2023-08-22 16:56:10 ET
Summary
- Marqeta finally extended its partnership with its largest customer, Block.
- Despite renewed optimism, fundamental uncertainty arises due to how the new deal is structured.
- Valuation remains attractive with sentiment and price trend flipping to the upside.
- I highlight 8 reasons why Block could end up acquiring Marqeta.
- I highlight 3 reasons why I continue to hold the stock.
Introduction
Marqeta ( MQ ) is a modern card issuer processor that allows businesses to launch customized card programs that are highly configurable, scalable, and simple. Through its cloud-based, open API platform, Marqeta aims to disrupt the issuing side of the legacy payment ecosystem.
Q2 was a breakthrough quarter for Marqeta as the company finally extended its partnership with its largest customer, Block ( SQ ).
Before the extension, the Block partnership, which consists of two separate contracts, Cash App and Square Card, was set to expire in March 2024 and December 2024, respectively.
The renewal of its contract to continue to power the Cash App all the way through June 2027 eliminates the risk of a major customer leaving the platform - at least for the next four years.
On the other hand, the Square Card contract has yet to be renewed - but given the significance of this new deal, I expect the Square Card contract to be renewed as well.
That being said, this article aims to discuss Marqeta's Q2 results as well as the implications of the Cash App renewal on the business.
Here's the main takeaway of the article:
Marqeta finally announced its highly-anticipated extension of its partnership with Block, which dilutes the risk of its largest customer abandoning the platform.
Despite a flip in sentiment, fundamental uncertainty arises with the new deal, particularly with how pricing and financial reporting are structured.
Nevertheless, Marqeta remains an undervalued fintech stock with decent upside.
Growth
In Q2, Marqeta processed a Total Processing Volume of $54B, which is up 33% YoY.
As you can see, growth has been slowing down over the last few quarters but this is expected as the company grows over a larger base. Nonetheless, TPV still grew 7% QoQ, extending its incredible streak of sequential growth.
TPV growth was due to growth across all major verticals, with notable growth from financial services, on-demand delivery, as well as Powered by Marqeta (PxM) customers.
In addition, the top five customers grew by 34% which outpaced the overall business, while TPV from all other customers grew by 25% in Q2. In other words, the larger customers are growing faster than the smaller customers, which increases concentration among the top five customers.
On another note, Revenue grew by 24% to $231M due to the growth in TPV that flowed through Marqeta's platform. However, growth was offset by unfavorable changes in its card programs mix, as well as Klarna - the Swedish Buy Now Pay Later company - migrating a portion of its programs to a competitor starting in Q3 2022.
Management guided for an 18% growth in Revenue in Q2 so this is a good beat on guidance. This also beat analyst estimates by $11M.
As you may have noticed, Revenue growth is much slower than TPV growth and this is due to unfavorable card program mix, particularly the growth of its PxM offering as compared to Managed by Marqeta (MxM), as well as the increasing concentration from larger customers.
Keep in mind that Marqeta operates a usage-based business model with two primary services: MxM and PxM.
- For MxM relationships , Marqeta receives interchange fees for processing its customers' card transactions and the company shares the majority of the interchange fees as Revenue share. These Revenue share payments act as incentives for customers to increase processing volumes on Marqeta's platform, and as customers' processing volumes increase, the rates at which Marqeta shares Revenue with these customers generally increase. In other words, the higher the TPV for a particular customer, the lower the proportion of Revenue that Marqeta gets to keep.
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For PxM relationships , Marqeta does not receive interchange fees but instead prices its services on either a percentage of processing volume or on a fee-per-transaction basis.
Here's a snapshot of Marqeta's business model:
To repeat, the higher Revenue share payments to larger customers as well as the mix shift towards PxM, are reasons why Revenue growth was slower than TPV growth. These are also reasons why Take Rates have been dropping over the last few quarters.
Management did mention during the earnings call that Gross Profit Take Rate is the best proxy for pricing but as you can see, Gross Profit Take Rate is at its lowest point, at just 0.16%. Furthermore, the Cash App renewal is expected to reduce Gross Profit Take Rate from Cash App by 40%, which means additional downward pressure on Take Rates moving forward. This raises concerns about Marqeta's pricing power.
