposit amount of $50.

Payments and POS Square Cash

Copyright 2017 Abdullah Sheikh 35


Square Cash allows person-to-person money transfer via the Square Cash app or e-
mail. In March 2015, Square introduced Square Cash for businesses, which includes
the ability for individuals, organizations, and business owners to use a unique username
to send and receive money, known as a $cashtag. Deposits find themselves in user
accounts the next business day.

Exhibit: Square cash allows person-to-person money transfers

Source: www.squareup.com

Payments and POS Square Invoice

Square allows merchants to request payment for goods or services with Square
Invoices from their online Square Dashboard or from a supported mobile device. From
Dashboard, merchants can create and send invoices, create recurring invoice series,
and schedule invoice deliveries. As the exhibit below shows Square Invoice from the
perspective of a merchant logged into Square Dashboard. Square charges 2.9% +
$0.30 per paid online invoice.

Copyright 2017 Abdullah Sheikh 36


Exhibit: Square Invoice on Square Dashboard

Source: https://squareup.com/dashboard/invoice

Payments and POS Square Appointments

Square Appointments is scheduling software that provides merchants with an online


calendar and the ability to create a booking site. Merchants can give direct access to
employees and customers, allowing for a more seamless meeting and selling
experience. A booking site allows customers to directly book a time for a specific
service. For example, customers can book an appointment for a haircut with a specific
employee at a salon via an online booking site. Square Appointments can be accessed
from Squares POS system.

There are three plans available: Just Me plan at $30 per month, 2-5 Staff plan at $50
per month and Unlimited plan at $90 per month. As the exhibit below shows a
summary of Square Appointments main features.

Exhibit: Square Appointments provides an online booking site for scheduling

Source: https://squareup.com/appointments

Payments and POS Square Online Store

Copyright 2017 Abdullah Sheikh 37


Square Online Store allows merchants to set up an e-commerce site. As the exhibit
below shows Square online store from the perspective of a merchant logged into
Square Dashboard. Square Online charges 2.9% + $0.30 per transaction processed.

Exhibit: Square Online Store on Square Dashboard

Source: https://squareup.com/store/admin/onboarding/info

Payments and POS Build with Square

Square allows developers the ability to re-program its Application Programming


Interfaces (APIs) for their purpose, all the while utilizing Squares payment processing
abilities. This allows programmers to build an ecosystem for businesses to accept
payments online, in store, or on the go.

The exhibit below illustrates Squares mobile and POS API.

Copyright 2017 Abdullah Sheikh 38


Exhibit: Description of Square mobile and POS payments API

Source: https://squareup.com/developers

The exhibit below shows a description of Squares e-commerce API.

Exhibit: Description of Square e-commerce APIs

Source: https://squareup.com/developers

Marketing Services Square Customer Engagement

Square Customer Engagement is a suite of Customer Relationship Management (CRM)


tools that allow for effective email marketing campaigns, response to feedback from

Copyright 2017 Abdullah Sheikh 39


customers, and allow for development of customized loyalty programs. Square
Customer Engagement comprises of: Email Marketing software at $15 per month, free
Customer Feedback software and Square Loyalty at $25 per month per location.

Exhibit: Square Customer Engagement is a suite of CRM tools

Source: https://squareup.com/customer-engagement

Square has recently introduced Square Gift Cards. This allows customers the ability to
send gift cards to friends and family, as the exhibit below shows. There are three
choices for merchants: Starter Packs ($2 per card, 20 cards per pack), Quick Cards
($1.5 per card, 125-card minimum) and Custom Cards ($1.5 per card, 500 card
minimum).

Exhibit: Square Gift Cards allows customers to send friends and family gift cards

Source: https://squareup.com/gift-cards

Marketing Services Caviar

Caviar enables restaurants that do not currently deliver to reach new customers and
increase sales. Caviar manages the logistics of delivery through its purpose-built

Copyright 2017 Abdullah Sheikh 40


courier and order management app. However, as Caviar positions itself between
customers and restaurants, it is not business-to-business (B2B), but rather
business-to-customer (B2C) operation. Caviar charges restaurants a service fee,
as a percentage of total food order value, and customers, a fixed fee per delivery plus a
service fee.

Caviar FastBite a subdivision of Caviar offers a different service to Caviar. Caviar


Fastbite curated meals and provides delivery in as little as 15 minutes. Caviar is
currently available in New York, Los Angeles, San Francisco, and Philadelphia.

Square ecosystem Integration with third party apps

Squares platform integrates with a very wide variety of other software solutions in the
industry, as specified in their app marketplace website2 as the exhibit below shows.

Exhibit: Squares payment processing services sync with many different


specialized software applications

For example, Square seamlessly integrates with:

Accounting & Tax apps such as Intuit QuickBooks, Xero and Shogo
E-Commerce apps such as Weebly, Bigcommerce and WooCommerce
Point of Sale apps such as TouchBistro and Vend.
Inventory apps such as Shopventory, Stitch Labs and Intrakr.
Invoice apps such Jobber, Invoice ASAP and Breezeworks.
Restaurant management apps such as Fresh KDS, PeachWorks and
MarketMan.
Employees & Scheduling apps such as Deputy, Humanity and Homebase.

3) Management and key shareholder information on Square Inc.


Management and ownership information

Exhibit shows the management team currently in place, led by charismatic CEO Jack
Dorsey, also a co-founder of Twitter Inc. the popular social media company.

2
For full list of apps, please see: https://squareup.com/app-marketplace

Copyright 2017 Abdullah Sheikh 41


Exhibit: Square Management team
Jack Dorsey, 39 Co-Founder, Chairman, Chief Executive
Officer and President
James Morgan McKelvey Jr., 51 Co-Founder and Director
Sarah Friar , 43 Chief Financial Officer
Kevin Burke Head of Customer Acquisition
Jacqueline D. Reses, 46 People Lead and Square Capital Lead
Source: http://www.bloomberg.com/research/stocks/private/people.asp?privcapId=83920810

Finally, the exhibit below shows key statistics on ownership, insider holdings and insider
trades as captured by Nasdaq. Insiders own a significant percentage of the company,
led by CEO Jack Dorsey, who owns nearly 20% of shares outstanding. There have
been no major insider sales over the last year or so.

Exhibit: Square Large outside holders

Source: http://www.nasdaq.com/symbol/sq/ownership-summary

Exhibit: Square Large inside owners and trades

Source: http://www.nasdaq.com/symbol/sq/ownership-summary

Copyright 2017 Abdullah Sheikh 42


Chapter 3: Reasons for Squares rapid growth
This chapter covers reasons for Squares rapid success in micro-merchant payment
processing and is divided into the following sections:

1) Overview of Squares financial success


2) First-mover advantage in micro-merchant payment processing
3) Favorable economic environment since inception in 2009

1. Overview of Squares financial success


Square has been very successful in acquiring micro-merchants. This is reflected in
rapid revenue growth as their fourth quarter 2016 earnings report demonstrates. The
exhibit below shows key results from their Q4 2016 shareholder letter.

Exhibit: Squares Q4 2016 results show continued rapid profitable revenue


growth and raised guidance

Copyright 2017 Abdullah Sheikh 43


Source: Square Q4 2016 shareholder letter

Some key points from the Q4 quarterly results are as follows:

GPV is up 34% year over year, Adjusted revenues3 are up 43% year over year.
While the company is losing money, that loss has narrowed significantly year
over year. Taking out the effects of stock-based compensation, Adjusted
EBITDA turned position at $30 million, which represents a 16% margin.
Square has issued financial guidance for 2017 after raising guidance for three
straight quarter, reflecting a series of positive results. The 2017 guidance calls
for Adjusted revenue of $880 - $900 million, and adjusted EBITDA of $100 - $110
million.

Many of Squares micro-merchants participated in the original Initial Public Offering


(IPO4) and are regulars on the Companys quarterly earnings call.

2. Squares financial success has been a function of first-mover


advantage in micro-merchant payment processing
Squares rapid growth has been a function of providing the micro-merchant market with
the ability to use debit and credit card processing technology using their smartphones
and tablets, all for a flat fee per transaction. High smartphone and credit card
3
Adjusted revenues take out the effects of their terminated partnership with Starbucks and allow for
transaction expenses associated with their core payment processing business.
4
From Q4 2015 shareholder letter: At the time we went public, we offered our sellers the ability to buy
equity in Square at the IPO price. Over 14,000 sellers did, and we are thrilled that they are now also
owners of the company. The proceeds from this Directed Share Program beneted the Start Small
Foundation, a foundation Jack created to invest in artists, musicians, and local businesses, with a focus
on underserved communities. We look forward to welcoming these seller-shareholders to our earnings
call and hearing from them during Q&A.

Copyright 2017 Abdullah Sheikh 44


penetration rates in the U.S., together with a financially unsophisticated micro-
merchant market, have been the magic formula for Squares success.

Square has jumped at the opportunity to serve the traditionally unprofitable micro-
merchant market. As the exhibit below shows, Square simplifies the process for micro-
merchants by providing an easy to use service for one fee per swipe of 2.75% and 3.5%
+ 15c for every keyed-in card payment together with chargeback protection of up to
$250 per month, for merchants who follow best practices.

Exhibit: Square offers an easy to understand card payment platform with flat
rates

Source: www.squareup.com

There is one flat price, no monthly fees, no hidden fees, full PCI compliance,
deposits in one or two business days, charge back protection, and payment
dispute assistance. Square has attracted micro-merchants who want to avoid dealing
with the long list of charges a typical merchant account statement would show. Exhibit
shows 19 charges a merchant might see on their card processing statement. With
Square, a merchant does not have to deal with these complex charges.

Exhibit: List of fees and charges typically found on a merchant account statement
Discount rate Monthly Network access Chargeback /
statement/Support/Service fee retrieval fee
fee
Transaction fee Internet gateway fee PCI non- Annual fee
validation fee

Copyright 2017 Abdullah Sheikh 45


PIN debit Voice authorization fee Surcharge / Cancellation /
transaction fee partial qualified / termination fee
non-qualified fee
Address Monthly minimum fee Application / Hidden / Junk
verification setup fee fees
service
transaction fee
ACH/daily batch Transaction fee Re-programming
fee fee
Source: http://www.transfirst.com/resources/merchant-basics/merchant-account-fees

Square offers easy access to either a free or low cost card reader, fully compatible with
the latest Payment Card Industry Data Security Standard (PCI DSS). Squares
hardware is cutting edge, offering EMV transaction processing speeds of just 4.2
seconds, compared to industry standards of 8 13 seconds. Square offers its
hardware at a discount to competitors. For example, Square Contactless and Chip
Reader sells for $49, PayPal Chip Card Reader sells for $79 and Shopify Tag, Chip.
And Swipe sells for $89. The exhibit below shows the two card readers and their prices
from the respective websites.

Exhibit: Square hardware is priced at a significant discount to competitor


products, such as PayPal and Shopify

Copyright 2017 Abdullah Sheikh 46


Source: https://hardware.shopify.com/products/tap-chip-and-swipe-card-reader?variant=6732491201,
https://www.paypal.com/store/, https://squareup.com/shop/hardware/us/en/products/chip-credit-card-reader-with-nfc

Square highlights the reasons why micro-merchants have been attracted to its payment
processing solutions in an investor presentation below, as the exhibit shows.

Exhibit: Square highlights advantages of its payment processing solution for


micro-merchants vs. traditional solutions in an investor presentation

Source: Investor presentation

Square also offers an attractive suite of software solutions for the micro-merchant
market. In its investor presentation, Square describes the transition from a pen-to-
paper solution to a full digital solution that micro-merchants achieve as they transition
their businesses to a digital solution. As the exhibit below illustrates, this can be a good

Copyright 2017 Abdullah Sheikh 47


experience, given how Squares ecosystem almost instantaneously organizes a micro-
merchants transactions and business activity.

Exhibit: Square makes it easy for micro-merchants to go from a pen-and-paper


trail to a digital solution

Source: Investor presentation

Square also ranks highly with the Better Business Bureau (BBB). The Better Business
Bureau (BBB) is a private nonprofit organization that receives consumer complaints and
rates the performance and reliability of businesses based on several criteria. The BBB
aims to promote ethical business practices, leading to an environment where buyers
and sellers can operate under a common understanding of trust.

The Better Business Bureau (BBB) rates Square an A+. This is despite 1,453
complaints, as Exhibit, a screenshot from BBBs website shows, as it views Square
overall as being a positive for the micro-merchant market. A good rating from the BBB

Copyright 2017 Abdullah Sheikh 48


is a positive to onboarding new micro-merchants searching for an online payment
solution.

Exhibit: Squares BBB Rating

Source: Better Business Bureau

3. Favorable economic environment since inception in 2009


Squares rapid growth since inception in 2009 has been facilitated by an economic
recovery since the financial crisis. This economic recovery has been aided in some
measure by U.S. and global government initiatives, such as the JOBS Act and
Quantitative Easing programs, the latter leading to lower interest rates that have
encouraged credit growth in various forms (mortgages, business loans, re-leveraging
and credit card spending). The result in the U.S. has been a positive economic growth
rates, job growth, rising business formations and a rising stock market.

Exhibit below show the performance of the Russell Microcap Index since 2009 (Ticker:
RMICRO). Since the lows on March 9, 2009, the IWC is up 348%, a compounded
annual total return of 20.7% per year. Square launched in February 2009, right in the
depths of the financial crisis. Business performance has benefited immensely from the
effects of an economic recovery through this period.

Copyright 2017 Abdullah Sheikh 49


Exhibit: Russell Microcap Index is up 348% since March 2009 a tailwind to
Squares micro-merchant payment processing business

Source: Bloomberg

Positive economic growth has a dual-effect on Squares GPV growth. First, GPV
growth benefits due to sales growth associated with existing micro-merchant clients.
Second, GPV growth benefits due to more micro-business formations and client
acquisitions. This dual effect can lead to high levels of top line GPV growth during
periods of economic expansion. This is partly the reason for Squares outperformance
of analyst estimates over the last five quarters, as the exhibit below shows.

Exhibit: Square has outperformed analysts expectations over the last four
quarters due to dual tailwinds of micro-merchant acquisitions and GPV growth
400 10.00%

9.00%
350
8.00%
300
7.00%
Revenues ($ millions)

250
6.00%
Surprise

200 5.00%

4.00%
150
3.00%
100
2.00%
50
1.00%

0 0.00%
Q4 2016 Q3 2016 Q2 2016 Q1 2016 Q4 2015

Actual Adjusted Revenue ($ million) Consensus Adjusted Revenue ($ million) Surprise (%)

Copyright 2017 Abdullah Sheikh 50


Period ending Actual Adjusted Consensus Surprise (%)
Revenue ($ Adjusted
million) Revenue ($
million)
Q4 2016 191.9 187.7 +2.2%
Q3 2016 177.8 172.9 +2.8%
Q2 2016 170.8 159.4 +7.2%
Q1 2016 146.2 134.6 +8.6%
Q4 2015 374.4 344.7 +8.6%
Source: Bloomberg

Another measure of the current mood surrounding small business is the National
Federation of Small Business (NFIB) Optimism Index. The Small Business Optimism
Index is a composite of ten5 indicators that provides a monthly, summary data point for
the state of the small business economy. It is a coincident indicator of the national
economy, though it also offers direction for the small business sectors immediate
prospects. As the exhibit below shows that the NFIB reached highs not seen since
2007, thanks in part to a post-election spike.

Exhibit: Small Business Optimism is approaching all-time highs

Source: National Federation of Independent Business (NFIB)

5
The ten indicators include: good time to expansion, general economic outlook, expected sales, current
earnings, planned capital outlays, current job openings, hiring plans, inventory status, expected inventory
change, and expected credit conditions.

Copyright 2017 Abdullah Sheikh 51


Chapter 4: Squares competitive landscape
This chapter covers Squares key sources of competitors. It is broken down into the
following sections:

1. Competition source #1: Mobile payment service providers, who compete for
the same micro-merchant customer base as Square
2. Competition source #2: Small business solution providers, focusing on
mobile and non-mobile payment processing services
3. Competition source #3: Small business solution providers, focusing on
providing services that compete with Squares suite of ecosystem products
Competition source #3a: Financial Services providers, competing with
Square Capital and Square Payroll
Competition source #3b: Payment and Point of Sale product providers,
competing with Square Point of Sale, Hardware, Analytics, Employee
Management, Instant Deposit, Cash, Invoices, Appointments, Online Store
and Build with Square
Competition source #3c: Marketing Services providers, competing with
Square Customer Engagement and Caviar

1. Competition source #1: Mobile payment service providers, who


compete for the same micro-merchant customer base as Square
Mobile payment service providers focusing on the micro-merchant market operate in a
very competitive business. www.toptenreviews.com recently did a thorough analysis of
all major players in micro-merchant mobile payment processing and maintains a
website which showcases the results of their research. The complete research can be
found here:

www.toptenreviews.com/business/payment-processing/best-mobile-credit-card-
processing/

In addition to independent research, in this section, I lean on their work to help me


compare a wide variety of providers.

Toptenreviews.com specializes in doing independent research on a wide variety


of products and services across a broad range of industries, such as electronics,
health, software, financial products and services. Some of their recent work
includes finding the best Wi-Fi speakers, telemedicine for healthcare professionals and
patients, portable oxygen concentrators, bike trainers, TVs, VR headsets, Sous Vide
machine, camping axes, structured settlement annuity, DSLR camera lenses, anti-virus
software, sleeping bags and DIY home automation systems.

The exhibit below ranks a list of 15 micro-merchant mobile payment service providers
compiled by toptenreviews.com.

Copyright 2017 Abdullah Sheikh 52


Exhibit: Highly-rated mobile payment service solutions for micro-merchants as
ranked by toptenreviews.com

toptenreviews.com summarizes the noteworthy feature of each service provider and


what the company is potentially best for. Exhibit summarizes this research.

Exhibit: Notable features and best for research from toptenreviews.com


Provider ranking Noteworthy Feature Best For

1. Square Business-support features Growing businesses


2. Cartwheel Point of Sale+ No hardware required Larger tickets
3. EMS+ Low swipe rate Pay-as-you-go
4. CDGCommerce Good rates Larger tickets
5. Spark Pay No fees Process where you bank
6. QuickBooks GoPayment Includes invoicing Service- based businesses
7. PayPal Here Chip & PIN hardware Pay-as-you-go
8. Moolah Includes Authorize.net
Pay-as-you-go
access
9. Yowza Merchant (acquired
Low swipe rate Larger tickets
by Spindle)
10. Flagship ROAMpay Robust customer support Businesses of all sizes
11. CreditCardProcessing.com Lowest debit swipe rate Growing businesses
12. Elavon One of the largest
Businesses of all sizes
processors
13. Cayan Small and medium
Good rates
businesses
14. Chase Paymentech Large processor and bank Processing where you bank
15. Pay Anywhere Good rates Seasoned businesses

Source: toptenreviews.com/business/payment-processing/best-mobile-credit-card-processing

Copyright 2017 Abdullah Sheikh 53


2. Competition source #2: Small business solution providers,
focusing on mobile and non-mobile payment processing services
Square also faces competition from traditional merchant account providers and
payment processors for its successful merchants. A business processing a
significant amount of card payment volume would almost certainly be approached
with very low card payment processing rates by one of the traditional payment
processors or one of their affiliates (known as Independent Sales Organizations 6
(ISOs) and Member Service Providers (MSPs).

ISOs and MSRs are not payment processors, card networks or issuing banks but
simply third-party intermediaries that look to acquire merchants through independent
sales and marketing efforts.

A full list of Squares competitors for higher volume accounts is long, as


becoming a ISO is a low barriers-to-entry business due to low capital
requirements and limited technical expertise necessary, as the payment
processors do all the heavy lifting. Payment processors, such as Wells Fargo
Merchant Services, First Data and Vantiv, have active programs 7 that assist formation
of new ISOs. Visas Global Registry8 of Service Providers lists all companies
currently Point of Saleed with Visa as a ISO (over 5,000 entries). Square operates
under four types of validations that allow it to accept and process Visa branded debit
and credit cards. This includes PCI DSS compliance9, PCI-PIN compliance10,
Visa TPA Program (ISO-C11) and Visa TPA Program (ISO-M12).

To focus on Squares competitors and narrow down the list from over 5,000 entries, in
Exhibit below, I list the companies that fit a narrower criterion. The criteria are three-
pronged in nature requiring a) registration in Visas ISO-M program b) PCI DSS
compliance and c) POS / card present processing capabilities. Filtering Visas
Global Registry of Service Providers using these three factors results in the short list

6
ISO/MSPs are required to show affiliations with underlying processing banks. For example, Global
Payments, has the following disclosure: Global Payments Direct, Inc. is a Point of Saleed ISO of Wells
Fargo Merchant Services Bank, N.A., Walnut Creek, CA. Global Payments Direct, Inc. doing business as
Global Payments Direct, Inc. is a Point of Saleed ISO/MSP of HSBC USA, N.A. Buffalo, NY.
7
Details of Vantivs ISO program can be found here: https://www.vantiv.com/partners/independent-sales-
organizations, First Datas ISO program can be found here: https://www.firstdata.com/en_us/about-first-
data/first-data-partners/iso-partnerships.html
8
Detailed list of ISOs can be found at: http://www.visa.com/splisting/searchGrsp.do
9
The Payment Card Industry Data Security Standard (PCI DSS) is a proprietary information security
standard for organizations that handle branded credit cards from the major card brands including Visa,
MasterCard, American Express, Discover, and JCB.
10
The PIN Security Program outlines the minimum acceptable criteria for securing Personal Identification
Numbers (PINs) and encryption keys.
11
ISO Cardholder (ISO C) conducts cardholder solicitation, card application processing services
and/or customer service activities.
12
ISO Merchant (ISO M) conducts merchant solicitation, sales, customer service, merchant
transaction solicitation or merchant training activities; acts on behalf of a client for merchant solicitation,
sales or service of Interlink capable POS terminals.

Copyright 2017 Abdullah Sheikh 54


shown in Exhibit. These ISOs are active merchant acquirers soliciting merchants with
POS solutions that are PCI DSS compliant. In other words, many of these companies
are Squares competitors for small business accounts.

Exhibit: ISOs that satisfy being Point of Saleed in Visas ISO-M, are PCI DSS
compliant and POS / card present processors are Square competitors
1. 2C Processor USA, LLC. 2. National BankCard Services
3. ABC Financial Services, Inc. 4. National Merchant Center
5. Adyen B.V (VI) 6. North American Bancard, LLC
7. Amazon.com 8. Paymaxx Pro, LLC
9. Base Commerce, LLC. 10. Payment Data Systems, Inc.
11. Beanstream Internet Commerce 12. Payment Logistics, LLC
Corp.
13. Blackstone Merchant Services, Inc. 14. Payment Processing Partners, Inc.
15. Bruber Financial Services, Inc. 16. PayPal
17. Bytemark, Inc. 18. PaySimple, Inc.
19. ClearChoice Merchant Services DBA 20. Paywire Incorporated
ClearGate
21. Convenient Payments LLC 22. Phreesia Inc
23. Credomatic of Florida, Inc. 24. Pivotal Payments, Inc.
25. CyberSource (including 26. Planet Payment, Inc.
Authorize.Net, Managed Hosting,
and K.K.)
27. Easy Pay Solutions, Inc. 28. Plug & Pay Technologies, Inc.
29. Electronic Payment Exchange (EPX) 30. Preferred Health Technology, Inc.
31. EVO Merchant Services 32. ProPay USA, Inc.
33. Financial Transmission Network Inc 34. Retail Point, LLC
35. First American Payment Systems, 36. Sage Payment Solutions, Inc.
Inc.
37. First Data Merchant Services 38. Spindle, Inc.
39. FrontStream Payments, Inc. 40. Sterling Payment Technologies, LLC
41. Global Payments Direct, Inc. 42. Total Merchant Services
43. GOTOBILLING, Inc. 44. TouchNet Information Systems, Inc.
45. Heartland Payment Systems 46. TRXServices LLC
47. Highline Software Inc 48. United Merchant Services, Inc.
(UMSI)
49. i2c Incorporated 50. Vanco Payment Solutions, Inc
51. JRE VIRTUAL ARCHITECT LLC 52. VMC Equity Partners, LLC
53. Merchant e-Solutions 54. WePay Inc
55. Mercury Payment Systems, LLC. 56. Worldpay SN, LLC
Source: Visa Global Registry of ISOs

Some names on the list are familiar. For example, First Data Merchant Services and
PayPal. While other names are less familiar, such as Easy Pay Solutions and Spindle
Inc. However, all compete with Square to convert successful merchants into POS
payment processing clients.

Copyright 2017 Abdullah Sheikh 55


One prominent mobile and non-mobile payment solution provider that actively
competes for micro-merchants and small business accounts is Clover by First Data.
To cut into Squares market, First Data launched Clover in April 2012 - a mobile
point of sale system targeting micro merchants and small businesses. Clover
offers all the functionality that Square offers, from hardware, software and financial
services as the exhibit below shows.

Exhibit: Clover allows a range of products targeting micro and small merchants

Source: www.clover.com

Clovers suite of hardware, software and financing solutions is very


comprehensive. It includes:

Clover Go, Clover Mini, Clover Mobile and Clover Station provide an
extensive line up of Contactless, Chip, and Swipe Card Readers, fully featured
mobile / non-mobile Point of Sale systems and Point of Sales
Clover Accessories gives merchants access to printers, barcode scanners,
PIN pads, printers, drawers, weight scales, printing paper, merchant keypads,
bill & coin trays, pin shields, mobile docks and clips.
Clover technologies support payment security and check acceptance.
Clovers online store allows merchants to set up websites with fully functional
payment technology and compatibility with a broad range of apps.
Clovers gift cards allow customization to allow merchants to attract new
customers.
Clover marketing solutions are geared towards increasing awareness of a
merchants products through online and offline marketing solutions.
Clovers Free market intelligence software allows businesses to benchmark
performance against similar businesses in the industry.
Clover productivity apps gives access to proprietary and third party software
that allow businesses to improve accounting, employee and time management.
Clover Capital allows merchants to turn their future credit card sales into
working capital.

