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Investors Need to Be Very Wary of Square Stock Ahead of Earnings

Vince Martin

As I’ve written before, Square (NYSE:SQ) stock was an exaggerated reflection of last year’s broad market. As major indices gained in the first three quarters of 2018, Square stock soared. In fact, Square stock nearly tripled over that time. When investors sold off stocks in the fourth quarter, SQ plunged, at one point losing 50% of its value in less than three months.

Square Stock sq stock

Source: Chris Harrison via Flickr (Modified)

Oddly, 2019 has been a bit different. Like many stocks, SQ rallied at the beginning of the year. Since the company reported seemingly strong Q4 results back in February, however, Square has diverged from the rest of the market, and the rest of tech. SQ actually has lost about 10% of its value while other ecommerce/payment plays like Shopify (NYSE:SHOP) and PayPal Holdings (NASDAQ:PYPL) have continued to rise.

And so there’s an obvious path to upside coming out of Square earnings on Tuesday afternoon. A report that includes both a beat and strong and/or raised guidance should mean that SQ itself can join in the rally. Anything less, however, is a problem. Square stock still isn’t cheap and still isn’t pricing in any sort of disappointment.

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Square Earnings Expectations

For the first quarter, Wall Street is expecting Square to continue its impressive revenue growth of late. Consensus estimates suggest a 56% rise in adjusted revenue. Square calculates adjusted revenue as total sales less transaction costs, bitcoin costs, and purchase accounting adjustments.

Earnings are expected to be relatively light, at just $0.08, against $0.06 the year before. It’s likely that analysts are expecting investments behind key initiatives like the Square Card and the acquisition of Weebly to hit near-term margins and profits.

Investors should expect those consensus estimates will be beaten. In fact, Square appears to have topped expectations in every quarter since its late 2015 IPO. With the economy still strong, that trend seems unlikely to change. One potential red flag, if a small one: small business confidence has weakened in recent months.

And that trend had better not change. While SQ has struggled in the last two months, it’s still up 29% so far this year and still trades at about 90x full-year 2019 EPS estimates. An earnings or guidance miss is not priced in.

But at this point, even a headline beat probably isn’t enough to move the needle. To some extent, given Square’s history of conservative guidance, investors likely are pricing in better results than analysts are modeling. And so a beat and even raised guidance alone aren’t likely to lead to a huge gain in SQ stock after earnings. Rather, Q1 earnings might be more about the story Square can tell and the progress it’s making in key growth areas.

The Story Behind SQ Stock

To at least some extent, the core Square business model of providing payment services to small- to mid-sized businesses appears priced in. Again, SQ stock isn’t cheap, or close. To get back to the valuations that drove SQ to $100 in early October, Square needs to convince investors it has growth drivers outside of that core business.

And so it’s likely the ancillary initiatives here that will be the focus of investors, rather than just the headline revenue and EPS growth figures. Investors will want to know whether the integration of Weebly is progressing, as Square looks to become a more viable competitor to Shopify’s e-commerce platform.

Larger sellers (above $500K in annual volume) are becoming an increasingly large part of Square’s ecosystem: that category drove 24% of payment volume in Q4 2018, up from 16% two years before. Further expansion there would limit Square’s reliance on more volatile (and more cyclical) small businesses, and perhaps de-risk the story in the eyes of some investors.

Square is looking to get a bank license. Investors will be looking for an update on that front. Impressive Venmo user growth has driven PYPL stock higher. Can Square position its own Square Cash app as a viable alternative and a driver for SQ stock?

Again, valuation here already is high. In this market, however, it clearly can move higher. But it’s not going to be a matter of just ‘beating’ earnings. Square has to again convince investors that it’s a leader in payments with wide-ranging growth opportunities.

Doing so will mean that Square gets treated the way it was last year and the way SHOP stock is now. That’s the way that the rally in Square stock jumpstarts after Tuesday’s report.

Is Square Stock a Buy?

Is that path viable enough for investors to buy SQ ahead of earnings? It’s likely a matter of taste. I’ve long liked Square as a business, having once compared it to Amazon.com (NASDAQ:AMZN), if at a much smaller scale. But I’ve also argued, often incorrectly, that Square stock is overvalued. I think the same is true of Shopify stock at these levels.

There are risks both into and out of earnings, as the sharp fall in Q4 showed. Investors clearly have to trust the overall market, given how hard SQ stock fell when overall sentiment turned sour. And competition isn’t going anywhere, whether it’s Paypal, Visa (NYSE:V) and Mastercard (NYSE:MA), or other private fintech plays.

That said, for growth stock investors, there really aren’t a lot of opportunities left out there that aren’t at all-time highs, or close. And it’s possible to see a narrative in which Square earnings are impressive, allowing SQ stock to play ‘catch-up’ to the rest of tech in coming months. It’s not a trade I would make. But ahead of the report, I can see why other, more aggressive, investors might.

As of this writing, Vince Martin has no positions in any securities mentioned.

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