How Square is Cashing In. Plus, IPO-Palooza

Balance your trading strategy by adding futures. CME Group helps you manage risk and capture opportunities in all market environments. Capitalize on around-the-clock access to highly liquid global futures and options markets across all major asset classes. Visit your online broker to get started. See what adding futures can do for you at cmagroup.com/podcast. Derivatives are not suitable for all investors and involve risk of losing more than the amount originally deposited and any profit you may have made. This is not a recommendation or offer to buy, sell, or retain any specific investment or service.

Square was born out of the last recession where we saw our customers struggle, who were looking for a way to never miss a sale, to use credit card to process with customers where that was historically done with cash, and were looking for ways to grow their business over time. And so that's the journey we've been on now for more than a decade with sellers.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard is Amrita Ahuja. She's the chief financial officer of a company called Square. It went public 5 years ago at $9 a share, and the early stock performance wasn't great. But now the stock price is over $200. That makes Square about as valuable as Caterpillar or CVS or General Electric. In a moment, We'll learn more about why investors are going so gaga for Square stock, and we'll say just a few words about sizing up stocks that recently went public like Airbnb and DoorDash. Listening in is our audio producer Meta. Hi Meta!

Hey Jack.

Important question for you right off the top: have you ever had bubble tea?

I have had that. It's many years ago and I didn't love it.

Ooh, slamming the bubble tea industry. I can't believe it.

It's a little too sweet.

All right. I had my first bubble tea this past week. I was in the center of our little town and my daughter said, let's get bubble teas. And she said there was a new Korean takeout restaurant that makes them. And we went there. There are lots of different iced teas to choose among and lots of little balls to put in the tea. Some are tapioca-like and others are filled with clear fruit-flavored liquid, and you drink the tea and the balls through this wide straw. I was a little worried about accidentally inhaling the balls. I was thinking about, like, an obituary saying, Jack died drinking milk tea with blueberry balls just a little too enthusiastically. But I survived and Bubble tea wasn't my only first this week. Remember a few weeks ago when Visa Chief Al Kelly told us on this podcast about contactless credit card payments? Al said that tap-to-pay is the norm in Europe and much of the world, but it's only now beginning to spread in the U.S. Well, I went to pay for my bubble tea and the woman behind the counter asked if my card had a Wi-Fi symbol on the back. And I looked and it did, so she said I could just put it near this white plastic square to pay. And that was that. And Meta, who do you think is the company that makes that white plastic point-of-sale square?

Let me guess, it's Square.

You know what, this would have been a much stronger story if it were Square. It would have led perfectly into my call with Amrita over at Square, but this box was made by a Square competitor called Clover. And that's okay because Clover will be important for our conversation later. For now, just know that if you want to open a shop that lets customers pay by credit card, you need access to what's called a merchant acquirer. That's the middleman between credit card companies and stores, and historically dealing with merchant acquirers has stunk for small stores. Opening accounts was cumbersome. Here's Chris Brendler, a payments analyst at Seaport Global Securities, talking about how that process used to look.

I think there was 227 different fields in this contract, and you can imagine it was, you know, white, yellow, and pink copies, and it took about a week to get approval. And I think, you know, some 30% or so of businesses would not get approved for being too small or being in a riskier segment of the market.

Chris says merchant acquirers were notorious for, as he puts it, ripping off small stores. There were a lot of hidden fees. Total fees on card transactions in some cases were close to 4%. That was a state of the business more than a decade ago when— Meta, I'm trying to cut down on story detours, but I gotta be honest, I feel a doozy coming on. You got any music?

Sure.

