Pando

Square is no Twitter

By Kevin Kelleher , written on March 10, 2016

From The Earnings Desk

Finally, some good news for Jack Dorsey: Square, it seems, is no Twitter.

And that means that Dorsey can actually preside over a quarterly earnings report, explaining to analysts and investors what's happening at one of his companies, without precipitating a long round of handwringing, second guessing, and, most of the time, declining share prices.

Square reported its first-ever earnings as a public company Wednesday, following weeks of volatility in its own stock. Square's share price rose as high as $13 a share on its first day of trading, before falling as low as $8 a share last month, and then rebounding back to $12 a share right before Wednesday's report.

The report itself was mixed. Yet the response in the press was refreshingly, if questionably, positive. “Square beats on first-ever earnings, stock pops,” read onecheery headline

Well, sort of. Revenue in the quarter ($374 million) did surpass analyst expectations ($322 million). But “earnings” refers to what a company earns, better reflected on the bottom line. And the bottom line (a loss of 34 cents a share) was much worse than analysts had expected (a loss of 14 cents a share). As for the pop, Square's shares were trading 1 percent above its official closing price in after-hours trading.

If anything, investors are greeting Square's first-ever earnings with neither enthusiasm nor despair, but a sense of uncertainty as well as a willingness to wait to see what happens throughout the year. And that makes Square a different beast than Twitter, which has used up most of the patience that investors were willing to grant it as it tried to reach its potential.

Overall, Square is down 9 percent from its closing price on its first day of trading back in November, roughly in line with the Nasdaq Composite's performance in that time. Twitter, meanwhile, has lost a third of its market value in that time. Compared to its $9 a share offering price, Square has risen 34 percent - which is nice until you remember the offering price was abruptly lowered at the last minute from the $13 a share price initially proposed to investors.

More importantly, both Square's offering price and its current market price are both well below the $15.46 a share price of its last private round of financing in October 2014. Some people will argue that when IPO valuations fall below private ones, it's not as bad as it may look because a private-round valuation can factor in certain perks investors receive. Square's inaugural earnings revealed the danger such perks hold for public investors.

Investors in that private round, a $150 million Series E investment, received an assurance that, if Square's IPO priced below $18.56 a share, they would receive enough additional shares to guarantee them a 20-percent return on their investment. Square has now quantified the toll that provision took on its financials. And it's not pretty.

Square recorded a $32 million dividend in the quarter to certain investors who bought preferred stock in the Series E round, adding to its already sizable net loss. The extra shares that Square issued to its Series E investors also boosted its shares outstanding by 53 percent, from 152 million in the third quarter to 235 million in the fourth quarter.

How dilutive was that to other investors? Consider that Square's net loss rose to $80 million in the fourth quarter of 2015 from $54 million in the third quarter, a rise of 49 percent. But on a per-share basis, thanks to the new shares, the net loss actually declined to 34 cents a share from 35 cents a year earlier. So yes, it made the loss look better, but think about what happens if and when Square does swing to a profit. The closely watched EPS figure will be truncated, thanks to this generous perk to private investors.

In the current quarter, Square said its shares outstanding will rise even further – to 332 million, expanding its share count by another 42 percent. Not all of these new shares will add to the supply available for trading in the stock market, but in time some will, and that could make it harder for new demand to push Square's stock price higher.

Public investors have another reason to wait and see how Square fares in coming quarters. It's not clear when the company can reach profitability. It's welcome news that Square's revenue grew by a stronger-than-expected 49 percent over the past year (64 percent if you factor out the ill-starred Starbucks deal). It backs up the story Dorsey likes to tell about Square's momentum: that its technology is making payments faster and easier for consumers and merchants alike.

Merchants have ordered 350,000 Square readers that can read chip-embedded credit cards and handle Apple Pay and Android Pay. Many of those merchants are also amassing data that can help them run their businesses better. And Square uses that data to assess the risk of lending to merchants through Square Capital, which extended $400 million in credit last year. Square is also offering services like instant deposit, invoices and restaurant delivery, seeding new areas of revenue growth for the future.

That's the pitch, and judging from the top line it's working. It's less clear what's happening further down the income statement. Operating losses continue to grow as well, albeit at a slower rate than revenue: 38 percent from the year-ago quarter. Sarah Friar said in a conference call discussing earnings that the company's R&D spending will decline as a percent of revenue as the business scales, while sales and marketing costs can be adjusted each quarter as necessary.

That's good news, because Square is forecasting its revenue growth rate (ex-Starbucks) to nearly halve this year to about 35 percent from 64 percent in 2015. And many of the company's newer initiatives have a lower gross profit margin than the core payments business, so as they become a larger part of the overall business they could slow Square on its path-to profitability.

Square is like Twitter in that it remains to be seen whether the company can deliver on the story Dorsey has been telling. Unlike Twitter, it seems fairly likely to get there – perhaps because, unlike Twitter, Dorsey has actually spent a good deal of time as its full-time CEO. This led to the inevitable question from an analyst about how Dorsey is handling his dual roles as CEOs of both companies.

“Yeah, yeah,” Dorsey replied, before launching into an answer that was virtually identical to the vague one he gave on Twitter's earnings call last month – he has a structured schedule with each leadership team, yet flexibility in case one needs more time, and did you know both companies are across the street, etc. – then concluded in a blithe tone, “It's been working out really well, thank you for asking.”

Has it, though? Square's future is far from secure, as evidenced by its rocky transition from a private company to a public one. Square was once seen as the kind of big-name offering that could rekindle the damp market for tech IPOs. Just count how many tech IPOs have followed in the interim four months, and you'll have an idea how far Square still has to go to prove itself.