Since the lows in March of this year, shares of Square (NYSE: SQ) are up over 500%. But one of the factors responsible for Square’s exceptional performance has been bitcoin, which not only misleads investors, but could also drive the company’s valuation to dangerous and unearned heights.
Square’s business model consists of two ecosystems. First, it provides small and medium-sized businesses with all the tools they need to easily set up and manage their stores. Second, it offers the Cash app, which started out as a small peer-to-peer payment app, but over time has grown into a one stop shop for all things. Consumer credit. In 2018, Square gave consumers using the Cash app the ability to easily trade bitcoin.
Every time a customer purchases bitcoin on the Cash app, Square generates money by charging a nominal fee on those transactions. However, due to accounting rules, Square is required to recognize the entire transaction as revenue. Even though Square only makes a tiny fraction of the money changing hands – it keeps less than 2% of bitcoin transactions as gross profit – it is forced to show revenue growth rates that don’t reflect the actual performance of the underlying business. In its most recent quarter, Square’s revenue grew 140% year-over-year. However, if you exclude bitcoin, revenue for the rest of the business only increased by 25%.
Is Bitcoin Revenue a Good Thing?
Despite these small margins on bitcoin purchases, investors should consider any additional functionality within the Cash app as a net positive. Don’t let accounting overshadow the big picture: the more things customers can do with the Cash app, the more reasons they have to sign up and use it. In this case, Bitcoin helps Square acquire new customers and retain existing customers.
The goal for Square, at the end of the day, is to get as much money as possible on the Cash app. The app will become more and more important to its users as Square continues to roll out different tools and features for it. This means that Square can still make money with its users through other characteristics like the Cash Card or instant transfer. And while waiting for the appropriate licenses, Square could potentially deploy, lend, or invest the money on its platform for better returns. He even started testing this through small payday loans to a small group of consumers.
Overall, the most important metric going forward is gross margin. This metric cancels out the bitcoin volume and gives a realistic snapshot of the progress of Square’s initiatives, before including operating or capital expenses. It also offers a decent view of user actions within the Cash app regardless of bitcoin trading.
During Square’s last quarter, the combined gross margin of the Cash app and its commercial services grew by $ 294 million, or 59% year-over-year, a significant acceleration from the previous quarter. previous year, where it only increased its gross margin by $ 147 million.
While the seller ecosystem still accounts for over 50% of the overall gross margin, it only increased its gross margin by 12%, compared to the 212% growth in gross margin from the cash application. So, despite the fact that bitcoin trading somewhat artificially inflates Square’s total revenue, the feature appears to be a useful customer acquisition tool, and it also appears to affect users’ money on other features of the app. .
While bitcoin appears to be a useful feature for Square as a whole, it still risks skewing the company’s valuation if investors pay too much attention to income. My biggest concern is that if bitcoin falls out of favor, its trading volume could decline. After all, nothing changes investor sentiment like price. A drop in transaction volume could mean a drop in revenue and potentially less use of the Cash app as a whole. This makes it difficult to accurately calculate the lifetime value of anyone who primarily uses the Cash app to trade bitcoin.
Like I said earlier, shareholders had better focus on gross profit and make sure they don’t overpay Square shares. This means balancing the price-gross profit multiple of the stock with its overall growth rate for that gross profit.
Currently, Square is trading at a price-to-gross profit ratio of 43, while a year ago it traded at 14. However, growth in total gross profit has also accelerated, it It should come as no surprise then that investors are more enthusiastic now than a year ago. These two variables should show how the business is progressing and the price investors are willing to pay for the stock.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are heterogeneous! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.