Summary
- Block is currently overvalued from my margin of safety price.
- Block has a growing moat that will continue to deepen alongside its ecosystem.
- There is a glaring issue with stock-based compensation and equity ownership dilution.
Investment Case
I'm rating Block, Inc. (SQ) a Strong Buy at my margin of safety price of $55.94 and a Buy at the current price of $76.60. Block has fantastic growth opportunities across massive addressable markets and should continue to grow rapidly as it builds out its product ecosystems. These growth opportunities come with risks, as management has become increasingly dependent on stock-based compensation, which will dilute ownership significantly over time. Further, SQ is dependent on a high velocity of money to drive growth. The velocity of money measures how quickly money circulates through the economy, which is greatly impacted by recessions. In times of inflation and recession, we can expect a natural slowing of this velocity, which may make Block's ambitious growth targets less realistic. Even though I estimate SQ is currently overvalued, I believe in the growth story and the immense value added by the Block ecosystem, so long-term buy-and-hold investors should be willing to pay a premium.
Valuation
My discounted cashflow model estimates a current equity valuation of $55.94 / share, making SQ currently overvalued by about 36.94% at the current price of $76.60. Here you can see I'm using the current 40% growth rate for the next 3 years, then dropping it to 30%, and then dropping to 20% after another 3 years. Also, I adjusted the reported GAAP net income. Reported net income was about -$540m for 2022, but I excluded amortization of intangible assets, acquisition-related costs, and bitcoin impairment values from that figure to get -$127m. In the adjusted EBITDA figure, management uses some accounting wizardry to yield a figure of over $900m in adjusted EBITDA this year. In that calculation, they exclude a variety of costs including ~$1B in stock-based compensation expenses. I do not believe the investor of today should exclude the impact of stock-based compensation diluting their ownership, so I am being a bit harsher than management would be in this valuation model. Further, I'm assuming a return to sustainable profitability this year and a big jump back to positive GAAP net income. This assumption is based on the Q4 earnings call, in which management stated their focus on cost-efficiency this year. The 2022 results were impacted by a major Bitcoin drawdown and a big acquisition cost, so I expect net income will normalize back to sustainably positive levels going forward.
DCF Model of Block, Inc (Created by author)
The final relevant considerations/assumptions here are related to FWD P/E and shares outstanding. I could be extremely conservative here and use a figure of 1.5B shares outstanding instead of 600m, which would reflect the total amount of common A and B shares SQ is authorized to issue. They are rapidly approaching that level and have indicated that they plan to continue utilizing stock-based comp in the future. To avoid an outright guess, I'm using their current outstanding amount of 600m even though that's unlikely to be the total amount outstanding 10 years from now. Finally, I adjusted the FWD P/E value up from 43 (provided by Seeking Alpha) to 80, to bring it closer to the historical average multiple (it got up to 324 in 2020). I assume the 2022 bear market will not last for 10 years and that we will see a return to some of the ridiculous multiples we saw in late 2020 and throughout 2021. If I'm incorrect, then I'm overestimating the equity value.
An Ecosystem of Ecosystems
Block offers a variety of tools and services that allow people to participate in the economy. This company is led by the co-founder of Twitter Jack Dorsey, who founded Square in 2009. Jack has proven his ability to take a tech business from idea to scale while driving shareholder returns. He isn't in it for the money, in fact, his salary at Block was a whopping $3 this year (granted he is still a billionaire). His entire compensation is stock-based, meaning he is well-incentivized to continue driving shareholder value and growth. Although Block is publicly traded, its terms of incorporation have allowed Jack to maintain majority voting power over the company. Block offers class A and class B stocks. They are authorized to issue up to 1 billion class A shares (~539m outstanding) and 500 million class B shares (~61m outstanding). The key difference in the shares is that class B offers 10-to-1 voting rights to class A shares. The majority of Jack's stock is held in the B shares, giving him over 50% voting rights and effectively sole decision-making authority over the company.
Block classifies its products as ecosystems, which it defines as a set of tools and services that work together cohesively. Block has 3 major reportable segments which will be the focus of this article: Square, CashApp, and Bitcoin. The overarching goal of management is to build an ecosystem of ecosystems, which mostly means seamless integration between CashApp and Square products:
The connective tissues between the two are offerings like CashApp cards (debit and credit), Afterpay (a 'buy now pay later' service), and Bitcoin. The Square ecosystem includes over 30 products that span capabilities for payments, customer relationship management ((CRM)), employee management, and banking:
Block, Inc. 2022 Annual Report
This ecosystem puts Block in competition with formidable companies across a number of industries, like Salesforce (CRM), Automatic Data Processing (ADP), and retail business banks. There are two conflicting thoughts I have about this. First is that companies like CRM and ADP are more focused on developing products for their specific addressable market (customer relationship management and employee management, respectively), while these are but a few among Block's many offerings. Presumably, Salesforce has a much more holistic CRM offering than Block, since this is its main focus. But having many offerings may be a competitive advantage for Block. Although they are less focused on each individual offering, the convenience for businesses of all sizes having all the tools required to run their business through one company is clear. Instead of getting CRM solutions from Salesforce, employee management from ADP, and maintaining a retail business account through an archaic big bank, businesses can get all these solutions and more from Square. Square also offers e-commerce solutions, further deepening this advantage. Take a look at all the offerings available when you get a Square terminal:
Block, Inc. 2022 Annual Report
Square provides businesses with a clear value-add in the convenience of its array of offerings.
