2023-11-05 20:00:05 ET
Summary
- The stock is having a strong comeback, surging 20% following its 3Q FY2023 earnings results but reversed its course to 10% last Friday, creating a buying opportunity.
- SQ reported solid 3Q earnings, beating expectations, and has shown consistent growth and improved margins. The company anticipates GAAP earnings breakeven in FY2024.
- The company is confident in achieving Rule of 40 in FY2026, which could establish positive momentum for the stock.
- SQ's valuation multiple has been largely reset, trading at 0.61x of PEG non-GAAP Fwd, 50% below its sector peers.
What Happened
Block (NYSE: SQ ) has experienced a 20% rebound following its 3Q FY2023 earnings results. I believe the price action can be attributed not merely to better-than-expected earnings results but also to a clear indication of improving profitability in FY2024 and beyond. The company is confident to achieve Rule of 40 in FY2026. This could be a catalyst to establish a positive momentum for the stock in the future. The rally reversed its course to 10% after market closed last Friday, which I think created a buying opportunity.
Before the post-earnings rally, the stock had been under pressure, declining nearly 30% since early August this year. I admit that my previous price at publication in my previous article was significantly higher than the current level. However, the recent sell off was coincided with a recent 100-basis point spike in long-term yields , given that SQ is currently unprofitable on a GAAP basis. From a discounted cash flow perspective, higher interest rate significantly discounted its earnings and FCFs that SQ would generate in the future, which in theory makes the stock very sensitive to the yields movement. Therefore, I believe the recent drop in yields will generate positive sentiment for SQ as well.
Moreover, the recent news of Jack Dorsey taking over as Square's CEO after Alyssa Henry stepped down can help alleviate another source of uncertainty that had been impacting the sentiment around the stock. Therefore, I reiterate my bullish outlook on SQ, as its valuation has been largely reset. Although the current valuation may not be considered cheap, a more promising outlook for margin expansion and earnings growth will offer a more favorable upside for the stock in terms of future prospects.
3Q FY2023 Takeaway
SQ reported solid 3Q FY2023 earnings, beating expectations in both revenue and adjusted EPS. Despite facing growth headwinds, I still see SQ as a growth company. Top-line growth has consistently maintained a mid-20% YoY growth trajectory over the past three quarters. Furthermore, its GAAP operating loss was narrowed to under $10 million, approaching the break-even point. When considering the adjusted basis, its adjusted EBITDA showed an impressive 45.9% YoY growth, significantly surpassing street consensus.
As shown in the chart, it's evident that there has been an expansion in SQ's adjusted EBITDA margin since 2Q FY2022. This highlights a gradual recovery in its margin following a significant decline in FY2021.
Regarding SQ's forward guidance, the management has revised the 4Q FY2023 adjusted EBITDA guidance to a range of $430 million to $450 million, suggesting an even stronger growth of 56.6% YoY. Once again, this guidance surpasses consensus significantly. The outlook implies an expected adjusted EBITDA margin of 22.4%.
The company is expected to achieve $2.4 billion in adjusted EBITDA in FY2024, representing a growth of over 40% compared to their FY2023 guidance. Additionally, they are anticipated to deliver robust growth in adjusted FCF for FY2024.
However, the shareholder letter also highlighted that this robust forward guidance is contingent on the absence of any further macro deterioration. It's important for investors to be cautious of current GPV headwinds, as the management has observed a decline in processing volumes among existing sellers. Furthermore, the company believes that GPV per seller has been affected by macro trends, particularly in discretionary verticals, and this impact has extended into October.
Regarding the Cash App, the company anticipates a decline in Cash App Business GPV in 4Q FY2023. In the short term, SQ's top-line growth could be significantly affected by slow consumer spending if the U.S. economy enters a recession. However, it's worth noting that high-valuation, non-profitable stocks have the potential to outperform in a lower interest rate environment, which could serve as a positive factor for the stock price.
Nonetheless, for long-term investors, it's crucial to keep our focus on SQ's growth trajectory across multiple economic cycles.
Achieving Rule of 40 in 2026
Company model
The 3Q FY2023 shareholder letter also laid out SQ's commitment to achieving the Rule of 40 by FY2026, which involves combining gross profit growth and the adjusted operating income margin (adjusted operating income divided by gross profit) to reach or exceed 40%. Based on the guidance, we can estimate that SQ is expected to achieve 21% in 4Q FY2023.
During the 3Q earnings call , the management provided insights into how they plan to achieve this goal:
"We plan to reach the Rule of 40 in 2026 with at least mid-teens gross profit growth and an approximately mid-20% adjusted operating income margin."
To attain this objective, the management will prioritize the efficiency of their workforce by implementing a strict cap on the number of employees in the company. They anticipate having a smaller team by the end of FY2024, with a cap set at 12,000 employees, compared to the over 13,000 employees in the last quarter. This strategic move is expected to enhance the company's operating margin over time.
Furthermore, the company will make concerted efforts to reduce expenditures in corporate overhead areas and improve the overall cost structure. Therefore, I believe that this margin improvement will not only help SQ reach GAAP earnings breakeven sooner but also have the potential to expand its valuation multiple.
Valuation
Currently, SQ is trading at a P/E non-GAAP TTM of 34x, which is slightly higher than the Nasdaq index. The chart demonstrates that SQ's valuation has undergone a substantial reset due to margin contractions and the high yield environment. When looking at a forward-looking basis, the stock is trading at a P/E non-GAAP fwd of 26x, which is 80% lower than its 5-year moving average. Notably, I'd like to emphasize that SQ's PEG ((Price/Earnings to Growth)) non-GAAP fwd is quite appealing at 0.61x, nearly 50% less expensive than the sector average. This suggests that SQ's earnings growth potential for the upcoming fiscal year is expected to be significantly higher than its peers. Lastly, I believe the stock holds strong upside potential when interest rates reach their peak and subsequently decline in FY2024.
Conclusion
In summary, SQ is currently on track to achieve profitability breakeven in FY2024, with a strategic focus on achieving the Rule of 40 by FY2026 through increased efficiency and cost control measures. While it faces challenges like GPV headwinds and potential economic downturn effects on consumer spending, SQ's valuation is getting attractive, trading at a lower P/E non-GAAP Fwd and a compelling PEG non-GAAP fwd ratio, indicating strong earnings growth potential in the future. Furthermore, anticipated lower interest rates in FY2024 could provide further upside for stock as well. Therefore, I maintain bullish outlook on SQ as its long-term growth thesis remains intact.
For further details see:
Block Q3 Earnings: Strong Guidance Makes The Current Valuation Attractive