On Friday, Square’s stock price (NYSE: SQ) tumbled 15% after the company lowered its guidance for the third quarter. This was despite the company beating top and bottom-line estimates for the 8th consecutive quarter.

The guidance was lowered by about 10%, prompting traders to dump the stock. The tech sector had one of its largest prices drops of the year on Friday, so Square’s 15% decline can be partly attributed to that. However, there may be more to it, and investors should pay attention to the company’s valuation.

 

Robust Revenue Growth Continues

Revenue of $563 million was $5.3 million ahead of estimates and up 46% year over year. Non-GAAP EPS of $0.21 were $0.05 ahead of estimates. The Cash App ecosystem generated nearly half the firm’s revenue of $260 million and included $150 million in Bitcoin payments.

Growth was robust across the board. Sales of hardware including its Terminal, Register, and Reader devices grew 21%, and loans to merchants grew 36%. Gross payment volumes were $26.8 billion, up 25% from a year ago.

The firm also announced that it is selling its food delivery business, Caviar, to DoorDash for $410 million. This is probably a good move considering how competitive the food delivery space is. The sale will give Square more capital to invest in its platform business and, more importantly, the ability to focus on its core businesses.

 

Lower Guidance

Some analysts are concerned that Square is struggling to gain traction with mid-sized and large businesses, and that it may struggle to improve its operating margin which is close to zero.

The company cut its third-quarter guidance for EPS to 18-20 cents compared to current consensus estimates of 22 cents. This prompted at least two analysts to immediately downgrade the stock sighting concerns over the margin, valuation, and increasing competition.

The question now is whether Square’s management is merely trying to lower the bar to make sure it beats in the next quarter, or whether it sees growth slowing soon. The company has made a habit of managing expectations and then beating, so this may just be a repeat. However, some analysts are concerned that Square is struggling to gain traction with mid-sized and large businesses, and that it may struggle to improve its operating margin which is close to zero.

While revenue growth still appears robust, margin growth does seem to have decelerated slightly. If growth continues and the operating margin continues to improve, the current price around $68 appears attractive.

 

Can Square Turn A Profit?

However, if it turns out that the operating margin can’t improve much, the valuation will look high. A price to sales ratio of 9.3 will look excessive if growth slows and the operating margin is close to zero.

There is also some concern in the market that some of the fastest-growing tech companies are paying too much for their growth. These are companies that get away with losing money because they show strong sales growth. The fear is that they are selling money-losing products and have a flawed business model. Tesla is the extreme example here.

Square operates at close to break, even at the operating level. It may, therefore, be lumped in with other fast-growing, money-losing tech stocks if the market turns against them. Until the current quarter’s earnings are released, Square is likely to track the more speculative software stocks.

Investors will need to pay attention to sentiment in the sector, and whether the market continues to focus on revenue growth or shifts its focus to profitability.