Moving to the CashApp segment, there's a strong network effect driving value for users. A fintech app like this is an extremely intimate app for people since it deals with the reliability of sending and receiving money. Trust, convenience, and scale are key. People have to trust that they can send and receive funds seamlessly and access the funds through a variety of channels, such as with CashApp debit and credit cards or secure transfers to bank accounts. The most comparable app is PayPal (PYPL), which similarly offers a full suite of financial services such as money movement, stock and crypto investing, and buy now pay later payment schedules. Here's a look at the CashApp ecosystem and the services that generate revenue:
Block, Inc. 2022 Annual Report
CashApp inflow and outflow journeys (Block, Inc. 2022 Annual Report)
Block is achieving impressive growth targets. Jack's rule of 40 is ambitious and probably not sustainable in the long run. On the 4Q 2022 Earnings call, Jack stated:
Using these principles, our investment framework can be articulated in a single sentence. Block, in each of our ecosystems, must show a believable path to gross profit retention of over 100% and Rule of 40 on adjusted operating income. This is an ambitious goal, especially at our scale, and one we aren't meeting today... Our ability to retain a customer over time tells us a lot. It says, we found product market fit, we have the right set of services and features, we're providing the right customer support, we're able to efficiently cross-sell into more products, and we have the right pricing... Historically, both Cash App and Square have delivered positive gross profit retention... over the long term, we expect the average annual gross profit retention of our ecosystems to be above 100%... Turning now to the second component of our investment framework, which is Rule of 40. We want to further raise the bar on our growth rates and our efficiency. We believe measuring our ecosystems on growth plus margins is the best framework to enable this. A growth plus margin framework provides flexibility for products and businesses at different stages of maturity. It's a useful and universal formula for evaluating each of our ecosystems with different growth trends and margin profiles today, and for those we might launch in the future.
It also ensures accountability. When we increase our investments, this framework forces us to think critically about the expected returns. And if growth slows, it encourages us to adapt, to operate with more discipline or to pursue different investments.
Even a few years of hitting this target is a mouth-watering prospect for investors. The issue here is that SQ seems to use somewhat aggressive accounting when computing Adjusted EBITDA, which can be used to artificially inflate their margin. They exclude a variety of things to compute adjusted net income, including the exclusion of shares that could have dilutive effects on net income per share (for example, some of the convertible notes I touched on earlier are considered dilutive).
Reconciliation of Net income and Adjusted Net income (Block, Inc. 2022 Annual Report)
The rule of 40 sounds outlandish for a company already worth over $40B with revenues rapidly approaching $20B, but take a look at Block's Q4 2022 highlights:
Block, Inc. 4Q 2022 Shareholder Letter
Not only did they achieve 40% gross profit growth, but they also have an impressive 51 million monthly active users on CashApp. Further, a growing percentage of Square's profit comes from sellers (businesses using Square payment terminals) that use four or more products. Conveniently, these sellers have a 15x better retention rate than sellers that use only one product, so Block can presumably drive margin growth in these high retention rate customers. Square also has a good trend with larger businesses comprising a growing share of Gross Payment Volume ((GPV)):
Block measures seller size by GPV or the total payment volume that flows through Square terminals in a given year. This is wonderful for Block because they earn more transaction-based revenue from higher GPV clients, who are also more likely to require numerous products and therefore will have a much higher retention rate. These trends translated to a 19% growth in transaction-based revenue in 2022. Most transaction-based revenue is attributable to the Square segment, while the rocketing 68% growth of subscriptions and services-based revenue is attributable to both CashApp and Square.
The more important metric than total net revenue growth of -1% is the revenue growth excluding bitcoin revenue, which results in 36% growth. Bitcoin had a historically challenging year which is unlikely to be repeated again. Bitcoin (BTC-USD) is the final major piece of Block's ecosystem. CashApp users can buy Bitcoin on the app, which is custodied by Block. Block has invested about $220m in Bitcoin to date, which has been written down to a touch over $100m. BTC had an exceptionally tumultuous year but this volatility was not caused by fundamental weakness in BTC itself, but rather the drama in the wider crypto space. Crypto was rocked by historic levels of fraud in the FTX case in 2022. While this does highlight the risks inherent to the crypto as a whole, Block only has BTC. Compared to alternative cryptocurrencies, BTC is still a sound investment. In the past few years, BTC has gained traction with smart money and governments (some governments have outright banned crypto like China, while others have allowed its adoption and use) . While the wider crypto space has a lot of muck and grime to sort through, BTC remains the most investable and useful option available. 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.
