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$SQ: A Hypergrowth Fintech Distribution Machine (In Process)
Many good deep dives have been written on $SQ, amongst them this one by @wolfofharcourt. For this reason, today I am going to be building on top of Wolf´s deep dive and I will be addressing higher levels of abstraction.
$SQ May Now be a Value Play
Before we get into the details, allow me to lay out the investment opportunity concisely. $SQ has a market cap of $48.7b as I am writing this and has more than 40m monthly active users on Cash App. The stock has come off a long way from its ATHs.
The market is effectively valuing $SQ at 1,200$ per Cash App MAU, when the fair value per MAU is arguably much more than that and the company still has a huge growth runway ahead. This assumes that smartphones (specifically, digital wallets) will become the new bank branches. I will go through this assumption in detail below.
The rest of its business would resultingly be trading “for free”.
$SQ is Building One of the Largest Fintech Distribution Machines
If you think about why you use one phone carrier vs another, you may be able to track it back to different competitive features. However, an honest exercise will likely reveal that it was mostly due to their ability to make you aware of their solutions or in other words, due to the power of their distribution channel/s.
The same happens with commercial finance, in which it is hard to differentiate one solution from another, except for pricing. Whilst product features do make a difference, a product that is somewhat worse than another may win if it can leverage a better distribution channel. This is actually a common theme across many areas of commerce.
$SQ is building a very powerful distribution machine, on top of being very good at making customers happy. $SQ has two core offerings:
Sellers: a solution to help merchants accept payments and conduct their business.
Cash App: a P2P payments app, that allows individuals to send money to each other.
Both offerings have grown phenomenally over time and are amongst the leaders in their respective spaces, with Sellers running a two horse race with Clover ($FISV) and Cash App growing really fast relative to competitors. Yet, both solutions have been largely disconnected from each other, losing out on potential additional network effects.
Through the all stock acquisition of $AFTPF (Afterpay), $SQ is looking to bridge this gap to tap into new network effects, by incorporating the below flywheel into their ecosystem. ($AFTPF is a BNPL (buy now pay layer) company, which allows consumers to do just that).
$APT´s flywheel brings in more merchants as it brings in more users. Incorporated into the $SQ ecosystem, this means that more Cash App users bring in more Sellers and viceversa. Additionally, $AFTPF has been growing very fast over the past few years, which makes even more likely that it will catalyze the overall $SQ ecosystem. The results could be mind blowing.
This is not all clear water, as I will go through below, because BNPL adds plenty of credit risk to $SQ´s balance sheet.
$SQ´s solutions have only penetrated a small fraction of the overall TAM. Today, around 70% of the world´s GDP ($80,934,771,028,340) derives from consumption, which is basically consumers handing merchants money in exchange for good and services. Sellers and Cash App effectively point at / aim to wrap around 70% of the world´s GDP.
GPV at $SQ today is only $45b, which is a relatively infinitesimal amount. As such, it seems that $SQ has a long runway ahead still.
It has taken me a while to realize this, but there is one more factor that explains why $SQ may primed to grow very fast. This reason is culture.
Commerce is Culture
In my research I learned that $AMZN tried to compete with $SQ Sellers in 2014. By late 2015, $AMZN gave up. Yesterday, I was listening to a podcast featuring $SQ co founder Jim McKelveey attributing this success to the “Innovation Stack” - the large amount of tiny things $SQ did to satisfy customers that $AMZN could not figure out.
This story teaches us that focus pays off big time. Focus allows you to hire the right people for the job, which then promote the right culture which then equates to many tiny actions that build up a moat. In the case of $AMZN vs $SQ, this led to a seemingly strong moat in its merchant solution.
It turns out that you can track forward the development of this intangible force through $SQ´s relatively short history. Cash App (2013) was launched way later than its closest competitor Venmo (2009, owned by $PYPL). Today, however, it is catching up with Venmo in terms of active users. Why?
*Side note: Zelle is owned by seven of America's largest banks: Bank of America, BB&T (now Truist), Capital One, JPMorgan Chase, PNC Bank, U.S. Bank and Wells Fargo, so it calls for a different type of analysis.
In short, it seems that $SQ has managed to tap Cash App into culture, with the app being constantly mentioned on hip-hop / rap songs. This seems to have led to very fast growth.
I do not think I would have understood why tapping into culture would lead to growth without reading “Influence” by Robert Cialdini, in which he explains the 5 most powerful psychological principles in social sciences. The key one for Cash App being the Principle of Reciprocity.
Through time, for a number of reasons we have evolved to be reciprocal to each other. As a result, the urge to be reciprocal is very powerful and can override many other impulses. Consider, for instance, the uncomfortable feeling of owing someone money. That is due to the Principle of Reciprocity and this in fact seems to be fueling the growth of payment apps.