Great. That was the state of the business more than a decade ago when a St. Louis glassblower named James McKelvey was trying to sell a $3,000 bathroom faucet over the phone to a woman in Panama. I'm going somewhere with this, I promise. She, she wanted to use American Express, but James only took Visa or MasterCard. The woman said she'd check if her husband had one of those when he got back home in a week, and the sale never happened. Now, James the glassblower was complaining about it over the phone to his friend Jack— Jack Dorsey, co-founder of Twitter. How did he know Jack? Well, James the glassblower had a computer business back in the 1990s, and a coffee shop owner at the time told him You should hire my 15-year-old son Jack as an intern. He's good with computers. So James did, and the two kept in touch. Now, Twitter was in its infancy when James talked to Jack about his blown glassblowing sale. James looked at his smartphone and said it should be all he needed to process card payments. There was an internet connection, a touchscreen, security. So James and Jack came up with a dongle that plugged into phones and allowed them to read cards. And in 2009, 3 years after Jack co-founded Twitter, he and James co-founded Square. Today Square has much more than dongles—a full suite of hardware including payment registers and dozens of software services. It's also more than twice as valuable as Twitter, by the way. One more thing. Square is not a merchant acquirer, even though it might look like that to stores. It's what's called a payments aggregator. You know how I said earlier that merchant acquirers are middlemen between card companies and stores? Think of Square as a middleman before you get to those middlemen. A small store doesn't have to apply for its own merchant account. It just signs up quickly with Square, and Square serves as the merchant of record. That makes it easy for stores to get started quickly, and Square can use its heft to secure reasonable fees to pass along to stores. Square competes with other payment aggregators like PayPal and Stripe. Remember Clover from my bubble tea purchase? Its point-of-sale devices make it look a lot like Square, but it's owned by Fiserv, which is a merchant acquirer. In other words, Clover might look like an upstart trying to disrupt the incumbents, but it's really an incumbent trying to fend off the disruptors. That's enough background for now. To learn more about Square's growth, I recently spoke with its Chief Financial Officer, Amrita Ahuja.

How are you?

Doing well, thanks. I think this is the first time we're speaking, so it's nice to meet you, and thanks very much for making a few minutes to speak with us.

No, thank you for having me. I appreciate it.

I asked Ambrita how she got interested in the payments business, and she says the need for economic empowerment is something she's felt in her bones since growing up in Cleveland, Ohio, as the daughter of immigrant small business owners.

I saw the struggle firsthand. They started their business, which is a daycare, one-site establishment. They started their business back in 1980 with a loan through the SBA at an 18% interest rate. They mortgaged the house. My dad worked double shifts to pay it back.

Amrita's parents did their business planning and record keeping with paper and pencil.

You know, every Thursday night my mom sat at the kitchen table and, and wrote out payroll. She'd then hand her calculations to my dad, who'd cut the physical checks, and then she'd hand them to her staff Friday morning. That whole process, we know now, obviously can be fully automated. And had my parents had access to those sorts of tools and technology that Square provides, You know, maybe they could have had a night off every once in a while.

Today, Square offers services for payroll, invoices, business loans, loyalty programs, and more. Toward the end of last year, Square's gross payment volume was growing by 25% year over year. But during the second quarter of this year, growth turned negative as small businesses were shut down by the pandemic. During the third quarter, the company returned to growth. Gross payment volume rose 12% year over year to nearly $32 billion. That's a good sign for Square and maybe the economy. Amrita says two keys that have helped the company succeed with merchants are speed and trust.

We saw that in the last recession and we see this in this one. What speed means is fast access to their own funds. Fast access to credit when needed to grow their business, fast onboarding to new products and growth vehicles that can enable them to reach their buyers wherever they are. What trust means is we don't lock our customers into contracts, that we're transparent with the fees and pricing that we provide. And, you know, we try to build our business and conduct ourselves with a long-term orientation.

Square's standard processing fee for most transactions is 2.6%. Plus 10 cents. It also sells hardware and makes money from add-on services. Depending on their volume, merchants might be able to get lower fees by shopping around, but payment services can also differentiate themselves with their software, and Square's high customer retention is a good sign. So far we've talked only about Square's seller services, but But there's another side of the company. It was launched 7 years ago and it's called Cash App. You can use it to send or receive money just like with another service called Venmo. And you can deposit paychecks and tax refunds. You can spend online using a debit card or buy stocks or even Bitcoin. Here's Amrita.

What it's grown into over the years is a way to frankly help people manage their money. And what we want to do over time is help redefine your relationship with your money, making it more relatable, instantly available, universally acceptable, accessible. And so, you know, the business Cash App has grown tremendously over the years. We now serve over 30 million transacting customers on a monthly basis. And that runs the gamut of individual customers and now increasingly some small businesses as well through Cash for Business.

Now growth for Square's seller services has been healthy considering the pandemic, but growth for Cash App has been bananas, in part because of the pandemic. In the third quarter, revenue for Cash App rose 574% year over year. Remember those stimulus checks the government sent out? Here's Chris, the analyst from Seaport Global Securities.

