The Ratings Game: Here’s why Square could be seen as a ‘proxy’ for the most vulnerable businesses

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Square Inc. shares tumbled again Wednesday as investors worried that business lockdowns and an economic slowdown could help realize some of Wall Street’s worst fears about the company.

The payment processor has seen explosive growth since its November 2015 IPO by making it easier for small businesses to accept credit-card payments and leveraging its relationships with those merchants to sell add-on services like payroll management. Square SQ, -11.69%  also provides loans to its sellers and has a consumer-facing business featuring bitcoin and equities trading.

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Square’s stock had enjoyed a more-than-500% rise since the IPO at the time of its recent peak in February, but a chief concern among bears amid Square’s rally was how the company would fare in an economic slowdown. The company not only handles payment processing for small businesses, which are viewed as the most at-risk during downturns, but it also lends to those merchants.

“Square’s unique and now challenged exposure will make the stock a proxy for some of the most vulnerable businesses, where federal response will be crucial,” Citi analyst Peter Christiansen wrote in a Wednesday note, while downgrading Square’s stock to neutral from buy. “Until then, we think Square will trade in a wide range and likely away from fundamentals at times.”

The company’s “seller” segment accounts for about 70% of revenue, and Christiansen estimates that Square could see gross payment volume (GPV) drop 65% in the second quarter as the outbreak of COVID-19, the disease brought on by the novel coronavirus, forces merchants to temporarily shut their doors and leaves business owners in a tough position in terms of cash flow.

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“We would expect Square to be disproportionately impacted from a likely wide spread of COVID-19 in the United States,” Christiansen wrote. While Square could cushion the blow somewhat from the geographical diversity and segmentation of its merchant base, the company still has sizable small-business exposure, and “it remains unclear if Square’s vertical mix is under-indexed to staple-like businesses (supermarkets, drug stores, etc.).”

The company generated 45% of its volume in the fourth quarter from businesses that did less than $125,000 in annualized GPV.

Another source of concern for Christiansen is Square’s lending business. While most of the loans are sold off to third-party investors, limiting Square’s balance-sheet risk, the capital lending program is still a meaningful source of revenue and earnings, he said. At the same time, he does see a possibility down the road in which the government would “offer or direct lending institutions to ramp financial assistance” to small- and medium-sized businesses, and this could prove an opportunity for Square to grow its business.

Square announced late Wednesday that the company received conditional approved by the Federal Deposit Insurance Corporation for an industrial-loan charter that will allow the company to operate a subsidiary bank, Square Financial Services, that can provide loans to small-business customers.

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Christiansen said the stock doesn’t warrant a sell rating because Square has more than $2 billion in cash, strong free-cash flow, a “high-caliber” management team and the ability to more quickly adapt due to data advantages.

A Square spokesperson declined to comment on the impact of temporary store closures on its business. The company is holding a virtual investor-day event Tuesday.

Square shares lost nearly 12% in Wednesday trading, after falling as much as 27.7% earlier in the session. The stock saw its worst single-day percentage drop on record in Monday trading, but clawed back a bit Tuesday amid a broader market rally and an upgrade from Cowen & Co.

The stock has lost 37% so far this year, as the S&P 500 SPX, -5.18%  has dropped 26%.