Clover provides a hardware, software and a financing platform compatible with a wide
variety of payment processing pricing plans offered by First Data, including flat rate
pricing, tiered pricing or interchange plus pricing.

Copyright 2017 Abdullah Sheikh 56


Broadly speaking, merchant accounts can have two types of pricing schedules for the
per transaction component of the bill (known as the merchant discount rate): tiered
pricing or inter interchange plus pricing (also known as cost plus).

1) Tiered pricing: Typically, under this formula, merchant account providers or


processors offer different rates for qualified, mid-qualified and non-qualified
card transactions. The table below shows three13 tiers using nine common
Visa interchange categories.

Exhibit: Example of tiered pricing schedule


Interchange Processor's Processing
Category Interchange Fee Tiered Rates Markup

Retail Debit Regulated 0.05% + $0.21 1.64% + $0.04


Retail Debit Qualified:
unregulated 0.95% + $0.20 1.69% plus 0.74% + $0.05
Visa CPS/Retail 1.51% + $0.10 $0.25 0.18% + $0.15
Card Not Present
Debit 1.60% + $0.15 Mid-Qualified: 0.65% + $0.16
Rewards I 1.65% + $0.10 2.25% plus 0.60% + $0.21
Retail Key Entry 1.80% + $0.10 $0.31 0.45% + $0.21
Business Card - Retail 2.20% + $0.10 Non- 1.15% + $0.21
Signature Preferred 2.10% + $0.10 Qualified: 1.25% + $0.21
Corporate Card - 3.35% plus
Retail 2.10% + $0.10 $0.31 1.25% + $0.21

Source: https://www.cardfellow.com/tiered-pricing-merchant-account-services/

Like the flat pricing structure offered by Square, tiered pricing is simpler for
merchants to understand as there are only three categories of charges.
However, like Square, this leads to higher rates for the merchant.
CardFellow.com thinks merchants who use tiered pricing can save 40-50% by
moving to an interchange plus model. The biggest costs can come from the
processor routing more transactions through the non-qualified category, but
showing very low qualified rates (which only cover a small set of payment card
options typically used). Sometimes, processors using tiered pricing also keep
returned interchange fees on refunds, that are in fact due back to the
merchant. This can lead to higher costs for the merchant.

2) Interchange Plus pricing: Interchange plus is the term used to describe a


merchant account pricing model where a fixed processor markup is applied
directly to interchange fees published by Visa, MasterCard and Discover. The
processor markup is typically in basis points and can be anywhere 0.05% to
0.2%. There is also an additional authorization request fee that is charged

13
Some 3 tiers programs have added 2 classifications for debit cards that are processed without a PIN or
with a PIN for a total of 6 rate classifications.

Copyright 2017 Abdullah Sheikh 57


each time a merchant sends a transaction to the customers issuing bank. The
markup assessed to a transaction is the same regardless of which interchange
category a transaction qualifies to. The interchange charges and markup
combine to yield the merchant discount fee, which is the merchant's cost to
process the transaction.

Interchange plus is the most transparent, cost-effective form of merchant


account pricing. The separation of processing costs with interchange
plus also allows for the optimization of interchange expenses.

One example of interchange plus pricing comes from Dharma Merchant


Services, a Point of Saleed ISO of Wells Fargo Merchant Services. Dharma
charges 0.25% + $0.10 per transaction above interchange. On a Visa CPS
Retail card this can work out to 2.1% per transaction, as the exhibit below
shows. Dharma does have other charges like a regular merchant account,
which means that its services are attractive to customers transacting at least
$10,000 in card volumes.

Exhibit: Dharma Merchant Services pricing example

Source: https://www.dharmamerchantservices.com/storefront-rates/

More recently, innovations in the industry have led to interchange plus zero pricing.
For example, Payment Depot charges membership fees and passes through
wholesale pricing to its clients. In other words, it takes no percentage markup on
interchange, but does charge the per transaction amount it pays to processors.

Copyright 2017 Abdullah Sheikh 58


Exhibit: Payment Depot passes through wholesale rates, also called
interchange plus zero, to members who only pay an annual membership fee

Source: www.paymentdepot.com

Separate merchant accounts require an application from the business owner and
have a longer due diligence time frame than opening a Square account, which can be
instantaneous. It is worth noting that Squares instantaneous account opening
process is somewhat a case of semantics, because Square does due diligence once
the account is opened and terminates many accounts post this due diligence due to
poor risk profile. So while Square accepts 95% of sellers who apply14, a significant
number of accounts are subsequently closed down due to high risk. Examples of
high risk businesses include dating websites, debt collection agencies, multi-level
marketing companies and adult websites, to name a few.

3. Competition source #3a (Part I): Small business solution


providers competing with Square Capital

Square provides merchants with loans to fund their working capital or short term
expansion needs. These loans are then paid back with receipts from future debit and
credit card sales. The loan is due at the end of the 18-month period, however,
merchants have the option of paying it back sooner. Square moved away from
giving merchant cash advances which are not loans per federal law to
making loans though Celtic Bank, selling these loans to investors. In both
cases, repayments are financed through future credit and debit card receivables.

14
As per S1 filing

Copyright 2017 Abdullah Sheikh 59


Square Capital competes with other providers of capital to micro-merchants. This can
include loans via personal and business credit cards, friends and family. Many of
Squares mobile payment processing peers, such as PayPal and Clover, also offer
similar merchant loan services on their platforms. However, these services are not
competitors to Square Capital, since micro-merchants on Squares platform do
not have access to PayPals or Clovers merchant loans. In theory, micro-
merchants could switch to PayPal or Clover just to get access to capital, however, this
seems like an unlikely outcome. Square Capital also has little competition from
traditional banks, since a) small business lending by big bank has gone down
significantly post 2008 financial crisis as the exhibit below shows and b) many micro-
merchants would not qualify for bank loans given their credit history and business
operating history.

Exhibit: Small business lending by big banks such as JPMorgan and Wells
Fargo has gone down significantly post 2008 financial crisis

The Kaplan Group has put together the exhibit below showing the range of options
now available under three models: Broker, Crowdfunding, P2P and Direct Lending.

Copyright 2017 Abdullah Sheikh 60


Source: The Kaplan Group

Square Capitals main source of competition comes from non-bank financial


technology (fintech) companies. Given the number of fintech companies providing
loans to micro-merchants, www.MerchantMaverick.com has done some due diligence
and shortlisted some providers, providing a range of options:

Exhibit: Merchant Mavericks short-list of best credit options for small


businesses

Source: www.merchantmaverick.com

Merchant Cash Advances: Merchant Financing, PayPal, Square, Credibly


and Can Capital
Line of Credit: Street Shares, OnDeck, Lending Club, BlueVine and Kabbage.

Copyright 2017 Abdullah Sheikh 61


Small Business Loans: Fundation, Street Shares, Smartbiz, OnDeck and
Funding Circle.

Each of these companies, and many others, compete for business when a micro-
merchant is looking for credit in some form. Like card payment processing,
providing credit is a commoditized product that competes primarily on price.
Since the cost of capital for non-bank fintech companies, including Square, is
significantly higher than for traditional banks, micro-merchants offer a ripe opportunity
for lenders to earn higher returns for taking on higher levels of risk or, in the case of
Square, using their captive customer base for high APR loans.

Competition source #3a (Part II): Small business solution providers


competing with Square Payroll
To better understand competitors to Squares suite of software products, I leverage
the work of G2 Crowd. G2 Crowd is a peer review and expert opinion driven
website that provides recommendations on business software. The complete
research can be found here:
https://www.g2crowd.com/categories

Per G2 Crowd, the best Payroll Software products are determined by customer
satisfaction (based on user reviews) and scale (based on market share, vendor size,
and social impact) and placed into four categories on a Grid. The categories are:

1. Leaders offer products that are rated highly by G2 Crowd users and have
substantial scale, market share, and global support and service resources.
2. High Performers provide products that are highly rated by their users, but have
not yet achieved the market share and scale of the vendors in the Leader
category.
3. Contenders have significant Market Presence and resources, but their products
have received below average user Satisfaction ratings or have not yet received
enough reviews to validate their products.
4. Niche products do not have the Market Presence of the Leaders. They may have
been rated positively on customer Satisfaction, but have not yet received enough
reviews to validate their success.

In addition to independent research, in this section, I lean on G2 Crowds work to help


me compare a wide variety of providers.

Square Payroll allows business owners to process payroll for their employees
and handles a business' withholdings, payroll payments, and tax filings.
Square Payroll is available in Alaska, Arizona, California, Florida, Georgia, Illinois,
Maryland, North Carolina, New Hampshire, Nevada, New York, South Dakota,
Tennessee, Texas, Virginia and Wisconsin.

Copyright 2017 Abdullah Sheikh 62


Square Payroll competes with several standalone applications. The exhibit below,
sourced from https://www.g2crowd.com/categories/payroll, shows some key
competitors splitting into Leaders, High Performers and Contenders.

Exhibit: Some standalone competitors to Square Payroll

Leaders High Performance Contenders

QuickBooks Desktop Pro Wagepoint QuickBooks Online


Fuse Workforce
UltiPro Management Workday
SurePayroll Patriot Payroll PeopleSoft

Kronos Workforce Central APS Payroll Solution Paylocity


ADP Workforce Now Rise Intuit Payroll

Kronos Workforce Ready eStratEx Paychex Flex


Dayforce Gusto
QuickBooks Enterprise
ADP RUN
ADP Vantage HCM
Source: https://www.g2crowd.com/categories/payroll

Competition source #3b: Small business solution providers


competing with Squares Payment and Point of Sale products

Copyright 2017 Abdullah Sheikh 63


Square Point of Sale

Square Point of Sale is Point of Sale (POS) software. Square Point of Sale combines
payment processing with point-of-sale functionality like itemization and inventory
management. Square offers POS systems customized to the following industries:
Food & Beverage, Restaurants, Coffee Shops, Bakeries, Food Trucks, Retail,
Apparel, Groceries, Beauty Professionals, Salons, Spas, Health & Fitness, Home &
Repair Services, Professional Services, Leisure & Entertainment and Transportation.
Square Point of Sale competes with other POS systems, as the exhibit below shows.

Exhibit: Some standalone competitors to Square Point of Sale

Leaders High Contenders Niche


Performance
Oracle Retail
Xstore Point-of-
Square Breadcrumb Service Vend
QuickBooksPOS Lavu Aloha POS Maitre'D
TouchBistro
Shopify POS Restaurant POS Lightspeed Retail
Source: https://www.g2crowd.com/categories/pos

Square Hardware

Copyright 2017 Abdullah Sheikh 64


Squares range of hardware options includes Square Stand for Contactless + Chip,
Contactless + Chip Reader, Chip Card Reader and a free Magstripe Reader.

There are several standalone providers of payment processing hardware that


compete with Squares hardware products. The exhibit below lists these providers.

Exhibit: Standalone competitors to Square hardware


1. Verifone 2. SZZT Electronics Co. Ltd
3. Ingenico S.A. 4. Shenzhen Xinguodu
5. PAX Technology, Ltd. 6. Equinox Payments
7. Fujian Newland 8. CyberNet Inc.
9. Bambora Group 10. Spire Payments Ltd.
Source: Verifone 10K

Square Analytics

Square Analytics is free business intelligence software. Business intelligence


software helps companies gain perspective on their business operations. It is
the process of transforming unstructured business data into reportable data sets and
visualizing that data into graphs and tables that expose valuable insights. This
software often creates automated reports and dashboards that can be deployed to
end users, as well as non-technical user interfaces for business users to either slice
and dice data on their own or perform ad hoc reporting. The exhibit below shows
some standalone competitors to Square Analytics.

Exhibit: Some standalone competitors to Square Analytics

Leaders High Contenders Niche


Performance

Copyright 2017 Abdullah Sheikh 65


IBM Cognos
MicroStrategy Alteryx Analytics Birst
Domo BOARD Jaspersoft Panorama Necto
GoodData Easy Insight Oracle BI Highcharts
Tableau Desktop Halo Pentaho Analyzer
ZAP Business
Sisense Intelligence Business Objects Klipfolio
SAS Business
QlikView Exago Intelligence Datorama
Logi Info Phocas Software TIBCO Spotfire Grow
SAP ReportServer
BusinessObjects
Microsoft Power BI Chartio Roambi
Tableau Server Megalytic Zoho Reports
Google Chart
Tools Izenda JMP
Salesforce Wave
InsightSquared Geckoboard Analytics
Qlik Sense Windward Studios Zoho Reports
Looker InetSoft JMP
SAP Crystal Salesforce Wave
Reports iDashboards Analytics
SAP
BusinessObjects
Lumira Segment
Dundas BI
Statpedia
Periscope Data
NinjaCat
Q Research
Software
Source: https://www.g2crowd.com/categories/business-intelligence

Square Employee Management

Squares employee management software allows merchants to filter reports by


employee, device, or location. It also allows them to see revenue-per-labor-hour
reports, find the most efficient employees and view which employees closed which
cash drawers. The exhibit below shows some standalone competitors to Square
Employee Engagement.

Exhibit: Some standalone competitors to Square Employee Engagement

Copyright 2017 Abdullah Sheikh 66


Leaders High Performance Contenders
UltiPro Namely PeopleSoft
BambooHR APS Core HR Solution Kronos Workforce Central
Zenefits, When I Work Paychex Flex
Kronos Workforce Ready
Dayforce
ADP Vantage HCM
Source: https://www.g2crowd.com/categories/workforce-management

Square Instant Deposit

Square Point of Sale allows has embedded functionality called Instant Deposit,
that allows merchants to deposit cash into their linked bank accounts for a 1% fee.
Instant Deposit gives merchants immediate access to their card sales.

Most mobile POS take 1-2 business days to deposit funds. Only PayPal offers the
ability to instantly access funds, but even that only through a PayPal account. Pay
Anywhere offers next business day funding. Chase Paymentech funds next day for
merchants with a Chase business account. The exhibit below shows details of these
merchant funding programs.

Exhibit: Square competitors offering fast access to funds from card sales
Provider Fast cash product
Clover Go Varies by reseller/bank; PNC and
Bank of America offer next-
day funding in some circumstances

Copyright 2017 Abdullah Sheikh 67


Chase Paymentech Next business day with a Chase
account
GoPayment / Spark Pay 1-2 business days
PayPal Here Instant with PayPal account
Pay Anywhere Next business day for sales
processed by 5PM ET
Source: Author research

Square Cash

Square Cash allows person-to-person money transfer via the Square Cash app or e-
mail. In March 2015, Square introduced Square Cash for businesses, which includes
the ability for individuals, organizations, and business owners to use a unique
username to send and receive money, known as a $cashtag.

Square cash competes with other online money transfer services, such as:

1. Venmo
2. PayPal
3. Google Wallet
4. Dwolla
5. Facebook Payments
6. Popmoney

Most of these services allow free transfer of cash from person-to-person. Dwolla
enables users to send payments via email, phone numbers, Facebook, and
LinkedIn. It connects to your bank account and allows you to move money for just
$0.25 per transaction, or free for transactions $10 or less. Dwolla also allows bulk
payments. Dwolla MassPay allows users to pay out up to 2,000 people at once
through the Dwolla network, with the same fee structure payments < $10 free, and
$.25 fee for all payments greater than $10.

Square Invoices

Square allows merchants to request payment for goods or services with Square
Invoices from their online Square Dashboard or from a supported mobile device. From
Dashboard, merchants can create and send invoices, create recurring invoice series,
and schedule invoice deliveries.

The exhibit below shows some standalone competitors to Square Invoices.

Exhibit: Some standalone competitors to Square Invoices

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Leaders High Performance Niche

Apptivo Project
QuickBooks Desktop Pro BigTime Management
NetSuite ERP ZipBooks Replicon
FreshBooks Avaza BillQuick
VUE Billing and
Zoho Invoice Collections
Bill.com
Source: https://www.g2crowd.com/categories/billing

Square Appointments

Square Appointments is scheduling software that provides merchants with an online


calendar and the ability to create a booking site. Merchants can give direct access to
employees and customers, allowing for a more seamless meeting and selling
experience. A booking site allows customers to directly book a time for a specific
service. For example, customers can book an appointment for a haircut with a
specific employee at a salon via an online booking site. Square Appointments can be
accessed from Squares POS system.

The exhibit below shows some standalone competitors to Square Appointments.

Copyright 2017 Abdullah Sheikh 69


Exhibit: Some standalone competitors to Square Appointments

High Performance Niche


Calendly timetrade
Doodle Front Desk
YouCanBook.me SimplyBook.me
HouseCall Pro assistant.to
Acuity Scheduling Booker Software
Source: https://www.g2crowd.com/categories/billing

Square Online Store

Square Online Store allows merchants to set up an e-commerce site. The exhibit
below shows some standalone competitors to Square Online Store.

Exhibit: Some standalone competitors to Square Online Store

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Leaders High Contenders Niche
Performance
Shopify CloudCraze Demandware Volusion
IBM WebSphere
BigCommerce FastSpring SuiteCommerce Commerce
Magento Avangate Oracle Commerce cleverbridge
Community Edition PrestaShop SAP Hybris MarketLive
Infusionsoft Miva Merchant CIMM2
Magento
LemonStand Enterprise Edition
WooCommerce
Skubana
Unify Enterprise
Slatwall
nopCommerce
Shopify Plus
Episerver Digital
Commerce
Source: https://www.g2crowd.com/categories/e-commerce-platforms

Build with Square

Square allows developers the ability to re-program its Application Programming


Interfaces (APIs) for their purpose, all the while utilizing Squares payment processing

Copyright 2017 Abdullah Sheikh 71


abilities. This allows programmers to build an ecosystem for businesses to accept
payments online, in store, or on the go. The exhibit below shows key competitors to
Squares mobile and POS APIs.

Exhibit: Key competitors to Square mobile and POS payments API


Judopay Klarna Skrill
Adyen Affirm Sumup
Fortumo Paytm Ensygnia
Spreedly
Source: Author research

Exhibit shows standalone competitors to Square e-commerce APIs.

Exhibit: Some standalone competitors to Square e-commerce APIs

Leaders High Performance Contenders Niche


Braintree Repeat
Billing WePay Worldpay BlueSnap
PayPal Payments Authorize.Net Dwolla
CyberSource
Payment
Management
Stripe Subscriptions Platform
Pay with Amazon
Source: https://www.g2crowd.com/categories/email-marketing

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Competition source #3c: Small business solution providers
competing with Marketing Services providers
Square Customer Engagement

Square Customer Engagement is a suite of Customer Relationship Management


(CRM) tools that allow for effective email marketing campaigns, response to feedback
from customers, and allow for development of customized loyalty programs. Square
Customer Engagement comprises of: Email Marketing software, free Customer
Feedback software and Square Loyalty.

Square Marketing software helps merchants send email campaigns. There are
several standalone competitors, as the exhibit below shows.

Exhibit: Some standalone competitors to Square Email Marketing

Leaders High Performance Contenders Niche


Salesforce Email
Studio ExpressPigeon iContact VerticalResponse
SendGrid Marketing
MailChimp Mad Mimi Email
Constant Contact Emma Zoho Campaigns
Campaign Monitor Adestra Benchmark Email

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AWeber Delivra Mailjet
OpenMoves Email
GetResponse Marketing Platform MessageGears
Robly SendinBlue
SendPulse MailerLite
Klaviyo Customer.io
Source: https://www.g2crowd.com/categories/email-marketing

Square Feedback allows merchants to have communication with customers to


resolve any issues privately/not in public channels, through their receipts. The exhibit
below shows some standalone competitors to Square Feedback.

Exhibit: Some standalone competitors to Square Feedback

Leaders High Contenders Niche


Performance
Qualtrics Clicktools MaritzCX Confirmit
Vision Critical Medallia Satmetrix
GetFeedback UserVoice
Grade.us TopBox
CXQuest
AskNicely
Source: https://www.g2crowd.com/categories/enterprise-feedback-management

Copyright 2017 Abdullah Sheikh 74


Square Loyalty lets businesses manage their loyalty programs from their point of
sale. Square Gift Cards allow customers the ability to send gift cards to friends and
family. The exhibit below shows some standalone competitors to Square Loyalty.

Exhibit: Some standalone competitors to Square Loyalty

High Performance Niche


Tango Card Klout
LevelUp
GetBadges
Source: https://www.g2crowd.com/categories/gamification-loyalty

Caviar

Caviar enables restaurants that do not currently deliver to reach new customers and
increase sales. Caviar manages the logistics of delivery through its purpose-built
courier and order management app. However, as Caviar positions itself between
customers and restaurants, it is not business-to-business (B2B), but rather
business-to-customer (B2C) operation. Caviar charges restaurants a service
fee, as a percentage of total food order value, and customers, a fixed fee per delivery
plus a service fee. Many food delivery apps, such as Grub Hub 15, also offer
restaurants logistic services.

15
Similar to Cavair, GrubHub has an active driver program to assist restaurants deliver with little upfront cost. Se
here for details: http://driver.grubhub.com/

Copyright 2017 Abdullah Sheikh 75


The exhibit below shows some Caviar competitors.

Exhibit: Competitors to Caviar


Grubhub Postmates
Seamless Sprig.com
Delivery.com BeyondMenu
Eat24hours OrderingOnline
Ubereats.com ChowNow
Foodtoyou.com OrderAhead
DoorDash Zuppler
MyPizza.com Foodler
Source: Author research

Caviar FastBite a subdivision of Caviar offers a different service to Caviar.


Caviar Fastbite curated meals and provides delivery in as little as 15 minutes. Caviar
is currently available in New York, Los Angeles, San Francisco, and Philadelphia.
The exhibit below shows some Caviar Fastbite competitors, namely companies that
offer curated cooked meals for home delivery.

Exhibit: Competitors to Caviar Fastbite


Maple Topchefmeals.com
Arcade Savory
Peach Munchery
Eatclub GoodMeal
Source: Author research

Copyright 2017 Abdullah Sheikh 76


Chapter 5: Management and Wall Street analysts view of
Squares business prospects
This chapter is divided into the following sections:

1) Managements view of Squares business prospects


2) Analysts opinion of Squares business prospects

1) Management view of Squares business prospects


We gain insight into managements perspective on Squares business prospects
through their November 2016 Investor Presentation 16. Management believes that
Square should be attractive to investors for six key reasons:

1) Large target addressable market


2) Unique assets that can operate at scale
3) Attractive cohort economics
4) Strong brand has created market leadership position
5) New products will spur growth
6) Business model has operating leverage as revenues scale

Below we show managements perspective on each of the above topics, sourced


directly from the investor presentation.

Exhibit: Management believes Squares Target Addressable Market is very large

16
Investor presentation can be found here: https://d1g145x70srn7h.cloudfront.net/documents/investor-
relations/presentations/11-16-overview.pdf

Copyright 2017 Abdullah Sheikh 77


Exhibit: Management believes Squares assets are unique and can operate at
scale

Exhibit: Management believes Squares has attractive cohort economics

Copyright 2017 Abdullah Sheikh 78


Exhibit: Management believes Squares has demonstrated market leadership

Copyright 2017 Abdullah Sheikh 79


Exhibit: Management believes new software and ancillary products will spur
further growth

Exhibit: Management believes Squares business model will allow for profitable
growth over the long term

Copyright 2017 Abdullah Sheikh 80


Exhibit: Management believes as revenues grow, operating leverage will result in
profitability

Source: Investor presentation

2) Analysts opinion of Squares business prospects


Square is a very well covered stock by analysts. The exhibit below shows the list of
firms providing a research opinion on the stock.

Exhibit: Firms providing research opinion on Square


1) Guggenheim Securities 2) William Blair & Co 3) Keefe, Bruyette &
Woods, Stephens Inc.
4) BTIG 5) RBC Capital Markets 6) Nomura
7) Needham & Company 8) Jefferies 9) Evercore ISI
10) Canaccord Genuity 11) Barclays 12) Morningstar, Inc.
13) Craig-Hallum 14) Compass Point 15) Piper Jaffray
Research
16) Stifel 17) Pacific Crest Securities 18) Morgan Stanley
19) JPMorgan 20) Mizuho Securities 21) Credit Suisse
22) Wedbush 23) Monness, Crespi, 24) SunTrust Robinson
Hardt & Co. Humphrey
25) Freedom Finance 26) Susquehanna 27) Goldman Sachs
Financial
28) EVA Dimensions 29) M Science
Source: Bloomberg

Copyright 2017 Abdullah Sheikh 81


In the exhibit below, we show some key statistics around analyst view of Squares
stock. At the current stock price, Square trades at high multiples relative to analyst
earnings estimates.

Exhibit: Key analyst statistics on Square common stock


Consensus Price Target $17.64
Buy / Sell / Hold recommendations 19 / 10 / 0
Price / (2017/18/19E Consensus 96X / 49X / 33X
Earnings)
EV / (2017/18/19E Consensus Revenues) 6.1X, 4.7X, 4.0X
EV / (2017/18/19E Consensus EBITDA) 57.6X, 30.2X, 19.1X
Source: Author calculations, Bloomberg

While there is a long list of analysts covering Square, there is a notable lack of diversity
in opinion. That may be due to Squares short operating history as a public company
and the surprising resilience of its earnings since it started reporting as a public
company.

Below I delve into one research analyst report (JPMorgan) in detail, while
providing highlights from other research firms.

While initiating coverage at overweight, JPMorgan cites three key bullish themes, that
are repeated by many sell side analysts:

1) Unlocking a large, underserved market: JPMorgan cites a $150 billion to $440


billion opportunity amongst the 21 million businesses that do not accept cards
and that Square has only penetrated 7% of the micro-merchant market.
JPMorgan also cites the opportunity to move up-market to SMBs, a $510 billion
opportunity.
2) Square has the intangibles to disrupt: CEO Jack Dorsey and management
team are established leaders, bringing a seller first culture.
3) Tech-enabled payments is a winning theme and Square is the pure play:
JPMorgan believes up-selling cohesive value-added services given its vertically
integrated model will lead to continued growth.