Nevertheless, despite a challenging market environment and tough YoY comps, Marqeta still manages to post 30%+ TPV growth, which is a confirmation of Marqeta's strong value proposition, increasing adoption of fintech applications, and the growth of Marqeta's high-quality customers.
Profitability
Turning to profitability, Gross Profit for the quarter was $85M, which only grew by 8% YoY. As such, Gross Margin dipped to its lowest level ever, at just 37%. Despite the margin pressure, management was only expecting Gross Profit to grow by 2% in Q2, so Marqeta is still performing beyond expectations.
That said, Gross Margin fell due to a 40% increase in Card Network Fees, a 42% increase in the number of transactions, as well as unfavorable changes in the company's card program mix.
Gross Margin is typically the lowest in Q2 due to incentive timing whereby incentive contracts with the card networks run from April to March each year. Thus, incentive packages reset in Q2, thus lowering card network incentives for the quarter.
In addition, Block Revenue concentration increased from 76% in Q1 to 78% in Q2, which added more pressure to Gross Profit growth and Gross Margin.
The increasing revenue concentration is weighing our overall margin since our Block margin is over 40 points lower than the rest of the business .
(CFO Mike Milotich - Marqeta FY2023 Q2 Earnings Call ).
You can see why high Revenue concentration is a major risk when it comes to investing in Marqeta as it meant lower Gross Profits and ultimately lower earnings potential for shareholders.
Moving on, Marqeta turned Adjusted EBITDA profitable once again - nothing to be excited about though as it was only $1M in AEBITDA in Q2. Nonetheless, it is still trending in the right direction.
On the other hand, Marqeta is still unprofitable on a GAAP basis. As you can see, Net Margin is still very negative at (25)%, as a result of high Compensation and Benefits due to a one-time restructuring cost of $8M, a $10M one-time post-combination expense related to the acquisition of Power Finance, as well as high Share-based Compensation.
As you can see, Compensation and Benefits remain elevated at 55% of Revenue in Q2, with SBC accounting for 19% of Revenue.
All in all, Marqeta is still very unprofitable on a GAAP basis. Margins are still negative and fluctuating here and there which doesn't give me the impression that the company is achieving economies of scale or operating leverage.
That's probably management reinvesting into growth and that should pay off in the long run given its unique value proposition in modern card issuing.
Still, I would like to see a moderation of SBC spending as well as a material improvement in the bottom line, in order to build a stronger conviction on Marqeta.
Financial Health
Despite being severely unprofitable, Marqeta has a strong balance sheet with a Cash position of $1.4B and virtually no debt, which puts its Net Cash position at $1.4B. To put that into perspective, that is almost 50% of its Market Cap of $3B as of this writing.
The drop in Cash level in recent quarters was due to the company acquiring Power Finance for a purchase price of $222 million back in February 2023. Power Finance is a cloud-based platform for companies to create new credit card programs and this acquisition should strengthen Marqeta's credit product line.
On the other hand, Marqeta's cash flow is still unpredictable and that is probably one of the most frustrating things as an investor.
As of Q2, Free Cash Flow was $(26)M, which represents a FCF Margin of (11)%. To make matters worse, it seems that FCF is trending in the wrong direction.
The good news is that Marqeta doesn't seem to be burning a lot of Cash, at just an annual run rate of $100M, which is tiny compared to its Cash hoard of $1.4B. Still, it would be nice to see FCF turn positive... consistently.
That said, the combination of low Cash burn, high Net Cash position, and a plunging stock price prompted Marqeta to buy back shares.
In fact, Marqeta has been buying back shares aggressively at current price levels. On September 2022, Marqeta announced a $100M repurchase program and the company has completely exhausted that program. That led to management announcing another $200M share repurchase program on May 2023 which shows management's confidence in the business as well as the attractive valuation to acquire shares at these levels.
In Q2, the company bought back 10.2M shares at an average price of $4.75 for $49M, which is nicely timed given current prices.