Achieving the Rule of 40
Block is aggressively moving to hit its 40% target. They are using a combination of cost-consciousness to improve margins and rapid revenue growth to achieve this. Block had exceptionally high costs this year driven primarily by the Afterpay acquisition and the associated increase in payroll / HR costs. The most noteworthy growth strategy in my opinion is the pursuit of additional credit offerings. This is the logic underlying the roughly $18B acquisition of Afterpay, a buy now pay later ((BNPL)) service. BNPL consists of micro-loans to consumers with short repayment periods. Block assumes all repayment risk and doesn't charge any interest, with revenue only coming from late fees and advertising fees on the platform. In October 2022, they expanded into longer-term loans that do not have late fees or compounding interest but do charge interest up to a pre-defined maximum amount and are paid in monthly increments. Additionally, they offer SQ Loans which are loans to merchants that use SQ products. These generate revenue in two ways: 1) Block can sell the book of loans to a 3rd party investor and act as the loan servicer, in which case they earn proceeds from the sale of the loan book and from a servicing fee; or 2) Block can service loans and earn interest income. Block supplements the BNPL product with Cash App Borrow which gives short-term loans for a small fee and additional late fees if necessary.
Block's expansion into various higher-margin offerings is complemented by its moat. Morningstar gives Block a 'Narrow' moat rating, which I couldn't disagree with more. The focus shouldn't be the ease of switching between CashApp and PayPal or competition in the payment terminal space. The focus should be on the overall ecosystem, which is where I see an extremely impressive moat developing. Sellers with 4 or more Square products have a 15x higher retention rate than those with only 1, and Block is seeing strong growth in higher GPV businesses. Higher GPV clients should use more products and Block can enjoy a higher retention rate. As these businesses expand, they'll be likely to continue deepening their relationship with Block. The key to the moat will be in product engineering and development, which is Block's largest expense making up about 1/3rd of total OPEX:
Block, Inc. 2022 Annual Report
The continued improvement of the Block ecosystem is the continued growth of their moat. 10 years from now, Block should have a huge castle surrounded by a massive moat filled with sharks and piranhas. There is a clear value added for Block users, which compounds as the network expands and the interconnections deepen in the ecosystem. Overall, Block presents an extremely lucrative opportunity when looking at top-line growth and the growing scale of the Block network. Jack Dorsey passes the scuttlebutt test for me, and it's abundantly clear through reading the annual report that this management team is extremely passionate about the work they are doing. Despite strong fundamentals though, there are a few noteworthy risks that must be considered.
Risks
The rule of 40 is an ambitious target. Ambitious business goals require a good plan and a good team to execute that plan. 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:
Block is rapidly approaching the 1 billion class A shares they are authorized to issue. This may lead to two things down the road, either: 1) an authorization to issue more A shares, or 2) issuance of B shares (61m outstanding of 500m authorized) or convertible preferred (0 outstanding of 100m authorized) in incentives or future acquisitions. Either way, this represents ownership dilution of all investors holding common A shares today.
This may not be of major concern in times of abundance, but if Block hits obstacles on the way the impact may be more felt. Block needs to continue navigating a challenging environment to scale its network, but they are not immune to inflationary and recessionary headwinds. The more often people exchange money, the more revenue Block will generate through total GPV volume on the Square ecosystem. If recession fears for 2023 are realized, the velocity of money in the economy will slow and a slowdown or reversal of growth in total economic transaction volumes could cause Block's total GPV growth to stagnate or begin shrinking. These issues compound when you consider Block's ambitious credit strategy and the nature of short-term debt cycles. What's not yet known though is whether short-term micro-loans offered by Afterpay will display similar cyclical characteristics to other forms of longer-term debt.
The Afterpay acquisition was a pricey endeavor, but management believes it's key to building their interconnected product ecosystem. Block may be walking headfirst into a recession huge book of loans that could face higher default risk amid challenging conditions. When customers use Afterpay, Block pays the merchant in full up front and assumes the risk of non-repayment, yet charges no interest. It will be imperative for any investor to closely monitor the size of the BNPL book and to pay close attention to anything management mentions about default rates on BNPL loans, and the other credit services Block is expanding into.
Conclusion
Despite a few risks of concern to an investor, Block doesn't seem to face any threats to its viability as a business and looks like it's here to stay. There may be headwinds, but Block has a strong likelihood of compounding over time. I'm rating Block a Buy at current levels because I believe the growth prospects offered here will reward patient, long-term investors.
For further details see:
Block: Rapid Growth With A Hint Of Risk