At $29 Billion, Square Overpays For Afterpay

Square — the San Francisco-based payments processing company — plans to use $29 billion worth of its stock to acquire Melbourne Victoria, Australia-based Afterpay, a provider of installment payment services.

This raises a question in my mind: Why is Square paying nearly 30% of its stock market capitalization for a company that’s growing more slowly than Square and generated a mere 4% of its revenues in 2020?

I can’t figure out an answer and I view the massive overpayment as a reason to sell its stock.

Square is exuberant about this deal. As Jack Dorsey, Co-Founder and CEO of Square, said in a statement, "Square and Afterpay have a shared purpose. We built our business to make the financial system more fair, accessible, and inclusive, and Afterpay has built a trusted brand aligned with those principles. Together, we can better connect our Cash App and Seller ecosystems to deliver even more compelling products and services for merchants and consumers, putting the power back in their hands."

Beyond a shout out from Jim Cramer, I can see no reason to justify the 8% surge in Square’s stock.

(I have no financial interest in the securities mentioned in this post).

Square and Afterpay’s Second Quarter Results

Square fell short of analysts’ revenue expectations in the second quarter. According to MarketWatch, on August 1 Square reported second quarter revenue of $4.68 billion — up 144% from the year before — but $350 million short of what analysts polled by FactSet expected.

Square’s bitcoin revenue rose 207% to $2.72 billion while its transaction revenue of $1.23 billion increased 81%, according to MarketWatch. In addition, Square’s adjusted earnings of 66 cents a share beat analysts’ expectations by 113%.

Afterpay provides installment credit services to consumers. Its “technology allows users to pay for goods in four, interest-free installments while receiving the goods immediately. Customers pay a fee only if they miss an automated payment, a transgression that also locks their account until the balance is repaid,” according to the Wall Street Journal.

It’s a fast growing, cash immolating business that would represent a tiny fraction of Square’s business.

In 2020, Square’s revenue grew 102% to $9.5 billion. Afterpay’s top line of $384 million — 4% of Square’s -- was up an impressive 97%. Afterpay’s negative free cash flow of $188 million represented the highest in a four-year string of FCF-immolating years.

What Square Gets From Afterpay

Square said that one of the big attractions of Afterpay was its ability to do business with younger consumers who are feeling “a growing wariness toward traditional credit,” according to the Journal.

These consumers who have been particularly hard hit by Covid-19 related lockdowns -- which “crushed many hospitality and casual jobs” — help generate most of Afterpay’s revenue. That’s because retail merchants pay the company a percentage of each consumer order plus a fixed fee.

Afterpay succeeded where Square did not. As the Journal wrote, “In 2017, the company began offering financing options to consumers through its business clients that also used Square to send and manage their invoices. But the service never really took off.”

Square aspires to tie Afterpay’s installment loan technology into its Cash App — a digital payment services that allows people to store and transfer money. Square’s Cash App enjoyed massive growth in 2020 as consumers used it to

• Deposit pandemic stimulus checks,
• Send money to friends and family,
• Make purchases online with their Cash App debit cards, and
• Buy bitcoin and stocks through Cash App Investing, noted the Journal.

Square envisions that Afterpay customers will be able to use Cash App to make payments on their installment loans and to find merchants that offer Afterpay’s financing.

I question whether that additional revenue will be enough to offset the decline in future Cash App revenue resulting from the end of the stimulus checks as the pandemic ends.

How Much Is Square Overpaying For Afterpay?

Why not just form a partnership with Afterpay instead of paying $29 billion to acquire it — a 31% premium over its market value?

Given that Afterpay is burning through cash, it is hard to envision a scenario in which this expensive deal would pay for itself.

I see two possibilities:

• Square could cut Afterpay’s costs and increase its revenues enough to create positive net cash flow. In theory, enough additional cash flow from the deal in current dollars could more than offset the $29 billion deal price.
• Afterpay would add so much revenue to Square’s top line that Square could exceed analysts’ revenue forecasts significantly — which would boost its stock.

The numbers do not seem to make either option look feasible. After all, CashApp has 40 million actively-transacting users while Afterpay has 3.6 million users, noted the Journal.

If all CashApp’s users signed up for Afterpay, Square’s revenues would increase. Is that realistic?

Perhaps not — after all, the installment industry is highly competitive and Afterpay is not on solid regulatory ground. As the Journal noted, “some banks are now offering installment plans for purchases. [And] PayPal’s PYPL Pay-in-4 product mimics Afterpay in allowing shoppers to pay in four, interest-free installments but is cheaper for merchants than Afterpay.”

If such competition does not threaten Afterpay, increased regulatory scrutiny could. “Afterpay skirts the definition of a loan under some U.S. laws so isn’t subject to the same regulation. The state of California reached a settlement with Afterpay in April last year over what it said were illegal practices,” wrote the Journal.

I don’t know how much Square is overpaying for Afterpay, but whatever the amount, I don’t see how the revenue and cash flow from the deal will offset giving 30% of its market value in exchange for a money-burning business that will add only 4% to its revenues.