Square – Not the Next PayPal

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Howard Mason


September 27, 2015

Re: Square – Not the Next PayPal

“You are simply asking for people that no one else would want to become your customers … [Square] is a terrible business model” Sam Hamadeh[1], CEO PrivCo, July 2015

“We don’t see ourselves building a payments company … we see ourselves building a commerce company” Jack Dorsey, CEO Square, Fall 2013

  • With Reuters[2] reporting on Friday that Square plans to file for an IPO in the next two weeks, we note that the $6bn valuation (30x estimated current revenue of $200mm net of processing and fraud costs) of the most recent financing ($150mm in October 2014) seems high. Investors are betting that, having established a beachhead providing payment services to micro-merchants (with annual card volumes of an average $35,000 – see Chart), Square can march up-market from this segment, which is not profitable even for incumbent scale players[3] because of turnover and fraud, to serve small-and-mid-sized (SMB) retailers. Rather than such Christensenian[4] disruption, we think it more likely that First Data (itself expected to raise $3bn at a valuation of $20-25bn in an October IPO) and Verifone (PAY) will march down market to the SMB segment from their core franchises serving large retailers (as PAY already has in the case of taxi fleet- and convenience store-owners, for example).

Chart: Purchase Volume per Active Merchant Outlet for Large US Acquiring Processors

Source: Nilson Report, SSR Estimates for Square

  • Square engaged micro-merchants through reducing the set-up costs for card acceptance with innovations in technology (using the headphone jack of a smartphone or tablet as a modem to transport card credentials) and business process (acting as the “PSP[5]” merchant-of-record for physical retailers on the Visa and MasterCard networks just as PayPal does for e-commerce merchants). However, unlike micro-merchants with a singular focus on reducing set-up costs, SMB retailers care about integrating card-payments into business management applications (including, for example, book-keeping, inventory tracking, and customer relationship management) and large retailers care about costs-per-transaction, terminal performance-management, and data-security.
  • While Square has responded to SMB needs by launching a series of business-management solutions through its Square Register app, it will not be able to compete with the feature-set offered by third-party developers on the app-stores of competing iOS/Android-enabled solutions, such as Clover Station from First Data, and the VHQ terminal management system from Verifone (PAY) which is preferred by large retailers over consumer-based platforms because it supports specialized approaches to data-security and terminal performance-management. A key difference between these solutions and that offered by Square is that Square Register is vertically-integrated with processing while First Data and PAY offer “app-store-connected-to-gateway” solutions that decouple the choice of front-end software from the choice of acquiring-processor.
  • We agree with PAY CEO Paul Galant that “the best way to use the [terminal] device is connected through a secure commerce architecture where everything is encrypted that touches it, pushes it to a gateway, and that gateway pushes it to the acquirer and makes a connection to whatever is going on online”. We expect SMB as well as large retailers to prefer PAY’s solution of an industrial-strength terminal-management system connected to a gateway over Square’s use of a consumer-based operating system bound to its own processing because of the advantages generated in terminal management and processor pricing:
  • Terminal Management: A difference between iOS/Android and VHQ is reliability: if a consumer smartphone dies it is an annoying inconvenience but outage of a merchant terminal can threaten lifeblood cash-flow through longer checkout times and lost sales. Like the industrial internet at GE, VHQ addresses reliability through an “internet of terminals” where a terminal is identified by an IP address, as well as serial number and location, and then serviced remotely with native applications for asset performance-management (including, for example, remote monitoring and diagnostics, lifecycle management, predictive maintenance, and operational intelligence).
  • Processor Pricing: Gateways provide an interface between front-end payments software and back-end processing into the Visa/MasterCard networks; the significance to industry-structure is that in effect they unbundle the choice of software from the choice of acquiring processor. This promotes price-competition versus the vertically-integrated model at Square (where the Square Register front-end software is bundled with the back-end processing) which will be favored only by micro-merchants with a singular focus on cost-of-set-up over cost-per-transaction. Over time we expect Square to unbundle Square Register from processing and offer it on the app-stores of competing platforms such as Clover and VHQ. While this may allow improved penetration of SMB and larger retailers, it leaves Square with the same pricing dynamics as the many other independent software vendors or ISVs in the market for business management apps.


With Square announcing the imminent filing of an S-1 ahead of a planned IPO, this note looks at the acquiring-processing market and the prospects for Square to grow through extending its franchise beyond early-adopting micro-merchants and to widen margins through selling value-added business-management software along with the low-margin core processing business. We conclude that both objectives will be challenging as Square is able to charge supra-competitive processing rates only by vertically-integrating its business-management software (delivered through the Square Register app) with processing. This is in direct contrast to the unbundled models for competitors, such as Clover Station from First Data running on consumer-based operating systems such as iOS, Android, and Windows and such as the VHQ terminal-management solution from Verifone (PAY). The latter is payments-specialized software supporting performance-management tools for terminals (including, for example, remote monitoring and diagnostics, lifecycle management, predictive maintenance, and operational intelligence) and secure connectivity between business-management apps and a payments gateway.

