Square Stock Has Way Too Much Exposure Because of Its Loan Business

Stocks to sell

Square (NYSE:SQ) is a leader in the fast-growing, competitive fintech industry, but Square stock has had a volatile year adding only a little more than 1% since January.

Square Stock Has Way Too Much Exposure Because of Its Loan Business

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As of Oct. 22, shares of Square resided more than 29% below the 52-week high. Conversely, the Global X FinTech ETF (NASDAQ:FINX) is 12.43% below its 52-week. Year-to-date, FINX is higher by 24%.

A case can be made that Square’s year-to-date gain is rather deceiving. The stock closed just under $59 on Oct. 22, but in October 2018, it was flirting with $100. Technical bulls may argue that there’s a sizable gap that needs to be filled due to a massive August slump that could take Square stock back to $80.

Identifying when that gap will be filled, well, that’s another matter. Sure, there are potential near-term catalysts for Square stock. The company reports third-quarter earnings on Nov. 6. The company is expected to earn three cents a share, but more important will be any revealing on 2020 guidance.

“We sense many investors may be waiting for some type of clearing event in order to become more constructive on shares,” said Bank of America analyst Jason Kupferberg in a note out earlier this month. “In our view, this could come in the form of preliminary 2020 guidance, which we think is currently an overhang.”

Problems Could Be Brewing

In a recent analysis of Shopify (NYSE:SHOP), I noted that small- and medium-sized businesses (SMBs) are notoriously volatile and contend with high failure rates. That’s something to consider with Shopify and with Square stock because with the latter, it’s SMBs that are that company’s bread and butter.

I’m not ringing the alarm bells on a recession quite yet, but if that economic scenario arrives, it would be bad news for Square stock and not just because payment processing volume would likely decline. Another reason a slowing economy or outright contraction would punish Square is the company’s increasing SMB loan exposure.

This is something other fintech companies are guilty of, too. As one example, PayPal (NASDAQ:PYPL) offers loans to merchants that frequently use that platform. However, as I noted last month, Square Capital’s increasing loan exposure (now north of $4.5 billion) is problematic if a recession arrives because defaults are likely to spike.

Additionally, there’s a dirty little secret with Square Capital’s “loans.” I’m using the quotes there because the company calls these things loans, but what they really are something called a merchant cash advance (MCA). With MCAs, borrowers repay the lender on a daily basis, every day banks are open.

There’s nothing unique about MCAs, aside from the fact that only a loan shark would charge a higher rate of interest. These products have been around for years and for business owners that are desperate enough to need an MCA don’t need Square.

Hundreds, maybe thousands of companies across the U.S. offer MCAs. Said another way, in the small business lending realm, Square isn’t doing anything special and has no competitive moat.

Bottom Line on Square Stock

Yes, there’s a chance Square stock will rise again and it can hard if not risky underestimating the crowd’s enthusiasm for companies that appear to be “techy” and doing something unique.

The market views this as a growth stock (54.6x) forward earnings when the traditional financial services sector is the cheapest on valuation in the S&P 500. Another market against Square stock is its lack of moat.

“We see Square as a narrow-moat niche operator, not a disrupter, with market share limited by its relatively high pricing and long-term margins constrained by its relative lack of scale,” according to Morningstar. “We think the company’s most value-creative long-term opportunity lies in expanding internationally, as opposed to displacing leading domestic acquirers.”

As of this writing, Todd Shriber did not hold a position in any of the aforementioned securities.

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