In spelling out its investment thesis, JPMorgan makes seven key points:

1) Big Growth, Not Just in Payments, But Across All Tech


2) Unlocking the Large, Underserved Cash Centric Micro-Merchant Market
3) Outside the Box Payment Service Provider with Scale and Tech Roots
4) Timely Product Innovation Gives Square a Change to Move Up-Market
5) Large, Underserved Client Mix Creates Unique Opportunity to Cross-Sell Value
Added Services
6) Square Capital Opportunity
7) Strong Brand and Culture Led by CEO and Co-Founder Jack Dorsey

JPMorgan does recognize some of risks in its analysis. These include:

Copyright 2017 Abdullah Sheikh 82


1) Delays in selling unproven value added services, given their price target
requires rapid growth in ancillary product sales
2) Downturn in credit cycle, which would negatively impact Square Capital since it
relies on third parties to fund its loans
3) SMB penetration could weigh on take rates, given Squares abnormally high
margins due to its catering of the micro-merchant market
4) Uncertain commitment to profitability, given Squares desire to grow rapidly
while ignoring short-term profitability
5) Key man risk in CEO Jack Dorsey

In coming up with a $15 price target, JPMorgan explains its rationale and financial
forecasts:

We are modeling 35% and 29% adjusted revenue and GPV growth, respectively, in
2016, and 23% and 21% compounded adjusted revenue and GPV growth, respectively
through 2020. We see Square turning EBITDA positive in 2016 (2Q16), with margins
expanding to almost 19% by 2020, as the company realizes scale benefits and better
monetizes its merchant base by upselling additional services.

We see adjusted operating margins, which exclude stock compensation expense and
intangibles amortization, expanding more than 30 points from -16% in 2015 to +16% by
2020, driven primarily by growth in high-margin Software and Data revenues and
general operating leverage and scale.

Our forecast assumes Square reaches high 30% incremental adjusted operating and
EBITDA margins in FY19 and FY20, which is consistent with managements long-term
objectives.

We are forecasting the fastest relative growth in the high-margin Software & Data line,
which we see increasing six-fold over the next five years, growing from $52M in FY15 to
$314M in FY20. Driven primarily by growth in Square Capital merchant loan business,
which we think can extend $2.5bn in loans and generate $162M in revenues by 2020,
up from roughly $340M in loans and $14M in revenues in FY15.

In our view, Square is a unique asset, with unique growth characteristics, mission and
corporate culture. Given Squares early stage growth profile and ongoing investments,
we believe near term profit-based valuation parameters are less applicable. We think a
combination of best-in-class payment processors and high growth services companies
which trade at 9.5 times and 10.7 times CY16 consensus revenue estimates, are the
most relevant comps. Out $14 December 2016 price target is based on a 7x forward
EV/revenue multiple, which represents a three-turn discount to the high growth software
and services forward revenue multiple and a two-turn discount to the best-in-class
payment forward revenue multiple. We also did a SOTP DCF analysis on page 41.

Copyright 2017 Abdullah Sheikh 83


JPMorgans financial model is shown in the exhibit below. Note this is the updated
model from November 2016, while the above commentary is taken from its initial
report published in December 2015. Given Squares operating performance since
then, JPMorgan has raised estimates.

Exhibit: JPMorgans financial forecasts

Source: Bloomberg

Below I provide a snapshot of key highlights from other research analysts.


Stifel focuses on two themes:

1) Square has the potential to sell to over 20 million small businesses that do not
accept credit cards.
2) Square can leverage its ancillary software services to grow rapidly and achieve
its long revenue and margin targets. Stifel is particularly bullish about Square
Capital, given the difficult of getting loans and the ease of access than Square
Capital provides merchants.

BTIG is bullish on the company and expects it to achieve Adjusted EBITDA margins of
35%-40% for three main reasons:

Copyright 2017 Abdullah Sheikh 84


1) Square has only reached 15% of its target market in the U.S. of brick and mortar
stores and has a large international opportunity.
2) Square offers value added products in addition to its payment processing
services.
3) Square could be an acquisition target for Apple, Samsung and Google as they
continue to build out their payments capability.

Canaccord Genuity cites similar reasons to other analysts for their bullishness on
Squares stock:

1) Large market with tailwinds


2) Large merchants are an attractive opportunity
3) Value added services including Square Capital

Copyright 2017 Abdullah Sheikh 85


Chapter 6: Short thesis on Square
In this chapter, I set out my short thesis on Squares common stock.

As the exhibit below shows, as at as at 2/23/16, there were 10.3 million shares short out
of a total float of 169.5 million, with a short interest ratio of 2.9. The Blacklight
Composite Rate at mid was 0.23%. Squares stock does not pay a dividend.

Exhibit: Short interest statistics on Square


Short interest17 10.3 million
Total float 169.5 million
Short interest ratio 2.9
Markit Short Interest Score18 0
S3 Blacklight Market Composite Rate19 0.23%
Source: Bloomberg

This chapter is divided into the following sections, each of which covers a key aspect of
my short thesis:

1. Squares customer base is fundamentally unattractive


2. Analysts comparing Square to PayPal or First Data are comparing apples and
oranges; Square has more in common with Fitbit and GoPro
3. Extreme competition from ISOs/MSRs and traditional merchant acquirers will limit
Squares growth and margins
4. Squares gross margins will come down due to lower take-rates and stubbornly high
transaction costs
5. Square has a limited Target Addressable Market in the U.S. and internationally
6. Analysts are overestimating growth of Square Capital, which will likely experience a
fate similar to other non-bank lenders, like On Deck Capital
7. Micro-merchants have neither the business need nor financial wherewithal to afford
Squares me-too software products
8. Unattractive industry economics and poor capital allocation decisions will detract
from shareholder returns

17
Short interest ratio is the short interest divided by the Average Daily Trading Volume.
18
The Markit Short Score is based on the percentage of shares outstanding in the security that are put
out to on loan. A score of 0 indicates < 1%.
19
Weighted mid-market rate of borrow and loan activity.

Copyright 2017 Abdullah Sheikh 86


Short thesis #1: Square business model is fundamentally
unattractive
Squares payment service caters to financially disadvantaged micro-merchants
processing small amounts of debit and credit card volumes. To better understand
the dynamics of Squares customer base, consider the breakdown of GPV by customer
from Squares Q3 2016 shareholder letter.

Exhibit: Squares customers are micro-merchants as GPV mix by seller size


illustrates

Source: Q4 2016 shareholder letter

Unfortunately for investors, Square does not disclose how many customers are in
each category. Rather the graphic only illustrates how total GPV is split between type
of seller. This graphic can thus be misinterpreted to suggest, as management has
implied, that Square is experiencing success with larger sellers. However, this is
distinctly not necessarily the case.

There are, in fact, only a small number of large sellers with Square processing over
$500,000 in annual GPV. Per my calculations detailed later in the section
modeling Squares customer dynamics out of Squares almost 2.6 million
customers, less than 12,000 have GPV over $500,00. Less than 200 have annual
GPV greater than $1 million.

These handful of large customers constitute almost 14% of Squares total Q4 2016
GPV. The story depicted by the graphic above is not of success with large sellers, but

Copyright 2017 Abdullah Sheikh 87


rather one where a handful of large sellers have experienced revenue growth while
being on Squares overpriced payment processing platform. Over 99% of Squares
sellers, by number, are micro-merchants with annual GPV of less than $5,000 not
businesses of any significant size. Management is misleading analysts about Squares
success with large sellers

How many employees does a business processing less than $125,000 and $500,000 of
annual GPV typically have? The Small Business Administration 20 (SBA) provides
information comparing average company revenues with number of employees. Note
that revenues are likely to exceed GPV, which captures card sales only, since the latter
is a subset of total sales for any one business.

Exhibit: Average number of employees and revenues


Firms with Average Annual Receipts

1-4 employees $387,000

5-9 employees $1,080,000

10-19 employees $2,164,000

20-99 employees $7,124,000

100-499 employees $40,775,000


Source: SBA

As per Squares Q4 2016 shareholder letter, 86% of GPV comes from customers with
less than $500,000 GPV, with 58% coming from customers with less than $125,000
GPV. In other words, most of Squares customers are micro-merchants with less
than 9 employees with annual revenue less than one million dollars.

Many 1-9 person firms doing less than one million dollars in revenue are bare bones
operations, or deeply negative EBITDA startups. Thus, many of these customers have
elevated business risks, including bankruptcy potential. Square has chosen quantity
over quality. A typical Square customer has fewer card transactions to process than a
small business and comes with a higher risk of fraud, retrievals and chargebacks,
necessitating frequent holds, freezes and account terminations. This customer base is
not very attractive to most merchant acquirers, as profitability per customer is often not
justified by cost of acquisition. The exhibit below compares Squares transaction losses
vs. Heartland Payments over the last five years. Transaction losses are incurred
primarily due to frauds and chargebacks. Squares transaction losses are 10X and 45X
Heartlands, which focuses on higher quality SME customers, for 2014 and 2015,
respectively.

20
The SBA is a U.S. government body, with the motive of providing support for small businesses and entrepreneurs.

Copyright 2017 Abdullah Sheikh 88


Exhibit: Squares elevated transaction losses vs. Heartland show the low quality
of Squares customer base
Square Heartland Payments

0.16%

0.14%
Transaction losses as % of GPV

0.12%

0.10%

0.08%

0.06%

0.04%

0.02%

0.00%
2014 2015

Company 2014 2015

Square 0.09%* 0.14%*


Heartland Payments 0.009% 0.0031%

Source: Heartland Payments 10K, Square 10K. Transaction losses for Square are calculated after deducting merchant advance
losses of $3.8 million and $2.4 million from Squares transaction and merchant advances for 2015 and 2014, respectively.

Square has high churn rates amongst its customers that are not apparent due to a
lack of disclosure and a conducive economic environment for micro-merchants.
Consider that Square has over 2 million customers, which is ten-fold the number
Heartland Payment Systems a reputable small business merchant acquirer had
before they were acquired by Global Payments Inc. Analysts are projecting this number
will grow rapidly over the next few years, without taking into elevated attrition rates
characteristic of this micro-merchant customer base. It is very unlikely that Square
will be able to grow its customer base as rapidly as analysts are expecting,
particularly if we see an economic slowdown or recession in the next few years.

Logic suggests that there are likely quite a few firms in Squares two million strong
customer base that are not contributing to total GPV, simply because their businesses
are not thriving or potentially even failing. At any point in time, these firms are at risk of
being one of the many firms that drop off Squares platform. On the other hand, there
are also likely a handful of firms that are contributing a disproportionately high amount
to Squares GPV, due to thriving businesses, with a large proportion of Squares
customers probably contributing around their fair share. Squares S1 indicated over 2
million sellers generated 97% of total GPV of $28.4 billion over the 12 month to
June 2015. This implies an average GPV per seller of only $14,200 a year, or less
than $1,200 a month. This compares to Heartland Payment Systems and First Data,

Copyright 2017 Abdullah Sheikh 89


which had an average GPV per SME merchant of $510,064 and $515,152 per year 21, or
$42,505 and $42,929 per month, respectively. In other words, Squares contribution to
total GPV by customer forms a highly positively skewed distribution as the exhibit below
shows.

Exhibit: Most of Squares over two million customers are low contributors to total
GPV with a risk of falling out of the ecosystem
# of customers

High risk customers High risk


customers

Source: Author illustration Contribution to GPV


The median Square customer processes significantly lower volumes that $14,200 per
year. This is because the mean of a positively skewed distribution is greater than the
median. In the second to last chapter, where I model the dynamics of Squares
customer base, I calculate the median GPV for a Square micro-merchant to be
close to $5,000 per year, which implies GPV of $417 a month. The median Square
merchant is extremely financially disadvantaged.

Consider three eventualities for a given Square micro-merchant at any point in time
(which, given enough time, cover 100% of business outcomes):

1. The business fails: There are no transactions to process and the customer
exits Squares ecosystem. This is the left tail of our distribution in the
exhibit above. (Estimated probability22: 40%)
2. The business succeeds: Revenues scale and the customer realizes (as we will
show later) the overpriced nature of Squares services and transitions or
considers transitioning to a more competitive payment service provider. This is
the right tail of our distribution in the exhibit above. (Estimated probability:
30%)

21
Calculated as follows: Heartland Payment Systems: $93.1b processing volume over 182,5526 customers as at end of 2015, per
2015 10K. First Data: $1.7 trillion processing volume over 3.3 million customers in the U,S, per 2015 10K.
22
Estimates of the percentage of new businesses that fail vary but typically range from 50-90%
depending on the measurement time period. The Bureau of Labor Statistics publishes details statistics
on https://www.bls.gov/bdm/us_age_naics_00_table7.txt showing a 50% failure rate over five years.
Some studies suggest that 80% of micro-merchants fail. I have chosen 40% as a conservative
assumption.

Copyright 2017 Abdullah Sheikh 90


3. The business muddles along: The business does not scale yet the owner
continues to operate on Squares platform as it does not represent a primary
source of income and / or income from the business is just enough to support the
small number of employees. This is the center of our distribution in the
exhibit above. (Estimated probability: 30%)

Based on my estimated probabilities, given enough time, close to 70% of Squares


customers will eventually either go out of business (40%) or, if they are successful
(30%), leave or consider leaving Squares platform for a potentially cheaper
alternative. While Squares growth has been fueled by a first mover advantage in
mobile payment processing for micro-merchants, it needs a constant influx of
new micro-merchant owners to replenish its existing cohort of older micro-
merchant owners. This presents a serious and potentially crippling churn problem for
Squares management team.

Management is very opaque about this issue. It does not provide investors with
clarity on churn numbers. We are not told how many accounts were opened,
closed or frozen during any period. In fact, Square presents a blatantly misleading
graphic, the exhibit below, in its investor presentation that seems to imply that Square
somehow has little churn in its accounts, something that defies logic given the sheer
number of disadvantaged micro-merchant customers Square has. Management claims
a payback23 period of four to five quarters, which does not take the likely high churn
rates that are characteristic of the micro-merchant market.

Exhibit: Square presents a picture of little churn in its customer base of fickle
micro-merchants

23
Management defines payback period as the number of quarters it takes for a quarterly cohort of sellers
cumulative transaction revenue net of transaction costs to surpass sales and marketing spending in the quarter in
which the cohort was acquired.

Copyright 2017 Abdullah Sheikh 91


Source: Investor presentation

We know there is churn in Squares customer numbers because it would be


terrible business for Square not close accounts that posed a risk of elevated
transaction losses. Square does not do any underwriting on customers upfront,
thus closing some customer accounts is almost guaranteed. The exhibit below
shows their promise to prospective customers.

Exhibit: Square does not do underwriting on accounts upfront but once the
account is active

Source: www.squareup.com

Copyright 2017 Abdullah Sheikh 92


What Square does behind the scenes is act as a micro-merchant aggregator,
working with Chase Paymentech and Wells Fargo Merchant Services to allow
payment processing through a master merchant account. With a master merchant
account in place, Square is free to onboard as many new micro-merchants as possible
without the time and resource consuming separate application process needed for each
micro-merchant account. Due to the higher fraud and chargeback risks associated with
these point-of-sale type micro-merchant accounts, to manage the risk of fraud and
chargebacks on these accounts, Square must establish volume limits on transaction
volumes, put frequent holds on funds for extended periods at times and close accounts
that are in high risk industries or pose a high risk of fraud. These rules are a function of
payment card network rules, payment processor rules, issuing bank rules and Square
rules, all to mitigate risk and manage transaction losses.

Reading customer complaints on www.pissedconsumer.com tells us that Square is


indeed quick to put holds, freezes and terminate accounts it deems to be high
risk to control transaction losses.

On January 19, 2017, the following complaint was filed:

After a day's transaction, Square wanted some documents for verification. I sent them
that and since my account has been deactivated without any notice.
It's been 4 plus months now. If your account is deactivated you cannot even call their
customer care, as you need to key an account number (that gets invalidated as soon as
an account is deactivated). I wouldn't mind having to deal with a company that has
various security checks before you sign in, instead of dealing with thieves like square
who make it easy to join but hold your funds after you've made transactions.
DEVIOUS COMPANY! STAY AWAY FROM SQUARE!!!

https://square.pissedconsumer.com/square-credit-card-payment-processing-service-
review-20170119993690.html

Rachel E. Review on Better Business Bureau website complains against Square:

I have never had dealing with a company's customer service that could offer you no
information in resolving your problems. I processed a larger payment thru them.
Received the conformation that the payment had been approved but was later notified
that they would need to review the transaction and would need 3 months of my bank
statements, photo id and other information to do this. I complied and gave them all the
information that they asked for and was supposed to receive a reply in 1-2 business
day. I received no reply and the funds were not transferred to my account. It wasn't until
I called them that they said they could not give me my money. They were not apologetic
nor did they give me any explanation for why this was happening. Also they said there
was no one I could speak to about it. And that they were putting a limit on my account
from here on out of 1 transaction every 90 days. My only option is to refund the money
that they were holding hostage. They had no problem charging me a fee to take money
from my customer. If they took the time to inform people of their limits ahead of time
then it could save headache for everyone. I would have gone somewhere else. Now I

Copyright 2017 Abdullah Sheikh 93


have to humiliate myself by letting my customer know what happened and hope that
they get their refund swiftly so I can start the process again with a reputable company.
Save your self the frustration and humiliation and do not use this company. How do they
have an A+ rating with a 92% negative review?!

https://www.bbb.org/greater-san-francisco/business-reviews/credit-card-merchant-
services/square-inc-in-san-francisco-ca-370609/reviews-and-complaints

Complaints against Square mostly refer to holds, freezes and terminations of accounts.
This makes sense given the high-risk dynamic of the micro-merchant market, however,
also confirms the issue of churn that Square has not addressed explicitly in its
disclosures to investors.

What makes Squares non-disclosure of churn rates strange is that this is one
issue that is likely to cause them significant headaches in the future. Given their
focus on micro-merchants, it is highly likely that churn rates will be very elevated
relative to other payment processors in the industry, particularly come an
economic slowdown or recession.

Heartland Payment Systems a ISO of Wells Fargo and payment processor for small to
mid-sized businesses discloses what it terms merchant attrition.

Merchant attrition is expected in the card payment processing industry in the ordinary
course of business. We experience attrition in merchant card processing volume
resulting from several factors, including business closures, transfers of merchants
accounts to our competitors and account closures that we initiate due to heightened
credit risks, We measure SME processing volume attrition relative to all SME
merchants that were processing with us in the same month a year earlier, During the
year ended December 31, 2015, we experienced 10.0% attrition in our SME card
processing volume compared to attribution of 12.7% and 12.9% for the years ended
December 31, 2014 and 2013, respectively.

We can take a guess around what percentage of Squares customers are at risk of
attrition in any given year.

The exhibit below defines some terms used throughout this report.

Exhibit: Definitions of terms used in analysis


Term Definition
P Probability
Fail Business failure, as revenue falls to insignificant levels
Success Business success, as revenue rises
Muddle Business muddling along, as revenue stays range bound by
current levels
Leave Business leaves Squares platform

Copyright 2017 Abdullah Sheikh 94


P (Leave | Fail) Probability of leaving Square given business failure
P (Leave | Success) Probability of leaving Square given business succeeds
P (Leave | Muddle) Probability of leaving Square given business muddles along
Source: Author definitions

The exhibit below shows my probability estimates of the terms used.

Exhibit: Probability estimates of Square micro-merchant business outcomes in


any given year

Measure Estimate
Probability of Failure (A) 30%
Probability of Success (B) 10%
Probability of Muddle (C) 60%

Probability of Leaving Given Business 100%


Failure (D)
Probability of Leaving Given Business 30%
Success (E)
Probability of Leaving Given Business 10%
Muddle (F)
Source: Author estimates

By the Law of Total Probability:

P (Leave) = { P(Leave | Fail) x P(Fail) } + { P(Leave | Success) x P(Success) } + {


P(Leave | Muddle) x P(Muddle) }

P (Leave) = 100% x 30% + 30% x 10% + 10% x 60% = 39%

The exhibit below calculates the probability of a merchant staying with Square, given
business success and muddle.

Copyright 2017 Abdullah Sheikh 95


Exhibit: Probability estimates of Square micro-merchant business outcomes in
any given year

Measure Estimate
Probability of Staying with Square Given
Success (G) 7% { A x (1 - E) }
Probability of Staying with Square Given
Muddle (H) 54% { C x (1 - F) }
Probability of Leaving Square (I) 39% ( 1 G H )
Source: Author estimates

My guesstimate is that the attrition rate within Squares customer base in a steady
state will be almost 40%. Square must make up these lost customers through new
acquisitions. Note the attrition in customer numbers will significantly exceed the
attrition in GPV for Square, since many of the businesses experiencing failure will
not have been big contributors to GPV in the first place. However, those customers
leaving due to business success will have a disproportionate impact on GPV, due to
their disproportionate contribution pre-dropping out. It is difficult to estimate the impact
of customer churn on GPV.

The issue of merchant attribution becomes a serious one during economic downturns
and recessions. Consider the following disclosure in Heartlands 2009 10K:

During 2009, 2008, and 2007, we experienced average annual attrition of 22.6%,
17.3%, and 12.6% respectively of our SME bankcard processing volume. Much of
our attrition is related to business closures, which accelerated in 2009 due to
weak economic conditions, and in 2009 our volume attrition was significantly
impacted by overall contraction in same stores sales.

Copyright 2017 Abdullah Sheikh 96


An economic recession will have a dual-effect on Squares GPV. First, GPV will suffer
due to a decline in sales and potential bankruptcies associated with existing micro-
merchant clients. Second, GPV growth will suffer due to fewer micro-business
formations and client acquisitions. This dual effect will lead to large declines in GPV
during periods of economic recession.

Heartlands GPV attrition rate in 2009 was 22.6%. Heartland serves the Small-and-
Midsize Merchant market and has an application process where it does due diligence
on customers before onboarding. Square serves the micro-merchant market and has
no upfront due diligence on customers.

Squares GPV attrition during an economic slowdown will be significantly higher


than Heartlands. In a severe recession, using the greater risk of bankruptcy
associated with micro-merchants, Squares GPV attrition could easily be 30% or
more.

Summary

While most merchant acquirers seek financially strong and commercially thriving
customers, Square targets exactly the opposite; desperate micro-merchants looking for
a quick and easy payment processing solution with low up-front cost. Square attempts
to onboard as many of these financially disadvantaged micro-merchants as possible
with free or highly subsidized debit and credit card readers in the hope that a few
successful micro-merchants will justify the acquisition costs of the millions of
unsuccessful others. The hyperbolic growth Square has experienced over the last few
years is not sustainable. Square needs a constant influx of new micro-merchants to
replenish its existing cohort of older micro-merchants, close to 70% of whom are at risk
of leaving the platform at some point during their respectively business lifecycles. The
underlying dynamics of Squares business are ugly, characterized by an overpriced and
commoditized mobile payment processing platform, a customer base with median card
sales of just over $400 a month, high levels of merchant and GPV attrition, reaching
40% and 15% in a normal year, respectively, and potential recessionary merchant and
GPV attrition rates, exceeding 50% and 30%, respectively. This will significantly
dampen Squares Return on Invested Capital, compared to other payment service
providers, such as PayPal and Heartland Payment Systems.

Copyright 2017 Abdullah Sheikh 97


Short thesis #2: Analysts comparing Square to PayPal or First Data
are comparing apples and oranges; Square has more in common
with Fitbit and GoPro

In this chapter, I detail why comparing Square to PayPal or First Data are misplaced,
and why Square has more in common with Fitbit and GoPro. This chapter is divided
into the following sections:

1) Comparisons to PayPal are misplaced: PayPal is the internets preeminent


online wallet that engages both buyers and sellers thereby creating strong
network effects, high switching costs and structurally higher margins. Square
engages only sellers, resulting in no network effects, zero switching costs and
significantly lower margins. PayPal Credit caters primarily to prime borrowers
and is an item-by-item specific consumer centric line of credit, while Square
Capital caters to sub-prime borrowers and is an open-ended micro-merchant
working capital lending facility.
2) Comparisons to First Data are misplaced: First Data commands structurally
higher margins due to being a vertically integrated merchant acquirer and
payment processor. Square is a ISO that commands a low level if influence in
the payment processing food chain.
3) Square has more in common with Fitbit and GoPro: Fitbit and GoPro share
many similarities to Square. Both were pioneers in their respective markets and
subsequently severely underperformed lofty analyst projections because of the
effects of brutal price competition in a commoditized low-barriers-to-entry
business.

Analysts have cited the success of payment service providers, such as PayPal and
Global Payments, and payment processors, such as First Data and Vantiv, to argue that
Square could achieve similar success. For example, JPMorgan argues:

PayPal went public in 2002 at $13 share, which equated to an $800M market cap,
or ~7.4x trailing twelve month revenues. Today, PayPals market cap exceeds
$43B. Well see if Square can build equity value longer-term, but we think
recalling the PayPal case study is important in recognizing there is significant
value potential for innovation in payments at the low-end of the market assuming
execution is sharp.

Guggenheim Securities compares Square to First Data, Vantiv and Global Payments,
as the exhibit below shows.

Copyright 2017 Abdullah Sheikh 98


Exhibit: First Data and Vantiv are not Squares peers

Source: Guggenheims Square initiation report

1. Comparisons of Square to PayPal are misplaced

PayPal is the internets preeminent online wallet that enjoys a monopolistic position in
the online payment processing landscape due to network effects it has developed by
creating a captive audience of buyers and sellers. This contrasts to Square, which
engages only sellers and thus has practically no network effects. PayPals network
effects are like Facebooks very difficult to replicate.

Exhibit: PayPals two-sided platform creates network effects vs. Squares seller
only platform

Copyright 2017 Abdullah Sheikh 99


Source:
PayPal 10K

PayPals relationship with consumers is a significant advantage relative to Square and a


revenue enhancer. For example, PayPal offers a range of consumer credit products,
known as PayPal Credit, on which it earns interest and fees.

