2023-06-12 10:35:26 ET
Summary
- Block operates in the highly competitive financial technology market which recently has begun to face concerning macroeconomic conditions.
- Its competitive edge has been faltering with accusations of fraud and user inflation, as well as contentious acquisition sentiment.
- Despite reporting strong earnings in Q1, Block’s overall financial metrics and valuation seem unclear.
- Until Block has proven its ability to navigate its macroeconomic climate and headwinds, investors are advised to watch from the sidelines.
pymnts
Company Overview
Block, Inc. (SQ) is a financial technology company that has sought to expand beyond its original credit card reader business to embrace other diverse business lines and blockchain technologies. Despite strong recent Q1 earnings , there remain significant macroeconomic challenges and headwinds that cast doubt on the attractiveness of Block's valuation.
Block’s business model works in 2 main operating segments:
Square
Square provides businesses with a comprehensive ecosystem of commerce solutions, business software, and banking services. Their primary service is a payment system designed to simplify business management through software. While they have seen success in dealing with small to mid-sized businesses (SMBs), as the overall market intensifies in competition, Square needs to begin securing larger customer bases or improving its moat in order to continue growth.
Cash App
This segment enables peer-to-peer payments, facilitates direct deposits, and allows for easy Bitcoin and stock investments. Their flagship product, Cash App , also provides a physical debit card, the Cash Card, for making purchases and withdrawing funds from ATMs. In Block’s financial statements, we see that Cash App does make significant net revenue from transaction costs with Bitcoin. However, its inclusion of such revenue is quite confusing. It not only complicates the company's financial analysis for investors but also inflates the total revenue figure while contributing minimally to gross profit. As seen in the future below, despite Bitcoin only adding to profits by only $50M, the addition of a total net revenue of over $2B only adds confusion and muddles the reported revenue change YOY.
Block 2023 Q1 10-Q (Block)
Macroeconomic Concerns
To better gauge Block’s recent downtrend, its essential to consider the recent macroeconomic climate. In early 2021, the e-commerce industry and digital payment services experienced a remarkable surge in growth, owing to the pandemic and its strict regulations for in-person interactions. Notably, companies such as Block, PayPal, and other similar companies witnessed unprecedented growth during this period. However, as pandemic regulations have eased and the World Health Organization declared COVID-19 no longer a global public health emergency as of May 5th, 2023, these once thriving companies are now facing a slowdown in their growth trajectory. Resumption of in-person spending and increased use of cash has decelerated e-commerce spending, which can easily be observed in the growth rate of PayPal, the market leader of the digital payment market. With competition only continuing to rise, in order for Block to maintain its market position and foster continued growth, it must build upon its market operations and strengthen its economic moats.
Value of payments processed of PayPal (Statistica)
Furthermore, during the pandemic, Block made significant strides in expanding the reach and adoption of Bitcoin. The company launched two initiatives, TBD and Spiral, aimed at developing Bitcoin projects and promoting the overall exchange system. Despite these efforts, the hype around cryptocurrency has largely waned in response to its high volatility and risk. With Bitcoin's value plummeting by over 50% from its peak and the subsequent collapse of the FTX exchange magnifying these concerns, ongoing challenges such as the persistent threat of fraud, cybercrime, and mounting regulatory scrutiny have further intensified the precarious position of these initiatives. Consequently, this has led me and many investors to raise valid concerns about the future of Block's growth initiatives and their potential for success.
Seeking Alpha
Financial Analysis
Taking a closer look at Block's financials, we see that Block’s market capitalization has declined to $38.44B, a fraction of its value during the peak of the pandemic. Likewise, while Block’s significant revenue growth during the pandemic is reflected by its 43% CAGR, recent trends indicate a deceleration in growth. Analysts anticipate a tapering off of growth in the coming years, projecting a more modest 15% revenue YOY change.
TIKR Revenues (Seeking Alpha)
Despite the overall slowdown, this quarter has brought surprising results for Cash App, which reported revenue of $1.11B, up 52% year over year (excluding Bitcoin transactions). Additionally, Square has also demonstrated strength, with Block reporting them to be up 15% gross profit YOY and 15% revenue YOY. Despite clearly improving from Q1 of 2022, it is important to acknowledge that Block is still operating at a $6M gross operating loss. While Block’s 13% increase in operating expenses (22% increase YOY) is cited in its 10-Q report largely due to its recent acquisition of Afterpay, the main principles of Buy Now Pay Later and the mounting bad debt associated with Afterpay raise concerns about the long-term profitability of this acquisition.
Block
Furthermore, it is worth noting that Block has been consistently partaking in stock-based compensation. In its Q1 report, it amounted to $279.59 million, greatly outweighing the impact of the company's most recent share buyback of 4.73 million shares. By examining the graph depicting Block's total shares outstanding, we can observe a gradual increase in outstanding shares, with a significant spike in January 2022 following the Afterpay acquisition. With share-based compensation showing no sides of stopping due to poor profitability and cash flow, it is reasonable to anticipate decreased demand and a potential reduction in investor stakes.
Headwinds
1. A hit to ESG and social responsibility
A couple of months ago, Hindenburg released a highly critical report regarding Block, raising concerns about misleading metrics due to user inflation, and accusations of Block's involvement with fraud and other illegal activities. This resulted in a hit to Block’s already average ESG rating, with key considerations being its involvement with issues regarding customer relations and privacy, and data security. These issues can be rooted in the fact that customers can create a Cash App account with only their email and instantly be able to send, receive, and use small amounts of money. Scammers are able to create false accounts with names of celebrities, strangers, or even acquaintances, and use Cash App to quickly steal an identity, make an account, transfer money, then evade many repercussions. This paper leads many investors to question if Block is purposely allowing these illegal practices to continue in order to boost acquisition volume and inflate metrics, and spotlights Block’s questionable behavior and lack of effective measures to address these issues. Despite Block’s response , they largely only addressed their the overexaggerated user inflation but did not directly respond to other issues such as fraud expenses, and interchange revenue.