For people using Cash App, and you know, a lot of them may not have a traditional bank account. And Cash App put it right into the app itself on the front page. Click here to get started on how you get your stimulus check. And it spread like wildfire because what's so exciting about Cash App is it's got viral growth. People who use it love it and want others to use it, too. So it, it grows faster the more people use it because every new user effectively becomes a promoter.

Even Square's misfires haven't exactly been flops. It bought a food delivery service called Caviar back in 2014, and last year it decided to get out of that business to focus more fully on payments. So it sold Caviar to DoorDash for $410 million. That's 9 times its purchase price. Meta Quick Focus Group, which delivery services have you used? DoorDash, No. Caviar?

Yes.

Grubhub? Yes. Uber Eats? No. Chowtown?

No.

Munchwagon?

No, I don't know those.

I made those last two up. Pretty sure those names are still available if we have any entrepreneurs out there. Anyhow, Square has been an incredible stock market performer. It came public about 5 years ago at $9 a share, and the stock wasn't a fast starter. But shareholders who held on have made more than 1,600% over the past 5 years. Analysts are still warming to the stock. Last month, Mark Palmer at BTIG upgraded it to buy from neutral, writing that Cash App's growth during the pandemic has been nothing short of remarkable and that the seller business is recovering faster than he expected. This month, Chris at Seaport Global Securities initiated coverage of Square with a buy rating. I asked him, aren't you worried that the stock has climbed so far so fast? He says he's a little worried about fourth quarter results for Cash App because the growth rate could decelerate, and he's not sure Wall Street's expecting that. But he also expects growth to pick back up by tax time That's because people might want to use Cash App to receive their tax refunds. Also, Square just bought a free tax filing service called Credit Karma Tax. Now, as far as the valuation goes, Chris says the stock looks very pricey compared with current earnings, but that those earnings understate the company's profitability. It's growing quickly, and many of its costs to develop its products were paid upfront. Also, the revenue mix is shifting from seller services, which have relatively low margins, toward Cash App, which has high margins. Chris thinks Square can become a powerful earner over time.

The reason why the stock can look cheap at 192 times earnings is because those earnings are actually going to be a lot, lot higher in the future as their margins ramp up because they don't— all their costs are product development and marketing. And as you get into billions of dollars of revenue, you're not going to be able to spend that kind of money on your operating expenses. The chances will be much lower and we'll start growing a lot slower because the law of large numbers, you just can't spend $10 billion on marketing, for example.

I'll leave it to listeners to decide whether Square stock has run too far, too fast for now. One last question for Amrita. Where does she think Square is in its growth? She says she sees 3 growth horizons. Today, the company's in the first stage, which is growing its networks, both Seller Services and Cash App. Stage 2 will be getting better at cross-selling between the two. And Stage 3 will be connecting the networks. She says the company has less than 3% share in its markets, providing plenty of opportunity for growth.

If we can scale these two ecosystems such that if there's enough overlap and we are seeing both the buyer and seller of transactions, I think we have an opportunity here to really provide unique value and to grow our business differentially.

Meta, do we have a quick question? We do.

We have a question from a young investor named Barnabas. He says he is from Eritrea, East Africa, and he currently works in Manchester in the UK. And he didn't record his question, so I'll go ahead and read it. You ready?

Hang on. I'm delighted to hear from Barnabas, but I also want other listeners to record their questions if they can, rather than just write them out. Meta, what if you read the question, but in a slightly sad voice? One that says, "Thanks for getting in touch, but we wish we could hear your voice." I agree.

Okay, you ready? Okay, let's do it. Why do some startups go for direct listing and others for IPO?

That was your sad voice.

That's my sad voice. You don't think it sounded sad? No. Do you have a sad voice? Okay, let me see. Why do some startups go for direct listing and others for IPO?