When you owe someone money, they will now say “do you have X app?”, which essentially promotes viral growth, with low costs of customer acquisition (5$ for Cash App vs way more for traditional banks). X will be equal to the app that is tapped into their culture and in turn, every reciprocal exchange further cements the cultural relevance of the given app.
One can now see what the Tidal acquisition is about. Investing to merge a payment app with culture pays off big time, because commerce is an inherently cultural pursuit.
Hyper Growth, Disruption and Competition
I think that $SQ´s ecosystem turning into a consumer/merchant magnetic flywheel, together with its seemingly cultural mastery prime the company for massive growth over the next decade. On top of the growth, there are two disruption trends that I see happening over the next decade, which do not paint a straight path for $SQ:
Web 3 rails maturing.
Wallets taking mind space away from traditional banking.
Firstly, $SQ´s infrastructure today runs on relatively old rails, which are costly to run. Meanwhile, you have Web 3 technologies maturing, promising to deliver free transactions scalably one day. As you can see below, a large chunk of $SQ´s revenues come from transaction fees:
For this reason alone, I believe Jack Dorsey is right to be pointing the company at blockchain technologies, re branding it to Block. One thing we have seen with crypto is that operating with it is not that easy for most people, so I believe $SQ has the chance to make up for transaction fees that it will likely lose through additional services. Who knows, but this trend is there and $SQ will have to figure out a lot of things along the way.
The flip side of this trend is that as people do more things on their phones, traditional bank branches and their relatively outdated distribution methods get increasingly uncomfortable for people. Payment apps (digital wallets) due to their tech native and viral nature, have a very big chance of becoming the predominant perfect substitute. This still applies even if VR takes over our current heads-down approach, because it is not so much a function of the app as it is of the mindspace the app occupies.
I think the above is a reasonable assumption to make going forward. However, it looks like the combination of digital wallets and web 3 rails will monetize in ways we cannot imagine yet, if they do at all. There is still a chance that in 10+ years time the fair value per Cash App MAU is 0$ because the game may be completely different by then. Whatever the case, so long as Cash App continues to dominate, $SQ will have a front row seat to figure it out.
Further, whilst $SQ faces intense competition from the likes of $PYPL, $FISV (Clover) and now $APPL it seems, I argue that the same intangible forces that enabled it to survive when facing $AMZN and that have enabled Cash App to grow so fast, will continue to push it forward through time. There is no certainty of whether $SQ will be a winner in the space, but it definitely looks like it will be a key player, whilst there is still a big market out there to capture for all them. $SQ is quick to point this out:
First of all, as @wolfofharcourt points out, the explosion in $BTC revenue is mostly due to $SQ recognizing the nominal amount of $BTC that end customers buy as revenue. Basically, when a customer buys $BTC, $SQ buys that amount and then sells it to the customer for a fee. $SQ is recognizing that amount + the fee as revenue. For this reason, the dependence on crypto is smaller than it would seem at first sight.
Secondly, $SQ has $4.5b in cash and $4.7b in debt, that seems prudent with a FCF of $521.7m in the TTM. However, it is now onboarding $964M in debt for Afterpay´s balance sheet. I am not so concerned about the amount per se but rather what it can spiral into, after plugging Afterpay´s flywheel into the ecosystem. $SQ better have some awesome credit managers in-house.
Whilst Web 3 rails kick in, gross profit growth is looking very healthy for $SQ, with margins on the rise and Cash App becoming a bigger piece of the business. Cash App is no where near its full potential of implementation, with many more financial services that could be delivered through it. I think that as viral growth continues, $SQ is an excellent position to more deeply monetize it and we will see this show in the numbers. The trend is excellent so far:
It seems that a large % its recent green numbers in its bottom line are due to unusual items:
A bit of a negative consideration here is how dilutive $SQ has been to shareholders since its IPO. In 10/2021 it had 399 million shares outstanding, whilst in 2015 it had 27m. This is not exactly shareholder friendly, but indeed the company has augmented its asset base almost as fast as it has grown revenue.
Another interesting thing is that most of the financial metrics we see, start from revenue billed almost exclusively to the US. This gives a quantitative snapshot of really just how much room to run $SQ has ahead of it:
All in a all, if you believe digital wallets will be the core of commercial banking, $SQ seems like a good buy now that its stock has fallen out of favor. The company seems to be taking steps towards huge ecosystem growth. However, as I mentioned, Web 3 rails will pose a challenge down the line.
I think Dorsey´s management is good and regardless, the company seems to be very efficiently run. I say this because of the way it survived against $AMZN and the way it has outpaced competitors which were way ahead of them, specially in the P2P payments space. Quantitative measures such as RoE and RoA seem to support this, but I think the qualitatives tell a much more detailed story.
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