And as of Q2, Marqeta still has $152M available for future share repurchases so I expect more buybacks in the next few quarters.
More importantly, the share buybacks helped to negate the dilutive effects of high SBC. As you can see, Shares Outstanding have been dropping in recent quarters, which is great to see.
Outlook
Now let's talk about the outlook of the business.
As you may already know, Marqeta and Block signed a four-year extension to the Cash App contract - the new deal is structured very differently, which has a major impact on the financials of the company moving forward.
Let's dig deeper into the Cash App renewal. According to the company:
In addition to reduced pricing for the Cash App program , the Amendment provides that Block will be responsible for defining and managing the Cash App program with respect to the primary card network going forward. The reduction in pricing paired with the expected change to our revenue presentation occurring as a result of the Amendment, will reduce reported net revenue . In addition, on an overall basis, we expect the revised relationship will decrease gross profit and increase our gross margin percentage .
Let me elaborate further.
Previously, Marqeta manages the financial relationship between Cash App and the Card Networks. As part of the new agreement, Marqeta will no longer be responsible for this relationship, which resulted in lower pricing, and therefore, lower Revenue and Gross Profit.
Consequently, fees owed to Issuing Banks and Card Networks related to the Cash App primary Card Network volume - which is historically Marqeta's liability - will now be passed directly to Cash App and will no longer be recognized in Cost of Revenue, thus leading to Gross Margin expansion.
The good news is that Revenue and Gross Profit concentration from Block will drop meaningfully following the amendment:
What we expect based on this is that our revenue concentration is likely to fall, sort of in the mid to high 20s percentage points. And gross profit concentration is likely to fall around 10 percentage points based on this deal going forward.
(CEO Simon Khalaf - Marqeta FY2023 Q2 Earnings Call).
In other words, there's going to be a lot of changes in terms of the company's financial reporting moving forward.
And that creates a lot of uncertainty with respect to the growth and margin profile of the business, so much so that management did not provide formal guidance for Q3 and FY2023 in their earnings release - but they did during the earnings call.
My guess is that they want to prevent investors from panic selling - I believe they want investors to first acknowledge the company's strong Q2 results and that it finally extended its Cash App contract, and then slowly clarify the implications of the new contract on the company during the earnings call.
This is what management said - brace yourself:
Our expectations for Q3 are as follows; Net Revenue is expected to contract by between 49% and 51% with an approximately mid-70s percentage point decline due to the Cash App renewal. Roughly 15% of the renewal impact is a result of the new pricing terms, while the remaining 85% is due to our anticipated shift in accounting treatment.
(CFO Mike Milotich - Marqeta FY2023 Q2 Earnings Call).
That's a tough pill to swallow.
Q3 Gross Profit is expected to decline as well but at a much lower magnitude than Revenue. As such, Gross Margin is expected to expand significantly:
Gross Profit is expected to contract between 9% and 11% with an approximately mid-to-high 20s percentage point decline due to the Cash App renewal. Our Gross Margin should be in the low 70s .
(CFO Mike Milotich - Marqeta FY2023 Q2 Earnings Call).
Despite higher Gross Margins, it is important to note that Gross Profit is expected to decline. This will lead to a decrease in AEBITDA Margins in Q3, even factoring in a "high single-digit percentage" decline in Adjusted Operating Expenses:
Adjusted EBITDA margin is expected to be negative 12% to 14% on an organic basis, excluding the one point negative margin impact of the Power acquisition. This includes in approximately mid-teens percentage point decline due to the Cash App renewal, almost half of which is due to the new accounting treatment because of the lower revenue denominator.
(CFO Mike Milotich - Marqeta FY2023 Q2 Earnings Call).
On the bright side, Q3 is likely to be the trough in terms of performance, and things should improve in Q4 and beyond.
Consistent with what we thought a quarter ago, we expect our Q4 for performance to be a little better than Q3 as we continue to lag the impact of heavy renewal activity in 2022. Compared to Q3, we expect Net Revenue growth to be one to two points better, Gross profit to be three to four points better and Adjusted EBITDA margin to be four to five points better.