There are few direct substitutes to PayPals payment service, with potential competition
from Venmo, Google Wallet and Amazon Payments. Only Venmo has managed to gain
traction in large numbers (processing nearly $3.2 billion of transactions in the first
quarter of 2016), and was purchased by PayPal through its acquisition of Braintree for
$800 million in 2013. PayPal has 192 million active customer accounts. Google
Wallet has 16 million users (in 2014) a very distant second. Square has several
substitutes (as we outline in the next section), with many such as PayPal Here and
Clover gaining significant traction with customers.

Like Facebook, switching costs out from PayPals network are very high because there
are few other online platforms that have the critical mass and broad accept that PayPal
has. PayPal customers are sticky. PayPal account holders have an average of 30
transactions per account per year. Once a merchant and a buyer have a PayPal
account, they are likely to transact using this account for most online transactions where
possible. Switching costs out of Squares network are practically zero, given card
payment processing can be transitioned by merchants easily, given discounted
hardware with merchant accounts is a common marketing practice. For example, Pay
Anywhere offers a free tablet, as the exhibit below shows.

Copyright 2017 Abdullah Sheikh 100


Exhibit: Pay Anywhere offers a free tablet thus significantly reducing switching
costs from a Square hardware platform

Source: www.payanywhere.com

PayPal has structurally higher transaction profit margins than Square. Exhibit
shows PayPals and Squares take-rate, expense rate and profit margin per transaction
in Q3 2016. In Q3 2016, PayPals take-rate was 2.65% 24 - a function of the fee PayPal
charges sellers. PayPals transaction cost in Q3 2016 was 0.95% 25, resulting in a
transaction profit margin of 1.70%. Like Square, the transaction expense that PayPal
incurs is a function of interchange, processing and assessment fees it pays to financial
intermediaries. Contrast this to Squares take-rate of 2.94%26 and transaction cost of
1.92%%, resulting in a transaction profit margin of 1.01%. PayPals transaction
expense is almost 100 basis points lower than Squares.

24
Take-rate calculated as follows: Transaction revenues of $2,314 million on GPV of $87,403 million.
25
Transaction costs of $830 million in the quarter.
26
Take-rate calculated as follows: Transaction revenues of $388 million on GPV of $1,320 million.

Copyright 2017 Abdullah Sheikh 101


Exhibit: PayPal has structurally higher transaction profit margins than Square
PayPal Square

3.50%
2.94%
3.00%
2.65%
2.50%

1.92%
2.00%
1.70%

1.50%
0.95% 1.01%
1.00%

0.50%

0.00%

Metric PayPal Square


Take-rate 2.65% 2.94%
Expense rate 0.95% 1.92%
Profit margin 1.70% 1.01%
Source: Square and PayPal Q3 2016 earnings, Author calculations

The reason for PayPal extremely low expense rate is the zero cost of sales when
buyers fund a purchase from a PayPal balance, bank account instant transfer and
PayPal Credit. In this case, PayPal still charges the seller 2.9% + $0.30 for the sale,
however, incurs no transaction charge. This is stated explicitly on page 19 of PayPals
2015 10K:

We pay significant transaction fees when consumers fund payment transactions using
credit cards, lower fees when consumers fund payments with debit cards, nominal fees
when consumers fund payment transactions by electronic transfer of funds from bank
accounts, and nominal fees when consumers fund payment transactions from an
existing PayPal account balance or through our PayPal Credit products.

This pushes down PayPals transaction expense relative to GPV to 0.95%. Exhibit
below shows the rate sellers owe PayPal on every sale, regardless of funding source.
PayPal charges sellers every time they transact, regardless of the funding source, even
when it costs PayPal nothing to transfer the money. Square does not have this dynamic
at play.

Copyright 2017 Abdullah Sheikh 102


Exhibit: PayPal charges sellers for every sale regardless of funding source

Source: https://www.paypal.com/us/webapps/mpp/paypal-fees

In addition to these 100% margin transactions, PayPal benefits from structurally higher
margins than Square for two other reasons:

a. Online platform: Card-not-present transactions allow PayPal to charge


higher rates than offline transactions, since the interchange fees are higher
due to fraud risk. Squares very high card-present fees of 2.75% mean their
take-rates are higher than PayPals, which is one indication of how overpriced
Squares payment processing platform currently is.
b. International sales: PayPal generates 46% of its revenue internationally vs.
less than 5% for Square. Regulation has capped interchange fees in
international markets like the U.K., Europe and Australia, allowing PayPal to
generate higher margins on these transactions.

Square has very high transaction expenses compared to PayPal at 1.92% of GPV
due to the small average ticket size associated with its micro-merchant
customers and how interchange fees are structured. Interchange fees are the
largest component of card processing expenses and typically have both a percentage of
transaction component and fixed per item component. For example, a Square retail
customer might fall under three Visa programs for interchange:

1) Visa Regulated Debit that has interchange capped by the Durbin Amendment at
0.05% + $0.22
2) Visa CPS/Small Ticket for a card present and signature small ticket (less than
$15.00) credit transaction that has interchange set at 1.65% + $0.04.
3) Visa Custom Payment Services27 (CPS) Retail program that has interchange
set at 1.51% + $0.10.

27
Custom Payment Services is a set of Visa rules and pricing programs that allow merchants to pay lower
interchange rates based on the type of information presented in the authorization process. MasterCard has a similar
program called Merit.

Copyright 2017 Abdullah Sheikh 103


In all three cases, assessment fees charged by the card networks typically amount
to 0.13% + $0.02 per transaction, while processing fees come to around 0.05% per
transaction. Exhibit below shows this dynamic for a typical Square transaction under
two Visa CPS programs given a $15 sale.

Exhibit: Squares small ticket size results in very high transaction expenses as
illustrated by three different Visa programs
SQUARE TRANSACTION COST AS % OF $15 SALE

Visa CPS / Retail Credit 2.49%

Visa CPS / Small Ticket Credit 2.23%

Visa Reg. Debit 1.83%

0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00%

Metric Visa Reg. Debit Visa CPS / Small Visa CPS / Retail
Ticket Credit Credit
Interchange fee 0.05% + $0.22 1.65% + $0.04 1.51% + $0.10
Assessment fee 0.13% + $0.02 0.13% + $0.02 0.13% + $0.02
Processing fee 0.05% 0.05% 0.05%
Total transaction cost 0.23% + $0.24 1.83% + $0.06 1.69% + $0.12
Transaction cost as 1.83% 2.23% 2.49%
% of $15 sale
Source: Visa, Author calculations

This dynamic explains Squares stubbornly high transaction expense of 1.92%


compared to PayPals transaction expense of 0.95%. Despite utilizing regulated
and small ticket programs, Squares transaction expenses are very high and more
than PayPals. Small ticket sizes are not conducive to low transaction expenses
in the payment processing industry. Comparing Square to PayPal is comparing
apples and oranges.

Analysts are keen to highlight the potential of Square Capital as an online lender, with
comparisons to PayPals success with PayPal Credit. As at 12/31/2016, PayPal had
approximately $5.348 billion of loan and interest receivable on its balance sheet. During
the year ended 12/31/2015 and 12/31/2104, PayPal purchased approximately $7.4
billion and $5.6 billion in credit receivables, respectively. While Square does not intend
to hold loans on its balance sheet, analysts cite PayPals success as an alternative
lender as reasons to be optimistic about Square Capital.

Copyright 2017 Abdullah Sheikh 104


These comparisons are misplaced. PayPal Credit is an item-by-item specific
consumer centric line of credit, not a general-purpose working capital micro-merchant
loan. This has a significant impact on the quality of credit outstanding. The exhibit
below splits the principal amount of U.S. consumer loans and interest receivable by
FICO score. Over 50% of loans and interest receivables outstanding are for prime
borrowers with FICO scores about 680. Less than 10% of credit outstanding was for
sub-prime borrowers with FICO scores less than 600.

Exhibit: PayPal Credit loans and interest receivables by FICO score

Source: PayPal 10K

This contrasts with Square Capital, which provides an open-ended micro-merchant


working capital lending facility. Most Square Capital loans are to financially
disadvantaged micro-merchants, who are willing to pay high APRs of 16%-28%28 on
short-term loans, as they do not have access to better sources of funding. In other
words, most of Square Capital borrowers are sub-prime, which stands in stark contrast
to PayPal Credit borrowers.

2. Comparisons to First Data are misplaced


Square also stands in contrast to First Data a vertically integrated merchant acquirer
and payment processor. Other examples of vertically integrated payment processors
include Vantiv. Wells Fargo Merchant Services and Chase Paymentech. Note that
Square uses Wells Fargo Merchant Services and Chase Paymentech to process
transactions. The exhibit shows the payment processing chain, with Squares position
overlaid. In the payment processing landscape of payment processors, card
networks and card issuing banks, Square occupies a position of low influence as
a micro-merchant acquirer.

28
APR calculations are detailed in Chapter 1: Introduction to Square Inc. Subsection: Square Capital

Copyright 2017 Abdullah Sheikh 105


Exhibit: Square occupies a position of low influence in the payment processing
food chain

such as First Data

Source: Author illustration

First Datas competitive advantage and abnormal profits stems from its influence in the
payment processing food chain. Unlike Square, First Data is not a ISO, it has direct
payment processing capabilities. In fact, First Data has active ISO programs that
enable third party companies, like National Bankcard, to compete with Square using its
Clover suite of hardware and software platform. This is also the source of First Datas
abnormal segment EBITDA margins of 40% as, unlike Square, its cost per transaction is
very low at interchange. Squares cost per transaction is interchange plus the
processors markup, typically 0.05% to 0.20% or higher per transaction, which eats
directly into its margins.

Squares low level of influence is not implied, it is explicitly stated by card


associations. Payment card networks like MasterCard and Visa are not fans of
giving too much power to payment processing providers. You only need to look at
Squares own Payment Terms to see this. The following highlights are taken directly
from Squares Payment Terms29:

The (Card) Networks require that any person that signs up for a Square Account to use
Payment Services (a Seller) and processes more than Network specified amounts of
Cards sales enter an agreement directly with Squares acquiring banks.

Similarly, American Express states the following:

If American Express considers you to be a high valued customer, it may require that
you maintain your agreement directly with American Express.

Successful merchants are required to establish a separate merchant account


agreement (and essentially start the transition away from Square) once they hit a
certain payment volume. In the card processing food chain, Square does not

29
Available on: https://squareup.com/legal/payment

Copyright 2017 Abdullah Sheikh 106


command enough influence to retain and / or maintain its high pricing structure
with successful customers.

This creates an unpleasant dynamic for Square, which at some point during a
successful micro-merchants life has the unenviable task of trying to justify its extreme
mark-up on every transaction it processes.

This phenomenon was apparent in its deal with Starbucks in 2012. Starbucks signed
up to Squares platform for three years at very attractive rates, which guaranteed
Square would lose money on each transaction it processed (due to the low-ticket value
and high volume nature of Starbucks business). When Square finally asked for a
higher rate more in line with the rate it charges other merchants Starbucks
refused and transitioned to Chase Paymentech and First Data, for non-mobile
payments and mobile payment respectively. This was an obvious choice, given
Chase Paymentech was already processing card payments for Square. Simply put, it
was hard for Square to beat Chases bid.

3. Square has more in common with Fitbit and GoPro

Square has more in common30 with Fitbit and GoPro, than PayPal or First Data. The
exhibit below sets out five similarities between Square, Fitbit and GoPro.

Exhibit: Squares industry and business shares significant similarities to Fitbit


and GroPro
Key attribute Description
Pioneers in niche markets Fitbit pioneered the market for wearable
connected health and fitness trackers in
2007. GoPro pioneered the market for
on-person mountable action cameras in
2002.
Run by charismatic CEOs Fitbit is run by Founder/CEO James Park.
GoPro is run by Founder/CEO Nick
Woodman. Square is run by
Founder/CEO Jack Dorsey.
Low barriers to entry products, with few Health tracking, video capturing and
network effects and low switching costs editing, and card payment processing
hardware and software is widespread and
easily replicable without many patents.
There are few network effects developed
from the use of fitness trackers, action
cameras and payment processing as the
ultimate service offering is very personal

30
There are some differences. Fitbit and GoPro operate in different industries to Square and serve
consumers, not businesses. However, Squares industry and business dynamics are like Fitbit and
GoPro in many significant ways.

Copyright 2017 Abdullah Sheikh 107


and individualized. Thus, there close to
zero few switching costs associated with
changing providers.
Claim differentiation of their There is an extensive range of cheap
commoditized product on brand appeal unbranded no-frills activity trackers and
and ecosystem vs. no-frills alternatives on-person mountable cameras available
and other established players offering from Amazon and Wish.com. Larger
similar product competitors have released products at
similar price points with extensive
ecosystems, such as Microsoft Band and
Apple Watch. Square also faces an
extensive range of cheap no-frills
solutions from companies such as EMS+,
Cartwheel Point of Sale and
CDGCommerce. Larger competitors
have released products at similar price
points with extensive ecosystems, such
as PayPal Here, Clover Go, SparkPay
and Intuit GoPayment.
High R&D expenses relative to revenues Fitbit spends 13% of revenues on product
signifying short product cycles develop, GoPro spends 29% and Square
spends 42%. All three has frequent new
product introductions. Fitbit frequently
introduces new fitness trackers, GoPro
releases new versions of action cameras
and Square releases new hardware and
software products.
Source: Author research

Fitbit had an Initial Public Offering (IPO) in 2015, while GoPro had a IPO in 2014. While
there was significant analyst and management optimism at the time of the IPOs, both
companies undershot lofty analyst expectations, leading to sharp subsequent revisions
down to both revenue and adjusted EPS estimates. While it is difficult to do an exact
attribution analysis on which factors led to the underperformance, in my opinion, it is
likely a combined effect of operating in a low barrier-to-entry commoditized market, with
few network effects and low switching costs. The exhibit below shows consensus
analyst Adjusted Earnings Per Share (EPS) estimates on Fitbit and GoPro and how
they have come down over time.

Exhibit: Fitbit and GoPro share similarities with Square and have severely
undershot lofty analyst projections

Copyright 2017 Abdullah Sheikh 108


Source: Bloomberg

In my opinion, Fitbit and GoPro should serve as a cautionary tale to Squares current
investors, on the combined effects of lofty expectations and operating in a brutally
competitive and commoditized market.

Summary

As a micro-merchant aggregator, Squares overpriced and commoditized product has


high transaction expenses, no moat, no network effects, no vertical integration, suffers
from extreme competition and has almost zero switching costs. This contrasts with
PayPals online payment platform that has a monopolistic presence as the internets
preeminent online wallet, a funding mix that frequently results in 100% margin
transactions and high switching costs due to network effects developed from engaging
both buyers and sellers. PayPal Credit caters primarily to prime borrowers and is an
item-by-item specific consumer centric line of credit, while Square Capital caters to

Copyright 2017 Abdullah Sheikh 109


sub-prime borrowers and is an open-ended micro-merchant working capital lending
facility. Square also stands in contrast to First Data a vertically integrated merchant
acquirer and payment processor that earns abnormal profits due to low customer
acquisition and payment processing costs. Analysts comparing Square to PayPal, First
Data and Vantiv are comparing apples and oranges. Square has more in common
with Fitbit and GoPro pioneers in the connected fitness and action camera markets,
respectively that severely undershot lofty analyst projections because of the effects of
brutal price competition in a commoditized low-barriers-to-entry business.

Copyright 2017 Abdullah Sheikh 110


Short thesis #3: Extreme competition from ISOs/MSRs and
traditional merchant acquirers will limit Squares growth and
margins
Mobile payment service providers operate in a commoditized and brutally competitive
business with very thin margins. In this section, I expand on the work done at
www.toptenreviews.com. www.toptenreviews.com has done a thorough analysis of all
major players in mobile payment processing and maintains a website which showcases
the results of their research. The complete research can be found here:

www.toptenreviews.com/business/payment-processing/best-mobile-credit-card-
processing

In addition to independent research, in this section, I lean on their work to help me


compare a wide variety of providers. The exhibit ranks a list of 15 mobile payment
service providers compiled by toptenreviews.com.

Exhibit: Highly-rated mobile payment service providers as ranked by


toptenreviews.com

Source: http://www.toptenreviews.com/business/payment-processing/best-mobile-credit-card-processing/

The exhibit below shows is an in-depth comparison of these mobile payment processing
solutions across a range of dimensions, also courtesy of the toptenreviews.com. The
main dimensions covered are:

1) Pricing & Fees: Transparency & Consistency, Monthly Fee, Monthly Minimum,
PCI Compliance, PCI Non-Compliance, Chargeback Fee
a. Flat-Rate Pricing: Swiped Rate, Keyed-In Rate, Per Transaction
b. Tiered Pricing: Swiped Debit Card, Swiped Credit Card, Per Transaction
2) Set-up & Service Terms: Ease of Application, No Contract Required, Quick
Setup Time, Quickly Clears the Account

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3) Customer Support: Customer Service, Dedicated Account Rep.,
Knowledgebase, Phone 24/7

Below we show the results of this independent research.

Exhibit: Comparison of mobile payment processors across different factors

Source: toptenreviews.com

toptenreviews.com then aggregates all the sub-categories into an aggregate score


using a proprietary and undisclosed weighting scheme.

Copyright 2017 Abdullah Sheikh 112


Exhibit: Comparing mobile payment processors across a range of dimensions

Source: toptenreviews.com

Judging from the final rankings, reviewers place emphasis on Fees & Pricing and
Setup & Service Terms over Customer Support. Thus, their top three mobile

Copyright 2017 Abdullah Sheikh 113


payment service providers are Square, Cartwheel Point of Sale and EMS+. All three
receive high grades in Fees & Pricing and Setup & Service, and poor grades in
Customer Support. Basically, flat pay-as-you-go fees without any contract stipulations
and monthly/annual charges are a winning formula for toptenreviews.com. The exhibit
below shows the top three rated mobile payment service providers have
practically identical offerings across key dimensions.

Exhibit: Comparing Square, Cartwheel Point of Sale and EMS+ across key
dimensions
Metric Square Cartwheel Point of EMS+
Sale
Swiped Rate 2.75% 2.6% + $0.24 2.25%
Keyed-in Rate 3.5% + $0.15 2.6% + $0.24 3.5% + $0.15
Monthly fee No No No
Early termination fee No No No
Annual fee No No No
Monthly minimum No No No
Setup fee No No No
Free magstripe card Yes Yes Yes
reader
Free app Yes Yes Yes
Ecosystem Yes No Yes
(Invoicing, Inventory
management,
receipts etc.)
Source: Author calculations, toptenreviews.com

In general, there is a trade-off between Fees & Pricing / Setup & Service Terms
and Customer Support. Providers offering flat fees with instant onboarding without
any contractual terms generally offer poor customer support. Perhaps this is because
these providers are aware that quick set up attracts micro-merchants with low payment
volumes and sometimes a spotty record as it relates to retrievals, chargebacks and
fraud. Square is no exception. Square consistently receives a failing grade for
customer service. The reason for Squares low grade in customer service is
related to customer frustration around withheld funds and account terminations
without customer support to help merchants navigate the process. Square directs
merchants to online FAQs and automated systems to respond to questions, rather than
live personnel.

The exhibit below compares the worst ranked providers by toptenreviews.com across
some key dimensions. These providers typically offer variable rate pricing plans, such
as tiered formulas or interchange plus pricing, along with monthly fees, monthly
minimum volume requirements and PCI compliance / non-compliance fees. In other
words, toptenreviews.coms worst ranked mobile payment service providers
receive low grades due to complexity, not because they are necessarily offering a
poor service to customers. In many cases, the service offering is superior in terms of

Copyright 2017 Abdullah Sheikh 114


a lower price and better customer service. In this respect, it is worth taking
toptenreviews.coms rankings with a grain of salt. In fact, Squares product is
ranked highly, even though it is often a financially worse option for many merchants
than alternative solutions.

Exhibit: toptenreviews.com ranks providers such as Elavon, Cayan, Chase


Paymentech and Pay Anywhere with complex pricing plans poorly relative to
Square
Metric Square Elavon Cayan Chase Pay Anywhere
Paymentech
Swiped Rate 2.75% Flat ($2.65 + Tiered (Debit: Flat rate (2.75%), Flat rate (2.69%),
$0.19), Tiered 0.28%, Credit: tiered (Qual. 1.99% tiered (Qual. 1.69%,
(Debit 1.49% + 1.54%) or + $0.25, NQ 3.76% NQ 2.69%)
$0.19, Credit Interchange Plus + $0.25) or
1.69% + $0.19) (0.2% + $0.10) interchange Plus
or Interchange
Plus
Keyed-in Rate 3.5% + $0.15 Flat (3.5% + Tiered or Flat rate (2.75%), Flat rate ($3.49 +
$0.19), Tiered Interchange Plus tiered or $0.19), tiered ($3.69
or Interchange interchange Plus + $0.19)
Plus
Monthly fee No $10 + $35 PCI $4.95 $25 Flat rate No,
non-compliance Tiered ($12.95)
Early termination fee No No No No Yes
Annual fee No No $99 PCI compliance No Tiered ($79 PCI
fee compliance fee)
Monthly minimum No No No No Flat rate No,
tiered ($79)
Setup fee No No No Yes No
Free magstripe card Yes No No Yes Yes
reader
Free app Yes No Yes Yes Yes
Ecosystem Yes No No Yes Yes
Source: Author calculations, toptenreviews.com

One prominent mobile payment solution that is missing from toptenreviews.coms


research is Clover by First Data. To cut into Squares market, First Data launched
Clover in April 2012 - an open architecture mobile point of sale system targeting
micro and small businesses. Clover offers all the functionality that Square offers,
from hardware, software and financial services. However, unlike Square, Clover offers
merchants a platform compatible with a wide variety of payment processing service
plans, including flat rate pricing, tiered pricing or interchange plus pricing. As the exhibit
below shows, Square and Clover are practically clones, except Clover offers
significantly more flexibility.

Exhibit: Square and Clover are clones, except Clover allows a range of flexible
price plans

Copyright 2017 Abdullah Sheikh 115


Source: Square investor presentation

Source: www.clover.com

Clovers suite of hardware, software and financing solutions is very


comprehensive. Unlike Square, which only offers a high flat rate pricing plan,
Clover provides a hardware, software and financing platform compatible with a
wide variety of payment processing pricing plans offered by First Data, including
flat rate pricing, tiered pricing or interchange plus pricing.

Below is an example of a basic plan for Clover Go the equivalent of the basic Square
dongle used for smartphones. The plan is like Squares, except the merchant needs to
pay for a basic magstripe card reader. Note merchants who want to accept
NFC/EMV technology would need to order a NFC/EMV compatible card reader
regardless of payment service provider, as these are not offered free of charge.

Exhibit: Square and Clover Go are similar, except for the free card reader
Square Clover Go
Swiped Rate 2.75% 2.70%
Keyed-in Rate 3.5% + $0.15 3.5% + $0.15
Monthly fee No No
Early termination fee No No
Annual fee No No
Monthly minimum No No
Setup fee No No

Copyright 2017 Abdullah Sheikh 116


Free magstripe card Yes No
reader
Free app Yes Yes
Ecosystem Yes Yes
Source: Author, https://merch.bankofamerica.com/clovergo-pricing

Clover sells its platform primarily through an authorized reseller program. For example,
National Bankcard a ISO affiliated with Wells Fargo Merchant Services offers the
following rates with a range of Clover point of sale systems, such as Clover Go, Clover
Mini, Clover Mobile and Clover Station. The merchant is required to buy the hardware
separately, as is the case across most payment service providers including Square.
Thus, the cost of hardware depends on the point of sale system being purchased.

Exhibit: National Bankcards mobile processing rates with Clover are


substantially lower than Squares

Source: National Bankcard

Recall Square charges a flat 2.75% per swipe (and 3.5% + $0.15 for keyed-in
transactions). National Bankcard and several other ISOs now offer mobile
processing rates compatible with Clovers hardware and software solutions that
make Squares rates look higher than Willie Nelson on a weekend 31.

The above pricing schedule requires a separate merchant account application. In


practice, this means that the merchant account bill will have additional line item charges
than those listed above. These additional charges include Address Verification fees,
PCI compliance fees, ACH / batch fees, chargeback/retrieval fees, amongst others,
depending on activity over the month. Thus, for this solution to make economic sense

31
Direct quote from a Senior Sales Manager, Credit Card Processing Solutions, National Bankcard.

Copyright 2017 Abdullah Sheikh 117


vs. Squares, a certain minimum volume of transactions need to be processed.
However, the key takeaway is for a merchant transacting a decent volume of
card sales Clovers mobile payment processing solutions come at significant
discount to Squares, for an ecosystem that is comparable, if not better.

Management is a fan of showing Squares market leadership using number of


downloads in iOS App Store as a proxy as the exhibit below shows.

Exhibit: Management believes Squares has demonstrated market leadership

Source: Investor presentation

However, this graphic is inconclusive at best and misleading at worst because, per IDC,
almost 90% of smartphones operate on Android. Any insight from these downloads is
limited to the number of micro-merchants who use iPhones vs. Android devices. There
are reasons to be skeptical of a claim that most micro-merchants use iPhones. Android
is found in low end smartphones, which may be more popular amongst a financially
disadvantaged micro-merchant crowd.

Exhibit: Most smartphones run on Android

Copyright 2017 Abdullah Sheikh 118


There are also other data points to suggest that Squares competitors are gaining
traction with merchants. For example, at First Datas recent investor day, they
highlighted Clovers success.

Exhibit: Clover is gaining traction amongst merchants

Source: First Data investor presentation

Below are some quotes from Dan Charron, Head of Global Business Solutions at First
Data, during their investor day.

Starting with Clover Station, our lineup expanded in 2015 to include EMV-ready Clover
Mobile, Clover Mini and Clover Go, which now has hundreds of thousands of users in
record time.

Since launch, we shipped more than 260,000 Clover devices. And when you add
Clover Go, it's quickly approaching 500,000 devices.

