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Square’s Miniature Margins and Why Investors Shouldn’t Worry

Under closer inspection it would appear that Square's (NYSE: SQ) transaction margins -- which currently make up the bulk of the company's revenue -- are pretty slim. However, have no fear. Square's numerous other high-margin offerings will more than make up for this. Fool.com analysts Dylan Lewis and Sarah Priestley discuss the mechanics of Square Capital -- how it works and why investors should be paying close attention. The analysts also touch on why Square is driving for bigger businesses in this clip from Industry Focus: Technology.

A full transcript follows the video.

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This podcast was recorded on Aug. 19, 2016.

Dylan Lewis: One of the interesting things with them, to go back to this idea of them not being a processor, is that they lean quite heavily on the existing payment infrastructure for how they operate. And you see that in the breakdown of how much they take on a lot of the transactions that they process.

Sarah Priestley: Absolutely. They take 2.75% cut of every amount that you receive. At first glance, that seems like quite a lot. But actually, 0.15% of that is taken from MasterCard (NYSE: MA) or Visa (NYSE: V), and they enable the transaction tap and they do the ...

Lewis: The actual processing.

Priestley: ...the actual processing, yeah. And 2% is taken from the bank that releases the funds. So, they're left with 0.6%.

Lewis: Which is razor-thin as a margin.

Priestley: It's tiny, yeah. It really is. We'll probably talk about this later, but it really shows, the transaction processing for them is really their entry point into the market to offer all these great other services that they do.

Lewis: We started talking a little bit about some of the different product offerings that they have. Most people encounter Square (NYSE: SQ), they're at a farmers market or some local store or something like that, and they see something they want to buy, and they have the merchant with a dongle in an iPhone or an iPad or some sort of other tablet device, and they just get built like that, the same way they would at point-of-sale. That's how most people encounter it. 

The reality is, on the seller side, there's a pretty robust offering that Square has been building out. I think they've been forced to do that because the margin business on payment facilitating just really isn't all that great. You touched a little bit on Square Capital before. Do you want to dive into that a little bit more, and some of the benefits that it offers to sellers?

Priestley: Absolutely. I think Square Capital indicates a unique insight into the small business world. Just a bit of background on this: it's very difficult for small businesses to acquire loans. Usually, you have to have been in operation for two years, have about $250,000 on your revenue, and also have collateral, usually a house, to secure the loan. This doesn't require you to have that. And the brilliant thing behind it is that Square has access to a huge amount of sales data. They're processing every single one of your transactions. That means they can see if you have slow periods, what your good days are, what your bad days are, what your drum beat is like. And they use all this data to offer you a loan that they know you will be able to repay. The repayment of that is usually 10% to 11% that's taken from the gross payment value daily from that customer.

Now, Square doesn't fund these loans, that's the important thing. They're basically a facilitator. They take all this data, they analyze it, look at it scientifically, and see who is prospective for the loan. And then they pair those with investors. And what this has resulted in is a really good averaged default rate of 4%.

Lewis: That's incredible.

Priestley: It is, yeah. In 2014, for small businesses, the average default rate was around 7%. Understandably, this has grown hugely for them. In the second quarter of 2016, they extended $189 million, which was up 23% sequentially, 123% year over year. That's an explosion of growth. They added five investors in the last quarter. And it makes sense from an investor's point of view. This is a pretty safe loan in a very unsafe territory traditionally.

Lewis: Yeah. And those are the two metrics that you want to key in on to see the success of this segment. The amount that's extended continuing to rise, and the people that are interested on the financing side continuing to rise, then, adding new investors. That's a proof of concept in a stamp of validation that investors are seeing the ROI and they're not getting stuck with bad loans that they're offering out.

To give you a sense of why this is so valuable for Square, the sellers that use their platform, you look at their customer mix, and most of them fall into that small business loan category.

Priestley: They do. They're definitely improving the mix. If you look at the past quarter, second quarter of 2016, 58% of their customers were under $125,000 annual gross GPV.

Lewis: Which is gross payment volume. That's basically the total amount that they're processing via Square.

Priestley: Yeah. 28% were between $125,000 and $500,000. Then, only 14% were above $500,000. That mix has drastically improved from where it was in 2014, when there was only 7% above $500,000. Understandably, and if you even glance at either of the past two earnings calls, you'll see the term "up market" thrown about many times. What they mean by moving up market is that they want to access more of these higher-earning companies.

Dylan Lewis has no position in any stocks mentioned. Sarah Priestley has no position in any stocks mentioned. The Motley Fool owns shares of and recommends MasterCard and Visa. 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.