That said, here are management's expectations for FY2023:
- Revenue down by "low teens percentage".
- Gross Profit up by "low single digits".
- AEBITDA Margin to be "negative low to mid-single digits".
In short, the Cash App renewal (including the 40% reduced pricing) is putting pressure on both the top and bottom lines of the business.
That aside, Marqeta is seeing massive traction in bookings, which should support overall business growth. In particular, bookings for the last three quarters grew 150% compared to the same period a year ago, with a 50-50 split between new and existing customers. Most notably, Q2 bookings grew 60% QoQ driven by embedded finance, and one-third of the deals signed were so-called "flip deals" where Marqeta replaces an incumbent provider, which means customers are migrating to Marqeta's platform.
With that being said, despite the changes in financial reporting - and maybe, fundamentals - the outlook for the company looks bright as Marqeta continues to disrupt the issuing-facing side of the payment ecosystem as well as capture the growing embedded finance market.
Even so, I'm not sure how the markets will rerate Marqeta's stock given all the moving parts in its financials. That increases uncertainty risks in terms of valuation, which is what I'm discussing next.
Valuation
Marqeta stock is still down 80%+ - high interest rates, management changes, overvaluation, slowing growth, and Block contract expiration were all valid reasons for the selloff. That last one might be the biggest factor for the underperformance of the stock.
With the Cash App renewal in place, sentiment has changed to positive. And with the stock price (finally) trading above the 200-Day Simple Moving Average, the trend has shifted to the upside. Despite having rallied more than 60% from its bottom, these two reasons alone give me confidence that there may be more upside for Marqeta stock.
In terms of valuation, Marqeta trades at an EV to Revenue multiple of just 2.0x, which is way lower than its high of 48.8x and its average of 10.6x. By historical standards, Marqeta is trading very cheaply.
I've done a DCF analysis on Marqeta as well, but this is a challenging exercise given all the changes due to the Cash App renewal. Regardless, here is my key assumption:
- Revenue : I will follow analysts' estimates for the first three years. Analysts expect Revenue to decline by (13.1)% for FY2023 as the new Cash App contract kicks in, which is also in line with management's expectation of a "low teens percentage" decline. In FY2024, analysts also expect Revenue to contract by (9.3)% as the company continues to experience Revenue headwinds from the Cash App renewal (as a reminder, the renewal begins in July this year). After fully lapping the Cash App renewal, analysts expect Marqeta to return to growth mode, growing at just 1.9% in FY2025. Moving forward, I expect growth to reaccelerate in FY2026 to 20% and then stabilize to just 12% by 2032.
- Gross Margin : There's not much visibility on the Gross Margin profile of the business yet but management did mention that Q3 Gross Margin will be in the "low 70s" and improve by "three to four points" in Q4. That means Marqeta will have a Gross Margin profile of about 75%. To be conservative, I'm projecting a long-term Gross Margin of 73%.
- FCF Margin : Again, not much visibility here, but I will assume a long-term FCF Margin of 25%. For context, Visa (V), Mastercard (MA), and PayPal (PYPL) have FCF Margins of 61%, 45%, and 19%, respectively.
Based on all these assumptions, I expect Marqeta to achieve a Revenue of $1.6B by 2032, with a FCF Margin of 25%.
Using a discount rate of 12.0% and a perpetual growth rate of 2.5%, I arrive at a fair value estimate of $7.15 for Marqeta, which is slightly higher than the average price target of $6.64 set by analysts. Based on the current price of $5.58, I see a potential upside of 28% for Marqeta stock.
Even though valuation multiples and my DCF model show that the stock is undervalued, I won't be adding to my position as there's a lot of uncertainty and moving parts in terms of the fundamentals of the business.
In addition, I'm not sure how the markets will react when Q3 results come out - when the headlines potentially say: Marqeta's Revenue plunges by 50%.
For that reason, I'm considering trimming my position heading into Q3 results - provided we see a big rally in the stock.
Nonetheless, I think there's a potential catalyst that could see the stock rise substantially: Block acquiring Marqeta.