2. Customer Acquisition Inflation
Building upon Hindenburg's research, one of Cash App's perceived advantages has been its seemingly low customer acquisition costs. Hindenburg’s accusation of the true number of unique customers Block actually has corroded one of Block's key drivers for success. While Block has refuted Hindenburg Research's report that said former Block employees estimated 40% to 75% of accounts were fake, they still acknowledged inflation of 16% -31% in their internal user counts, understating their true acquisition costs and damaging their competitive edge. Despite this, Cash App has seen remarkable growth (even exceeding Square’s gross profit recently) and Block has already largely recovered from Hindenburg’s report.
3. Afterpay Acquisition and Buy Now Pay Later
In January 2022, Block closed its acquisition of Afterpay , a Buy Now Pay Later (BNPL) service, for $29B. The execution of the BNPL service by Block has generated controversy among investors, including myself, as Afterpay does not assess an individual's credit history to determine their ability to repay loans. This approach raises concerns about the potential long-term consequences of enabling people to accumulate additional debt without considering their future repayment capabilities. Despite Block's mission to empower everyone to “participate and thrive in the economy”, mounting concerns in Australia regarding Afterpay's expense management loopholes, regulatory tightening, and debates about the transformation of "buy now pay later" into "buy now pay never" cast doubt on the future prospects of this acquisition. While Afterpay has demonstrated profitability in the short term, the culture of fostering financial irresponsibility among its primary demographic of younger consumers could lead to disaster and financial ruin in the future.
Valuation
Due to the sudden surge and crash of the digital payment industry, both Block and its competitors have faced a slowdown in revenue growth and a decline in profitability. As opposed to doing a DCF to find the fair value of the company, I instead opted to utilize a comparable companies analysis using trailing twelve months [TTM] data, historical trends, and sector medians to assess Block's market position.
Analyst's valuation
Examining Block's P/E ratio of -113.49x, we see this large negative P/E comes from its negative net income despite its strong revenue numbers. While we can attribute the negative net income to the recovery from the pandemic’s highs (as also seen in Global Payments, Shopify, Toast Inc.), when we compare its P/E ratio to its historic P/E, it seems evident that Block is trading at a fairer value than at its peak. Despite this, the comparables average P/E of -69.48 still demonstrates that Block is considerably overpriced relative to many of its industry peers.
Historic 3-yr P/E Graph (TIKR)
An interesting point of comparison is PayPal , the market leader in the digital payment market, which, despite experiencing a decline of over 50% from its 3-year average, has managed to retain profitability at a much lower TTM P/E ratio of approximately 26.83x. As such, it becomes apparent that while Block may show indications of eventually achieving profitability and a more attractive valuation similar to PayPal during its post-pandemic recovery, it remains relatively overvalued compared to its industry peers. Therefore, I advise investors to hold off on purchasing Block at this time. To delve deeper into the analysis, I also examined Block's EV/EBITDA ratio. Given Block's struggles with profitability and financial challenges post-pandemic, its TTM EV/EBITDA value is unsurprisingly a staggering -675.17x. This metric reflects the company's current unsustainable operations and ongoing net losses despite revenue growth. However, it's important to exercise caution in interpreting these valuations, as revenue and cash flow growth is recovering for the company and its long-term outlook is still uncertain at present. On a technical analysis note, it is worth considering that Block has had found historic psychological support zones in the range of $50 to $55. These levels suggest a much more appealing P/E ratio and valuation for potential dip buyers looking to take advantage of mean reversion. Currently, Block appears to be consolidating between approximately $90 and the said $50-$55 range. However, as Block continues to mature and respond to the new market landscape, a move above these support zones, along with crossing the 200-day exponential moving average (red line) and the 50-day EMA (green line), would signal bullish consumer sentiment and overall health for Block.
Heiken-Aishi Candle Sticks (ThinkOrSwim)
ESG
MSCI
MSCI
While I wish I could offer ESG-conscious investors some concluding solace, despite some advancements in sustainable energy, such as the Bitcoin Clean initiative and the use of solar energy for mining, Block's ESG performance falls short of expectations. With a BBB MSCI rating (downgraded from an A in May 2021) Block falls in the bottom 50% of companies in its sector. Key criticisms from the Hindenburg report, including information theft and security breaches, as well as concerns about Block’s involvement in illegal activities and user inflation, have led to its tarnished ESG standing. However, Block still has the potential to improve its ESG score by leveraging its strengths in management, governance, and sustainability, provided they implement future measures to fully address the criticism it received from Hindenburg.
Bottom Line
In summary, my recommendation for Block is a HOLD, with a slightly short-term bearish inclination. Block has shown promising revenue growth and short-term success with Afterpay, and Cashapp, and its management team and CEO's strong support for Bitcoin suggest potential for long-term growth. However, the current macroeconomic climate presents significant vulnerabilities for Block, as even market leaders like PayPal are facing challenges. While I believe it is crucial for Block to improve its financial responsibility with Afterpay and implement effective measures to uphold social responsibility, I advise investors not to dismiss Block entirely. Instead, I suggest monitoring the company from the sidelines closely, waiting for a more attractive entry point and definite valuation.
Analyst recommendation by: Ian Hartana
For further details see:
Block: Tough Roads Ahead