It's just as I suspected. You can't be sad. Thank you, Barnabas. You know, we're getting a lot of questions on initial public offerings lately, and it's easy to see why. The U.S. this year has already broken the previous record for IPO volume set in 1999. Companies want to sell when prices are high, and with the S&P 500 index trading at 23 times the highest earnings it's ever had from 2019, Prices look a bit high. You asked about direct listings, Barnabas. That's when companies sell shares to the public that were owned by employees or early investors. The shares already existed, they just weren't publicly traded yet. In a traditional IPO, a company creates new shares to sell to the public. Sometimes there's a lockup period that prevents existing shareholders from selling for a while. So the biggest difference between a direct listing and an IPO is that an IPO raises new money by creating new shares. A direct listing is for companies that don't need to raise money and just want to create an easy way for shareholders to sell. Direct listings are cheap because they avoid the need for underwriters. Underwriters are Wall Street banks that help issue shares to the public. But the lack of underwriters also means that there won't be a network of banks drumming up interests in the offering. So direct listings are best for companies that ordinary investors are already familiar with. That's a pretty small universe—companies that are familiar, that don't need money, and that aren't publicly traded but want to be. So direct listings aren't that common. Two examples of ones from recent years are Slack and Spotify. Slack went public in June of last year at an opening price of $38.50. But when we spoke with Slack chief Stewart Butterfield on this podcast this past May, the stock was down to about $30. Just this month, Slack agreed to be bought out by Salesforce for cash and stock worth just under $44 based on Salesforce's recent share price. So shareholders who've held since the IPO have made a so-so profit. Spotify stock, on the other hand, has roughly doubled in price since it began trading in 2018. Pretty much all of that rise has happened since this past April. Meta, didn't, didn't our podcast launch a month before that, including on Spotify?

Oh yeah, it was right around the same time.

Is it safe to say that excitement over this podcast is probably what has doubled Spotify stock price?

I can't see what it is if not that. Right.

Well, Barnabas, you probably saw that DoorDash and Airbnb came public this past week. Those were traditional IPOs, sort of. In a typical IPO, the underwriters help set the deal price based on conversations with investors. Sometimes the price is well below what investors are actually willing to pay, and the price jumps on the first day of trading. That looks like a successful offering, but in reality, it means companies could have issued shares at a higher price and raised more money. That was the case with a lot of IPOs during the first half of this year. They shortchanged companies by an average of more than 30%. Let me tell you about two alternatives for companies that don't want to get shortchanged. One is issuing shares through what's called a Dutch auction. That's where the shares are allocated to the highest bidders. Alphabet used the Dutch auction when it went public back in 2004. Now, another alternative is what DoorDash and Airbnb are doing. That's called a hybrid model. Investors submit bids, but the companies and their underwriters determine the deal price and who gets allocated shares. Judging by the fact that DoorDash and Airbnb each posted eye-popping stock gains in their first day of trading, I'm not sure I can call the pricing a big success. Regardless of how companies go public, once they begin trading, anyone can buy in. I'm sure we'll get a chance to look more closely at DoorDash and Airbnb in the future. I'll just say a quick word about buying recent IPOs in general. A University of Florida professor named Jay Ritter keeps a scorecard of long-term performance for IPOs. From 1980 to 2018, He calculates that the average IPO underperformed the broader market by more than 17% over 3 years. But he also finds that returns were particularly poor for small companies with not much revenue. Big companies on average beat the market over the 3 years following their IPOs. Both DoorDash and Airbnb are big companies, but it might be a mistake to assume that the current time period resembles the average time period from recent decades. Valuations, as I said, look high in general. Every stock price is based partly on math and partly on emotion. DoorDash and Airbnb are promising, fast-growing companies, but it's possible that an investor who buys today could be right about the prospects for these companies and still lose money because overall market froth subsides. On the other hand, it's also possible that an investor could have bullish predictions for these companies that don't pan out in the quarters ahead but could still make quick profits because market conditions grow even frothier. If you're a trader looking to ride market momentum, none of this will bother you. But if you're an investor who makes predictions about company fundamentals and tries to buy at reasonable valuations and hold for the long term, I think it's an especially difficult time to size up fast-growing companies immediately after their IPOs. If you've carefully researched one of these companies and you feel confident about buying shares, then good luck, but don't buy in if it's only because you're worried about missing out. Thank you, Barnabas, for sending in your question, and everyone, please keep the questions coming. Just tape on your phone and send the recording in an email to jack.how@investingintheupside.com. That's H-O-U-G-H, at barons.com. It'll really lift Meta's spirits. Feeling any better, Meta?

No, I'm still feeling very sad. Nope.

No, you're definitely not. Thank you for listening. Meta Lootsoft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, You can follow me on Twitter. That's @JackHough, H-O-U-G-H. See you next week.

At Janus Henderson Investors, we believe working together is the way to work better. Like combining your portfolio plans and our in-depth strategies Your valued assets and our valuable insights. Your vision and our mission working in harmony to seek the right investment opportunities. Janus Henderson Investors. Investing in a brighter future together.