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Could Square Be a Millionaire-Maker Stock?

Matthew Cochrane, The Motley Fool

Since its initial public offering (IPO) a little over three years ago, Square Inc. (NYSE: SQ) has returned 350% to investors who had the fortitude and foresight to hold onto their shares, and that includes the 40% haircut the stock price has taken since Oct. 1. While that's a monstrous return, what matters now to investors is where the stock is going, not where it's been. Given the volatility the share price has shown in recent months, it's as good a time as any to evaluate the company's prospects and determine what sets it apart from its competition.

Customer using a smartphone at a Square Register to pay for coffee.

Innovative products such as the Square Register have kept gross payment volume rocketing higher for Square by giving clients the tools that they need. Image source: Square Inc.

Square's primary business

CEO Jack Dorsey founded Square after a friend had difficulty selling an art piece because he could not accept a credit card as a method of payment. What soon followed was a dongle that could plug into a mobile device's headphone jack, making card acceptance for merchants more accessible than ever before. No longer would small merchants need expensive hardware or even a dependable landline service, important factors for mobile retail sites (think farmers markets and food trucks).

Square's payment processing services have since evolved, and now include a much more robust suite of hardware products, including Square Register and the newly introduced Square Terminal. Square Register comes ready to operate right out of the box and features two screens, one for the customer and one for the merchant. Customers can pay by swiping (magnetic strip), dipping (EMV chip), or tapping (contactless) their cards. As these offerings come with the usual trappings and features that established merchants are familiar with, it helps Square compete for their business, too. Square Terminal offers much of these same features without the screens, making it perfect for crowded countertops. 

The strategy seems to be working. Square's gross payment volume continues to rocket higher, growing to $22.5 billion in Square's 2018 third quarter, a 29% year-over-year increase. Square's appeal to larger merchants also seems to be working. In Q3, 24% of Square's sellers had more than $500,000 in annualized payment volume, up from 16% just two years ago. Better yet, Square's merchants seem to be growing within the Square ecosystem: 40% of Square's large sellers in the third quarter (defined as merchants with more than $125,000 in gross payment volume) started off as micro sellers (sellers with less than $125,000 in gross payment volume).

What makes Square special

Still, if Square was just another payment processing company, it wouldn't deserve its premium valuation and probably not a place in investors' portfolios, either. After all, payment processing is little more than a commoditized service today, and offering card processing on mobile devices, while a once deserving innovation in the space, was quickly mimicked by others.

What separates Square from others in the space, though, is the specialized offerings it can give its clients, often services and products that were previously unavailable or cost-prohibitive for these merchants to have. These services include Square Capital, a microloan platform for businesses; Caviar, a food delivery and order-ahead platform for restaurants; Instant Deposit, a feature that allows merchants to instantly access money from their sales; and Square Installments, a platform that lets businesses extend credit to their customers, giving them a chance to make payments in installments.

These services are bundled together in Square's subscription and services-based revenue category. In Q3, excluding recent acquisitions, revenue in this segment rose to $141 million, a 117% increase year over year. The explosive growth these services are experiencing also speak to their high demand, proving that smaller merchants are finding it difficult to get these needs met elsewhere. In the company's 2018 first-quarter shareholder letter, management stated that more than half of Square's large sellers used multiple products from the company.

Besides its fast-growing contribution to the bottom line, this segment also deepens Square's relationship with its sellers, making it difficult for them to leave for competitors. This is an aspect that Dorsey has consistently tried to get across in the company's recent quarterly conference calls. In this year's Q1 conference call, he said, "[A]s these sellers use more products, we deepen our relationship with them." In the second quarter's call, he said, "We do have a unique advantage, though, given the deep relationships we have with our sellers and how seller-focused we are..."

Why Square could make you a millionaire

Square seems to be one of those rare companies that operates in a growing market with a sustainable competitive advantage against its peers. Its growth demonstrates there is a real need for its services, and as long as there are entrepreneurs, there should be a steady stream of new small businesses looking for these types of products. The best part is that as these small businesses grow and mature, they are not leaving Square's ecosystem but are actually subscribing to more of its products! Finally, Square's constant stream of innovation is giving it a widening moat from other payment processing companies. Ultimately, Square certainly seems to be a company that aspiring millionaires should consider for their own portfolios. That's why it's in my own.

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Matthew Cochrane owns shares of Square. The Motley Fool owns shares of and recommends Square. The Motley Fool has the following options: short January 2019 $80 calls on Square. The Motley Fool has a disclosure policy.