Bypass has already deployed over 3,000 Clover form factors running their software in
several major stadium and entertainment venues, and we expect many more to come.

Squares competitors are not sitting idly by, but are cementing and gaining market share
in the micro-merchant market and SMB market that Square is looking to target.

There are also new competitors entering the market. As per a sales representative,
Chase Paymentech will soon be releasing a micro-merchant mobile payment
processing solution with flat rates lower than Squares. Recently, Shopify has
introduced a POS system that competes with Square for micro-merchants and small
business owners. Shopify offers three plans: Basic Shopify, Shopify, and Advanced
Shopify.

Copyright 2017 Abdullah Sheikh 119


Exhibit: Shopify offers three plans for merchants to start processing in-person
card payments

Source: https://www.shopify.ca/pricing

Shopify offers a range of hardware options for merchants, as the exhibit below shows.

Exhibit: Shopify offers a range of hardware options for merchants to process in-
person card transactions

Copyright 2017 Abdullah Sheikh 120


Source: https://hardware.shopify.com/products/complete-kit

Verifone will soon be launching Carbon, a payment terminal with a POS platform in a
single device, as the exhibit below shows.

Exhibit: Soon to be launched Verifone Carbon will be a Square competitor

Source: http://www.silicon.co.uk/wp-content/uploads/2016/04/Verifone-Carbon_Full-Package-3.png

Poynt 5 and Poynt Smart Terminal are new open-architecture POS competitors to
Square, as the exhibit below shows.

Exhibit: Poynt 5 is a direct Square competitor

Copyright 2017 Abdullah Sheikh 121


Source: https://poynt.com/poynt5/specs

Exhibit: Poynt Smart Terminal will soon be Square competitors

Source: https://poynt.com/

Summary

A look at the micro-merchant mobile payment service provider landscape shows a


bewildering number of Square competitors offering cheaper no-frills alternatives or
similar polished products. No-frills competitors include EMS+ by Electronic Merchant
Systems, which offers a flat all-inclusive rate of 2.25% per swipe, compared to Squares
2.75%, with a free card reader included. Products with similar, and sometimes superior
pricing, hardware and software, solutions include Spark Pay by Capital One,
QuickBooks GoPayment by Intuit, PayPal Here by PayPal, Clover by First Data,
and Pay Anywhere. Traditional merchant account providers, which includes many
Independent Sales Organizations (ISOs) and Member Service Providers (MSRs), now
also offer mobile processing rates that make Squares rates look higher than Willie
Nelson on a weekend. First Datas Clover has been gaining market share with over
500,000 devices shipped and 16% market share amongst its SMB clients establishing

Copyright 2017 Abdullah Sheikh 122


a strong presence in a Square target market. There are also several new entrants.
Chase Paymentech will soon be releasing a micro-merchant mobile payment
processing solution with flat rates lower than Squares. Shopify has recently introduced
a suite of POS products competing for micro- and small businesses. Verifone will soon
be launching Carbon, a payment terminal with a POS platform in a single device.
Poynt 5 and Poynt Smart Terminal are new open-architecture POS competitors to
Square.

Copyright 2017 Abdullah Sheikh 123


Short thesis #4: Squares gross margins will come down due
to lower take-rates and stubbornly high transaction costs

Background

The slide below from Squares investor presentation shows transaction profits at around
1.01% of GPV.

Exhibit: Squares transaction profits have been consistently in the region of one
percent over the last five years

Source: Investor presentation

Analysts, such as JPMorgan and Stifel, are extrapolating these high margins into their
projections, as the exhibit below shows.

Exhibit: JPMorgan and Stifel are forecasting high transaction margins into the
future

Copyright 2017 Abdullah Sheikh 124


Source: JPMorgan and Stifel research reports

Analyst forecasts for transaction profits as GPV scales defy the fundamental laws of the
payment processing industry; GPV volume and transaction profit margins are inversely
related. There are reasons to believe that Squares margins are at risk of coming down
significantly over time due to:

1) Effects of extreme competition on take rates


2) A move upmarket to higher GPV accounts
3) Stubbornly high transaction costs, particularly interchange and assessment
fees, that have a strong upward bias over time

1. Effects of extreme competition on take rates

Squares pricing is higher than many of its mobile payment processing


competitors. The exhibit below compares flat pricing per swipe compared to several
other mobile payment providers. Many competitors are lower, sometimes significantly
so. For example, EMS+ offers 2.25% per swipe compared to Squares 2.75% per swipe
a full 50 basis points lower. Cartwheel Point of Sale requires no hardware. All the
listed competitors provide an ecosystem which, in the cases of Clover and QuickBooks,
are sometimes better than Squares.

As per their sales representatives, Chase Paymentech will be introducing a new


micro-merchant mobile payment processing solution with rates lower than
Squares soon. None of the plans have monthly fees or membership contracts.

Exhibit: Comparison of fee structure across some mobile payment service


providers

Copyright 2017 Abdullah Sheikh 125


Metric Square Cartwheel EMS+ Pay Intuit Chase
Point of Anywhere GoPayment Paymentec
Sale h
forthcomin
g
Swiped Rate 2.75% 2.6% + $0.24 2.25% 2.69% 2.40% + < 2.75%
$0.25
Keyed-in 3.5% + 2.6% + $0.24 3.5% + $3.49 + 3.40% + < 3.75%
Rate $0.15 $0.15 $0.19 $0.25
Monthly fee No No No No No No
Early No No No No No No
termination
fee
Annual fee No No No No No No
Monthly No No No No No No
minimum
Setup fee No No No No No No
Free Yes Yes Yes Yes Yes Yes
magstripe
card reader
Free app Yes Yes No Yes Yes Yes
Ecosystem Yes Yes Yes Yes Yes Yes
Source: Author calculations

Square is facing extreme competition on the rates it charges micro-merchants per


swipe. This dynamic, together with competitors such as Clover taking market share, is
likely to exert a downward influence on take-rates over time, as competitors scramble to
attract as many micro-merchants to their respective platform.

Its worth noting that Squares pricing for keyed-in transactions is high at 3.5% +
$0.15 vs. online payment processors, who also utilize the card-not-present rule
to authorize payments. Card-not-present transactions generally have increased
processing rates due to card networks charging higher interchange rates due to
elevated risks of fraud. Several online processors such as PayPal, Swipe and
Authorize.Net offer card-not-present rates starting at 2.9% + $0.30. In this respect,
there may be pressure on mobile payment providers to bring keyed-in rates in line with
online processing rates.

2. A move upmarket to higher GPV accounts will weigh on take-rates


Heartland Payment Systems (henceforth, Heartland) and PayPal offer insights into the
likely pressure on take-rates Square will experience as it moves up-market to customers
with higher GPV. PayPal offers some empirical evidence and a historical
precedent, while Heartland provides a forward-looking measure of significantly
lower transaction profit margins as Square moves to higher GPV customers.

PayPals take rate and transaction profit margin has come down over time

While PayPal commands a monopolistic position in terms of being the worlds online
wallet, it is not immune to the laws of size and take-rates in the payment processing
industry. This phenomenon occurs because larger GPV merchants can negotiate lower

Copyright 2017 Abdullah Sheikh 126


payment processing rates due to increased competition for their business amongst
merchant acquirers.

The exhibit below shows PayPals take-rate over time globally alongside GPV over the
last three years. As GPV has scaled, take-rates and transaction profit margins
have come down. For Square, the drop in transaction profit margins is likely to
be significantly more vicious than was the case for PayPal. This is because PayPal
has the benefit of earning 100% margins on seller transactions funded when buyers use
a PayPal balance, bank account instant transfer or PayPal Credit as their funding
source. Square does not have the same dynamic with sellers and thus contractions to
take-rates are likely to flow straight through to the bottom line.

Exhibit: GPV, take rates and transaction profit margins are inversely correlated,
as PayPals experience shows
Quarterly GPV Take rate Transaction profit margin

110 3.30%

3.10%
100
2.90%
GPV in USD millions

90 2.70%

2.50%

Rate
80
2.30%

70 2.10%

1.90%
60
1.70%

50 1.50%

Metric
3/31/2014 6/30/2014 9/30/2014 12/31/2014 9/30/2014 6/30/2016 9/30/2016 12/31/2016
Quarterly
GPV 53.676 56.736 58.184 66.039 58.184 86.208 87.403 99.4
Take-rate 3.11% 3.02% 3.01% 2.98% 3.01% 2.69% 2.65% 2.63
Transaction
profit 2.15% 2.09% 2.09% 2.08% 2.09% 1.75% 1.70% 1.67%
Source: https://investor.paypal-corp.com/, Author calculations

Heartland Payment Systems

Heartland provides card processing services to small and medium-sized merchants in


the U.S. As Square goes upmarket in terms of clients with higher GPV, there will be
more overlap with Heartlands clients. We can gauge insight into the degree of margin
compression Square can expect if it wants to onboard merchants with a similar profile to
Heartlands customer base. Additionally, Heartland is a Point of Saleed ISO of Wells

Copyright 2017 Abdullah Sheikh 127


Fargo bank, so shares a similar non-vertically integrated structure to Square. Like
Square, it is disadvantaged in the payment processing food chain.

As the exhibit below shows, in 2015, Heartlands net transaction revenue was $0.50 per
$2.30 of transaction revenue, before it was acquired by Global Payments Inc.
Heartland pays financial intermediaries about $1.80 per transaction, showing that like
Square it also occupies a disadvantaged position in the payment processing food
chain.

Exhibit: Heartlands payment processing economics

Source: Heartland 2015 10K

The exhibit below shows the comparison between Square and Heartlands take rate,
expense rate and transaction profit margin. Squares transaction profit margins are
double Heartlands primarily due to their target micro-merchant market. This is
likely to be a big source of margin compression as Square moves up market in
terms of GPV.

Copyright 2017 Abdullah Sheikh 128


Exhibit: Squares transaction profit margins are double Heartlands primarily due
to their target micro-merchant market
1.20%

1.00%

0.80%
Transaction margin

0.60%

0.40%

0.20%

0.00%
Square Heartland Payment Systems

Metric Square Heartland Payment


Systems
Take rate 2.93% 2.30%
Expense rate 1.92% 1.80%
Transaction profit 1.01% 0.50%
margin
Source: Heartland 10K, Square Q3 Shareholder letter

3. Stubbornly high transaction costs, particularly interchange fees


Square as a payment service provider is a price taker and has very little power
when negotiating transaction fees it pays to financial intermediaries. This is particularly
the case for interchange fees, which comprise the biggest cost to payment processors.
Interchange represents the fee paid to the card issuing bank once a transaction takes
place. As the exhibit above illustrated, it can comprise a large percentage of the
transaction cost. In Heartlands illustration, interchange was $1.66 out of the $2.30
transaction fee collected or 72%.

Evidence over the last six years collected from the Federal Reserve on Debit Card
Interchange Fees and Routing suggests that the largest component of Squares
transaction cost is likely to remain stubbornly high. The exhibit below shows the
interchange fee as a percentage of average transaction value on single-message 32
debit cards, such as ACCEL, AFFN, Maestro, PULCE, STAR and UnionPay, amongst
others and dual-message33 debit cards, such as Discover, MasterCard and Visa. The
interchange fees are on debit cards exempt from the Durbin amendment which capped

32
Single-message cards typically rely on a personal identification number as an authentication method.
33
Dual-message cards typically rely cardholder signature as an authentication method.

Copyright 2017 Abdullah Sheikh 129


swipe fees at 0.05% + $0.21 per transaction, plus a $0.01 fraud prevention
adjustment, if eligible.

Exhibit: Interchange fees are likely to remain stubbornly high as illustrated by


their persistence over the last six years
1.60%
Interchange fee as % of average transaction

1.40%

1.20%

1.00%
value

0.80%

0.60%

0.40%

0.20%

0.00%
2009 2011 2012 2013 2014 2015

Dual-message Single-message All Networks

Source: https://www.federalreserve.gov/paymentsystems/regii-average-interchange-fee.htm

In addition to setting interchange fees, card networks also set their own assessment
and other ad hoc fees that have a tended to be stubbornly high with an upward bias.
The exhibit below documents a few of the rate increases at Visa, MasterCard and
Discover over the last decade.

Exhibit: Assessment fees are likely to stay stubbornly high


Card Price increase details
Network

Visa In July 2016, Visa raised its assessment on debit volume from 0.11% to
0.13%. In January 2015, Visa raised its assessment on credit volume
from 0.11% to 0.13%.
MasterCard In January 2015, MasterCard increased its assessment by 0.01% on all
signature debit and credit transactions with an amount of $1,000 or less
from 0.11% to 0.12%.
Discover In April 2016, Discover's assessment increased from 0.11% to 0.13%.
In April 2015, Discover's assessment increased from 0.105% to 0.11%.
On April 15, 2016, Discover's Data Usage Fee increased from $0.0185
to $0.0195. On April 15, 2016, Discover's International Service Fee
increased from .55% to .80%.

Copyright 2017 Abdullah Sheikh 130


Source: http://www.vantagecard.com/price/interchange05.html

In its latest show of power, from February 2017, MasterCard will require all businesses
to pay a new Merchant Location Fee of $15 per year for location that accepts its cards.
Payment facilitators, like Square, must pay a reduced $3 per location. This is not a fee
that Square can negotiate on or pass to its customers it will come straight out
of margins. This is just the latest example of Squares disadvantaged position in the
payment processing food chain and the coming squeeze on margins, in part, due to
stubbornly high transaction costs.

While Square is likely to experience pressure on take-rates due to competition


and its efforts to move up-market, it is unlikely to receive much reprieve from
financial intermediaries. This particularly applies to interchange and assessment
fees that are set by card networks, given Squares disadvantaged position in the
payment processing food chain.

Summary

Squares outsized gross margins are likely to come down substantially over time as it
experiences pressure on take-rates from extreme competition and its efforts to move
upmarket to merchants with higher Gross Payment Volumes (GPV), all the while
experiencing rising transaction costs, particularly higher interchange and assessment
fees. Analysts are extremely sanguine on these key drivers of Squares profitability
forecasting stability far into the future despite several warning signs. PayPals decline
in take-rates and transaction margins over the last few years provides us with empirical
evidence and a historical precedent, while Heartlands transaction profit margins a full
50% below Squares show us the real-world challenges of merchant acquirers moving
up-market. Interchange and assessment fees, which comprise over 80% of the cost of
a typical transaction, are highly persistent as evidence over the last six years shows. In
the card processing food chain, card networks like Visa and MasterCard call the shots.
Square does not have the influence to maintain its high pricing structure or retain its
successful clients.

Copyright 2017 Abdullah Sheikh 131


Short thesis #5: Square has a limited Target Addressable
Market in the U.S. and internationally
In this chapter, I discuss the reasons why Square has a limited Target Addressable
Market (TAM). This chapter consists of the following sections:

1. Limited TAM in the U.S.


2. Limited international TAM
3. Regulatory risks and wrong side of technological megatrend

1. Limited TAM in the U.S.


Square management has repeatedly used the slide below in investor presentations to
illustrate the size of its Target Addressable Market (TAM) in the U.S. The slide
suggests that Square has a large TAM represented by U.S. Small and Medium (SMB)
spending on Payment and Point of Sale, Financial Services and Marketing Services.

Exhibit: Square management has misled analysts about TAM

Source: Investor presentation

Management has also used its quarterly shareholder letter to push the narrative that
Square is gaining traction with larger merchants. For example, in the Q3 2016 letter,
the fourth bullet point reads:

We grew GPV from larger sellers 55% year over year and maintained our
transaction revenue margin, demonstrating larger sellers continue to come to
Square for best-in-class services.

Copyright 2017 Abdullah Sheikh 132


Analysts have also accepted this narrative, frequently citing 21 million businesses that
do not accept credit cards as a target market for Square. For example, JPMorgan
writes:

21 million businesses in the U.S. still do not accept cards, a $150B to $440B
cardable opportunity.

While this narrative is appealing, it is worth understanding the nature of business that
would find Square appealing. Since Square charges a flat rate, rising volumes or ticket
sizes do not generate savings for the business34, as the exhibit below shows. For
simplicity, we assume no keyed-in transactions, for which Square charges 3.5% + $0.15
per transaction.

Exhibit: Due to Squares flat rate processing fee of 2.75% per transaction, rising
volumes does not generate savings for merchants
$700.00 3.50%

Merchant processing charge (% of GPV)


3.40%
$600.00
Processing fees paid to Square

3.30%
$500.00 3.20%

$400.00 3.10%
3.00%
$300.00 2.90%
$200.00 2.80%
2.70%
$100.00
2.60%
$- 2.50%

Gross Payment Volume per month

Source: Author calculations

34
The exception is when Squares gives specially discounted rates to businesses with larger volumes. For the
purposes of simplicity, I have modeled 100% card present transactions.

Copyright 2017 Abdullah Sheikh 133


Exhibit: Larger ticket size do not generate savings from Squares platform due to
flat rates of 2.75% per transaction
3.10%
Processing fees paid to Square as % of GPV

3.00%

2.90%

2.80%

2.70%

2.60%

2.50%
$5 $10 $15 $20 $25 $30 $35 $40 $45 $50 $55 $60 $65 $70 $75 $80 $85 $90 $95
$100
Ticket size

Source: Author calculations

Modeling a hypothetical merchant account

How does Squares pricing compare to a merchant account? We model a


hypothetical merchant using a set of fee assumptions for interchange, assessment, and
a merchant account. We also model activity on a merchant account for our hypothetical
merchant. These assumptions are shown in the exhibit below.

Exhibit: Assumptions underlying calculation of interchange fees


Visa program Percentage of Per transaction
transaction
Visa Regulated Debit 0.05% $0.22
Visa CPS / Small Ticket Debit 1.55% $0.04
Visa CPS / Small Ticket Credit 1.65% $0.04
Visa CPS / Retail Debit 0.80% $0.15
Visa CPS / Retail Credit 1.51% $0.10
Visa CPS / Card Not Present
Debit 1.65% $0.15
Visa CPS / Card Not Present
Credit 1.80% $0.10
Source: https://usa.visa.com/dam/VCOM/download/merchants/visa-usa-interchange-reimbursement-fees-2016-april.pdf

Exhibit: Assumptions underlying calculation of assessment fee


Fee type Percentage of Per transaction
transaction
Assessment fees (Visa debit) 0.13% $0.02
Assessment fees (Visa credit) 0.13% $0.02

Copyright 2017 Abdullah Sheikh 134


System File Transmission
Fee* $0.0018
Settlement Network Access
Fee $0.0025
Kilobyte access fee** $0.0047
Visa Fixed Acquirer Network
Fee (FANF)*** $2.90

Source: https://www.cardfellow.com/credit-card-processing-fees/, Visa.


* System File Transmission Fee applies to all Visa transactions and is charged in addition to other transaction-based assessments, such as the
Acquirer Processing Fee.
** Visa's kilobyte fee is charged on each authorization transaction submitted to Visa's network for settlement.
*** Visa introduced the Fixed Acquirer Network Fee (FANF) in April 2012. The FANF is a monthly fee that is assessed on a merchant taxpayer
basis and includes all merchant accounts owned by a business for credit card transaction processing.

Exhibit: Assumptions underlying calculation of merchant account fees


Visa program Percentage of Per transaction
transaction
If ticket size > $15, merchant
account margins 0.25% 0.10
If ticket size < $15, Merchant
account margins 0.30% 0.05
Monthly fee $10.00
PCI Compliance $7.95
Batch fee* $0.10
Wireless terminal fee $ 20.00
Source: https://dharmamerchantservices.com/storefront-rates/, National Bankcard
* A batch fee (also known as a batch header fee) can be charged to a merchant whenever the merchant "settles" their terminal. Settling a
terminal, also known as "batching", is when a merchant sends their completed transactions for the day to their acquiring bank for payment.
Some providers perform this automatically.

Exhibit: Account activity assumptions


Metric Assumption
Business days open in a month 29
Percentage debit cards 70%
Percentage regulated debit 80%
Percentage Card-Present 100%
Source: https://dharmamerchantservices.com/storefront-rates/, National Bankcard

For small ticket items, like coffee, food trucks, and fashion items, I assume that 70% are
funded from debit cards. Also, I assume 80% of debit cards are regulated by the Durbin
amendment i.e. issued by banks with greater than $10 billion in assets. Also, for
simplicity, I assume all transactions are card-present in nature. The results of the
analysis are most sensitive to these assumptions. Assuming the following transactions
would alsoef change the results of the analysis include:

Non-Visa debit and credit cards


Keyed-in and other card-not-present

Copyright 2017 Abdullah Sheikh 135


Visa Non-CPS
AVS/CCV/CVC verification
International cards
Refunds / retrievals / chargebacks / ACH rejections
E-commerce
Zero-dollar verification or phantom
PIN debit transactions

These types of transactions result in elevated payment processing expenses. For


example, Square charges clients 3.5% + $0.15 for every keyed-in transaction and Visas
card-not-present interchange rates are higher than card-present rates. American
Express has higher interchange rates than Visa, MasterCard and Discover and PIN
debit transactions route via debit card networks, not the credit card networks. However,
the main conclusions of the analysis are resilient to different assumptions regarding
non-standard debit and credit card transactions and extra charges, however, do change
the thresholds in favor of Square, which charges one all-inclusive flat rate.

Results of modeling hypothetical merchant account

The exhibit below shows the split between interchange fees, assessment and merchant
account provider fees for a merchant with an average ticket size of $20 and $10,000 of
monthly GPV.

Exhibit: Hypothetical merchant with average ticket size of $20 and monthly GPV
of $10,000
Fee Amount Percentage
Interchange $82.00 36%
Assessments $28.80 13%
Merchant account provider $115.85 51%
Total $226.60 100%
Percentage of GPV 2.27% -
Source: Author calculations

In a merchant account, payment processing fees are inversely proportional to both GPV
and ticket size, due to high fixed charges and lower variable rates, as the exhibit below
shows.

Exhibit: Rising volumes assuming a $20 average ticket size do generate cost
efficiencies for merchants

Copyright 2017 Abdullah Sheikh 136


$500.00 3.00%

Merchant processing charge (% of GPV)


$450.00
Processing fees paid to PSP
$400.00 2.50%
$350.00 2.00%
$300.00
$250.00 1.50%
$200.00
$150.00 1.00%
$100.00 0.50%
$50.00
$- 0.00%
$5,000

$100,000
$105,000
$10,000
$15,000
$20,000
$25,000
$30,000
$35,000
$40,000
$45,000
$50,000
$55,000
$60,000
$65,000
$70,000
$75,000
$80,000
$85,000
$90,000
$95,000
Gross Payment Volume per month

Fees charged in $ % charged

Source: Author calculations

Exhibit: Assuming $3,200 GPV per month, merchant account fees come down
with higher ticket size
6.50%
Processing fees paid to PSP as % of GPV

6.00%

5.50%

5.00%

4.50%

4.00%

3.50%

3.00%

2.50%

2.00%
$3 $6 $9 $12 $15 $18 $21 $24 $27 $30 $33 $36 $39 $42 $45 $48 $51 $54 $57 $60
Ticket size

% charged Series1

Source: Author calculations

Whether Square or a merchant account represents a more attractive solution depends


on both ticket size and GPV. The exhibit below shows the ratio of fees from a
Square account compared to a merchant account based on different ticket sizes
and monthly average GPV. The areas in green represent where Squares flat all-
inclusive pricing is more attractive than a merchant accounts custom pricing.

