PYPL - Block: Still Cautious On Near Term

2023-11-09 12:00:42 ET

Summary

• We are maintaining our Hold on Block.
• Consistent with our expectations, Block’s gross profit growth decelerated, and we expect gross profit to remain under pressure through 2024.
• SQ stock has declined about 16% in the last three months and underperformed the S&P 500 by over 15%.
• Operating expenses remain high. We don’t believe cost-cut measures will be enough to offset near-term slower growth.
• We expect the stock to be an inline performer through 1H24.

We are maintaining our Hold rating on Block (SQ) despite a strong earnings beat. Consistent with our expectations , Block's gross profit growth decelerated, and we expect gross profit to remain under pressure through 2024. We attribute the 12% stock post-earnings climb to expense discipline driving profit growth, which is a near-term positive but won't sustain longer financial outperformance, in our opinion. We think the post-earnings rally factored in the expectation of recovery; hence, we don't see favorable entry points at current levels.

In 3Q23, total net revenue increased 24% from the previous year to $5.62B. The revenue for the quarter minus BTC stood at $3.19B, a 16% increase from the prior year. Gross profit rose by 21% YoY to $1.90B and only 1.6% QoQ. A deceleration compared to the previous quarter, where gross profit rose 9.35% QoQ. We expect this deceleration to still be a near-term headwind going into 2024 and expect the stock to be an inline performer in 1H24. Management guides for gross profit of $1,960-1,980M next quarter, accounting for a 15-16% Y/Y increase from $1.66B in 4Q22.

The following outlines Block's profit growth in 3Q23.

The Gross Payment Volume or GPV processed was over $60B, a 10% increase YoY. The transaction-based gross profit margin was slightly lower at 1.12%, decreasing by 0.01% from the previous year and by 0.04% from the preceding quarter, as expected. We think management is doing well in reducing expenses and focusing on profitable growth; we think the reduced expenses may limit Block's growth given the competitive nature of the market. We don't see the stock outperforming materially into 1H24. We recommend investors stay on the sidelines.

The below graph shows the percentage change in the price of shares for PayPal (PYPL), Block, and the S&P 500 from September to November 2023. Block share price experienced a significant drop of 22% during this period, indicating a notable underperformance compared to the SPY, which decreased only by roughly 2%, suggesting that Block shares were more negatively affected than the broader market. Meanwhile, PayPal's shares also fell by 13%, reflecting a less severe but substantial decline. Overall, both Block and PayPal's share prices declined notably, with Block facing the steepest decrease among the three.

Valuation

Block is currently trading at an Enterprise Value to Sales ratio for CY24 at 1.2x, substantially lower than the peer group average at 4.4x. On a P/E basis, Block is undervalued, trading at CY24 at 17.8x compared to the peer group average of 25.0x. From a valuation point of view, we believe the stock is undervalued at current levels. Still, we don't think investors should buy the stock on weakness. We don't recommend investors leap into a position as we believe more favorable entry points will present themselves in the near future. The below outlines Block's valuation compared to its peers using Refinitiv data.

Word on Wall Street

Wall Street is currently split vis-à-vis Block's rating. Around 33 sell-side analysts rate Block with a buy compared to 14 as a hold and one as a sell. We think Wall Street is torn between Block's attractive valuation compared to the peer group and pressing concerns over macro headwinds weighing on gross profit. For Block, as expected, the price targets were revised down. The median price target is $70, and the mean is $72, which gives us, at the current price level, an upside of 34-38%. The below table outlines Wall Street's stance on the stock.

What to do with the stock

For us, Block remains a hold. The company's gross profit growth has slowed, consistent with our expectations, and we expect slow growth through 1H24. Block's shares have dipped by 16% in the past quarter, lagging significantly the S&P 500 by 15%. With operating expenses staying elevated, the company's cost-cutting efforts seem unlikely to fully counteract the slower growth observed. We believe Block's stock will perform in line with the market through the first half of 2024 and recommend investors stay on the sideline for the near term.

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