2023-07-11 00:25:18 ET
Summary
- Block has been posting solid growth for both Square and Cash App.
- The company wants to achieve a Rule of 40, but still has ways to go, as its SBC remains an issue.
- The company, meanwhile, faces questions about its Cash App metrics, as well as faces stiff competition in its largest Square vertical.
Block ( SQ ) has been putting up solid growth and its valuation has become more attractive, but questions remain about competition, the macroenvironment, and its Cash App business metrics.
Company Profile
SQ is a fintech company with businesses in several ecosystems. The company is best known for its Square ecosystem, which was originally set up to allow sellers to accept credit and debit card payments. The square ecosystem now has more than 30 software and hardware products to help sellers. This includes things such as vertical specific products like Square for Restaurants or Square for Retail, as well as solutions for online checkouts, invoices, appointments, fraud prevention, loyalty, payroll, and hardware solutions such as card readers and terminals.
The company’s Cash App, meanwhile, is an ecosystem of financial services to help users send receive, store, and invest money. The app is used primarily as a peer-to-peer payment network, which when linked to a debit account is free. Cash App has since gotten into offering services such as debit cards, instant rewards, saving, lending, tax preparation, stock brokerage account, and crypto services.
The company also has two emerging ecosystems centered around bitcoin and music.
Opportunities & Risks
Around the start of the year, SQ made a simple mission statement: “Block and each ecosystem must show a believable path to gross profit retention of over 100% and Rule of 40 on adjusted operating income.”
For those unfamiliar, the Rule of 40 is a popular metric used by SaaS investors and analysts to determine whether a company is growing efficiently, and just not growing for the sake of growing. The Rule of 40 is simply that if you were to add a company’s revenue growth rate with its profit margin it should exceed 40%. EBITDA margins or adjusted operating margins can be used in lieu of GAAP profit margins. Meanwhile, annual recurring revenue [ARR] or monthly recurring revenue (MRR) growth can be used instead of simple revenue growth, while for SQ I’d use gross profit growth given the nature of the business, as it is more akin to revenue.
For SQ, if we use Q1 gross profit growth (32%) and Adjusted EBITDA margins (21.5%) the company would be about 53.5%, well above 40%. However, the company has a lot of stock-based compensation excluded in that number. Add SBC back in the equation (~$386 million EBITDA - ~$280 million SBC) and the profit margin is around 6%, and SQ falls below the Rule of 40 at 38%. Use adjusted operating profit margin of 3%, and it also falls below at 35%.
The company also made an acquisition, so on a combined company basis, gross profits grew 27%. That put its Rule of 40 numbers at 32% for EBITDA including stock comp and at 30% for adjusted operating margin. So the company has some work to get to that Rule of 40 level.
For its part, SQ has said it wants to treat SBC as an ongoing expense, which I think is commendable. The company has been often criticized for its high SBC and rightfully so. Last year, SBC was nearly 18% of gross profits and over 16% in Q1. That’s a large expense.
Now SQ’s SBC isn’t going to meaningfully shrink overnight, and the company said it still sees it as a good way to attract and retain talent. However, it does want its teams to treat it as real expense when making decisions, and it thinks it will be able to drive efficiencies and leverage SBC over time. Acknowledging it as a real cost, though, is a step in the right direction.
When it comes to growth drivers, Cash App it both the largest and fastest growing part of SQ, with Q1 seeing the ecosystem’s gross profit rise 49% to $931 million. Innovation and introducing new features and ways to monetize its large user base is a big growth driver. Savings is one of Cash App’s newest innovations, launched in January of this year. The company said at the end of April in already ahead 3 million active accounts, with most having users having a savings goal or using Round Ups to automatically save.
The Cash App card, meanwhile, has been seeing tremendous growth. Recently adding the option to the onboarding process when users join has shown a nice uplift. The company has also been adding security features and its Boost instant reward program is also helping drive usage.
On the Square side of the business, the company is looking to drive growth through going upmarket, as well as expanding internationally. It is also looking to innovate and help omnichannel transaction, introducing over 100 new products, features, and partnerships across the ecosystem.
Moving upmarket to larger businesses in the restaurant, retail, and beauty industries is a focus. Approximately 38% of its sellers now have more than $500,000 in annualized GPV, which is up from 30% two years ago. The company said it has recently redesigned its homepage to help target these larger sellers. Internationally, meanwhile, it is looking to start offering the same product suites in international markets as in the U.S. On this front in Q1, the company just introduced Square for Restaurants and Square Loyalty in Japan.
When it comes to risks, the economy is a big one. As a transaction-based business, the Square side of the business is partially dependent on the sales strength of its collective customers. Its main verticals are restaurants and retail, which can see sales slow during recessionary periods.
Competition is another area to watch. Nearly a third of the Square business is related to the restaurant industry, and rival Toast ( TOST ), which I wrote about here , is making strong inroads. Toast has some of the best restaurant vertical solutions around and is a formidable competitor. Given its explosive growth, it could make sense for SQ to look to buy TOST before it become too big and wouldn’t be able to.
Meanwhile, Hindenburg Research has accused SQ’s Cash App of inflating user metrics and helping facilitate fraud. The firm makes some pretty bold claims, which can be found here . When dealing with unbanked customers, obviously there can be some controversy about whether a company is helping these customers or taking advantage of them. And just like Bitcoin, why these alternative methods are being used can also be questioned.
Valuation
I think the best way to value SQ is using an EV/gross profit metric. The company has gross margins of about 34.2% last year. Keeping that rate steady, based on the revenue consensus of $20.7 billion, it would generate about $7.08 billion of gross profit.
On that basis, the company trades at about a 5.8x multiple. That's a huge discount to where the stock traded pre-pandemic.
From an EBITDA perspective, the company is projected to post EBITDA of $1.39 billion. That puts it at about a 21.6x multiple. However, stock comp will likely wipe out most of those profits.
Conclusion
From a financial perspective, SQ looks pretty attractive priced given its growth, and these types of businesses it’s in are generally fairly attractive. The Cash App business is growing rapidly, and the company has been able to find ways to add services and better monetize the product. Meanwhile, inflation has been beneficial to the Square business, as higher costs can lead to higher transactional revenue.
While the Hindenburg accusations are a bit over the top, the firm does have a pretty good track record, although it doesn’t usually go after well-known companies like SQ. At the same time, I think TOST is outperforming the company in its largest vertical, the restaurant industry.
SQ also has a ways to go to improve its growth efficiency and get to that Rule of 40. I like that the company is acknowledging its SBC issue, but it has not fixed it.
Balancing out the risks and rewards, I lean slightly bullish on the name, but note quite enough to put in Buy territory.
For further details see:
Block: Solid Growth, But Some Concerns