2023-11-22 08:30:00 ET
Summary
- My Strong Buy calls on Block's stock have performed poorly as payment stocks got their moment of reckoning.
- Block has communicated ambitious goals to achieve the Rule of 40 by 2026, focusing on growth and sustainable profitability.
- However, Block faces immense challenges in operating within difficult macroeconomic conditions and slowing GPV growth.
- I argue why the recent recovery of nearly 50% shouldn't be considered the start of a bull market uptrend for SQ.
- Investors are better off considering other high-quality stocks with a proven business model, as SQ remains in a downtrend.
Block, Inc. ( SQ ) has been one of the toughest Strong Buy calls I have made over the past year. I first upgraded SQ to Strong Buy in July 2023 , but that thesis hasn't worked out according to my expectations. The subsequent Strong Buy call in August also didn't work out. Notably, the battering in payment stocks has also affected SQ, as it has underperformed the S&P 500 ( SP500 ) since then.
SQ fell steeply toward its recent October lows before staging an impressive rebound following Block's robust third-quarter or FQ3 earnings release in early November 2023. Observant investors should recall that the Jack Dorsey-led company presented its long-term growth outlook, providing valuable modeling points for investors to assess its long-term thesis.
Accordingly, management telegraphed its intention to achieve the Rule of 40 by 2026, demonstrating Block's ability to balance growth and sustainable profitability. As a result, the company will likely focus on gaining operating leverage through more robust monetization and cost-optimization strategies as its topline growth slows. Furthermore, Block provided confidence about achieving "mid-teens gross profit growth and approximately mid-20% adjusted operating income margin" by FY26.
Block reported an adjusted EBITDA of $477.5M in FQ3, equivalent to a "25% margin on gross profit." However, the conversion through adjusted operating income is relatively low, resulting in just a 5% margin on gross profit. As a result, some investors might consider Block's FY26 target of reaching mid-20% in adjusted operating income margin overly aggressive.
Moreover, Block is expected to operate within more arduous macroeconomic and industry conditions as consumer spending softened in Q3. Moreover, GPV growth is expected to slow further, impacting its ability to monetize faster. Accordingly, Block reported that Square's GPV achieved an 11% YoY growth in Q3 but slowed to a 9% increase in October. In addition, management expects the "Cash App business GPV to decline in Q4."
As a result, management is staking its game plan on "evolving its go-to-market strategy to improve the performance of these seller cohorts" for Square. At the same time, management expects to continue banking on "establishing Cash App as a primary financial hub for customers, with a focus on winning a majority of their direct deposit."
However, I'm less confident about Block's ability to gain significant operating leverage as the success of its monetization strategies remains unclear. As topline growth slows further, the criticality of its ability to cross-sell and improve its go-to-market motion becomes increasingly pivotal.
SQ Quant Grades (Seeking Alpha)
SQ is still assigned a "D-" valuation grade, suggesting a relatively substantial premium against its financial sector ( XLF ) peers. Its "C-" momentum grade underscores the uncertain buying sentiments, as SQ underperformed the S&P 500 over the past year.
I don't consider SQ's dramatic reversal from its November lows as validation for the start of a new uptrend in SQ. It appears to be a bear market rally that attracted dip-buying fervor as SQ fell to the $40 level earlier this month.
Given its more than 50% gain from those lows over the past month, its upward momentum could stall at a critical juncture. Accordingly, the 50-week moving average or MA (blue line) is expected to remain a critical resistance zone that has rejected a bullish recovery since early 2022. As a result, I believe it makes sense to be cautious about further gains in SQ from here until buyers can decisively regain control of the 50-week MA.
Rating: Downgraded to Hold.
Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.
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Block: Don't Be Fooled By The Recent Surge (Rating Downgrade)