Copyright 2017 Abdullah Sheikh 137


Exhibit: Squares pricing is favorable for merchants will low volume and small
ticket size
Ticket size
Volume $ 3 $ 6 $ 9 $ 12 $ 15 $ 18 $ 21 $ 24 $ 27 $ 30 $ 33 $ 36 $ 39 $ 42 $ 45 $ 48 $ 51 $ 54 $ 57 $ 60 $ 63
$ 200 0.11 0.11 0.11 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12
$ 700 0.26 0.31 0.33 0.34 0.34 0.34 0.34 0.35 0.35 0.35 0.36 0.36 0.36 0.36 0.36 0.36 0.36 0.37 0.37 0.37 0.37
$ 1,200 0.35 0.43 0.47 0.49 0.51 0.49 0.51 0.52 0.52 0.53 0.54 0.54 0.55 0.55 0.55 0.55 0.56 0.56 0.56 0.56 0.56
$ 1,700 0.40 0.52 0.58 0.61 0.63 0.61 0.63 0.65 0.66 0.67 0.68 0.69 0.69 0.70 0.70 0.71 0.71 0.72 0.72 0.72 0.72
$ 2,200 0.44 0.59 0.66 0.70 0.73 0.70 0.73 0.75 0.77 0.78 0.79 0.80 0.81 0.82 0.83 0.83 0.84 0.84 0.85 0.85 0.86
$ 2,700 0.47 0.64 0.72 0.78 0.81 0.78 0.81 0.83 0.85 0.87 0.89 0.90 0.91 0.92 0.93 0.94 0.94 0.95 0.96 0.96 0.97
$ 3,200 0.49 0.68 0.78 0.84 0.88 0.83 0.87 0.90 0.93 0.95 0.97 0.98 0.99 1.01 1.02 1.03 1.03 1.04 1.05 1.05 1.06
$ 3,700 0.51 0.71 0.82 0.89 0.93 0.88 0.93 0.96 0.99 1.01 1.03 1.05 1.07 1.08 1.09 1.10 1.11 1.12 1.13 1.14 1.14
$ 4,200 0.52 0.74 0.85 0.93 0.98 0.93 0.97 1.01 1.04 1.07 1.09 1.11 1.13 1.14 1.16 1.17 1.18 1.19 1.20 1.21 1.21
$ 4,700 0.53 0.76 0.88 0.96 1.02 0.96 1.01 1.05 1.09 1.12 1.14 1.16 1.18 1.20 1.21 1.23 1.24 1.25 1.26 1.27 1.28
$ 5,200 0.54 0.78 0.91 1.00 1.06 0.99 1.05 1.09 1.13 1.16 1.18 1.21 1.23 1.25 1.26 1.28 1.29 1.30 1.31 1.32 1.33
$ 5,700 0.55 0.79 0.93 1.02 1.09 1.02 1.08 1.12 1.16 1.19 1.22 1.25 1.27 1.29 1.31 1.32 1.34 1.35 1.36 1.37 1.38
$ 6,200 0.55 0.81 0.95 1.05 1.11 1.04 1.10 1.15 1.19 1.23 1.26 1.28 1.31 1.33 1.35 1.36 1.38 1.39 1.40 1.41 1.42
$ 6,700 0.56 0.82 0.97 1.07 1.14 1.07 1.13 1.18 1.22 1.26 1.29 1.32 1.34 1.36 1.38 1.40 1.41 1.43 1.44 1.45 1.46
$ 7,200 0.57 0.83 0.99 1.09 1.16 1.09 1.15 1.20 1.25 1.28 1.32 1.35 1.37 1.39 1.41 1.43 1.45 1.46 1.48 1.49 1.50
$ 7,700 0.57 0.84 1.00 1.11 1.18 1.10 1.17 1.22 1.27 1.31 1.34 1.37 1.40 1.42 1.44 1.46 1.48 1.49 1.51 1.52 1.53
$ 8,200 0.57 0.85 1.01 1.12 1.20 1.12 1.19 1.24 1.29 1.33 1.37 1.40 1.42 1.45 1.47 1.49 1.51 1.52 1.54 1.55 1.56
$ 8,700 0.58 0.86 1.03 1.14 1.21 1.13 1.20 1.26 1.31 1.35 1.39 1.42 1.45 1.47 1.49 1.51 1.53 1.55 1.56 1.58 1.59
$ 9,200 0.58 0.87 1.04 1.15 1.23 1.14 1.22 1.28 1.33 1.37 1.41 1.44 1.47 1.49 1.52 1.54 1.56 1.57 1.59 1.60 1.62
$ 9,700 0.58 0.87 1.05 1.16 1.24 1.16 1.23 1.29 1.34 1.39 1.42 1.46 1.49 1.51 1.54 1.56 1.58 1.60 1.61 1.63 1.64
$ 10,200 0.59 0.88 1.05 1.17 1.25 1.17 1.24 1.30 1.36 1.40 1.44 1.47 1.51 1.53 1.56 1.58 1.60 1.62 1.63 1.65 1.66
Source: Author calculations

Successful merchants could be defined as those with high GPV. For a ticket-size as
small as $9 per transaction, a separate merchant account begins to look
attractive at around $7,700 GPV per month or $92,400. This represents roughly
855 transactions over a month or 10,267 per year.

Many businesses also attempt to increase average ticket size i.e. wallet-share. The
threshold for a merchant account goes down rapidly as ticket size increases. At
a $30 ticket size, the merchant needs only $3,700 of monthly sales in a month or
123 transactions to make opening a merchant account more economically
attractive.

The exhibit below zooms-out and looks at a bigger set of merchants with larger ticket
sizes and higher GPV. This gives us a better sense of Squares target market and
shows us just how limited Squares TAM really is. For merchants with larger ticket sizes
and GPV, Square can be sometimes twice as expensive as a merchant account.

Exhibit: Squares pricing is very unattractive for most businesses with larger
ticket sizes and high GPV
Ticket size
Volume $ 5 $ 8 $ 11 $ 14 $ 17 $ 20 $ 23 $ 26 $ 29 $ 32 $ 35 $ 38 $ 41 $ 44 $ 47 $ 50 $ 53 $ 56 $ 59 $ 62 $ 65
$ 5,000 0.71 0.86 0.96 1.02 0.96 1.02 1.06 1.10 1.13 1.16 1.18 1.20 1.22 1.24 1.25 1.27 1.28 1.29 1.30 1.31 1.31
$ 10,000 0.80 1.00 1.13 1.22 1.14 1.21 1.28 1.33 1.38 1.42 1.46 1.49 1.52 1.54 1.56 1.58 1.60 1.62 1.63 1.65 1.66
$ 10,500 0.80 1.01 1.14 1.24 1.15 1.22 1.29 1.35 1.40 1.44 1.47 1.51 1.53 1.56 1.58 1.60 1.62 1.64 1.66 1.67 1.68
$ 11,000 0.81 1.02 1.15 1.25 1.15 1.24 1.30 1.36 1.41 1.45 1.49 1.52 1.55 1.58 1.60 1.62 1.64 1.66 1.67 1.69 1.70
$ 11,500 0.81 1.02 1.16 1.26 1.16 1.24 1.31 1.37 1.42 1.46 1.50 1.54 1.57 1.59 1.62 1.64 1.66 1.68 1.69 1.71 1.72
$ 12,000 0.82 1.03 1.17 1.27 1.17 1.25 1.32 1.38 1.43 1.48 1.52 1.55 1.58 1.61 1.63 1.65 1.67 1.69 1.71 1.72 1.74
$ 12,500 0.82 1.03 1.18 1.27 1.18 1.26 1.33 1.39 1.44 1.49 1.53 1.56 1.59 1.62 1.65 1.67 1.69 1.71 1.72 1.74 1.76
$ 13,000 0.82 1.04 1.18 1.28 1.18 1.27 1.34 1.40 1.45 1.50 1.54 1.57 1.61 1.63 1.66 1.68 1.70 1.72 1.74 1.76 1.77
$ 13,500 0.83 1.04 1.19 1.29 1.19 1.28 1.35 1.41 1.46 1.51 1.55 1.59 1.62 1.65 1.67 1.69 1.72 1.74 1.75 1.77 1.78
$ 14,000 0.83 1.05 1.19 1.30 1.20 1.28 1.36 1.42 1.47 1.52 1.56 1.60 1.63 1.66 1.68 1.71 1.73 1.75 1.77 1.78 1.80
$ 14,500 0.83 1.05 1.20 1.30 1.20 1.29 1.36 1.43 1.48 1.53 1.57 1.61 1.64 1.67 1.69 1.72 1.74 1.76 1.78 1.80 1.81
$ 15,000 0.83 1.06 1.21 1.31 1.21 1.30 1.37 1.44 1.49 1.54 1.58 1.62 1.65 1.68 1.71 1.73 1.75 1.77 1.79 1.81 1.82
$ 15,500 0.84 1.06 1.21 1.32 1.21 1.30 1.38 1.44 1.50 1.55 1.59 1.63 1.66 1.69 1.72 1.74 1.76 1.78 1.80 1.82 1.83
$ 16,000 0.84 1.07 1.21 1.32 1.22 1.31 1.38 1.45 1.50 1.55 1.60 1.63 1.67 1.70 1.72 1.75 1.77 1.79 1.81 1.83 1.85
$ 16,500 0.84 1.07 1.22 1.33 1.22 1.31 1.39 1.46 1.51 1.56 1.60 1.64 1.68 1.71 1.73 1.76 1.78 1.80 1.82 1.84 1.86
$ 17,000 0.84 1.07 1.22 1.33 1.23 1.32 1.40 1.46 1.52 1.57 1.61 1.65 1.68 1.71 1.74 1.77 1.79 1.81 1.83 1.85 1.87
$ 17,500 0.84 1.07 1.23 1.34 1.23 1.32 1.40 1.47 1.52 1.57 1.62 1.66 1.69 1.72 1.75 1.78 1.80 1.82 1.84 1.86 1.87
$ 18,000 0.85 1.08 1.23 1.34 1.23 1.33 1.41 1.47 1.53 1.58 1.62 1.66 1.70 1.73 1.76 1.78 1.81 1.83 1.85 1.87 1.88
$ 18,500 0.85 1.08 1.24 1.34 1.24 1.33 1.41 1.48 1.54 1.59 1.63 1.67 1.71 1.74 1.77 1.79 1.82 1.84 1.86 1.88 1.89
$ 19,000 0.85 1.08 1.24 1.35 1.24 1.34 1.41 1.48 1.54 1.59 1.64 1.68 1.71 1.74 1.77 1.80 1.82 1.84 1.86 1.88 1.90
$ 19,500 0.85 1.09 1.24 1.35 1.25 1.34 1.42 1.49 1.55 1.60 1.64 1.68 1.72 1.75 1.78 1.81 1.83 1.85 1.87 1.89 1.91
Source: Author calculations

Square becomes uneconomical with GPV growth for both small ticket and large ticket
merchants.

Copyright 2017 Abdullah Sheikh 138


Small ticket merchants benefit from special small ticket debit/credit card rates
from MasterCard
Large ticket merchants benefit from regulated debit card rates introduced by the
Durbin amendment

To illustrate the small ticket case, consider a coffee shop with an average ticket size of
$6. Visa Small Ticket interchange fees on debit and credit cards of 1.55% + $0.04 per
transaction and 1.65% + $0.04 per transaction, respectively, apply for items lower than
$15. This results in the payoff shown in the exhibit below. At $7,700 GPV per month,
or $92,400 per year, applying for a merchant account becomes more attractive relative
to Square.

Exhibit: Rising volumes assuming a $9 average ticket size result in Square


becoming uneconomical at GPV of $7,700 a month

Source: Author calculations

To illustrate the large ticket case, consider an apparel shop with an average ticket size
of $30. Interchange fees on regulated debit card rates of 0.05% + $0.22 per
transaction. This results in the payoff shown in the exhibit below. At $3,700 GPV per
month, or $44,400 per year, applying for a merchant account becomes more attractive
relative to Square.

Copyright 2017 Abdullah Sheikh 139


Exhibit: Rising volumes assuming a $30 average ticket size result in Square
becoming uneconomical at GPV of $3,700 a month

Source: Author calculations

Analysts have taken management at their word when they discuss moving up-market,
with little evidence of actual success with larger merchants. Analysis of a
hypothetical merchant account shows that Square faces significant hurdles
competing with traditional merchant accounts for their successful micro-
merchants.

2. Limited international opportunity


Analysts also do not recognize that Square has a very limited opportunity for
international growth. Analysts are being blind-sided by Squares growth in Canada35,
which like the U.S. has largely unregulated markets for interchange fees like the
U.S. Squares business model does not work as well in other developed markets,
such as the U.K., Europe and Australia, and emerging markets, such as China
and India.

In the case of the U.K., Europe and Australia, consumer interchange fees are
heavily regulated at very low flat rates between 0.2%-0.3%36, so Squares

35
Like the U.S., Canadian interchange fees on consumer cards are unregulated, thereby creating an
opportunity for Squares high flat pricing business model. Canadian interchange rates are on
MasterCards website:
https://www.MasterCard.com/ca/wce/PDF/MasterCard_Canada_Interchange_Rate_Programs.pdf
36
MasterCards interchange fees on consumer credit cards in the U.K. and Europe are between 0.20-
0.30%, significantly lower than the typical 1.5%+ fee found in the U.S. MasterCard publishes a complete
schedule of rates for Europe on its website:

Copyright 2017 Abdullah Sheikh 140


all-inclusive flat payment processing fee would be far less attractive even to
micro-merchants. The card processing system is already simple in these
countries. The exhibit shows U.K. domestic interchange rates on a range of
MasterCard branded consumer credit cards.

Exhibit: Unlike the U.S., U.K. interchange rates on MasterCard consumer credit
cards are capped at low rates

Source: Global Payments Inc.

Exhibit: European interchange rates on MasterCard consumer credit cards are


capped at low rates

Source: Global Payments Inc.

In the case of Emerging Markets, low levels of credit card penetration and
prevalence of cash transactions for micropayments, make Squares
solutions significantly less attractive. Square has very limited market
potential in the fastest growing large economy in the world China.
Chinese consumers overwhelmingly use online payment platforms such as
Alipay37, WeChat Payment and Baidu Wallet, for e-commerce. Were Square
attempt to enter the Chinese market, it is very unlikely that its Reader or
Stand hardware terminals would find popularity amongst Chinese merchants
or consumers.

3. Regulatory risks and wrong side of technological megatrend

https://www.MasterCard.com/us/company/en/whatwedo/interchange/Country.html. Visa publishes


interchange rates for Australia on its website: https://www.visa.com.au/about-visa/interchange.html
37
The latest statistics on AliPay are as follows: $519 billion (USD) of payment volume, 400 million Point of Saleed users, 270 million
active mobile users, 42.4 billion transactions, 175 million transactions per day. For complete statistics, please see:
http://expandedramblings.com/index.php/alipay-statistics/

Copyright 2017 Abdullah Sheikh 141


Square also faces severe regulatory risks that would potentially make its
business model unattractive for micro-merchants in the U.S. and Canada. If the
U.S. and Canada were to enact similar legislation to the U.K., Europe and Australia
mandating low and flat interchange fees on consumer credit card transactions,
Squares flat pricing model would be significantly less attractive. The Durbin
Amendment38 enacted as part of Dodd-Frank Wall Street Reform and Consumer
Protection Act enacted caps on debit card interchange fees, as the exhibit below shows.
A similar cap on credit card interchange fees, which is not a far-fetched
possibility, would be devastating to Square yet is not a possibility being
considered by analysts.

Exhibit: U.S. debit card interchange fee caps post Durbin Amendment

Source: Federal Reserve

In fact, countries like China are leap-frogging debit and credit cards to move straight to
online payment solutions. In this very significant respect, Square is on the wrong
side of a powerful technological megatrend towards digital payments and its
hardware gateways risk obsolescence from larger innovative digitally focused payment
solution providers, such as Apple, Google and PayPal, and new tokenization
technology, like that developed by Cartwheel Point of Sale39. Accentures survey of

38
Full Durbin Amendment can be found here: http://www.durbininterchangeamendment.org/pdfs/DurbinAmendment5-13.pdf. The rules
apply only to debit cards issued by banks with more than $10 billion in total assets. There is an argue that regulations on
interchange fees associated with credit cards are unlikely under a Trump administration. The Australian example, where both
conservatives (referred to as the Liberal Party) and democrats (referred to as the Labor Party) have overseen such regulation by the
Reserve Bank of Australia on interchange fees.
39
Cartwheel Point of Sale is a Point of Sale (POS) payment app priced lower than Squares that
processes online payments without any hardware (like a card reader). It uses the camera from a
smartphone to make a digital copy of a customers credit or debit card for online processing. This
process is called tokenization and also used by Apple Pay. It can be downloaded for free from the Apple
iOS store.

Copyright 2017 Abdullah Sheikh 142


consumer payment trends support the rising popularity of digital solutions in the
next few years.

Exhibit: Accenture survey of consumer use of payment options in 2016 to 2020

Source: 2016 North America Consumer Digital Payments Survey

Summary

Squares over-bullish management team has misled the analyst community on the
potential size of their Target Addressable Market in the U.S., by repeatedly citing
success with large sellers and U.S. card transaction volume of $10 trillion. The reality
is that 99%+ of Squares customers are financially disadvantaged micro-merchants, with
only a handful of SME customers. For a business processing debit and credit card
transactions with an average ticket size of $9 and monthly GPV greater than $9,000,
leaving Square for a merchant account becomes economically more attractive. For
businesses with higher average ticket sizes, the volume threshold is significantly lower.
For example, with an average ticket size of $30, the monthly GPV threshold falls to
$4,000.

Squares business model does not work as well in other developed markets, such as
the U.K., Europe and Australia, and emerging markets, such as China and India. In the
case of the U.K., Europe and Australia, consumer interchange fees are heavily
regulated at very low flat rates between 0.2%-0.3%, so Squares all-inclusive flat
payment processing fee is far less attractive to merchants. In the case of Emerging
Markets, low levels of credit card penetration and prevalence of cash transactions for

Copyright 2017 Abdullah Sheikh 143


micropayments make Squares solutions significantly less attractive. In this respect,
Square also faces regulatory risks that would potentially make its business model far
less appealing for micro-merchants in the U.S. and Canada. A cap on credit card
interchange fees, like debit card swipe fees implemented by the Durbin Amendment,
would be potentially devastating to Square, yet is not a possibility being considered by
analysts.

Square is also on the wrong side of a powerful technological megatrend towards digital
payments and its hardware gateways risk obsolescence from larger innovative digitally
focused payment solution providers, such as Apple, Google and PayPal, and even new
tokenization technology such as that used by Apple Pay and Cartwheel Point of Sale.
Accentures survey of consumer payment trends confirm the trend towards more digital
solutions over the next few years. In fact, countries like China are leap-frogging debit
and credit cards to move straight to online payment solutions like Alipay, WeChat
Payment and Baidu Wallet.

Copyright 2017 Abdullah Sheikh 144


Short thesis #6: Analysts are overestimating growth of
Square Capital, which will likely experience a fate similar to
other non-bank lenders, like OnDeck Capital

In this section, I detail why analysts are severely overestimating revenue growth from
Square Capital.

Squares core business as a payment service provider lacks operating leverage 40.
Driven by a promotional management team and strong short-term quarterly
earnings, analysts are forecasting rapid revenue growth of Squares value added
services.

For example, Guggenheim writes:

Squares ability to generate incremental revenues from the value-added services it


sells merchants is a key driver behind our EBITDA growth forecasts. A key component
of this is spread revenues from merchant loans originated by Square Capital. We expect
Squares Software and Data Products revenues to grow from $128M in 2016E to $298M
in 2018E (52% CAGR), largely driven by the increase in loan-related revenues.

JPMorgan writes:

We are forecasting the fastest relative growth in the high-margin Software & Data line,
which we see increasing six-fold over the next five years, growing from $52M in FY15 to
$314M in FY20. Driven primarily by growth in Square Capital merchant loan business,
which we think can extend $2.5bn in loans and generate $162M in revenues by 2020,
up from roughly $340M in loans and $14M in revenues in FY15.

Other analysts have similar views on the prospects of growth for Squares ancillary
product offerings, particularly Square Capital. There are two reasons why analysts are
severely overestimating sales growth of Squares ancillary products:

1. Square Capital loans are a poor deal for micro-merchants


2. Analysts are overestimating growth of Square Capital, which will likely experience a
fate similar to other non-bank lenders, like OnDeck Capital

1. Square Capital loans are a poor deal for successful micro-


merchants and large sellers
Square Capital is an attempt by management to counter the effects of churn
resulting from successful micro-merchants seeking more competitive payment

40
As GPV scales, so do transaction expenses which constitute the biggest cost of sales component for Square - resulting in a
muted increase to overall gross and operating margins. For, example, the year-over-year increase in transaction revenues of 38.2%
over Q3 2016, was met with a commensurate 39.6% increase in transaction expenses over the same period.

Copyright 2017 Abdullah Sheikh 145


processing solutions. This issue of churn is depicted in Exhibit below as the
right-tail of the distribution.

Exhibit: Most of Squares two million customers are low contributors to total GPV
with a risk of falling out of the ecosystem
# of customers

High risk customers High risk


customers

Source: Author illustration Contribution to GPV

Micro-merchants qualify for Square Capital financing by establishing a successful track


record of processing payments with Square. Square Capital then makes repeat41 high
APR short-term loans to these successful micro-merchants, who are then obliged 42 to
use Squares overpriced and commoditized payment processing services to pay back
these loans and support their fledgling businesses. This results in an unattractive
economic outcome for the successful micro-merchant on both the financing and
payment processing front.

On the financing front, Squares short-term loans have high APRs and are
extremely unattractive to successful merchants who have an established track
record of sales. Working Capital loans from Square Capital also sometimes
known as Merchant Cash Advances are expensive, when compared to other forms
of borrowing, such as small business loans. For example, Square Capital loans
typically have APRs in the region of 16%-28%43, depending on whether they are
paid over ten or eighteen months. Given this high cost of borrowing, Square Capital
is not a desirable source of funding for all but the most desperate and financially
disadvantaged micro-merchants.

For successful micro-merchants, there may in fact be significantly cheaper sources


of funding available from alternative capital providers. There are three SBA
programs relevant for successful micro-merchants that have APRs lower than
Square Capital loans: SBA 7(a) Small Loans, SBA Express Loans and SBA Non-
7(a) Microloans. The exhibit below shows details of these programs.

41
Repeat loans were cited as a major strength of Square Capital during their Q3 2016 conference call.
42
One of the conditions of any merchant taking out a loan with Square Capital is a commitment to use
Square as the sole payment processor until the loan is fully paid off.
43
APR calculations are detailed in Chapter 1: Introduction to Square Inc. Subsection: Square Capital

Copyright 2017 Abdullah Sheikh 146


Exhibit: SBA micro- and small loan programs offer more compelling
alternatives to Square Capital for successful micro-merchants
Max Loan Maximum interest
Program Amount Use of proceeds Maturity rates Who qualifies Benefits to Borrowers
Purchase machinery & equipment, Direct loans from nonprofit
fixtures, leasehold improvements; Negotiable with Must be a for profit intermediary lenders; Fixed-rate
finance increased receivables; working Shortest term intermediary. Subject to business & meet SBA financing; Very small loan
Non-7(a) capital. Cannot be used to repay possible, not to either 7.75 or 8.5% above size standards; show amounts; Technical assistance
Loans $50,000 existing debt. exceed 6 years intermediary cost of funds. good character, credit, available
May be used for revolving lines of Revolving Lines of Loans $50,000 or less; management, and Fast turnaround, Streamlined
credit (up to 7 year maturity) or for a Credit including prime+ 6.5%; Loans over ability to repay. Must process; Easy-to-use line of
SBAExpress $350,000 term loan (same as 7(a)). term out period.
Depends on $50,000;
Loans prime
less than + 4.5%$0 - be an eligible type of
7 years: credit
ability to repay. $25,000, Prime + 4.25% business. Prepayment
Term Loan. Expansion/ renovation; new Generally, $25,001 - $50,000, P + penalty for loans with
construction, purchase land or working capital & 3.25% Over $50,000, Prime maturities of 15 years
buildings; purchase equipment, machinery & + 2.25%; Loans 7 years or or more if prepaid Long-term financing; Improved
fixtures, lease-hold improvements; equipment (not to longer: 0 - $25,000, Prime + during first 3 years. (5% cash flow; Fixed maturity; No
working capital; refinance debt for exceed life of 4.75% $25,001 - $50,000 P year 1, 3% year 2 and balloons; No prepayment penalty
7(a) Small compelling reasons; inventory or equipment) is up + 3.75% Over $50,000, 1% year 3) (under 15 years). Plus
Loans $350,000 starting a business to 10 years; real Prime + 2.75%; Can also streamlined process.
Source: https://www.sba.gov/sites/default/files/files/Loan-Chart-Baltimore-June-2016-Version-A.pdf

These programs require participating lenders to conduct due-diligence on borrowers.


However, since Square Capital only extends credit to micro-merchants with a
successful payment processing track record, it is not a stretch to assume that many
of these micro-merchants would also qualify under one of these three SBA loan
programs, thus having a mechanism to lower their cost of borrowing. The interest
rates on SBA loans are capped due to government guarantees. The highest rates
on the three programs are for microloans at 7.75% - 8.5% over the intermediary cost
of funds, where cost of funds is based on the five-year Treasury Bill rate minus a
1.25% or 2.00% buy-down44. A SBA microloan program would incur a maximum
interest rate of 9.1% (Spread of 8.5% + Five-year yields of 1.88% - SBA discount of
1.25%). While application and closing fees are likely to result in an APR greater
than 9.1%, the final APR is likely to be significantly below Square Capital APRs of
between 16% and 28%. Square Capital offers poor economic value to
successful micro-merchants.

On the payment processing front, successful micro-merchants may have


crossed the threshold at which leaving Square for a separate merchant
account makes economic sense. The requirement to use Square as the sole
payment processor until the high APR short-term loan is repaid means that
successful micro-merchants are also simultaneously overpaying for payment
processing.

This perspective is shared by Phillip Parker45, a self-described crusader against


dishonest payment processors writes on his website:

44
Please see: https://www.sba.gov/sites/default/files/lender/Microloan%20Program%20FactSheet.pdf
45
www.cardpaymentoptions.com/financing/square-capital/

Copyright 2017 Abdullah Sheikh 147


Merchants who qualify for Square Capital may be precisely the kinds of merchants
that should consider switching away from Squares processing solution because
they have outgrown it.

Square Capital will also struggle to gain traction with large sellers, given the high APRs
on loans. Larger merchants will likely have access to significantly cheaper sources of
capital due to their established operating history and lower credit risk. Thus, analysts
are over-estimating Square Capital growth as Square attracts merchants with higher
GPV.

2. Analysts are overestimating growth of Square Capital, which will


likely experience a fate similar to other non-bank lenders, like
OnDeck Capital
Square Capital has much in common46 with OnDeck Capital, a publicly traded non-bank
financial technology company that makes term loans and extends lines of credit to small
businesses. The exhibit below sets out five similarities.

Exhibit: Square Capital has similarities to OnDeck Capital


Key attribute Description
Focus on micro- and small businesses Square Capital and OnDeck Capital both
focus exclusively on the micro- and small
business segment, arguing it is a massive
and underserved market. Both cite
28MM U.S. Small Businesses as target
market.
Non-bank disruptive fintech firms Square and OnDeck are more
technology, less financial services, firms
and do not have customer deposits to use
as a funding source for their loans
Claim superior underwriting due to OnDeck aggregates and analyzes
proprietary data and analytics engine transactional, credit, public records,
proprietary, social and accounting data to
assess the creditworthiness of small
businesses via the OnDeck Score.
OnDeck claims better insight into the
credit worthiness thanks to its proprietary
algorithms. Square claims that intimate
knowledge of the micro-merchant, due to
its relationship as payment processor,
provides unique insight into
creditworthiness.

46
There are some differences. Square makes loans repayable directly from future debit and credit card
receivables, while OnDeck makes commercial business loans, term loans and extends lines of credit.