We believe open solutions will dominate among retailers (except those micro-merchants with a singular focus on reducing set-up cost) because they will allow access to a broader set of vendors and hence wider capabilities and more competitive pricing (particularly for the core payments processing itself). Square is then boxed-in to micro-merchants unless it chooses to unbundle Square Register from processing in which case it faces the same pricing dynamics as other independent software vendors or ISVs in the market for business management apps. As shown below, and discussed in our note of September 6th titled “PAY – The Apple Strategy for Merchant Devices”, our favorite name in the payments-hardware space is Verifone.

Square: Pre-S1 Estimates

Square, expected to file an S-1 in the next two weeks[6], opened up the market of micro-merchants (i.e. with an average $35,000 in annual card sales) to card-acceptance through: (i) using the headphone jack on a smartphone or tablet as a modem to transport card credentials via a dongle; and (ii) obtaining network approval in 2011 to act as merchant-of-record so that end-merchants were not required to establish an acquiring account and incur the associated compliance costs for handling sensitive card data. However, standalone, the micro-merchant segment is not profitable, despite Square’s fees of 2.75% fees of purchase price and scale in servicing ~1mm merchants[7], because of high turnover and fraud costs. Specifically, the WSJ reports[8] Square had negative earnings of ~$100mm in 2013 and has burned through over one-third of the $490mm equity-financing raised since 2009 (with the last round of $150mm in October 2014 at a valuation of $6bn on gross 2013 revenues of $550mm netting down to just over $100mm after fraud and pass-through processing costs).

The $550mm revenue-estimate is based on the typical 2.75% fee on processing volume reported[9] in April 2014 for 2013 of $20bn. Since then, Square has indicated that its annualized processing volume is between[10] $30 and $40bn (since, collectively[11], Square’s micro-merchant clients would be the 13th largest US retailer – see Exhibit 1, left panel). Assuming $35bn, and adjusting for interchange and processing costs at an assumed average of 1.8% and fraud costs at 0.4%, this puts the firm’s revenue, net of pass-through fees and fraud, at ~$200mm. Even if Square Capital (which provides merchant-clients with cash-advances on sales) delivers a net interest margin of 20%, the revenue contribution is marginal at ~$20mm given total loan balances of “over $100mm”. Equipment sales are also likely to be revenue-marginal given the “dongle” (aka mag-stripe reader – see Exhibit 1, right panel) is distributed at no charge and sales of the more complete POS system, Square Stand which provides a fixed-dock for a tablet and retails at $99, are early-stage.

Exhibit 1: Square Merchant-Sales (in US vs. Large Retailers) and Product Line

Square: Evolution of the Business Model

Square’s technology-innovation was to use the headphone jack (as a modem in effect) on a smartphone to transport card credentials from its card-reading dongle to an app and hence, via the cloud, to Chase Paymentech which acts as Square’s acquiring processor. As a merchant-aggregator (a payment-service-provider or PSP in the lexicon of Visa[12] and MasterCard), Square submits the transactions under its own name thereby obviating the need for merchant-clients to establish their own merchant-accounts and substantially simplifying the on-boarding process for accepting card payments (since merchants that submit transactions under their own name must go through a burdensome process to ensure data-security through compliance with purchase-card-industry or “PCI” standards). The combination of using a smartphone or tablet to accept card payments, rather than a specialized POS terminal, and removing the need to establish an acquiring account, lowered the barriers to card-acceptance for micro-merchants so that Square found a market among vendors at farmers markets, out-of-town taxi cabs, and garage sales.

Given high turnover and fraud risk, this is not a market that was served by, or attractive for, traditional acquirers so that the impact of Square was more to convert cash transactions to card than shift card-transaction share from incumbent acquirers to Square and Chase Paymentech as its processing partner. It is also not a profitable market on a standalone basis and Square’s initial vision was to use the segment as a beachhead first to build out, as PayPal has done, the consumer as well as merchant end of the payments ecosystem and second to moved up-market with merchants. After the 2011 launch of its mobile wallet, Card Case (later rebranded “Pay with Square”), Square advanced both objectives with the startling announcement[13] in mid-2012 that Starbucks would switch its card-processing from Bank America Merchant Services to Square[14], would accept the Square wallet, and that CEO Howard Schultz would join Square’s board[15]. However, the consumer side of Square’s initial vision at point-of-sale[16] has since fizzled; the Square wallet was discontinued for point-of-sale payments in May 2014 failing largely because, unlike in the case of PayPal online, it did not meaningfully reduce authentication friction versus the card-swipe alternative[17].

