Jack Dorsey's Square gets some bad reviews from analysts

One of Wall Street's tried and true rituals arrived this week for Jack Dorsey's payments startup Square (SQ), but the results weren't quite the usual outcome.

A month after Square's semi-successful initial public offering, with the quiet period expiring, equity analysts at the seven banks that underwrote the deal all released their initial reports on the company.

Barring a massive move in the stock price, this ritual typically results in a wave of "buy" recommendations across the board. But Dorsey's company, even with its stock up only modestly from the $9 IPO price, got a more mixed reception: Along with five recommendations to buy came two of the dreaded "hold" labels.

Last month, the underwriters had hoped to price the deal from $11 and $13 per share, but could rustle up enough demand only for $9 a share. The stock managed to climb back into the expected range by the end of the first day of trading, closing at $13.07 on Nov. 19. It has since bounced in a narrow range and closed at the end of last week at $11.95.

Now, despite the lack of pop, it seems analysts at Stifel Nicolaus and Deutsche Bank aren't convinced that Square's stock is poised to rally much more. And even many of the buy recommendations offered modest upside price targets -- JPMorgan analysts said $14, while Jefferies, RBC Capital and Barclays opted for a $15 target. Goldman Sachs set the high bar with a target of $16.

All of the analysts remained impressed with Dorsey's leadership abilities ("the visionary that drives the unique culture at Square," JPMorgan analysts wrote) and his company's rapid growth and huge, loyal customer base. And all of the analysts also see at least some promise in Square's efforts to expand beyond processing payments into other areas such as small-business lending, payroll services and marketing analytics. The add-ons form "a cohesive roadmap to additional wallet share," in the words of RBC's analysts.

Square's peers

The real split is over just what kind of company Square will be in the end. Payments processing historically has been a profitable, if low margin, unsexy business and most public companies in the niche trade at modest multiples to their sales and profits. But cloud-based software and data analytics companies that show strong growth trade at high multiples, even without showing profits.

For example, PayPal (PYPL) trades at an enterprise value of 3 times its 2017 expected sales; Global Payments (GPN) trades at 4.7 times; and Heartland Payments (HPY) trades at 3.7, according to data from Goldman Sachs. But among so-called Software-as-a-service, or SaaS, companies, Salesforce.com (CRM) trades at 5.6 times its expected 2017 sales, WorkDay (WDAY) at 7.6 times and Netsuite (N) at 5.4 times.

Most of the bulls included the higher-multiple software group even though that's a small part of Square's current business. About 85% of its current adjusted sales are from payments processing. (The non-standard "adjusted" sales metric used by the analysts in the case of Square excludes the fees the company pays off the top to credit-card transaction processors. Analysts are also excluding the revenue from Square's now cancelled deal with Starbucks (SBUX) from the adjusted total.)

"While there are no perfect comps for Square, we selected a group of comparable companies which in aggregate reflect our view of Square’s long-term mix of payments and non-payments businesses (such as online lending marketplaces and SaaS software assets)," Goldman analysts noted in their report. They used a multiple of 7 times their projected 2017 adjusted sales of $802 million to reach the $16 price target.

Deutsche Bank analysts relied mainly on just the payments group to arrive at their hold recommendation. "We are most comfortable looking at peers in the payment processing sector since business models are most comparable (although SQ has no perfect comp, in our view)," the analysts wrote. Expecting slower growth than some other firms, the Deutsche Bank analysts decided to set a price target of 6 times the company's 2017 adjusted sales of $748 million.

Now it's up to Dorsey and his team to make one set of analysts or the other look smart.