2023-12-05 04:12:06 ET
Summary
- The digital payments industry is experiencing robust growth due to convenience and consumer preferences.
- Block is enjoying numerous tailwinds: namely, the Crypto bull market, macro trends, management discipline, explosive growth in BNPL schemes, and the ongoing growth of omnichannel.
- Online transactions have seen significant growth and payment service providers play a critical role in facilitating money movement and providing security.
Business Overview
I have covered Block, ( SQ ) three times in the past year. In my first article , I offered a valuation of Block, an overview of the business, and an analysis of management's strategy. Block has three major reportable segments: Square, CashApp, and Bitcoin. Square serves businesses by providing payment terminals, a customer analytics platform, customer relationship management software, and integration with CashApp, the leading payments app in the App Store. CashApp offers lower margins than Square but is critical to the Block ecosystem. MAU, monthly active users, is the most important metric for CashApp. The ongoing integration between Square and CashApp will continue to increase operating leverage for Block. The more interoperability between the Square and CashApp segments, the deeper the moat that Block will build. Finally, Bitcoin is significantly impactful to Block's overall revenue figure but contributes little to earnings. I'll touch on that more later.
My next article addressed the Hindenburg short report, which claimed Block overreports their MAU (monthly active user) metric and is widely used to facilitate fraudulent transactions. The report mostly ignored the Square and Bitcoin segments while exclusively focusing on Cash App. I offered my opinion of the valid points made in the report and its shortcomings. Further, Block offered comments in its most recent (Aug 2023) quarterly report :
In addition, the Company is subject to various legal matters, investigations, subpoenas, inquiries or audits, claims, lawsuits and disputes, including with regulatory bodies and governmental agencies. For example, the Company received inquiries from the Securities and Exchange Commission and Department of Justice shortly after the publication of a short seller report in March 2023. The Company believes the inquiries primarily relate to the allegations raised in the short seller report. The Company cannot at this time fairly estimate a reasonable range of exposure, if any, of the potential liability with respect to any of these matters. Although we may be subject to an adverse decision or settlement, the Company does not believe that the final disposition of any of these other matters will have a material adverse effect on its results of operations, financial position, or liquidity. However, the Company cannot give any assurance regarding the ultimate outcome of any of these matters, and their resolution could be material to the Company's operating results.
My third and most recent article was on Q1 earnings and why the operating performance increased my valuation. This used updated financials and conservatively estimated the worth of Block to be $56/share. The continued growth in the recent report increases my valuation. I believe Block is currently trading at a fair valuation and rate Block a Buy, because of fair valuation and numerous tailwinds.
Tailwinds
Block, Inc. has punished investors that chased the COVID bubble. The chart perfectly reflects why valuation always matters - despite rapid growth during COVID and stronger growth expectations, many that invested during the COVID run-up have been burnt.
I believe the 3-year selloff in Block, which intensified most through 2022, is overdone. Block has maintained strong operating performance throughout a challenging two years of macro uncertainty, rapid rate increases, increasing competitive headwinds, and liquidity draining out of the system.
Block's two major reportable segments, Square and Cash App, have both shown double-digit gross profit growth YoY despite the uncertain backdrop:
Block Q3 2023 Shareholder Letter
The third primary reportable segment, Bitcoin (BTC) is finally kicking back to life after a long Crypto winter. BTC recently eclipsed $40k per coin again, and the upcoming Bitcoin halving gives more reason to be bullish on this segment.
In other words, all three reportable segments have either continued growing or are set to turn the corner of challenging times. Block's business is now enjoying numerous tailwinds, including the Crypto bull market, macro trends, management discipline, explosive growth in buy-now pay-later ("BNPL") schemes, and the ongoing growth of omnichannel commerce. Let's explore these.
Bitcoin
Most of the muck and grime seems to be clearing out of the Crypto landscape, with legitimate use cases like cross-border money movement and online privacy becoming more prevalent. Alongside the upcoming Bitcoin halving , Crypto looks to be rapidly approaching another bull run, if we aren't already in the throes of it. I discussed the Bitcoin segment and its impact on Block's financial reporting in detail in a previous article titled Block: Rapid Growth With a Hint of Risk.
The most relevant snippet from that article is this:
Regardless, BTC is a very low-margin business for SQ. According to the annual report, "while bitcoin contributed 41% and 57% of the total revenue in 2022 and 2021, respectively, gross profit generated from bitcoin was only 3% and 5% of the total gross profit in 2022 and 2021, respectively." Block earns a small fee on all Bitcoin transactions, so transaction volumes should increase as Bitcoin emerges from the historic bear market of 2022, which should reverse the rapid negative growth in this segment. The cost of revenue is so large because Block holds Bitcoin for customers, meaning Block buys and custodies Bitcoin and then sells it to customers for a small fee. Although Bitcoin is a major focus for management since it aligns with their model of economic empowerment, it's a low-margin business and not very impactful to the investment case of Block. Because of recent accounting standards changes, Block has to impair its Bitcoin holdings when the price drops, but cannot revise them back up when the price increases. Depending on the widespread adoption of Bitcoin, this could result in Block reporting far less Bitcoin on its books than the true amount held in the future. They bought $220m worth initially, which could end up being worth significantly more, but will be marked at ~$102m on the books until the BTC is sold.
The accounting standard mentioned requires asset impairment of long-lived intangible assets, which is the category that BTC is in. As I mentioned, with an increase in Bitcoin price, Block holds significantly more value in Bitcoin than their reports will suggest in the future.
There is a causal relationship between BTC price and total BTC transaction volume on exchanges like Block, so the Bitcoin segment will begin contributing to revenue and gross profit growth again in 2024. As transaction volume increases, revenue generated through Bitcoin will increase. With this, we can expect a material drop in gross margin for Block, given the low-margin nature of its Bitcoin segment. This margin erosion should not concern investors, as I do not expect the look-through margin (which I'm defining as the gross margin ex Bitcoin) to change materially.
