Big Bitcoin Bet

Jack Dorsey, co-founder of Twitter ($TWTR) and founder of Square ($SQ), who regularly fasts for 3 days in a row and starts his day off with ice baths, just made his next crazy move… buying $50m of bitcoin with Square.

On Oct. 8, Square announced that it purchased over $50m of bitcoin, totaling 1% of its total assets in the second quarter. It’s a bold move for a large public company to invest in such a risky asset. For Square, it just might be crazy enough to work.

(Catchup: What is Bitcoin?)

The round pegs in the Square holes

Square largely makes its money by helping businesses process credit card payments and through its Cash App, a Venmo-like payment service. Why is a payments company buying a digital currency that has gone through several violent price swings over the past few years?

In 2018, Square expanded its Cash App to support bitcoin trading and is highly involved in other cryptocurrency projects. Dorsey is known to be a big believer of bitcoin and here’s why the purchase makes sense for Square:

• Locking in the cost of bitcoin… If the value of bitcoin goes up, Square would profit from selling bitcoin at which it purchased for a lower price.
• Using bitcoin as a cash alternative… Companies typically invest their excess cash into short term investments to earn interest. As a result of low-interest rates, these investments are now less attractive.

Don’t let your eyes deceive you

Square’s stock has grown nearly 3x in 2020 – benefiting from increased usage in digital payments. It generated $875m (45.5% of its total revenue) from its bitcoin business in the second quarter of 2020, up 600% from a year ago. Impressive… Until you see how much it took in from its bitcoin division as gross profits, the amount after deducting the cost of goods – $17m (gross margin of 1.9%).

Why so unprofitable? It’s how the numbers are recorded that inflates revenue.

• Users order ~$875m worth of bitcoin using Square’s Cash App (recorded as revenue).
• Square then buys the bitcoin from the market for $858m to sell to its users (recorded as cost).
• The difference, $17m is how much Square earned from the transaction (recorded as gross profit).

Meaning… Although the company’s revenue grew 63% in the second quarter, the majority of the growth came from its unprofitable bitcoin business.

For investors… Square’s bitcoin purchase is a risky but potentially lucrative bet. If the price of bitcoin goes up, Cash App’s gross profits will increase. However, if it goes down, Square could take a loss on its bitcoin holdings. Looking at bitcoin’s rocky past, Square could be taking a big risk on a digital currency that has fallen over 50% multiple times in the past few years.