Today, Square has a more singular focus on merchant services albeit also looking to explore whether these services can create advantage for itself as a merchant (through the acquisition of food delivery start-up Fastbite in April 2015, for example) as well as for its merchant-clients, and extending its footprint geographically (through partnering with Xoom, now owned by PayPal, in the Hispanic start-up alliance “Soy Empresaria” launched in November 2014). A key initiative is the attempt to move up-market from micro-merchants with VNTV CEO Charles Drucker commenting last November that “they found part of the market that for us wasn’t big … but [then] they got creative and figured out how to displace the terminal”. The cornerstone of this attempt at disruptive innovation[18] is the Square Register app which incorporates features that moderately-sized retail stores need. In addition to Square Capital (launched in March 2015 and basing underwriting on sales data), these business management solutions include inventory tracking (launched with Square PickUp in April 2014), customer communications and order-ahead (launched with Square Feedback and Order respectively in May 2014 and expanded to support email marketing in April 2015), book-keeping and CRM-support (launched with Square Analytics in August 2014), charge-back protection (launched in March 2015), and omni-channel support (through partnering[19] in March 2015 with BigCommerce and Weebly to support micro-merchants with out-of-the-box e-commerce solutions).

Square Register runs on iOS or Android and so requires retailers to compatible hardware. While this is no obstacle for micro-merchants using smartphones or tablets to accept card payments, or larger retailers equipping sales associates with tablets for mobile point-of-sale (as at Apple, for example), it creates a barrier to adoption for retailers using traditional cash-registers which do not run an operating system at all. The purpose of Square Stand, which acts as a fixed docking station for a tablet with a built-in card-reader, is to replace a “dumb” cash-register with an iOS or Android-compatible device that can then run Square Register. To some extent, Square is adopting a razor-and-blade strategy since its hardware is low-cost (free for a mobile dongle and $99 for Square Stand[20]) but locks the retailers into processing with Square and into the business management apps available through Square Register which, while expanding, still have limitations; for example, the support for third-party gift cards and loyalty programs is not as strong as that provided by competing solutions.

Competitive Response of Incumbents

Incumbent acquiring processors, while not concerned with micro-merchants, have moved to protect their small-and-mid-sized (“SMB”) retailer-franchises from Square/Chase-Paymentech by launching iOS/Android solutions of their own including Clover Station from First Data[21] (which, unlike Square Stand, is specialized hardware rather than leveraging a general-purpose tablet and integrates a receipt-printer and cash-drawer as well as a card-reader – see Exhibit 2). The economic challenge for Square is that the SMB segment is the most profitable business for acquiring processors and they are offering competing hardware/business-management software solutions to protect these franchises rather than to profit directly; Square, on the other hand, needs to monetize Square Stand and Register given that the firm is not profitable, and unlikely to become so given scale effects are mitigated by high variable cost, based on standalone processing for micro-merchants.

Exhibit 2: Tablet Docking Stations as Cash Registers

The result is asymmetrical competition in which First Data, expected[22] to raise $3bn in an October IPO for a valuation of $20-25bn, can offer Clover as an open system allowing retailers to select software from third-party developers via the Clover App store (and, indeed, select processors other than First Data[23]), while Square is a closed system where retailers purchasing the Square hardware can access only Square Register for business management apps and must process through Square. While Square’s vertically-integrated solution can work for micro-merchants who are concerned more with ease-of-set-up than ongoing cost-per-transaction or broader business-management capabilities, it becomes less interesting for larger-volume merchants where higher set-up costs are justified by the opportunity to select from a range of processor and business-management solutions.

The Limitations of Consumer-Based Platforms for Large Retailers

The broader question is whether payment terminals powered by consumer-based operating systems such as iOS and Android make sense for larger retailers. PAY, looking to defend and grow their business for specialized POS terminals (rather than general-purpose tablets), argues that it does not because of the specialized requirements of a POS terminal particularly around security and asset-performance. As PAY CEO Paul Galant puts it “the best way to use that [terminal] device is connected through a secure commerce architecture where everything is encrypted that touches it, pushes it to a gateway, and that gateway pushes it to the acquirer and makes a connection to whatever is going on online”. The significance of the gateway to industry-structure is that it lowers switching costs for acquiring processors and so is directly opposite to Square’s attempt to be the captive processor for Square Register.