Copyright 2017 Abdullah Sheikh 148


Short-term high APR loans used for OnDeck term loans, typically used for
working capital inventory, hiring staff and marketing, have
a term of 3-36 months and APRs of 43%.
OnDeck lines of credit, typically used to
manage cash flows, have a term of six
months and APRs between 14% - 40%.
Square Capital provides short term high
APR working capital loans which range
from 16% to 28%.
Third-party funding platform OnDeck Capital focuses on selling loans
to third-parties via credit facilities,
securitizations (75-85% of term loans)
and an online Marketplace of loans (15-
25% of term loans). Square Capital sells
loans to interested third parties via Celtic
Bank.
Source: OnDeck Capital 10K, Author research

OnDeck Capital experienced rapid origination growth, as it could sell loans to third-party
investors thanks to juicy yields and a claim to a superior loan underwriting process. In
many cases, sales of loans generated healthy gains, due to healthy demand, a chase
for yield and favorable credit market conditions. However, as credit markets
experienced hiccups particularly in Q4 2015/Q1 2016 funding sources for OnDecks
loans dried up and it was forced to hold and increasing percentage of originations on
balance sheet. The exhibit below shows loans held on balance sheet over the last ten
quarters.

Exhibit: Loans held on balance sheet have ballooned as third-party funding


sources have dried up due to credit market conditions and waning institutional
demand

Source: OnDeck Investor Presentation

Copyright 2017 Abdullah Sheikh 149


The effect of holding more loans on the balance sheet, vs. selling to third-parties, has
been a drastic increase in interest income as a proportion of total revenues as the
exhibit below shows.

Exhibit: The proportion of income from gain on sale has decreased to just 7%
vs. 30% one year ago

Source: OnDeck Investor Presentation

Coincidental to the decline in third-party appetite for OnDecks loans, origination and
revenue growth, and yield on loans, has declined, as the exhibit below from Stifel
shows.

Exhibit: OnDecks origination, revenue growth and effective yield on loans has
fallen sharply due to waning third-party interest in loans

As OnDeck has held more loans on its balance sheet, its cost of capital has gone up
due to shareholders facing loan losses due to defaults. The combined effect of these
developments has been a business that has failed to deliver, as the exhibit below
shows. The business is barely profitable after expenses are considered.

Copyright 2017 Abdullah Sheikh 150


Exhibit: OnDecks operating performance has crumbled as third-party financing
for business loans has dried up

Source: OnDeck Capital Investor Presentation

As might have been expected, the combined effect has been a sharp revision down in
analyst expectations, as OnDecks stock price has suffered from the weight of
disappointing results and guidance. In my opinion, OnDeck Capital should serve as a
cautionary tale on Square Capital, and the effects of being reliant on fickle third-party
investors as a main source of funding.

Exhibit: OnDeck Capital has severely undershot analysts projections due to its
reliance on third-party investors as a source of funding

Source: Bloomberg

Summary

Squares core payment processing business lacks operating leverage, so to justify


lofty price targets analysts are modeling rapid revenue and margin growth from
upselling of Squares value added services particularly Square Capital. Square

Copyright 2017 Abdullah Sheikh 151


Capital is an unattractive source of funding for all but the most desperate and financially
disadvantaged micro-merchants given APRs in the region of 16%-28%. In addition to
larger merchants, Square Capital also presents an economically inferior solution for
successful micro-merchants compared to alternatives. SBA working capital loans
targeted at profitable and growing micro-merchants have APRs a full 6% to 18% lower
than Square Capital. Square Capital is an attempt by management to stem the effects
of GPV attrition due to successful micro-merchants leaving Squares overpriced
payment processing platform for a more competitive solution. The failure of non-bank
online loan providers reliant on fickle third-party funding sources, like OnDeck Capital,
should serve as a cautionary tale for Square Capital.

Copyright 2017 Abdullah Sheikh 152


Short thesis #7: Micro-merchants have little need for
Squares me-too software
In this chapter, I detail why micro-merchants have little need for Squares me-too
software.

Squares suite of software products consists primarily of a bunch of me-too software


solutions, including Square Payroll and Invoice ( la Quickbooks), Employee
Management ( la Zenefits), Cash ( la Venmo), Online Store ( la Shopify) and
Appointments ( la Google Calendar). The full suite of software products is shown in
the exhibit below.

Exhibit: Software overview Squares suite of products `

Source: https://squareup.com/dashboard/software-overview

Copyright 2017 Abdullah Sheikh 153


These software programs fall into three categories: free, paid per transaction and paid
via subscription.

Exhibit: Square free, subscription-based and paid software


Free Paid per transaction Paid via subscription
Dashboard Instant Deposit Payroll
Point of Sale Invoice Employee Management
Analytics Online Store Appointments
Cash Gift cards* Email Marketing
Location Management Loyalty
Customer Feedback
Source: Author research. *Square Gift cards are ordered on a per batch basis.

Squares free software, such as Square Point of Sale and Analytics, serves to attract
micro-merchants into its ecosystem. Most micro-merchants appreciate the instant
access to some POS solution and analytics capability with zero upfront cost, due to their
financially disadvantaged nature. Square then sets about to upsell paid software, such
as instant deposit, invoice, payroll, employee management and appointments. In
effect, Square uses its free software to drive sales of its overpriced payment
processing solution, while selling paid software solutions to earn incremental
margins.

Few financially disadvantaged micro-merchants have a business need for this


suite of complex business software. As per Squares Q3 2016 shareholder letter,
82% of GPV comes from customers with less than $500,000 GPV, with 57% coming
from customers with less than $125,000 GPV. Based on firm sizing data from the SBA,
most of Squares customers are micro-merchants with less than 9 employees with
annual revenue less than one million dollars. Squares S1 indicated over 2 million
sellers generated 97% of total GPV of $28.4 billion over the 12 month to June 2015.
This implies an average GPV per seller of only $14,200 a year, or less than $1,200 a
month.

Consider a hypothetical Square merchant that has annual GPV of $30,000 47 and
employs two to three people on an hourly basis. This profile of micro-merchant
will have neither the business need nor the financial wherewithal to purchase
complex accounting, employee management, email marketing, and loyalty
programs. The average Square customer is largely a bare bones operation utilizing
extremely cheap or free software to run their business. One example of free software is
Google Calendar. Google Calendar offers almost all the functionality of Square
Appointments at a cost of $0 a year. Square Appointments on the other hand costs a

47
Per Squares S1, over two million merchants accounted for 97% of annual GPV of $28.4 billion over the twelve
months to June 2015. The average GPV per merchant based on these figures is approximately $14,200 per year.
Since the median of a positively skewed distribution is lower than the mean, the median Square customer has a GPV
less than $14,200 a year.

Copyright 2017 Abdullah Sheikh 154


whopping $600 per year. It is hard to compete with free. Square Appointments is
unlikely to gain mainstream traction with merchants.

Another software product unlikely to generate significant revenues is Instant Deposit,


which offers immediate access to card sales for 1% of funds, vs. the norm of one to two
business days, which results in APRs more than 365%. Given the exorbitant cost, I
anticipate Square Instant Deposit will appeal to only the most financially
disadvantaged micro-merchants experiencing cash flow problems or an
immediate cash crunch.

If our hypothetical merchant was to subscribe to Squares software offerings, including


Payroll, Employee Management, Appointments, Email Marketing, Loyalty, Gift cards,
they would end up paying almost $2,000 per year. This cost breakdown is shown in the
exhibit below.

Exhibit: Annual cost of Square software products for hypothetical micro-


merchant
Square software Annual cost

Payroll subscription $25 + $5 x 3 employees x 12 = $480


Employee Management subscription $5 x 3 employees x 12 = $180
Appointments subscription $50 per month X 12 = $600
Email Marketing subscription $15 per month X 12 = $180
Loyalty subscription $25 per month X 12 = $300
Gift cards purchase $40 per pack X 2 = $80

Total $1,820
Source: www.squareup.com, Author calculations

This is an exorbitant amount of money for a financially disadvantaged micro-merchant


simply to have access to a nice-to-have software suite. It does not make economic
sense for the median Square customer to buy Squares overpriced software.
Unlike transaction processing fees, which rely on GPV growth, sales of Squares
software are tied to the number of purchasing customers. This is likely to result in poor
sales of Squares me-too software suite, which will likely severely undershoot lofty
analyst forecasts.

Another confirmation of the lack of demand Squares ancillary software product


suite is likely to generate comes from payment service professionals at
toptenreviews.com an independent product review website. In ranking mobile
payment service providers, toptenreviews.com has developed the following criteria:

1. Pricing: Transparency & Consistency


2. Fees: Monthly Fee, Minimum Fee, PCI Compliance Fee, PCI Non-Compliance Fee,
Chargeback Fee
3. Flat-Rate Pricing: Swiped-Rate, Keyed-In Rate, Per Transaction
4. Tiered Pricing: Swiped Debit Card, Swiped Credit Card, Per Transaction

Copyright 2017 Abdullah Sheikh 155


5. Setup & Service Terms: Ease of Application, No Contract Required, Quick Setup
Time, Quickly Clears the Account
6. Customer Support: Customer Service, Dedicated Account Rep, Knowledgebase,
Phone 24/7

Ecosystem and software are notably absent from this list. This is surprising given
CEO Jack Dorseys comments during Squares Q3 2016 earnings call:

I think first and foremost that merchants come to Square because they are getting
access to our end-to-end ecosystem.

The experts at toptenreview.com do not agree. Despite management claims to the


contrary, payment service professionals do not consider ecosystem an important
driver of their decision when recommending a mobile payment service provider.

There is even a real-world client example of the lack of influence ecosystem plays in a
companys decision to select a payment service provider. Despite having used the
ecosystem for almost three years, Starbucks decided to terminate its partnership
with Square. It instead chose Chase Paymentech, for non-mobile payment processing,
and First Data, for all mobile payment processing services. For most businesses,
particularly those with operations and finance functions, it does not make sense
to overpay for payment processing simply to access other ancillary software
services.

Summary

Squares other value added services consist of me-too software solutions, such as
Square Payroll and Invoice ( la Quickbooks), Employee Management ( la Zenefits),
Cash ( la Venmo), Online Store ( la Shopify) and Appointments ( la Google
Calendar). The median Square customer is a financially disadvantaged micro-merchant
that has neither the business need nor the financial wherewithal to purchase complex
accounting, employee management, email marketing, and loyalty software. Given sales
of Squares software are tied to the number of customers subscribing to it, not GPV
volume, it is highly likely that software sales will undershoot analyst forecasts. Another
indicator of the low demand Squares ancillary software is likely to generate is the lack
of any mention of ecosystem by experts when comparing payment service providers.

Copyright 2017 Abdullah Sheikh 156


Short thesis #8: Unattractive industry economics and poor
capital allocation decisions will detract from shareholder
returns
Square investors will likely suffer from poor Returns on Invested Capital (ROIC). This is
because of two factors:

1. Unattractive industry economics due to thin margins and elevated Research &
Development (R&D) and Capital Expenditure (CAPEX) spending requirements
2. Poor company-specific capital allocation decisions due to an unfocused
management team with a growth-at-all-costs philosophy and one not shy away from
diluting existing shareholders via stock-based acquisitions (SBA) and compensation
(SBC)

1. Unattractive industry economics due to thin margins and elevated


R&D and CAPEX spending requirements
Extreme competition has led to a mobile payments processing industry with elevated
R&D and CAPEX spending. Companies are now in a constant bid to out-innovate
competitors, on both the hardware and software front. This has led to rapid
technological change and shorter product cycles, all to attract micro-merchants with
new products and features.

There are a few examples of this rapid innovation cycle in action:

Squares innovative flat rate per swipe, introduced in 2009, is now almost a
ubiquitous offering across micro-merchant mobile payment service providers.
Introduction and rapid adoption of Near Field Communications (NFC) and
Europay, MasterCard and Visa (EMV) payment technology has upended magnetic
stripe cards, due to the latters limited safety features. This has led to a sharp
increase in CAPEX spending by hardware providers of card payment technology to
introduce solutions that are compatible with the new security standards.
A proliferation of software features accompanying payment processing
hardware, such as Point-of-Sale and Analytics software as well as ancillary Payroll
and Marketing products, that attempt to attract customers by providing a complete
end-to-end ecosystem for enterprise management.

This extreme competition and resulting rapid innovation in mobile payment processing
has led to three undesirable industry dynamics for Squares business:

1. Hardware sales generate negative gross margins: Square is not able to recoup
the cost of its hardware from customers, which it sells at a discount to similar
products available from other providers. For example, Square Contactless and Chip
Reader sells for $49, PayPal sells an equivalent Chip Card Reader for $79 and
Shopify sells a Tag, Chip and Swipe card reader for $89. Selling hardware at a

Copyright 2017 Abdullah Sheikh 157


steep loss and undercutting competitors is a conscious strategy by management.
Low priced card readers and stands are used by Square as a gateway to onboard
new customers to their payment processing platform and ecosystem. The exhibit
below shows a section from Squares Q4 2016 shareholder letter. Over the 12
months ended 12/21/2016, Square generated hardware revenue of $44.3 million
at a cost of $68.6 million, resulting in gross margins of -55%.

Exhibit: Square generates negative gross margins on hardware sales

Source: Square Q3 2016 shareholder letter

2. R&D spending is extremely elevated given the commoditized and thin margin
nature of the industry: Over the twelve months ending December 31, 2016,
Square devoted a full $269 million to product develop or R&D. This is 39% of
adjusted revenues of $687 million. Excluding SBC attributable to product
development of approximately $91 million, R&D was still elevated at 26% of adjusted
revenues. This R&D is primarily for software development to maintain and grow
Squares ecosystem, but also to keep its hardware of card readers and stands up-to-
date. While management is keen to characterize this R&D spending as purely
growth-oriented, I believe it is better characterized as a mixture of growth and
maintenance-oriented, given the industrys competitive dynamics.

Exhibit: Squares product development spending as % of Adjusted Revenues


has been over 30% over the last nine quarters

Copyright 2017 Abdullah Sheikh 158


60.000%

50.000%

40.000%

30.000%

20.000%

10.000%

0.000%
Q4 2016 Q3 2016 Q2 2016 Q1 2016 Q4 2015 Q4 2015 Q4 2015 Q4 2015 Q4 2015
Source: Square Shareholder Letters

Squares elevated R&D spend is not unusual for software focused technology
companies. For example, Facebook spends 21% of revenues on R&D, Google
spends 16% and Microsoft spends 14%. However, these three companies, while
significantly larger, each command a monopolistic position in high margin industries
with high barriers to entry and few credible competitors. Square is a hybrid
hardware / software provider of payment based solutions and operates in a
commoditized low barriers-to-entry industry, with thin margins coming in at around
1% of GPV. It is likely that, given the dynamics of the mobile payment processing
industry, investors will see poor returns on Squares elevated R&D expense.

3. Regular acquisitions highlight the need for CAPEX spending: Square has
regularly undertaken acquisitions to supplement its hardware and software
capabilities. For example, in March 2015, Square acquired Toronto-based Kili
Technology, a fabless semiconductor company, to gain technological know-how on
NFC. More recently, Square bought a software technology related to network
connections for an undisclosed amount.

I believe the three dynamics above will likely continue, despite the anticipated
forthcoming squeeze on margins because of competition, GPV churn and as Squares
attempts to move up-market. Allowing for the full range of factors highlighted in this
report, I believe that - over an appropriate long period - the return to investors on current
R&D and acquisition spending will be unattractive.

2. Poor company-specific capital allocation decisions due to an


unfocused management team willing to dilute existing
shareholders via SBA and SBC

Copyright 2017 Abdullah Sheikh 159


If history is any guide, management led by CEO Jack Dorsey will also prove to
be poor allocators of capital. Before focusing more exclusively on the current growth
opportunity in small business payment solutions due to their success with micro-
merchants, Jack Dorsey spent significant shareholder resources developing a failed
food delivery business, first organically through Square Order, then through three
acquisitions Caviar in 2014 for $90 million, Fastbite in 2015 and Main Line Delivery in
2016. Like Caviar and Fastbite, Square Order was an app that allowed customers to
preorder drinks and foods from local vendors. The returns on these investments have
so far been poor. Square Order was shut down in early 2015. Per Bloomberg, Square
has since tried to sell Caviar to Uber, GrubHub and Yelp at cost but with little success.
Revenues for Caviar are included in their Subscription and services-based category.
As per Squares 2015 10K, Caviar related costs were approximately $22.5 million
in 2015, while my modeling suggests that Caviar revenues were approximately
$14 million. This suggests that Caviar is losing money on an operating basis.
This misfit of a food delivery business shows poor capital allocation skills

CEO Jack Dorsey is stretched thin, as he is also currently the CEO of Twitter, a
company desperately trying to turnaround operations.

Exhibit: Square is a prolific issuer of Stock Based Compensation


30.000%

25.000%
SBC AS % OF ADJUSTED REVENUES

20.000%

15.000%

10.000%

5.000%

0.000%
Q4 2016 Q3 2016 Q2 2016 Q1 2016 Q4 2015 Q4 2015 Q4 2015 Q4 2015 Q4 2015
Source: Shareholder letters, Author calculations

Staying true to its Silicon Valley roots, Square is a prolific issuer of stock for
acquisitions and to employees as compensation, thereby diluting existing
shareholders. Per TechCruch.com, Caviar was acquired for $90 million with Square
stock. Square issued $138.8 million of Stock Based Compensation (SBC), primarily to
its engineering, design, and product personnel in product development ($91.4 million),
over the twelve months ended 9/20/2016. This comes to 20% of the Companys

Copyright 2017 Abdullah Sheikh 160


Adjusted Revenue of $687MM over the same period. Given the details of Squares
2015 Stock Incentive Plan, SBC looks likely to continue in the future48.

Given what I believe to be Squares limited prospects for profitable growth, I believe this
generous SBC will significantly detract from shareholder returns. Using a dilution
adjusted Black-Scholes model, I calculate the negative impact value on equity of
outstanding stock options to be currently in the region of $800 million. This is based on
86.7 million stock options outstanding, with an average strike price of $7.3 and
expiration period of 7.4 years. Square is likely to continue to severely dilute existing
shareholders.

Summary

Extreme competition and the fast pace of innovation in mobile hardware and software
payment providers has led to unattractive industry economics with a need for extremely
high R&D. In the twelve months ending September 30, 2016, Square devoted a full
16% of revenues to product development, equaling $263 million. Given the lack of
traction Squares me-too software products are likely to have with micro-merchants, I
believe the return on this R&D will be poor. Operating in a commoditized yet fast faced
industry has led to high levels of capital expenditures (CAPEX), in the form of regular
acquisition spending. For example, to get in-house access to the latest NFC/EMV
technology for payment cards, in 2015 Square acquired Kili Technology a fabless
semiconductor company based in Canada. More recently, Square also bought a
software technology related to network connections for an undisclosed amount. I
believe such regular acquisitions, which highlight the elevated CAPEX needs of this
business, will continue, negatively impacting shareholder returns.

Before focusing more exclusively on the current growth opportunity in small business
payment solutions due to their success with micro-merchants, CEO Jack Dorsey spent
significant shareholder resources developing a failed food delivery business, first
organically through Square Order, then through three acquisitions Caviar in 2014 for
$90 million, Fastbite in 2015 and Main Line Delivery in 2016. The returns on these
investments have so far been poor. A misfit food delivery business shows a history of
poor capital allocation. Jack Dorsey is stretched thin, as he is also currently the CEO of
Twitter, a company desperately trying to turnaround operations.

Staying true to its Silicon Valley roots, Square is a prolific issuer of stock for acquisitions
and to employees as compensation, thereby diluting existing and future shareholders
if the practice continues. Over the twelve months ended 9/20/2016, Square issued
$137.7 million of Stock Based Compensation (SBC), primarily to its engineering, design,
and product personnel in product development ($91.5 million). This comes to 22% of
the Companys Adjusted Revenue of $630MM over the same period. Given what I
believe to be Squares limited prospects for profitable growth, I believe this generous
SBC will detract from shareholder value. Using a dilution adjusted Black-Scholes

48
For details, please see:
https://www.sec.gov/Archives/edgar/data/1512673/000162828016018485/exhibit101q216.htm

Copyright 2017 Abdullah Sheikh 161


model, I calculate the negative impact value on equity of outstanding stock options at
the current stock price to be approximately $800 million.

Copyright 2017 Abdullah Sheikh 162


Chapter 7: Modeling dynamics of Squares business
In this chapter, I model the dynamics of Squares business.

Square has three49 main sources of revenues:

1) Transaction revenues from its core payment processing services


2) Subscription and services-based revenue from sales of its ancillary products
such as Square Capital, Payroll, Employee Management, Appointments, Email
Marketing, Loyalty, Instant Deposit, Invoice, Online Store, Gift cards, Caviar and
Caviar Fastbite
3) Hardware revenue from sales of card readers and stands.

1) Transaction revenues from core payment processing services


To build a model of Squares transaction revenues, I estimate the following:

a) Squares steady state micro-merchant market share and customer base in ten
years
b) Growth and churn dynamics of Squares micro-merchant customer base over
time, which results in existing micro-merchants growing GPV as well as customer
attrition
c) Transaction margins as a function of GPV growth, which results in margin
compression as Square acquires higher GPV customers

I use the model to provide an evolution of Squares transaction revenues since inception
in 2009 and project revenues over the next ten years.

a) Estimating Squares steady state micro-merchant market share


and customer base

As the exhibit below shows, Oliver Wyman estimates that there are currently 23 million
non-employer micro-merchants in the U.S, with average revenue of $450,000 per year.
In addition, there are another 3.5 million employers with 1 4 million employees with
$400,000 of revenue per year, and 1 million employees with 5 9 employees with $1.2
million of revenue per year.

Exhibit: Squares target market comprises of employers with less than 5-9 full-
time employees and $1.2 million of revenue

49
Revenues from Starbucks for which Square was an exclusive payment service provider for three years beginning in 2012
have stopped in Q3 2016, as Starbucks transitioned to First Data and Chase Paymentech for mobile and non-mobile payment
processing, respectively.

Copyright 2017 Abdullah Sheikh 163


Based on earlier analysis on Squares current client profile, and taking into account
Squares payment processing pricing model of flat 2.75% rates, I assume that Squares
target addressable market comprises of employers with less than 5-9 full-time
employees and $1.2 million of revenue. This totals 27.5 million in the U.S. Employers
with revenues greater than $1.2 million a year may find separate merchant accounts
preferable to Square, based on cost analysis.

Micro-merchant market share estimates for Square and competitors

In the exhibit below, I show my estimates of the likely long-term steady state split of the
27.5 million micro-merchants between the mobile payment service providers. In my
opinion, mobile payment processing for micro-merchants will be a very fragmented
market, with several providers holding small pieces of market share. PayPal Here,
Clover, QuickBooks GoPayment, Spark Pay, Shopify and Chase Paymentech offer
polished solutions that are formidable competitors to Square, and are likely to gain
significant market share. Other non-mainstream competitors are also likely to garner
market share. This include "no-frills" solutions like EMS+ and Cartwheel Point of Sale
as well as ISOs/MSRs like Flagship ROAMpay, National Bankcard and CreditCard
Processing.com. Based on this reality, I estimate that, due to brand recognition
and first mover advantage, Square will likely hold a steady state market share of
25% out of the total 27.5 million market for micro-merchant payment processing.

Copyright 2017 Abdullah Sheikh 164


Exhibit: Square will likely hold a dominant long-term share of the micro-merchant
card payment processing market
Estimate of steady state micro-merchant market share

25%

15% 15% 15%

10%

5% 5%
3% 3% 3% 3%

Company Percentage # of customers in millions


Square 25% 6.88
PayPal Here 15% 4.13
Clover 15% 4.13
QuickBooks GoPayment 10% 2.75
Spark Pay by Capital One 5% 1.38
Shopify 5% 1.38
Chase Paymentech 3% 0.69
Pay Anywhere 3% 0.69
Verifone Carbon 3% 0.69
Poynt 3% 0.69
Others* 15% 4.13
Total 100% 27.50
* Others include "no-frills" solutions like EMS+ and Cartwheel Point of Sale, ISOs/MSRs like Flagship ROAMpay, National Bankcard and
CreditCard Processing.com. Author estimates.

b) Modeling the growth and churn dynamics of Squares micro-


merchant customer base

Copyright 2017 Abdullah Sheikh 165


To model the dynamics of Squares customer base, I use the assumptions made earlier
in this report on the probability of different business outcomes in any given year. These
assumptions are shown in the exhibit below.

Exhibit: Probability estimates of Square micro-merchant business outcomes in


any given year

Source: Author estimates and calculations

There are three key dynamics at play:

7% of Square micro-merchants will succeed each year and grow revenues over
the course of a year
54% of Square micro-merchant will maintain their revenues over the course of a
year as their business muddles
39% of Square micro-merchants will leave the platform due to success or failure
of their businesses

I assume that a successful Square micro-merchant has a decreasing probability of


finding itself in a higher tier of GPV over the course of a year, starting with a 50%
probability for $100,000 and decreasing at an exponential rate. For example, a
successful Square micro-merchant has a 50% probability of processing $100,000, a
3.1% probability of processing $500,000, and a 0.1% probability of processing
$1,000,000 at the end of the year.

Exhibit: Square micro-businesses will grow into higher revenue categories with
exponentially decreasing probabilities

Copyright 2017 Abdullah Sheikh 166


60.0%

50.0%

40.0%
Transition probability

30.0%

20.0%

10.0%

0.0%
$- $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000
Gross Payment Volume

GPV Transition probability


$100,000 50.0%
$200,000 25.0%
$300,000 12.5%
$400,000 6.3%
$500,000 3.1%
$600,000 1.6%
$700,000 0.8%
$800,000 0.4%
$900,000 0.2%
$1,000,000 0.1%
Source: Author estimates

c) Transaction margins as a function of GPV growth, which results


in margin compression as Square acquires higher GPV
customers
I assume that in a bid to keep successful micro-merchants on its platform, Square will
offer discounts to customers as GPV grows. The exhibit below shows the take-rate,
expense and profit per transaction for various levels of GPV.

