Square is best known for its disruptive card reader, but that's not the key to its success. Square's flagship card reader is one of the most recognizable devices in the payments industry; however, the hardware itself is not the engine of the company's growth. Instead, software and transaction processing are powering Square's profits, and, in fact, hardware is a drag on its bottom line. The summation of these segment-level trends shows that Square is a software company, not a hardware company. 

Square generates the bulk of its revenue from transaction processing fees: Transaction revenue represented 83% of the firm's total net revenue in Q2 2016. But hardware and software represent the other two key components of its overall revenue and profitability. Unpacking the performance of these two segments reveals diverging trends. 

Hardware

Square earns revenue when it sells merchants its mobile point-of-sale (mPOS) devices, which include its magnetic stripe reader and its newer contactless and EMV reader. However, factoring in hardware cost shows that its hardware segment has shed profits consistently, peaking around the time of the EMV shift. 

  • Square lost nearly $3 million in Q2 2016 on hardware: This was partially because sales of its readers cooled off after the company finished processing the vast majority of pre-orders of the new contactless reader in the prior quarter. 
  • Hardware produced major losses around the EMV shift: Hardware's gross losses were $7.9 million in Q4 2015, when liability for fraud officially shifted to the non-EMV compliant party. Square planned for this shift by developing an EMV-compatible reader and promoting it to new merchants. Losses peaked in Q1 2016 at $10.6 million. 

Its hardware segment is a loss leader. Despite generating losses, Square's hardware serves as the gateway to all of its other revenue streams, including transaction processing and software, and is therefore the fundamental product enabling its profitability. Think of it like ink jet printers — people can purchase printers at a relatively cheap price, but the cost to purchase ink is significant, and depending on usage, ink may need to be bought frequently. In this way, Square's goal seems to be distributing its reader cheaply to as many merchants as possible, giving the firm an opportunity to make up for the loss with other forms of revenue once the merchant is within its [...]