Investors following Square (SQ -1.97%) because of its acquisition of Tidal and aggressive investments in Bitcoin are missing the company's most enticing advantage. Square has the opportunity to rapidly become a one-stop-shop for financial services in a huge, underserved market by utilizing customer data in a way big banks can't.
Credit cards are just the beginning of the financial services Square's Cash App could offer. Image source: Square.
Big payoffs in 2020 and beyond
The Cash App is the heart of Square's disruptive effect on the banking industry. As of the company's last shareholder letter, Cash App's revenue and gross profits grew 400% and 162% year over year, respectively, with its monthly active user base up 50% to 36 million monthly active users. Cash App represents the largest, fastest-growing piece of Square's business, providing 63% of its $9.5 billion in total net revenue in 2020. In comparison, Square's Seller ecosystem revenue grew only 2%.
Cash App's rapid growth is important -- and unique -- because it homes in on a market that big banks can't afford to take on profitably: The unbanked and underbanked.
According to the most recent Federal Deposit Insurance Corporation (FDIC) report, 7 million U.S. households are unbanked, meaning no one in them has a bank account. An additional 20 million U.S. households are underbanked, meaning at least one member holds a bank account, but also utilizes supplementary financial services like payday loans. These two segments combined represent over 20% of the American population.
Thanks to its low marketing costs and otherwise comparably lean business model, Square can take on lower-income clients (including the unbanked and underbanked) for small-scale financial services while still turning a profit.
How Square can beat big banks
Square pays only $5 to acquire a Cash App customer; big banks' customer acquisition costs start at several hundred dollars. New Cash App customers come cheap because of the app's popularity in pop culture and social media, as well as its high volume of peer-to-peer transactions (when an individual sends money to another individual, who may or may not already be a Cash App user).
The number of peer-to-peer money transfers on the Cash App increased by almost 50% year over year in 2020. When users send money to friends who don't have the app, they create new Cash App customers -- a viral, potentially exponential growth effect. According to Square, that's one of the main ways Cash App attracts more users.
Now Square is in a better position than ever to serve the unbanked/underbanked and lower-income markets, with a newly granted bank charter and increased focus on Cash App customer acquisition. Square is planning specifically to increase product development, marketing, and SG&A spend by $800 million to $900 million in 2021.
Spending more to add new services and features to Cash App could help Square make each user more profitable. Meanwhile, those users keep bringing in additional users every time they send money to a non-user.
The PayPal problem
Despite Square's edge over big banks, industry giant PayPal (PYPL -1.83%) and its app Venmo present a formidable competitor. But even though PayPal boasts a huge active user base of 377 million, Venmo (with its 50 million active users) still isn't profitable -- unlike Cash App, which generated over $1.2 billion in gross profits in 2020.
PayPal management expects Venmo revenue to hit $900 million in 2021, while remaining unprofitable for the foreseeable future. Additionally, Venmo operates a bit more like a social network based around peer-to-peer transactions than the robust financial services app into which Cash App is evolving. Partially thanks to its wider range of features, Cash App's monthly growth rate rapidly exceeded Venmo's during the pandemic.
Whereas Cash App is a major focus for Square in terms of product development and customer acquisition, PayPal only mentioned Venmo five times in its 67-page 2021 Investor Day deck, instead focusing on its merchant ecosystem (including in-person strategy) and new "buy now, pay later" feature.
What this could mean five years from now
Square collects a trove of data on both individuals and small businesses in the process of providing services to its clients. There are many directions into which Square could conceivably branch out in utilizing this advantage beyond the standard small business loan offering.
Square might utilize its customer data for third-party advertising. Though the company hasn't announced any such plans yet, its Boost cashback rewards feature might make a great opportunity to target customers for specific offerings from third parties.
Square also has access to more than enough cash flow information to write loans to its clients without running credit checks and going through the manual screening steps that big banks do. It can also afford to offer smaller loan amounts, starting as low as $300 for small businesses. This concept could translate easily to other applications: Credit cards, mortgages, insurance, individual loans, and so on.
Cash App costs individuals less than traditional bank services, doesn't require a credit check, and has no requirement for minimum balance (which is the most commonly cited reason for unbanked individuals not holding a bank account, according to the FDIC). And the more offerings the company can provide, the better it will be able to convert new and existing users to one simple, vertically integrated banking system.
What's next for Square
Square stock seems to be an expensive buy, with a price-to-earnings (P/E) ratio upwards of 500 -- but there's more to the story. Square is in its early stages of growth relative to competitors like PayPal (with its P/E ratio of 72), so it's investing a significant amount of its top line back into the company to support growth.
When we look at its price-to-sales ratio instead, Square's 11.7 is lower than PayPal's 13.7. Long-term investors in Square can ride out most of the short-term volatility surrounding Square's current valuation by staying focused on the future, as the company continues to grow quickly and shifts its focus from the top line to the bottom line.
That said, Square will have to execute effectively on product development and marketing in 2021 to take on PayPal's massive user base and establish itself as individuals' preferred financial services app.
