2023-12-23 05:09:24 ET
Summary
- Block stock has struggled to regain positive market sentiment since its bubble burst in late 2021 - as has many of its Fintech peers.
- A difficult macro environment resulting in slowing near-term growth have been the primary drivers.
- Despite these headwinds, Block's underlying businesses remain strong with ample long-term potential.
- Increased managerial discipline and early signs of improving profitability are also being discounted by the market.
- As a result, Square looks attractive at current levels. Even after a sizable rally over the past two months.
Investment Thesis
Since its bubble burst in late 2021, Block (SQ) stock has failed to recapture positive market sentiment, underperforming the broader market. Yet the quality of Block's underlying businesses remains robust. Despite valid investor criticisms and a more uncertain growth trajectory, Block's long-term opportunity still looks compelling. A more disciplined managerial approach has led to early signs of improving profitability, which is becoming more vital as overall topline growth slows. Should the company continue this trend, SQ is a buy at current levels.
Fintech out of Favor
After popping a valuation-driven bubble in late 2021, Block has struggled to retake ground vs the S&P 500. My last article on Block was shortly after the sell-off - and SQ has hovered in the same range since.
Interestingly, the same has been the case for several of its fintech peers:
Only recently has the fintech sector seen some strength - perhaps Mr. Market is changing his mind. Much of the market's apprehension has been driven by a tenuous macro picture. Rising interest rates and inflation through 2022 and 2023 helped put riskier (and less profitable) sectors like fintech on the chopping block. Recent optimism was largely spurred by increasingly likely rate cuts in 2024 and 2025 along with cooling inflation and wage growth.
A loosening economy could spur just as strong of a rally for fintech stocks as the tight economy drove the downturn. The problem is, trying to judge short-term sentiment around the economy is a fool's errand. Investors are better off focusing their attention on the primary driver of long-term returns: underlying business performance. And Block's have shown durability even in a tough economic environment.
Underlying Business Strength
Square
My last article dove into the powerful cohort economics, rapid payback periods, and high ROIs that Block's merchant business, Square, has been able to routinely produce. Since then, Square has dealt with some headwinds as it's heavily tied to consumer spending, which dipped the past two years.
The result was a hit to overall gross payment volume ('GPV') which trickled down to slower revenue and gross profit growth.
This marked drop off in growth is enough to scare plenty of investors, but it makes more sense within the context of a stimulated 2021 economy and subsequent 2022 events. Block cofounder, Jack Dorsey, also recently retook the role of Square Head (great title). He kicked off the Q3 shareholder letter highlighting several internal inefficiencies and roadblocks hampering the potential of the business - and what leadership plans to do about it. Square is a high quality and innovative business well-positioned to ride numerous tailwinds within omnichannel commerce - this increased discipline should help the business capture it. To get an idea of the remaining runway, management estimated a total addressable market ('TAM') for Square of $120B in 2022, representing less than 3% penetration based on Square's TTM gross profit. On the innovation front, Square started with point-of-sale products and has expanded its offering to 35+ products for sellers. Additionally, the business has seen momentum both upmarket and internationally.
Square's move upmarket is a positive as large sellers tend to adopt more products and carry more stable budgets. The result is expanded recurring revenue and greater customer lock-in. International GPV climbed 30% in Q3 2023, highlighting more meaningful progress on this $25B TAM runway.
Banking has been another attractive area for Square, with its respective gross profit growing 24% YoY in Q3. Management sees Banking as a key for long-term customer acquisition and retention within Square:
"…we see banking today as more retaining our customers and when someone comes into the Square ecosystem, signing up for a loan or a card, a debit card or credit card or savings account, helps keep them. In the future, we do believe that this will become more and more an acquisition channel for us as well. And I think it's one of our strongest differentiators."
