When Square (SQ +2.34%) CFO Sarah Friar was asked in the company's most recent earnings call about the prospect of extending Square Capital beyond the company's current customer base, she said the company needs to "look at all alternatives" on "how can we grow the overall portfolio." She elaborated:
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.
"Not necessarily" using Square's own payment data? That seems like a big -- and wholly unwarranted -- red flag to me.
Giving away an advantage
As a payment service processor, Square analyzes payment data that it has unique access to, and it uses that information to offer what's usually a micro-loan to its customers. Rather than fronting the loans, Square is a conduit matching outside investors with small businesses. The loans are usually repaid by automatic deduction, as a percentage of the customer's daily gross payment volume. This system has produced great results for both the small companies involved and for Square, with a 4% default rate that beats the average rate of about 7% on small-business loans. In the past year, Square Capital has grown 122%, and now the "software and data" division -- of which Square Capital is a part -- accounts for 18% of Square's net income.
Square is inextricably linked to the companies it serves by virtue of being inside their day-to-day operations -- not just through transaction services but also with its many software offerings. At the time of Square's 2015 IPO, it had 2 million active customers using its products. Every time each of those 2 million customers accepts a payment, Square receives a cut of the transaction -- and just as importantly, it gains vital insight into that merchant. Moreover, the data Square uses to analyze loan eligibility is easy to obtain, accurate, and up to date.
That amounts to a perfect recipe for making small-business loans. So if Square doesn't "necessarily" need to use its own data, as Friar suggested, it seems as if the company would be sacrificing its most crucial advantage.
Flexing its "muscle"
The "muscle" that Friar said Square has at its disposal is essentially the system it uses for underwriting -- the data-analysis algorithms that establish candidates for loans and weigh up risk. The statement suggests that Friar views this system as Square's core advantage, not the quality of the data itself or the relationship with its customers.
And she may be right. Small-business loans are traditionally risky and unprofitable, which is why Square has such a great opportunity if it can be successful in this niche. Financial institutions have been trying to perfect underwriting for years and still struggle to identify the winners -- the average 7% default rate speaks for itself. Earlier this year, Friar described Square as "a commerce ecosystem at the end of the day, not a financial institution," but is Square suggesting that its recent experience with underwriting has produced such an exceptional algorithm as to be better than established banks?
Either way, going outside its customer base would mean using data from a third party, the quality of which could vary. Square has already partnered with Intuit (INTU +2.00%) on the company's QuickBooks service, but this type of data would potentially be out of date and could be window-dressed to a degree. Upserve is another possibility. Offering payment service processing to the restaurant trade, much like Square but without a lot of the added features, Upserve could provide data similar to Square's and so possibly could replicate Square's underwriting success. But repayments wouldn't be as slick, and it would still add a third party that would take its own cut.
Short-sighted and unnecessary
Two key questions arise, then. First, can Square work successfully with data from other sources, some of it potentially of lower quality? Second, will Square's investors like this move? Would they trust the data, and would they be content to have customers outside Square's sphere of control?
If the average default rate rises or Square finds it difficult to attract investors, this move could be detrimental. Being literally inside its customers' operations creates symbiotic relationships: Intelligent analysis of data leads to informed offers of capital to its customers, and its customers in turn use the capital to expand, buy inventory, and grow -- thus increasing gross payment volume and, consequently, Square's profits. This system is Square's greatest asset. In an underserved and traditionally overlooked segment of commerce, Square is offering uniquely value-added services that are enabling small and medium-sized companies to keep pace with, if not accelerate past, big businesses.
That's why the idea of offering loans outside the company's customer base seems short-sighted, especially given the demand potential within its current customer base. Square might overplay its best hand if it gives away this key advantage.