Square (SQ) is applying for an industrial loan company charter as the payment firm’s ambitions broaden into the wider financial services industry. The move is not surprising, as Square Capital has been offering credit for several years through a banking partnership. However, we think it’s too early to get excited about the company’s prospects. Square is not the only fintech firm targeting the lending space, and the banking industry is already extremely competitive. Furthermore, industrial loan companies typically rely on high-cost funding relative to traditional banks with access to plenty of non-interest-bearing deposits.
It’s possible that Square’s close relationships with small merchants could lower customer acquisition costs and raise switching costs in the lending business. Thus, we see the move as strategically sound. That said, the company is arguably targeting a high-risk segment of customers, and it’s difficult to have confidence in its underwriting until its practices and algorithms have been tested in an economic downturn.
As Square enters new industries, the potential market for its services is rapidly growing. The company already has offerings in banking, payments, and enterprise software. We expect revenue to grow quickly off a small base outside of payments, thanks to its established customer base. However, we think Square’s early success in payment processing was built on a first-mover advantage and a superior combination of hardware and software. Such advantages are difficult to maintain, Apple’s success notwithstanding. We have difficulty justifying the no-moat firm’s valuation relative to our $13 fair value estimate.
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Jim Sinegal does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.