Investor Essentials Daily

A cashless future bodes well for this payment company’s services

Square, Inc. (SQ)
July 21, 2021

In a world without cash, companies need a quick, easy way to process payments – whether they be digital or in person.

With cashless interactions booming because of the pandemic and its impact on technology adoption, this company should see demand for its products continue to grow.

Yet, rating agencies still rate its debt as high risk, which seems rather pessimistic given its significant cash-generating abilities.

Also below, the company’s Uniform Accounting Performance and Valuation Tearsheet.

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For as long as payments have been processed, sellers have been beholden to a small group of companies able to impose a significant degree of pricing power upon them.

These include manufacturers of processing equipment and software – such as cash registers and kiosks – as well as financial services companies that issue credit cards.

For most businesses, particularly small and medium sized ones, the services provided by these companies often came with costly strings attached.

If a small shop wanted to accept credit card payments from its customers, it would have to incur a substantial fee, and perhaps also commit to not accepting competing cards.

This presented a serious challenge, as the modern age of technological and financial innovation has driven more and more consumers to ditch cash in favor of debit and credit cards.

For a company like Square, Inc. (SQ), which offers a cheaper alternative to help process payments, this provides a golden opportunity to help small businesses stop losing customers and sacrificing profit.

Now, rather than being limited by high costs and unfriendly contracts, anyone with a cell phone can get a free “Square,” download the app, and process payments – all cash-free.

And, based on current trends in fintech innovation and consumer adoption, brought years forward by contactless checkout during the pandemic, Square appears well positioned to profit from an increasingly cashless future.

Yet, major ratings agencies view the company’s debt as highly speculative, notwithstanding its favorable market position.

S&P for example rates Square as a non-investment grade BB credit, implying a 10%+ risk of default over the next five years.

Relying on the major Wall Street ratings firms and as-reported financials, investors are led to believe Square is on the brink of default.

Here at Valens however, we see things a bit differently.

Our Credit Cash Flow Prime (CCFP) analysis is able to get to the heart of the firm’s true credit risk.

In the chart below, the stacked bars represent the firm’s obligations each year for the next five years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).

As depicted, Square has sufficient cash liquidity and therefore should have no difficulty meetings its future obligations. Moreover, even if the firm uses its cash on hand in other ways, cash flows alone are projected to exceed all obligations through 2023.

Rather than a distressed credit, Square is actually in a quite comfortable cash position. This is why S&P’s BB non-investment grade, speculative rating, with a 10%+ risk of default expectation, does not make much sense.

Using the CCFP analysis, Valens rates Square as an investment grade IG3+. This rating corresponds with an expected default rate below 2% within the next five years, a more realistic projection once a holistic understanding of the company’s risk is taken into account.

Ultimately, Uniform Accounting and the Credit Cash Flow Prime analysis highlight how Square’s credit risk profile is much safer than what rating agencies believe, especially when considering the tailwinds the company will continue to enjoy from the transition away from cash transactions.

SUMMARY and Square, Inc. Tearsheet

As the Uniform Accounting tearsheet for Square, Inc. (SQ:USA) highlights, the Uniform P/E trades at 220.7x, which is above the global corporate average of 23.7x, and its historical average of 128.6x.

High P/Es require high EPS growth to sustain them. In the case of Square, the company has recently shown a 3% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Square’s Wall Street analyst-driven forecast is an EPS growth of 18% in 2021 and immaterial growth in 2022, respectively.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Square’s $237.5 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to grow 59% annually over the next three years. What Wall Street analysts expect for Square’s earnings growth is well above what the current stock market valuation requires in 2021 and 2022.

Furthermore, the company’s earning power is 3x the corporate average. Also, cash flows and cash on hand are 2x above its total obligations—including debt maturities, and capex maintenance. This signals a low credit and dividend risk.

To conclude, Square’s Uniform earnings growth is below its peer averages and trading well above its average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research