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Square Is Extending Loans Beyond Its Reach

Image source: Square.

After a slow start to the year, Square's (NYSE: SQ) lending arm, Square Capital, rebounded in the second quarter. It extended $189 million in loans to its vendors, up 123% year over year and 23% sequentially. The lending arm is seen as a key profit driver for the company, which got its start with payment processing.

To keep expanding Square Capital, the company is reaching out to partner with Upserve. Upserve provides similar services as Square -- point-of-sale, customer management, and so on -- but it's tailored for restaurants. Square will use Upserve's data to extend loan offers to its vendors in an effort to continue expanding Square Capital.

Using what it knows

Square CFO Sarah Friar addressed the potential for Square to expand Square Capital to non-Square hardware customers. "I think we look at all alternatives here, on, how can we grow the overall portfolio for Square Capital," she told analysts. "It may be using the muscle of what we know in terms of if we have payment data, how we are able to underwrite margins. Does that need to be our payment data? Not necessarily."

That sentiment was echoed by Jacqueline Reses, head of Square Capital, in an interview with Bloomberg. "So long as we believe that we have a data advantage in underwriting, and it's relevant to our core business, you can see us extending beyond Square further."

Working with Upserve adds 7,000 potential customers for Square Capital, and Upserve is adding 200 to 250 new restaurants every month. By working with Upserve's data, Square should be able to maintain its relatively low default rate and continue attracting investors.

But if Square can do it, so can everyone else

Square's strength may be in its ability to analyze payment data to determine creditworthiness, but it's not the only company doing so. Intuit (NASDAQ: INTU), for example, uses data from QuickBooks customers to extend loans and lines of credit through QuickBooks Financing.

It isn't nearly as big of a business for Intuit as Square Capital is for Square, but if Intuit ever wanted to put some pressure on Square, it has the power to do so. It expects to have over 1.5 million QuickBooks online subscribers by the end of the year.

With this move Square is demonstrating to competitors that you don't need to have the same assets as it does in order to follow the Square Capital business model. If you can develop an algorithm to analyze sales data as part of the underwriting process, you just need to partner with companies that have that data.

Can Square sell non-customers on its loans?

On Square's latest earnings call, Friar explained the biggest advantage of Square Capital is that it's "providing Square Capital into our installed base." With its partnership with Upserve, it's coming in with no established relationships with business owners. That makes the job of its marketing and sales teams much harder.

That means an increase in sales and marketing expenses, cutting into the margins of Square Capital. Additionally, Upserve is likely taking a cut from the loans as well, producing still thinner margins compared to sticking with Square hardware customers.

Square is still in money-losing growth mode, but this seems more like growth for growth's sake. Not necessarily the smartest investment.

That's especially true considering Square says it's still seeing plenty of demand from its own customers, and it's faced lending capacity issues already during the first quarter. Square could be setting up one of its most promising products for a decline in margins instead of profitability.

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Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Intuit. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.