Industry Trends
The digital payments industry has experienced robust growth in recent years. The website Fortune Business Insights expects this growth to continue in the coming years:
Fortunebusinessinsights.com
This growth is mostly caused by convenience and consumer preferences. Digital payments are easier, quicker, and more secure than cash payments. The introduction of NFC (near-field communication) chips into mobile devices and debit/credit cards boosted this convenience to another level. Now, iPhone users can simply double-click their power button, unlock their digital wallet with Face ID, and bring their phone near the POS (point-of-sale) payment terminal to pay. Other smart devices, like watches, have similar functionality. Even if you don't have smart devices, cards with chips are now the industry standard and most have NFC payment capabilities.
Online payments have seen similar growth. While physical transactions have shifted away from cash, online transactions have experienced secular growth in the past twenty years and will continue to grow. This growth is both from the increasing penetration of e-commerce into the American economy and the ongoing adoption of Internet and digital payment technologies worldwide. Payment service providers are critical to this growth because they facilitate the actual money movement and provide security and fraud detection services to businesses.
Management Discipline
When I initiated coverage of Block, I titled the article "Rapid Growth with a Hint of Risk". The primary risk I was referencing was that of shareholder dilution. In the article, I present the risk as such:
Block is increasingly using stock-based compensation to reward and incentivize talent. In the 2022 annual report, they said "Share-based compensation expense has been, and will continue to be for the foreseeable future, a significant recurring expense in our business and an important part of our compensation strategy." Total common shares outstanding has grown from 138m in 2013 to 539m at the start of 2023. They also have ~$2.61B across 4 convertible notes spanning from 2023 to 2027, which have the option to convert to common A shares upon maturity. The investors holding common A shares should expect to see a continued significant dilution of their equity ownership position. In addition to the convertible notes and growing stock-based compensation for employee rewards and incentives, Block also used over 100m shares in the Afterpay transaction..."
Ownership dilution is a silent killer of long-term returns. Ongoing increases in shares outstanding make it increasingly difficult to grow EPS, which in turn can lead to multiple contractions. Management recognized this risk and addressed it wonderfully by announcing a $1B share buyback program. This will slow the pace of dilution and make it easier for Block to grow EPS and expand its multiple. I do not expect this buyback program to decrease shares outstanding, but it will at least stem the bleeding.
Additionally, Block CEO Jack Dorsey announced a hard limit of 12,000 employees (which the company currently exceeds) and gave a progress update on the Rule of 40. The Rule of 40 is commonly used in software companies to ensure sustainable growth over time by keeping the sum of their YoY growth rate and their gross margin at at least 40%.
In short, management has shown a commitment to operational efficiency alongside continued strong growth. This will be a strong tailwind over time as revenues grow and operating expenses stay contained.
Afterpay and the rise of BNPL
Perhaps the most recent and the strongest tailwind is the rise of BNPL or buy-now pay-later payment schemes. Block used a hefty amount of cash and stock to acquire Afterpay, a leading BNPL platform. Afterpay is showing its value within the Block ecosystem. According to Block , "BNPL transactions through Afterpay increased 19%, and Square sellers saw their Afterpay transactions grow 47%... As the popularity of mobile commerce increases, more consumers turned to the Afterpay app for all their shopping needs, with app usage up 16%."
Afterpay allows consumers more flexibility in spending without depending on high-interest credit from traditional credit card programs. Block earns revenue for each Afterpay transaction and generates revenue from late repayment fees. Other competitors with similar BNPL schemes, namely PayPal ( PYPL ) have also pursued a strategy of selling books of BNPL loans. KKR, a European bank, bought roughly $3B of BNPL loans from PayPal, which PYPL will continue to earn a servicing fee on. This shows the growth potential across the board for BNPL loans: more transactions generate more revenue and the selling of loan books can de-risk and earn money upfront while also securing a servicing fee over time.
BNPL, a proposition that I was initially bearish on, has become quite the tailwind for payments firms. Afterpay will continue driving strong growth for Block and provide management with numerous possibilities to grow revenue.
Omnichannel Commerce
Finally, wider industry shifts to omnichannel will sustain growth for Block over time. As noted during the Black Friday weekend, which kicks off the holiday shopping season in the US, omnichannel was a key strength for Block. Square allows sellers to easily manage inventory and sales through physical, online, and mobile commerce. Coupled with Block's intense focus on deepening its ecosystem, this shift to omnichannel will provide sustained growth for Block and will generate positive returns for shareholders over time. From Block's Black Friday report:
During the Black Friday and Cyber Monday shopping weekend, consumers turned out in droves to support their favorite businesses,” said Saumil Mehta, Head of Point of Sale and Omnichannel at Square. “We found that the holidays aren’t just for traditional retailers, as businesses across industries like restaurants and beauty lean into the major weekend. Given consumer sentiment has been positive around the holidays, and we know this weekend is often just the beginning, businesses should continue to expect an influx of shoppers, and be ready to meet them wherever they prefer to shop.
Final Thoughts
Block was a darling of the COVID bubble. Buying Block during COVID taught investors a valuable lesson in how important valuation is in stock picking. COVID was a catalyst for an increasingly digitized financial sector, so the stocks of leaders in digital payments naturally benefited. The issue of course is that the short-term growth expectations were overblown, leading to the recent multiple contraction and value destruction.
Now, we see the reverse. Short-term headwinds are blinding investors to the long-term growth potential and tailwinds of these companies and the industry in which they operate. Patient, long-term investors will be rewarded immensely for buying Block at current levels.
For further details see:
Block: Numerous Tailwinds Will Drive Impressive Returns