Exhibit: Higher GPV levels will require Square to offer more competitive pricing

Copyright 2017 Abdullah Sheikh 167


2.90%
2.79%
2.66%
2.54%
2.42%
2.30%
2.18%
2.06%
1.90% 1.88% 1.86% 1.94%
1.84% 1.82% 1.80% 1.78% 1.76% 1.82%
1.74% 1.72% 1.70%

1.00% 0.91%
0.80%
0.70%
0.60%
0.50%
0.40%
0.30%
0.20%
0.10%
0.00%

Take-rate Expense rate Transaction profit margin

Annual GPV Take-rate Expense rate Transaction profit


margin
<= $5,000 2.90% 1.90% 1.00%
$100,000 2.79% 1.88% 0.91%
$200,000 2.66% 1.86% 0.80%
$300,000 2.54% 1.84% 0.70%
$400,000 2.42% 1.82% 0.60%
$500,000* 2.30% 1.80% 0.50%
$600,000 2.18% 1.78% 0.40%
$700,000 2.06% 1.76% 0.30%
$800,000 1.94% 1.74% 0.20%
$900,000 1.82% 1.72% 0.10%
$1,000,000 1.70% 1.70% 0.00%
Source: Author calculations. * Heartland Payment Systems current average GPV and transaction profit margin.

I assume that customers with annual GPV above $1 million would be able to find more
attractive pricing away from Squares platform. In a similar vein, I assume that Square
would not be willing to offer the discounts necessary to retain such clients, given the
negative pressure it would exert on company margins. If this assumption is violated, it
is likely because Square is accepting lower margins on high GPV merchants, rather
than high GPV merchants accepting significantly unattractive rates.

Copyright 2017 Abdullah Sheikh 168


Evolution of Squares transaction revenues since inception in 2009
The exhibit below shows the model implied evolution Squares customer base since inception, including average GPV
per merchant and total number of customers.

Exhibit: Evolution of Squares customers as implied by the model, over the last eight years
$60 2.5
GROSS PAYMENT VOLUME (BILLIONS)

$50
2.0

# CUSTOMERS in millions
$40
1.5
$30
1.0
$20

0.5
$10

$- -
2009 2010 2011 2012 2013 2014 2015 2016
GPV (billion) $- $2 $7 $14 $22 $31 $40 $50
Customers (millions) - 0.3 0.7 1.0 1.4 1.7 2.0 2.4

Number of customers
Annual GPV in
U.S. dollars 2009 2010 2011 2012 2013 2014 2015 2016

5,000 0 338,571 677,143 1,015,714 1,354,286 1,692,857 2,031,429 2,370,000

100,000 0 - 8,811 22,540 39,011 57,014 75,871 95,205

200,000 0 - 4,406 11,270 19,506 28,507 37,936 47,602

Copyright 2017 Abdullah Sheikh 169


300,000 0 - 2,203 5,635 9,753 14,254 18,968 23,801

400,000 0 - 1,101 2,817 4,876 7,127 9,484 11,901

500,000 0 - 551 1,409 2,438 3,563 4,742 5,950

600,000 0 - 275 704 1,219 1,782 2,371 2,975

700,000 0 - 138 352 610 891 1,185 1,488

800,000 0 - 69 176 305 445 593 744

900,000 0 - 34 88 152 223 296 372

1,000,000 0 - 17 44 76 111 148 186

Model: GPV (in


billions) $0 $2 $7 $14 $22 $31 $40 $50
Total customers
(in millions) - 0.3 0.7 1.0 1.4 1.7 2.0 2.4
Source: Author calculations

The exhibit below shows the models output for GPV per merchant and percentage of customers with GPV greater than
$500,000.

Exhibit: Key statistics for Squares business implied by the model, over the last eight years

Copyright 2017 Abdullah Sheikh 170


16.0% $25

14.0%

$20

12.0%
% GPV > $500,000 ANNUALIZED GPBV

AVERAGE GPV PER MERCHANT


10.0%
$15

8.0%

$10
6.0%

4.0%

$5

2.0%

0.0% $-
2009 2010 2011 2012 2013 2014 2015 2016
Percentage of GPV > 500K 0.0% 0.0% 9.3% 11.7% 12.7% 13.3% 13.7% 13.9%
Avg. GPV per merchant ('000) $- $5 $10 $13 $16 $17 $18 $19

Source: Author calculations

Copyright 2017 Abdullah Sheikh 171


My model ties closely with Squares actual business results over the last three years, as the exhibit below shows, for both
total GPV and Percentage GPV > $500,0000. However, given Squares rapid growth, fitting an exact path to historical
results is not practical, nor ideal due to data mining issues that could result.

Exhibit: Model results correspond closely with actual results but Squares rapid growth makes the trajectory
difficult to capture exactly
Metric 2014 2015 2016

Model: GPV (in billions) 24 36 50


31 40 50
Actual: GPV (in billions)
Model: Percentage GPV > 500K 13.3% 13.7% 13.9%
Actual: Percentage GPV > 500K 9.0% 12.0% 14.0%

Source: Author calculations, Square Q4 2016 Shareholder letter

Copyright 2017 Abdullah Sheikh 172


Projection of Squares transaction revenues

The exhibit below shows the projected evolution of Squares business over the next 20 years in terms of GPV and number
of customers.

Exhibit: Projected GPV and number of customers


$250 8.0

7.0

$200
6.0
GROSS PAYMENT VOLUME (BILLIONS)

5.0
$150

# CUSTOMERS
4.0

$100
3.0

2.0
$50

1.0

$- -
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036
GPV (billion) $60 $71 $83 $95 $108 $120 $133 $146 $159 $172 $182 $188 $191 $193 $194 $195 $195 $195 $195 $195
Customers (millions) 2.8 3.3 3.7 4.2 4.6 5.1 5.5 6.0 6.4 6.9 6.9 6.9 6.9 6.9 6.9 6.9 6.9 6.9 6.9 6.9

Source: Author projections

Copyright 2017 Abdullah Sheikh 173


The exhibit below shows percentage GPV > $500,000 annualized GPV and transaction margins
.
Exhibit: Transaction revenues, expenses and profits
$0 $0

Billions
$0
$0

$0
Revenues and expenses (billions)

$0
$0

$0 $0

$0
$0

$0

$0
$0

$- $-
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036
Transaction revenue (billions) $1,56 $1,86 $2,18 $2,50 $2,82 $3,16 $3,49 $3,82 $4,15 $4,49 $4,76 $4,91 $4,99 $5,04 $5,06 $5,08 $5,09 $5,09 $5,09 $5,09
Transaction expenses (billions) $1,10 $1,31 $1,53 $1,76 $1,99 $2,23 $2,46 $2,70 $2,94 $3,17 $3,37 $3,48 $3,54 $3,57 $3,59 $3,60 $3,61 $3,61 $3,61 $3,61
Transaction revenues (millions) $602 $695 $787 $875 $957 $1,03 $1,10 $1,16 $1,21 $1,31 $1,38 $1,43 $1,45 $1,46 $1,47 $1,47 $1,48 $1,48 $1,48 $1,48

Transaction revenue (billions) Transaction expenses (billions) Transaction revenues (millions)

Source: Author projections

Copyright 2017 Abdullah Sheikh 174


The exhibit below shows the projected percentage GPV > $500,000 and transaction margins.

Exhibit: Percentage GPV > $500,000 annualized GPV and transaction margins
1.20% 15.2%

15.0%

1.00%

14.8%

0.80% 14.6%
Transaction margin (%)

% GPV > $500,000


14.4%

0.60%

14.2%

0.40% 14.0%

13.8%

0.20%

13.6%

0.00% 13.4%
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036
Percentage of GPV > 500K 14.0% 14.1% 14.2% 14.3% 14.4% 14.4% 14.5% 14.5% 14.6% 14.6% 14.8% 14.9% 15.0% 15.0% 15.0% 15.0% 15.0% 15.1% 15.1% 15.1%
Transaction margin 1.01% 0.98% 0.95% 0.92% 0.89% 0.86% 0.83% 0.80% 0.77% 0.77% 0.76% 0.76% 0.76% 0.76% 0.76% 0.76% 0.76% 0.76% 0.76% 0.76%

Percentage of GPV > 500K Transaction margin

Source: Author projections

Copyright 2017 Abdullah Sheikh 175


2) Subscription and services-based revenues from sales of its ancillary products

In this section, I model sales of ancillary products.

Square Capital

To model loan originations, I make the following key assumptions:

Square offers loans to successful micro-merchants defined as those processing $100,000 of


annualized GPV or more
70% of those offered loans accept a Square Capital loan
The average size of the loan equals $6,000 the average figure over 2015 and 2016
Square earns 6% of loan face value as fees

The exhibit below shows modeled originations and number of customers offered loans for Square over
the last eight years.

Copyright 2017 Abdullah Sheikh 176


Exhibit: Square Capital loan origination and customer growth over last eight years
200 $900
180 $800

Origination volume (millions)


# merchants offered loans

160 $700
140 $600
120
$500
100
$400
80
$300
60
40 $200
20 $100
- $-
2009 2010 2011 2012 2013 2014 2015 2016
Origination volume (millions) $- $- $74 $188 $326 $476 $634 $795
# customers offered loans ('000) - - 17.61 45.03 77.95 113.92 151.59 190.22

Source: Author projections

The exhibit below shows projected Square Capital originations and fees for the next 20 years, based on previously
modeled customer dynamics.
Exhibit: Projected Square Capital originations and fees over the next 20 years
$4,000 $250
Origination volume (millions)

$3,500
$200
$3,000

Fees (millions)
$2,500 $150
$2,000
$1,500 $100
$1,000
$50
$500
$- $-
2009 2010 2011 2012 2013 2014 2015 2016
Origination volume (millions) $959 $1,14 $1,35 $1,56 $1,77 $1,99 $2,21 $2,43 $2,65 $2,88 $3,10 $3,22 $3,29 $3,33 $3,35 $3,36 $3,37 $3,37 $3,37 $3,37
Square Capital (millions) $58 $68.9 $81.1 $93.8 $106. $119. $133. $146. $159. $172. $186. $193. $197. $199. $201. $201. $202. $202. $202. $202.

Source: Author projections

Copyright 2017 Abdullah Sheikh 177


Software revenues

To model software sales, I make the following key assumptions, based on analysis in the earlier
sections:

Only merchants with annual GPV greater than $500,000 of annualized GPV will subscribe to
Square Payroll, Employee Management, Appointments, Email Marketing, Loyalty, and Gift cards
Average spend on subscription per merchant will equal $2,000
Square Instant Deposit will attract the lowest tier of Squares micro-merchants, who will deposit 5%
of GPV instantly vs. the alternative of one to two business days
Square Invoice will charge 3% on the GPV generated by customers generating $500,000
Square Online Store will not be significant contributors to subscription and services-based revenue
I assume Square Caviar, Caviar Fastbite and Main Line Delivery grow in line with GrubHubs
projected five-year growth rate of 20%, with a terminal growth rate of 2.4% after ten years - in line
with ten-year Treasury yields. Growth rates between years five and ten fall in a linear fashion from
20% to 2.4%.

The exhibit below shows modeled subscription and services-based revenue for Square over the last
eight years. This aligns closely with actual subscription and services-based revenue of $129 million over
the last 12 months ended 12/31/2016.

Copyright 2017 Abdullah Sheikh 178


Exhibit: Square Capital subscription and services-based revenue over last eight years
$120.00

$100.00

$80.00
Sales (millions)

$60.00

$40.00

$20.00

$-
2009 2010 2011 2012 2013 2014 2015 2016
Square Capital (millions) $- $- $4.4 $11.3 $19.5 $28.6 $38 $48
Food delivery business (millions) $- $- $- $- $- $1.40 $7.00 $21.00
Subscription revenue (millions) $- $- $2.17 $5.55 $9.60 $14.03 $18.67 $23.43
Instant Deposit revenues (millions) $- $0.85 $1.69 $2.54 $3.39 $4.23 $5.08 $5.93

Source: Author projections

Copyright 2017 Abdullah Sheikh 179


The exhibit below shows projected Square software revenue for the next 20 years, based on previously modeled
customer dynamics.
Exhibit: Projected Square subscription and services-based revenue over the next 20 years
$500.00

$450.00

$400.00

$350.00

$300.00
Sales (millions)

$250.00

$200.00

$150.00

$100.00

$50.00

$-
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036
Square Capital (millions) $58 $68.9 $81.1 $93.8 $106.7 $119.8 $133.0 $146.2 $159.5 $172.8 $186.1 $193.5 $197.6 $199.9 $201.2 $201.9 $202.3 $202.5 $202.7 $202.7
Food delivery business (millions) $25.20 $30.24 $36.29 $43.55 $52.25 $60.87 $70.90 $82.59 $96.20 $112.0 $115.4 $118.8 $122.4 $126.1 $129.9 $133.8 $137.8 $141.9 $146.2 $150.6
Subscription revenue (millions) $28.25 $33.83 $39.83 $46.06 $52.42 $58.86 $65.33 $71.83 $78.34 $84.86 $91.38 $95.02 $97.06 $98.19 $98.82 $99.17 $99.37 $99.48 $99.54 $99.58
Instant Deposit revenues (millions) $7.05 $8.18 $9.30 $10.43 $11.56 $12.68 $13.81 $14.94 $16.06 $17.19 $17.19 $17.19 $17.19 $17.19 $17.19 $17.19 $17.19 $17.19 $17.19 $17.19

Source: Author projections

Copyright 2017 Abdullah Sheikh 180


3) Hardware revenue from sales of card readers and stands
The exhibit below shows my assumptions for modeling Squares hardware sales.

Exhibit: Key assumptions for modeling Squares hardware sales


Square hardware Target population % buying Price
Newly onboarded micro-
Magstripe reader merchants 100% $0
Newly onboarded micro-
Chip card reader merchants 50% $29.00
Micro-merchants with GPV
Contactless + chip reader between $100K and $500K 100% $49.00
Micro-merchants with GPV >
Square stand cost $500K 100% $169.00
Source: Author estimates

The exhibit below shows modeled hardware sales for Square over the last eight years. Last 12 month sales ended
9/30/2016 of $41.8 million correspond closely with modeled sales of $41.9 million. 76% of sales are for Square Chip
Readers, 19% are for Square Contactless + Chip Readers and 4% are for Square Stand.

Copyright 2017 Abdullah Sheikh 181


Exhibit: Modeled hardware sales over the last eight years
$50.00

$45.00

$40.00

$35.00

$30.00
Sales (millions)

$25.00

$20.00

$15.00

$10.00

$5.00

$-
2009 2010 2011 2012 2013 2014 2015 2016
Stand sales $- $- $0.18 $0.47 $0.81 $1.19 $1.58 $1.98
Contactless + chip reader $- $- $0.81 $2.07 $3.58 $5.24 $6.97 $8.75
Magstripe reader $- $- $- $- $- $- $- $-
Chip reader sales $- $4.91 $9.82 $14.73 $19.64 $24.55 $29.46 $34.37

Source: Author calculations

Copyright 2017 Abdullah Sheikh 182


The exhibit below shows projected hardware sales for the next 20 years, based on previously modeled customer
dynamics.
Exhibit: Projected Square hardware sales over the next 20 years
$160.00

$140.00

$120.00

$100.00
Sales (millions)

$80.00

$60.00

$40.00

$20.00

$-
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036
Stand sales $2.39 $2.86 $3.37 $3.89 $4.43 $4.97 $5.52 $6.07 $6.62 $7.17 $7.72 $8.03 $8.20 $8.30 $8.35 $8.38 $8.40 $8.41 $8.41 $8.41
Contactless + chip reader $10.55 $12.63 $14.87 $17.20 $19.57 $21.97 $24.39 $26.82 $29.25 $31.68 $34.12 $35.48 $36.23 $36.66 $36.89 $37.03 $37.10 $37.14 $37.16 $37.18
Magstripe reader $- $- $- $- $- $- $- $- $- $- $- $- $- $- $- $- $- $- $- $-
Chip reader sales $40.90 $47.43 $53.96 $60.49 $67.03 $73.56 $80.09 $86.62 $93.16 $99.69 $99.69 $99.69 $99.69 $99.69 $99.69 $99.69 $99.69 $99.69 $99.69 $99.69

Source: Author projections

Copyright 2017 Abdullah Sheikh 183


The exhibit below aggregates revenue projections from Transaction Revenues, Subscription and services-based, and
Hardware sales.

Exhibit: Aggregate Square revenues split between transaction, software and hardware revenues over last right
years
$800 1.2

$700
1

$600

0.8
$500

Revenue Growth Rate


Sales (millions)

$400 0.6

$300
0.4

$200

0.2
$100

$- 0
2009 2010 2011 2012 2013 2014 2015 2016
Subscription and services-based revenue (millions) $- $- $20 $39 $58 $78 $101 $133
Square hardware (millions) $- $4.91 $10.81 $17.27 $24.03 $30.97 $38.00 $45.09
Transaction revenues (millions) $- $17 $69 $140 $223 $311 $403 $517
Revenue Growth Rate 0.00% 97.23% 54.81% 37.78% 29.15% 28.08%

Source: Author projections

Copyright 2017 Abdullah Sheikh 184


Exhibit: Aggregate Square revenues split between transaction, software and hardware revenues over the next 20
years
$2,500 18.00%

16.00%

$2,000
14.00%

12.00%

Revenue Growth Rate


$1,500
Sales (millions)

10.00%

8.00%
$1,000

6.00%

4.00%
$500

2.00%

$- 0.00%
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036
Subscription and services-based revenue (millions) $153 $177 $204 $232 $263 $293 $324 $357 $392 $430 $456 $472 $483 $490 $496 $501 $506 $510 $515 $519
Square hardware (millions) $53.8 $62.9 $72.2 $81.5 $91.0 $100. $110. $119. $129. $138. $141. $143. $144. $144. $144. $145. $145. $145. $145. $145.
Transaction revenues (millions) $602 $695 $787 $875 $957 $1,03 $1,10 $1,16 $1,21 $1,31 $1,38 $1,43 $1,45 $1,46 $1,47 $1,47 $1,48 $1,48 $1,48 $1,48
Revenue Growth Rate 16.41%15.67%13.63%11.82%10.25%8.79%7.68% 6.76%5.98%8.33% 5.51%2.99%1.70%1.01% 0.64%0.44%0.33% 0.27%0.24%0.23%

Source: Author calculations

Copyright 2017 Abdullah Sheikh 185


Chapter 8: Valuation of Squares common stock
In this chapter, I derive a fair value of Squares common stock. The exhibit shows key
financial metrics for the company as at 2/24/2017.

Exhibit: Square - Key financial metrics


Shares Outstanding* 351.3 million
Share Price $17.43
Market Capitalization $6.1 billion
Cash & Cash Equivalents $514.3 million
Debt50 $1.3 million
Approximate Enterprise Value $5.6 billion
Source: Square 10K,10Q, Author calculations. *Class A: 162,988,864, Class B: 188,328,922. There are also 15,269,821 of
unvested restricted stock units outstanding as at 9/30/2016.

Options outstanding valuation

Square has significant options outstanding, which I value using a dilution adjusted
Black-Scholes model, as the exhibit below shows. These options represent an
overhang on the current market capitalization to the extent that they are in the money,
will be exercised and thus dilute existing shareholders.

Exhibit: Squares outstanding options are valued at almost $1 billion, based on a


$17.43 stock price, and represent an overhang on the companys valuation
Current stock price $17.43
Options Outstanding 86.7 million
Average Strike Price $7.32
Average expiration term 7.4 years
Standard deviation of Square stock 43.5%
Risk free rate 2.4%

Value per option $11.37


Valuation of outstanding options based on $985.5 million
dilution adjusted Black-Scholes
Source: Author calculations. Options outstanding as at 9/30/2016.

Discounted Cash Flow Valuation of Square

My analysis suggests that Square will likely see a sharp deceleration in revenue growth
over time as the realities of its fickle and financially disadvantaged customer base,
brutal competition and the laws of the payment processing industry, as they relate to
margins and GPV levels, become more apparent.

My estimate of Squares long-term market share of the 27.5 million strong U.S. micro-
merchant card payment processing market is 25% or approximately 7 million

50
Debt comprises mainly of capital lease obligations.

Copyright 2017 Abdullah Sheikh 186


merchants, with strong competition from PayPal Here, Clover, QuickBooks GoPayment,
Spark Pay, and Shopify. The exhibit below shows my steady state estimates of market
share.

Exhibit: Estimate of steady state micro-merchant market share of the micro-


merchant card payment processing market
30%

25%
25%

20%

15% 15% 15%


15%

10%
10%

5% 5%
5%
3% 3% 3% 3%

0%

# of customers in
Company Percentage millions
Square 25% 6.88
PayPal Here 15% 4.13
Clover 15% 4.13
QuickBooks GoPayment 10% 2.75
Spark Pay by Capital One 5% 1.38
Shopify 5% 1.38
Chase Paymentech 2.5% 0.69
Pay Anywhere 2.5% 0.69
Verifone Carbon 2.5% 0.69
Poynt 2.5% 0.69
Others* 15% 4.13
Total 100% 27.50
* Others include "no-frills" solutions like EMS+ and Cartwheel Point of Sale, ISOs/MSRs like Flagship ROAMpay, National Bankcard and
CreditCard Processing.com. Author estimates.

Copyright 2017 Abdullah Sheikh 187


In a steady state, I believe Square will generate revenues slightly over $2 billion.
Details of this estimate are shown in the exhibit below. I also show PayPals figures for
the last 12 months below.

Key metric Steady state assumption PayPal TTM 2016


# of customers 6.9 million 197 million
GPV $171 billion $354 billion
% GPV > $500,000 14.6% N/A
Transaction margin 0.77% 1.80%

Transaction revenues $1.3 billion $6.4 billion

Square Capital Origination $3 billion $8.4 billion**


volume
Square Capital gain-on-sale + $173 million N/A
interest revenues
Software subscription revenues $85 million N/A
Instant Deposit revenues $17 million N/A
Invoices revenues $43 million N/A
Food delivery revenues $112 million N/A

Total subscription and $500 million $1.352 billion


services-based revenues

Square hardware revenue $138 million N/A

Total revenues $2.1 billion $6.4 billion


Source: Author assumptions. * Assumes 6% revenues as % of loan size. ** 2015 origination volume. $7.4 billion PayPal Credit
originations + $1 billion PayPal Working Capital originations

To estimate margins, I consider GAAP and non-GAAP51 margins for PayPal, which I
believe shares the most similarity in terms of business model to Square. PayPals
GAAP operating margins were approximately 20% over 2016, with non-GAAP margins
coming close to 28%. Given what I believe to be Squares inferior customer base, and
likely pressure on gross margins due to extreme competition, I estimate Squares GAAP
operating margins at 15% and non-GAAP operating margins at 20%. I assume Square
achieves a Return on Invested Capital (ROIC) in a terminal state of 10%, which is close
to PayPals current ROIC. I assume Square has approximately $764 million of Net
Operating Losses (NOLs), with an effective tax rate of 30% once NOLs have been used
up.

Exhibit: Square Key steady state projected revenue metrics


Key metric Steady state assumption PayPal TTM 2016
GAAP operating income $315 million $1.59 billion
Non-GAAP operating income $420 million $2.17 billion
51
Non-GAAP margins exclude the effects of stock based compensation, acquisition-related transaction expenses, separation,
restructuring and amortization of acquired intangible assets.

Copyright 2017 Abdullah Sheikh 188


GAAP operating margin 15% 20.5%
Non-GAAP operating margin 20% 28%

Return on invested capital 10% 8.8%


Initial Cost of Capital 10% N/A
Terminal Cost of Capital 8% N/A
Source: Author assumptions.

The exhibit below shows the results of my DCF modeling. I arrive at a terminal value of
$3.1 billion for Squares stock, which discounted to the current time is roughly $1.2
billion. After allowing for net cash and the significant overhang of stock options
outstanding, I estimate a fair value of Squares stock at $2.1 per share, which is roughly
88% below current market levels.

Exhibit: Discounted Cash Flow modeling of Squares stock


Terminal cash flow (in millions) $172.09
Terminal cost of capital 8.00%
Terminal value (in millions) $3,071.05
Present Value of Terminal value (in
millions) $1,236.74
Present Value of Cash Flow over next 10
years (in millions) $91.24
Sum of Present Values (in millions) $1,327.98
Value of operating assets (in millions) $1,327.98
- Debt (in millions) $96.06
+ Cash (in millions) $514.30
Value of equity (in millions) $1,746.22
- Value of options (in millions) $985.45
Value of equity in common stock (in
millions) $760.77
Number of shares (in millions) 366.59
Estimated value per share $2.1
Source: Author calculations

Reverse DCF What is the market currently pricing in?

A reverse DCF, which allows us to try to back out the markets assumptions about
revenue growth and margin expansion. Combined with our modeling of Squares
customer dynamics, we can glean additional information about the business in a steady
state, as implied by the market. There are many permutations to arriving at the current
value, but one such permutation is shown in the exhibit below.

Exhibit: Square Market price implied customer and revenue statistics


Key metric Market implied steady state
# of customers 19.3 million
Percentage of micro-merchant market 70%
GPV $531 billion

Copyright 2017 Abdullah Sheikh 189


% GPV > $500,000 14.7%
Transaction margin 1.04%

Square Capital origination volume $9.1 billion


Square Capital gain-on-sale + interest $548 million
revenues*
Software subscription revenues $269 million
Instant deposit revenues $48 million
Invoice revenues $48 million
Food delivery revenues $122 million

Subscription and services-based $1,036 million


revenue

Square hardware revenue $402 million

Total revenues $7.0 billion


Operating income $1.4 billion
Operating margin 20%
Return on invested capital 20%
Terminal cost of capital 8%
Source: Author assumptions

By valuing Square at $6.1 billion today, the market is implying a business that will grow
revenues at close to 26% over the next ten years, generate nearly $1.4 billion in
operating income at margins of 20% a year. Using our customer dynamics model, this
implies a potential GPV of $531 billion at a transaction margin of 1.04%, Square Capital
loan originations of over $9 billion and total subscription and services-based revenues
of over $1 billion.

I believe this outcome is highly unlikely, given the realities of Squares customer base.

Copyright 2017 Abdullah Sheikh 190

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