2023-09-21 10:08:51 ET
Summary
- Square is facing macroeconomic headwinds as the lower-end consumer depends more heavily on credit.
- The tightening credit requirements in the market pose a risk to Square's core market and growth strategy, particularly in small-to-medium-sized business lending and consumer lending.
- Over half of US small business owners believe we are currently in a recession.
Block (SQ) is in a peculiar spot right now in this macroeconomic environment. On the one hand, the Fed is keeping rates higher for longer. On the other, per Reuters , the majority of small business owners believe the US is already in a recession.
No matter how you cut it, the business environment going into 2024 is poised to be a challenging one. An even bigger challenge is how we should be valuing the firm, whether it be compared to fintech firms, a bank, enterprise software, or even a credit card firm.
Valued as a bank, SQ shares are trading at 1.85x book value, well above the 1.03x average for the financials sector. As a tech company, 1.63x sales is a much more appealing valuation. Given their broad exposure, I believe the best way to value SQ is by a sum of the parts by a cohort of its peers by percentage of revenue. Given this SotP analysis, I give shares of SQ a sell rating with a price target of $46.71/share for a P/BV of 1.59x. With respect to the recent departure of Square CEO Alyssa Henry, I will mark down my valuation target to 1.5x book value for a price target of $43.93/share.
One of the biggest risk factors Block faces in the near future involves their core market and their growth strategy. Many of the larger banks have tightened credit requirements for Main Street lending. CNBC reported at the end of July 2023 that as credit conditions became stricter, demand for loans fell. According to the Senior Loan Officer Opinion Survey , banks also tightened the standards for consumer lending relating to credit card loans and other consumer loans. Banks are also raising the minimum level for credit scores when issuing personal loans. Though Block doesn't report their market's FICO scores, we might be able to add some color using one of their competitor's breakouts.
SoFi (SOFI) has a broad duration across the FICO spectrum. 55% of their customer-base has a FICO score below 700 with 13% residing below 599. Using Citizens Financial Group (CFG) for comparison purposes, the bulk of their consumer lending clientele reside above 680 with only 10% residing below the 680 mark. Assuming fintech runs in packs, my presumption for Block's clientele is that they're more comparable to SoFi than Citizens. Given this risk, the bank may run into a wave of delinquencies as the credit markets remain tight and the overall economy loses steam. Their BNPL business through Afterpay runs a similar or higher risk when compared to the standard consumer loan given the size and short duration of the loans as well as the types of consumption associated with these microloans. I can see this business going two ways, either consumers tighten their purse strings and make few purchases, which will negatively impact Afterpay, or they will more heavily rely on Afterpay to make purchases and put the firm at higher risk of delinquencies. Either way, I don't see a very rosy picture from the business unit. For valuation comparison purposes, I used Sezzle (SZL) and Affirm (AFRM).
With the risks involved with consumer lending comes the risks to their business-oriented lending unit. As described above, the majority of small business owners suggest the US is currently in a recession. With both high inflation and less resilient economic growth as seen in GDP and PMI readings, business conditions are becoming significantly more challenging. Because Square Capital typically caters to the small-to-medium-sized business space, credit quality can create challenges when looking from the outside in. Testing out their methodology, I set up an account with Square to find out exactly how easy/challenging it is to obtain a business loan. Square Capital only loans to those with existing cash flows within their ecosystem, which in my view is a quality guardrail for risk management. One detail I find interesting is that Square Capital does not publish rates on their loans and rather charges a set fee. The only information I could find on this relates to a 2016 Fortune article suggesting business loan fees range from 10-16%. Whether this figure still stands is questionable; however, given the current federal funds rate compared to the 2016 rate, this figure may be closer to 20%+. In addition to this, customers are charged a percentage of payments processed as opposed to making an independent payment to ensure the loan is repaid. These qualities lead me to believe that customers of their business lending department are on the lower end of the credit spectrum and pose a higher risk of default during times of economic stress.