Indeed, as PAY looks to standardize a specialized terminal-management system branded as Verifone Headquarters or VHQ, it is opening it up to third-party developers via its own app-store so that (as in the case of Clover Station from First Data but in contrast to the vertically-integrated solution from Square) terminal hardware, business management software, and processing back-end are unbundled. We expect this to emerge as the preferred model for all but micro-retailers with a singular focus on up-front costs because of the range of offerings and competitive dynamics it supports. This leaves Square without a route up-market except as an integrated software vendor or ISV provisioning Square Register onto third-party platforms such as Clover and VHQ, and therefore unbundling the software from processing at supra-competitive rates.

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. The analyst principally responsible for the preparation of this research or a member of the analyst’s household holds a long equity position in the following stocks: JPM, C, BAC, WFC, and GS.

  1. http://www.marketwatch.com/story/square-ipo-a-tough-sell-for-jack-dorsey-2015-07-27
  2. http://www.reuters.com/article/2015/09/25/square-ipo-idUSL1N11V28020150925
  3. Square outsources back-end processing to Chase-Paymentech but maintains the relationship with the end-merchant and bears the fraud risk.
  4. https://en.wikipedia.org/wiki/Disruptive_innovation
  5. Typically, merchants accepting cards for payment must open an account at an authorized “acquiring” bank to underwrite their obligations on the Visa system and comply with the Payment Card Industry (PCI) standards for data-management. In 2000, Visa introduced the idea of an internet payment service provider (IPSP) which could act as the merchant-of-record for smaller third-party e-commerce merchants thereby allowing them to accept card payments by piggy-backing on the acquiring account and PCI-compliance of an IPSP; this reduced the costs of setting-up for card acceptance among small merchants and was the catalyst for growth in the segment at PayPal. In 2011, Visa extended the idea of a payment service provider from e-commerce to physical retailers and made a strategic investment in Square.
  6. http://www.reuters.com/article/2015/09/25/us-square-ipo-idUSKCN0RP29Z20150925
  7. http://www.wsj.com/articles/square-gets-150-million-lifeline-1412639052
  8. http://www.wsj.com/articles/SB10001424052702303825604579513882989476424
  9. http://www.wsj.com/articles/SB10001424052702303825604579513882989476424
  10. 2014 revenue of Publix was $30.6bn and Best Buy $40.6bn.
  11. https://squareup.com/townsquare/100m-day/
  12. In 2011, just as it made a strategic investment in Square, Visa expanded its internet-payment service provider (IPSP) model allowing aggregators, such as PayPal, for e-commerce merchants to a more general payment service provider (PSP) model allowing aggregators, such as Square, for physical as well as e-commerce merchants.
  13. https://www.youtube.com/watch?v=T6Gvg-n-L4g
  14. WSJ reported that Square’s for processing Starbucks’ card transactions was just over 2% leaving it with a loss of at least $20mm in 2013.
  15. Mr. Schultz left Square’s Board in October 2013.
  16. Square has repositioned the wallet from POS to P2P payments with Square Cash, launched in October 2014, using BLE for proximity payments and Square providing the processing for SnapCash launched on SnapChat in November 2014.
  17. Online, the alternative is not a card-swipe but entering a 16-digit card number; PayPal does reduce authentication friction relative to this by requiring shoppers to enter only a user-name and password. Offline, Square did not meaningfully improve on the card-swipe even with geo-fenced enabled authentication based on face recognition and, in the case of Starbucks, required a QR-code based process which can be slower than a card swipe.
  18. In disruptive innovation, a newcomer establishes a differentiated business model in a segment that incumbents view as unattractive and then uses the scale and capabilities developed in this beachhead to invade the value-networks of incumbents.
  19. http://www.paymentssource.com/news/retail-acquiring/square-makes-an-ecommerce-appeal-to-small-merchants-3020709-1.html
  20. A competing system from First Data, called Clover, retails for $999 but can actually work out more cheaply than Square since it includes a tablet, receipt printer, and cash drawer all of which together can run at more than $1,000 and sometimes substantially more if a high-end iPad is used.
  21. Beyond offerings from independent acquiring processors, technology companies also offer dongles, including Local Register from Amazon (which meaningfully undercuts Square by charging 1.7% of transaction value) and PayPal Here as do bank-owned acquiring processors including Bank of America and USB/Elavon.
  22. http://www.wsj.com/articles/first-data-aims-to-raise-3-billion-in-ipo-1442859911
  23. In this sense First Data, as a top-3 acquiring-processor in the US, is looking to shape industry structure and prevent Square (and hence its processing partner Chase Paymentech) from establishing leadership in iOS/Android-enabled POS devices.
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