Here are some reasons why there's a good chance for Marqeta to be acquired by Block in my opinion:
First, the extension mentioned that Block will now be managing the relationship between Cash App and the Card Networks , while Marqeta continues to power the Cash App.
This means two things: 1) Block wants to have a direct relationship with the Card Networks and 2) Block still depends on Marqeta.
Some might argue that Block may be slowly moving out of the platform but the extension is a strong signal that Block still wants to work with Marqeta. Besides, CEO Simon Khalaf mentioned during the earnings call that Block is not building an in-house solution to replace Marqeta.
That said, I think Block wants to have a direct relationship with the Card Networks because if a merger does really happen, Block can communicate directly with the Card Networks without going through Marqeta. At the same time, Block can still use Marqeta's platform while allowing Marqeta to continue to operate independently.
Put simply, the deal makes a more efficient structure.
Second, Block accounts for more than half of Marqeta's Revenue , so it makes a lot of sense for Marqeta to sell itself to its largest customer.
Third, Marqeta and Block have been working together for almost a decade , so there's strong proof of concept and product-market fit.
Fourth, Marqeta powers Block's most important products , namely Cash App, Square Card, and Afterpay.
Fifth, the fintech space is increasingly getting more competitive - consolidation could be the right move to strengthen competitive positioning.
Sixth, Marqeta is certified to operate in 40 countries , which enables Block to expand globally quickly.
Seventh, insiders are buying shares . Just recently, two directors bought a combined $1.4M worth of Marqeta stock.
Finally, in its 10-Q filing, Marqeta disclosed the Cash App renewal, which also included this sentence:
The Amendment also includes a continuation of services for the Cash App program for a period of time in the event of a change of control of the Company .
(Marqeta FY2023 Q2 10-Q).
I'm not sure about you but that sentence seems unusual.
That said, if there's a Block/Marqeta merger, Marqeta stock could potentially get an acquisition premium.
Risks
Competition
While Marqeta is the first modern card-issuing platform, the company still faces tough competition. That includes legacy processors like Fiserv (FI), which processes much larger payment volumes. At the same time, Marqeta also competes with other fintech companies like Adyen (ADYEY) and Stripe. Then there's SoFi's (SOFI) Galileo which offers similar solutions as Marqeta, serving customers such as Chime, Robinhood (HOOD), and Paysafe (PSFE).
But to be honest, I'm not too concerned with competition as Marqeta has the best technology stack on the issuing-facing side of the payment ecosystem in my view, and I believe it would be very difficult for competitors to replicate Marqeta's technology.
Concentration
In Q2, Marqeta generated 78% of its Revenue from Block, and although Block Revenue concentration is likely to drop following the Cash App renewal, Block's concentration will remain more than 50% of Revenue which is still significant.
In addition, 77% of the company's TPV in Q2 was settled by its issuing bank partner, Sutton Bank.
If Block or Sutton Bank face their own company-specific challenges, Marqeta will be dragged down as well.
Fundamental Uncertainty
As mentioned earlier, due to the Cash App renewal and the 40% reduction in pricing, the fundamentals of the business are looking cloudy with no real visibility as to what the long-term margin profile and pricing power of the business look like.
While TPV reporting won't be affected, Revenue and Gross Profit figures will be distorted, and this fundamental uncertainty decreases my conviction in Marqeta stock.
Thesis
Although growth is slowing down, Marqeta is still a high-quality business with a long growth runway ahead as it disrupts the issuing-facing side of the payments ecosystem through its modern, cloud-based, open API card issuing platform, and despite all the competition, Marqeta remains the global standard for modern card issuing.
The Cash App renewal is proof that Marqeta has the best card-issuing platform in the industry. But unfortunately, I didn't really like how the new deal is structured, particularly with pricing and changes in financial reporting.
I have been very bullish on the company for quite some time, but recent developments with the company create fundamental uncertainty, which is why I'm downgrading the stock from Strong Buy to Buy.
Nevertheless, the three reasons why I continue to hold the stock are 1) Marqeta is the best modern issuer processor, 2) the stock looks undervalued, and 3) the company looks like a prime acquisition target.
For further details see:
Marqeta: Done Deal