Square (NYSE: SQ) has been a darling stock in the finance sector for quite some time. It recently posted its first-ever quarterly net profit, and with a smart and innovative business model, it's set for more wins. It isn't easy to be edgy and successful in this sector, but Square is managing, and it's getting a lot of investor love for it.
It'll get even more if one of its big ambitions is fulfilled.
Image source: Square
Banking on a license
Last month, it was revealed that Square is making another attempt at obtaining what is effectively a banking license.
In late 2017, it applied for permission to operate an industrial loan company (ILC). This is a form of corporation owned by nonbanks that can accept deposits, make loans, and conduct other activities usually reserved for banks.
Square's application was eventually withdrawn. The company ascribed this to technical reasons, saying in a statement that it pulled the application as "a procedural step in the review process that will allow us to amend and strengthen some areas of our FDIC insurance application."
If the new effort to obtain a license is successful, the ILC will be managed by a company arm called Square Financial Services.
Unlike standard banks, ILCs are not regulated by a clutch of federal agencies. Instead, they fall under the gaze of only one, the Federal Deposit Insurance Corporation (FDIC), in addition to the state issuing the license (Utah, in Square's case). Some critics argue that since ILCs are not operated by banks and escape the scrutiny of numerous federal bodies, their charters should be curtailed or even eliminated.
Square doesn't seem to mind courting controversy, and there's good reason it shouldn't. Owning what's a banking license in all but name would give it the scope to dramatically ramp up its lending activities.
Square currently offers loans to some of its clients, but since the company isn't licensed, it can't do so directly. Instead, it partners with an ILC, Celtic Bank, which originates the loans, then sells them to third-party investors.
That's an awfully clunky way to shovel money to clients. Perhaps that's why the growth of Square Capital -- encouraging as it's been -- was overshadowed by that of other units in the company. In Square's third quarter, total net revenue came in at $882 million, or 51% higher on a year-over-year basis. Square Capital, however, grew the tally for its loans by a comparatively modest 34% to $405 million.
With an in-house banking operation, Square would have no need for a lender like Celtic Bank. It could then concentrate on aggressively pursuing loans, and could provide them without having to coordinate among partners.
In Q3, according to Square, it facilitated more than 62,000 business loans totaling a combined $405 million. This dollar figure is a drop in the bucket of the massive U.S. small and mid-sized business (SMB) segment that is the core of the company's business. There is much more market share to carve out, and with its many services for SMBs, Square is beautifully positioned to do so.
On top of that, it has lately become much more successful in getting larger enterprises to sign on for its services. Often, the bigger the business, the hungrier it is for borrowing. Lending to this segment could really expand and deepen Square's loan portfolio, and contribute meaningfully to the company's results.
Lender of first resort?
Absent a deep recession in this country, I can't imagine a scenario in which Square Financial Services flops. After all, its parent is the scrappy upstart that took on more famous and entrenched players like PayPal Holdings (NASDAQ: PYPL) to carve out a niche in its business.
One reason for this is Square's clever leveraging of its disparate but related assets to create an ecosystem for its customer base. Using the growing list of Square services, clients can issue virtual gift cards, get money deposited in their accounts almost instantaneously, and handle employee payroll. As successful as PayPal has been, its menu is far more limited. We can say the same for many other merchant services providers.
There's a reason Square has been more popular with investors than PayPal and other rivals. It has a sticky business model, a great many clients that will need capital at some point, and a talent for integrating business lines and making them contribute to the parent company. And if Square can secure that ILC license, it'll jump into what could be the most promising business line of them all.
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Eric Volkman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends PayPal Holdings and Square. The Motley Fool has the following options: short January 2019 $82 calls on PayPal Holdings and short January 2019 $80 calls on Square. The Motley Fool has a disclosure policy.