Square has built a customer base of now over 4 million merchants and virtually controls the point-of-sale market at a 30% market share (by number of domains) according to 6-sense . What's more is there has been a clear focus on products that generate more recurring revenue through subscriptions & services. This high-margin portion of revenue has seen an uptick in growth and now represents a larger portion of Square revenues:
Square has done well in cross and up selling its product suite to drive further growth and increase customer lifetime value. Despite its near-term headwinds, Square's quality remains robust with plenty of long-term opportunity ahead.
Cash App
Block's consumer finance business, Cash App, has been a shining star for the company, now eclipsing Square in terms of gross profit and nearly doubling its growth rates. My previous article focused on Cash App's inherent network effects through its 80+ million annual actives. The focus then was increasing Cash App's monetization through peripheral products, financial services, and commerce - all of which have resonated since. Management's framework for evaluating Cash App's profitability has three pillars: monthly transacting actives, inflows per active, and monetization rate - each saw healthy YoY growth in Q3:
- Monthly transacting actives: 55 million, up 11%
- Inflows per active: $1,132, up 8%
- Monetization rate (gross profit/inflows): 1.43%, up 8 basis points
Improvements in Cash App's profitability have been largely driven by success in the categories just mentioned. Cash App Card reached 22 million monthly actives in Q3 up from 18 million last year, Cash App Pay recorded 2 million monthly actives which doubled since the prior quarter, and Cash App Borrow saw 2 million monthly actives, originating $900M in loans. Each of these combined helped generate 29% YoY growth in subscriptions revenue for Cash App. Similar to Square, Cash App has been able to rely less on customer acquisition in favor of monetizing existing customers. Long-term, Cash App is aiming to become the financial home for its customers, which would create more sustainable inflows and cross-sell opportunities. The business's early progress on that front is promising.
Another piece of Block's long-term strategy is further integration between its suite of ecosystems, primarily through Block's acquired buy-now-pay-later ('BNPL') business, Afterpay. The potential synergies here are compelling, as I alluded to in my last article. There has not been a ton of progress on this front besides tying the BNPL capabilities into Square and Cash App. BNPL contributed a small $94 million to Square and Cash app in Q3 but grew gross merchandise value ('GMV') 24% to $6.7B YoY. Management will now be reporting BNPL exclusively within Cash App as the focus is on driving actives to commerce.
Overall, the market is discounting the quality and remaining potential of Block's underlying businesses in my view. Near-term headwinds and slower growth have weighed down sentiment, even as operational discipline is improving.
Operating Improvements & Outlook
Even though I believe the slowdown in Block's growth is likely temporary, it does create greater reliance on improving profitability within the company's long-term thesis. This was an area of focus back in 2022 but with little fruit - in part due to a tough economic environment. Still, management is ultimately responsible. Lack of historical cost discipline, questionable capital allocation, and excessive stock-based compensation ('SBC') are all valid criticisms of leadership. In the company's Q3 letter, Dorsey opened discussing management's renewed discipline around operations, calling back to the objective target they set earlier this year:
" Block and each ecosystem must show a believable path to Gross Profit Retention of over 100% and Rule of 40 on Adjusted Operating Income ('AOI')… We believe this framework balances creating long term value for customers with the same for our shareholders. We believe we will reach Rule of 40 in 2026 , with an initial composition of at least mid-teens gross profit growth and a mid-20% Adjusted Operating Income margin."
Management appears to recognize the cost of SBC to shareholders by both reporting AOI (which includes SBC expenses) and by authorizing a $1B share repurchase to offset some of its dilution. Additionally, leadership is capping headcount at 12,000 which will reduce SBC expense. This also means they'll be trimming their workforce by 1,000 by the end of 2024, creating leverage within employee costs. Sales & marking expenses were down 1% in Q3 showing early signs of operating improvements. Block's overall profitability is already benefiting from this increased focus on shareholder value. AOI climbed to $90 million from $32 million last year and GAAP operating losses improved from -$49 million to -$10 million.
Looking forward, leadership expects record profitability in 2024 and revised previous estimates upward:
Keeping this improvement in operations in mind, let's move to valuation.
