Can Jack Dorsey’s Square Succeed in Micro-Lending to Food Carts and Shop Owners?

Can Jack Dorsey’s Square Succeed in Micro-Lending to Food Carts and Shop Owners?

Original Article on TheStreet

Jack Dorsey, CEO of Square, is certain he’s well on the road to remaking commerce in the 21st century.

His digital payments and services company has become enormously popular with small-business owners, especially those who work outside of a traditional office. For self-employed merchants, Square’s wireless dongles have made it possible to accept credit card payment wirelessly, bolstering sales for everyone from food truck vendors to locksmiths making house calls.

While few doubt Dorsey’s hardware offers great promise, his San Francisco company has struggled to convince investors that Square has the resources to compete with similar services from Apple, PayPal Holdings and First Data, among others. Dorsey also has had to calm fears that his second job as CEO of Twitter is diverting his attention away from Square.

Square CEO Jack Dorsey

Questions also have been raised about the sustainability of its micro-loan program, Square Capital. Square makes cash advances and direct loans to some of the more than 2 million users of its payment devices. These borrowers use its software to manage inventory and analyze sales data, affording Square insights into how they’ll handle a cash advance or a loan.

Dorsey was in Boston this week along with his finance chief, Sarah Friar, to assuage investors who turned on the shares earlier this month when Square reported that loans and cash advances to clients increased just 4% in the first quarter to $153 million because of “challenged credit market conditions.”

Analysts were expecting a higher growth rate. Square shares tumbled 22% on May 6, after it reported earnings, and the stock has declined 24% this year.

One concern about Square Capital is the quality of its due diligence. “We believe the exclusion of cost data, balance sheet data and management qualifications, combined with sales data that only spans an economic boom, severely limits the underwriting quality for [merchant loans],” Wedbush Securities technology analyst Gil Luria said in an investor note Tuesday.

Secondly, Luria disputed Square’s insistence that repeat loan business is a sign of healthy growth. Instead, Luria argued, a small-business owner coming back for a small loan “may be a red flag.”

The reasoning behind the loan program is a good one. “Small businesses just don’t have access to capital,” Friar said at JP Morgan‘s annual telecom, media and technology investor conference in Boston on Tuesday. Square’s average loan size is $6,000 to $10,000, indicating the financing is aimed more at cash flow than seed money.

Square uses third-party investors to underwrite the loans and advances, and Friar said it has secured two more investors for the program.

“By having a stronger spotlight on the lending space, it’s allowed us to really tell our story,” she added, referring to the fallout following the release of Square’s first-quarter earnings report. “From the install base to the data that helps us underwrite loans to the way it’s cohesively linked into our platform, we’ve seen really strong customer interest.”

Unfortunately for Square, its loan program has been met with confusion and doubt, BTIG financial analyst Mark Palmer wrote in an investor note on Wednesday. The confusion, he said, stems from how Square’s lending practices differ from those of a traditional bank. 

For one, Square gets its cash advances repaid each time a client uses its service to swipe a credit card, about 2.75% of its sale. Additionally, Square doesn’t use interest rates on loans, Palmer explained, but instead charges a one-time fee. Square is emphasizing loans over cash advances to allow businesses to pay off their debt more quickly.

“While investor demand for Square Capital’s loans remains the key to the platform’s viability, we believe Square’s unique access to the operating data of its applicants that facilitates better credit decisions and low defaults … translates into a compelling investment opportunity,” Palmer said.

Square’s recent market troubles might simply be an issue of communication or legitimate concerns about a startup entering a business as risky as banking. The Great Recession took down Bear Stearns and Lehman Brothers, each many times larger than Square. 

Nonetheless, investors also have grown impatient with the company’s long slog to profitability. While sales jumped 51% in the first quarter to $379 million, beating analysts’ expectations of $345 million, Square reported a wider-than-expected loss of 29 cents a share. In Boston on Tuesday, Friar reiterated that Square’s 2016 earnings excluding some costs would “break even.” 

Ironically, shares in the company surged Tuesday after investment bank BTIG raised its rating on the stock and tossed out the possibility that “a takeout at a healthy premium is a real possibility.” Short-sellers who have been circling Square for months were forced to buy shares to cover potential losses as Square jumped 7.2% to close at $10.14. (Shares were off slightly on Wednesday afternoon to $10.07.)

Friar, reflecting the unflappable demeanor of her boss, seemed unfazed by concerns over Square’s lending program, its march to profitability or the roller-coaster performance of its stock price.

“We’re still looking at the market opportunity ahead of us, which is still massive,” she said. “We want to be mindful to grow in a way that can appreciate, so we will continue to invest to grow, but we’ll do it mindfully and let some of that profitability start to show through starting now in 2016.”

That’s something investors would like to see.