Though there is a cohort of economists that are expecting a recession to set full course in either the second half of 2023 or first half of 2024, the evidence on Block's delinquency rates has yet to show signs of loan deterioration. 18% of their loan book has payments past due; however, much of this is skewed within their 1-60-day category.
Removing the shortest period provides a market rate much closer to the average rate of 4%. One of the bigger challenges I see facing this segment is the student loan moratorium lapsing with returning payments beginning in October. Though Block doesn't do business in this space, the overall stress on the consumers' balance sheet may bleed into Block's peer-to-peer transactions and lending operations.
Subscription and service-based revenue accounts for 26% of total revenue while gross margin stands far above their other segments at 81%. This segment primarily includes their retail operating software such as scheduling, payroll, and inventory management, amongst other services. This segment also happens to be the most stable and consistently growing segment on their books. Though I don't expect this segment to experience too much stress overall, growth may be challenged in the instance of broader economic stress to smaller businesses using their software.
On a macro basis, consumer sentiment is expected to drop to 67.7 in September, down from 69.5 as inflation and gasoline prices remain heightened. Despite the pessimism from consumers, spending remains high as Americans continue to spend; however, there are warning signs as the savings rate continues to tick down.
Accordingly, restaurant consumption remains strong as restaurant spending increased by 4% in aggregate in August.
Though this is great news for Square's business services, the cohort of restaurant spending from the consumer's perspective doesn't entirely cater to their demographics.
CENSUS_Consumer_Retail_and_Food_Services.pdf
In addition to this, August retail sales were relatively mixed as total sales were up 3%; however, categories that pertain to Block lending, credit cards, and BNPL may make this reading less enticing. Sales for home furnishings were down -4.3%, electronics down -2.2%, building materials down -2.5%, and gasoline stations down -13.6%. The primary gainers included health & personal care up +8%, vehicle & parts up 3.5%, food & beverage up +3.3%, and clothing up 1.4%. Though this economic data pertains to the broader market, the bulk of the items that would need financing, net of vehicles, were down for the month of August. This may be the beginning signs of stress on the consumer that may trickle into Block's business services.
Aside from this negative connotation, there are some strengths in Block's operations. Cash App inflows remained strong in q2'23 as reach continues to grow. Though Block doesn't charge for storing cash in their application, the firm does monetize same-day transactions as well as fees on B2C transactions. This feature may benefit Block in a tighter economy as consumers may require their cash to be more readily available to pay bills and expenses as savings are depleted.
Valuation
Overall, I see some challenges going into the next year for Block as the broader domestic economy is showing signs of a slowdown, especially for the small-to-medium-sized businesses and low-income individuals. As far as banking operations goes, Block didn't experience nearly as drastic of an unrealized loss on their debt assets as other regional banks, experiencing a mere 3% unrealized loss. Along with the consumer challenges Block may be faced with in the coming year, Bitcoin trading may experience a similar hit as consumers have less discretionary income to trade with. As Bitcoin trading accounted for 43% of revenue with a 34% growth rate, this volatile segment has the ability to significantly affect Block's overall topline growth rate.
With these risk factors in mind, I give SQ shares a sell rating with a near-term price target of $46.71/share based on a P/BV of 1.59x. That said, given the recent departure of Square CEO Alyssa Henry, I believe the valuation should be marked down to 1.5x book value for a price target of $43.93. Despite the broader financials sector scoring a 1.03x P/BV, I believe SQ shares should trade at a higher premium that's more comparable to their peer technology firms in BNPL and peer-to-peer transaction services. Though I do believe this sell rating is coming in more conservative, I also believe the diversity in their services requires the higher premium. Pending economic activity going into the end of the year, this recommendation may be revised down going into 2024.
SQ has a 3.01% short interest with a cost to borrow of 41bps. November 17th 47.50 puts are priced to strike around my price target with -0.27 delta and -0.026 theta. Delta should improve as we near the term with minimal time sensitivity, allowing stronger pricing action in the coming month.
For further details see:
Block Runs The Risk Of Being A Bank