Valuation
Management expects gross profit growth in the mid-twenties for 2023 and the mid-teens for the foreseeable future, with Cash App growing slightly above and Square slightly below. Given Block's historical capacity to grow at incredible rates and the innovative nature of its businesses, I believe this medium-term estimate somewhat understates Block's potential. Even management pointed out the estimates are based on current run rates, which have been hampered by the macro environment.
"So, what you see here with 2026 growth, what we've shared so far really is based on our current run rate trends. And of course, we'll periodically update this as we learn more, whether it's from a macro perspective or based on our own execution and ability to accelerate.
And relative to that current view of at least mid-teens growth, we'd expect Cash App's growth to be slightly above that and Square's growth slightly below. But our focus is on exploring new growth initiatives, and then we'll incorporate those as appropriate into our outlook over time. We have a history here of unlocking new innovation on products and across new audiences to continue driving outsized growth and we'll continue that work."
Additionally, the P2P and PoS global markets are expected to grow at a 18% and 15% CAGR through 2030 respectively. Nonetheless for conservatism, my base case has revenues growing at a CAGR of 13% through 2032. Gross margin gets a bit blurry thanks to Block's investment and holding of customer funds in Bitcoin, which heavily weigh down Cash App's margins:
For consistency I assumed a neutral impact from Bitcoin resulting in gross margins staying near 35% for the forecast period - relatively close to historical averages. For operating margins, I expect continued leverage within SG&A but less in R&D as the firm continues investing in future products. The result is base case operating margins reaching 11% in 2032. Additionally, my base case holds that fixed and working capital investment will remain close to historical averages:
- Capex at 1% of revenues
- Depreciation & Amortization at 90% of Capex
- Change in Net Working Capital averaging about 0.5% of revenues.
Lastly, I introduced an upside and downside case and assigned probabilities to each. This allows us to test a range of assumptions and estimate the likelihood of potential outcomes. As you can see from the below results, each case has wide variability in implied share price, with more upside than downside based on the case assumptions. Block's outcomes carry uncertainty, but should the company continue to improve fundamentals, the upside is significant at current prices. Additionally, I assigned a probability to each case, with the heaviest weight given to my base case. The result is an expected value of $88.68 or 14% upside.
Author Estimates
Risks & Uncertainty
With Block's uncertainty comes several internal and external risks investors should be aware of. As touched on earlier, Block has had a history of diluting shares largely through SBC.
Thankfully management has begun to deal with this cost to shareholders via the $1B share repurchase plan. Capital allocation has been a criticism on the part of leadership the past few years with Block paying a hefty $29B for BNPL platform Afterpay, several acquisitions that don't seem to add value to its core offering, and the company's sizable investment in Bitcoin. Nonetheless, leadership has done well in fortifying Block's balance sheet with $6.3B in cash and a debt-to-equity of 30%. The Afterpay acquisition was also done with all equity at a time when SQ stock was priced near all-time-highs. The deal was announced in August of 2021 at a value of $29B. But by the time the deal closed in January of 2022, SQ stock had fallen, and the deal was valued at $14B. Should leadership's rhetoric on a more disciplined approach come to fruition, capital allocation becomes less of a concern in my view.
Externally, Block continues to face competitive pressures but has done well in defending its market share for both Cash App and Square. Though it's not an 'apples-to-apples' comparison across fintech firms given their varying offerings, Block holds its own in terms of payment volume and take rates:
As we saw, Fintech has been out of favor in large part thanks to a more tenuous consumer. Block and peers are more sensitive to consumer demand and the overall macro environment. Data is mixed on how the economy will perform in 2024, but either way, this is at most a near-term risk in my view.
Lastly, SQ has seen a nice run-up since the beginning of November and may be overextended, presenting the possibility of near-term downside:
Conclusion
At current levels, Block carries more upside than downside in my view. Market sentiment the past two years pushed Block and fintech peers out of favor, overlooking the company's underlying business strength and potential. Despite slowing growth and near-term uncertainty, leadership has become more disciplined on several fronts, most importantly on generating long-term shareholder value.
For further details see:
Block: What Mr. Market Is Missing