Block: Fintech Powerhouse Has Obliterated Q3 Earnings (NYSE:SQ)

Block (NYSE:SQ) formerly known as Square is a fintech powerhouse that has an ecosystem of financial products. Founded by the legendary Jack Dorsey (who also founded Twitter), Block has grown its popular Cash App rapidly. In the third quarter of 2022, the company beat top and bottom-line growth estimates. This was despite macroeconomic headwinds and a decline in Bitcoin revenue. Its stock price is down ~77% from its all-time highs and thus in this post I’m going to break down the Q3 earnings in granular detail, before revealing its valuation, let’s dive in.

Strong Third Quarter

Block generated strong financial results for the third quarter of 2022. Revenue was $4.52 billion, up 18% year over year, and beat analyst expectations by $47 million. As mentioned in previous posts on Block, Bitcoin trading makes up ~40% of total revenue, thus its decline in price and popularity has impacted results. If we exclude Bitcoin, total net revenue was $2.75 billion, up a rapid 36% year over year. Therefore, it’s clear to see that Block’s core business is growing strong. It should also be noted that Bitcoin trading has never been a major profit driver for the company and was the low-margin part of the business. The company generated Gross Profit of $1.57 billion in the third quarter of 2022, which increased by a rapid 38% year over year. Block has two main Ecosystems the “Cash App” and “Square”, these are connected together by the Buy Now Pay Later [BNPL] provider Afterpay which was acquired at the end of 2021. I will now dive into each of the “ecosystems” in turn and the key financial drivers.

Cash App Ecosystem

The Cash App is a mobile application that enables consumers to execute easy peer-to-peer payments with the iconic “cash tag” which is derived from the “hashtag” commonly used in the social media world. However, the application has expanded to include Bitcoin trading, stock trading, and more. As Block states the app is the “easy way to send, spend, bank and invest”. In the third quarter of 2022, the application generated $2.68 billion in revenue, up 12% year over year. If we exclude Bitcoin and the BNPL platform, Cash App revenue was $817 million, up a rapid 41% year over year.

The Cash App saw a huge boost in popularity during 2020 as stimulus checks galore, resulted in a cash-rich consumer. Throughout 2022, consumer sentiment has been very different as has most people’s financial positions. Despite, these challenges Block has managed to increase Cash App Gross profit to $774 million, up 51% year over year.

Cash App’s gross profit is driven, by three leading indicators these are Actives, Inflows Per Active and Monetization Rate on Inflows. The company has invested significantly into building the Community, Financial Services, and Commerce parts of the App in the latest quarter, which has been successful. Cash App’s organic peer-to-peer network has enabled the application to spread virally. Block has executed a range of targeted marketing campaigns to reach “high-value” audiences. The campaigns have been successful as the company increased its transacting active users to 49 million, up 20% year over year.

The company has gradually expanded its product to include Banking and aims to merge together the offline with the online through a Cash App Card. This is a brilliant system as from my studies of mobile Application retention, I discovered that users are more likely to stick with an application and feel more connected to a brand if they have a physical card. In addition, a Tokenized debit card in an Apple pay wallet also helps to keep the brand top of mind for the consumer. The Cash App Card has proven to be immensely popular with its attach rate reaching 36% of monthly active users. Block has also introduced direct deposits, check deposits, and even paper money. The ability to add “Paper money” to a mobile application is genius. Here is how they enable this, Block has partnered with major merchants such as Walmart, 7Eleven, and more. A user simply heads into the store and gets the merchant to scan a barcode to deposit. Since its launch last year, Cash App has had over $3.5 billion in all-time paper money deposits.

Square Ecosystem

The second “Ecosystem” is Block’s iconic merchant solutions which consist of point of sale [POS] devices and software. The Square Ecosystem generated $1.77 billion of revenue in Q3,22, up 27% year over year. While the company also generated $783 million in gross profit, up 29% year over year. Its Buy Now Pay Later platform made up ~$105 million of revenue and $75 million in gross profit.

The company reported a lower percentage of debit card transactions which were close to pre-pandemic levels. Its overall Gross Payment Volume [GPV] increased by 20% year over year, with strong growth in International markets which increased by 40% year over year. This is part of Square’s strategy to expand internationally. In the third quarter, the business has introduced Instant Transfers in Australia and Square Loans in the U.K. as well as expanded its Buy Now Pay Later to Canada and the U.K. In Japan, QR code payments are extremely popular with the most dominant provider being a company called PayPay which has 51 million customers and captures two-thirds of Japan’s QR code GPV. Therefore, rather than competing directly with PayPay Block has enabled merchants to accept PayPay QR code payments through its point-of-sale systems. Square has also gradually moved “upmarket” and targeted larger merchants with over $500,000 in Annualized GPV. Its percentage of mid-market sellers has risen from 31% in 2020 to 40% by 2022.

The Square ecosystem is beautiful as the business captures all the transactions its merchant’s experience. Square can then use this data to identify spending patterns and underwrite loans via its Square Loans service. In the third quarter of 2022, the company originated 126,000 loans worth $1.14 billion, up a rapid 92% year over year.

Square’s developer platform is also a key selling point of the system. This enables merchant to create customized solutions and scale their business across multiple locations faster than with incumbent solutions.

Overall Expenses and Profitability

Back to the overall financials, Block reported $1.62 billion in operating expenses during the third quarter of 2022, which increased by an eye-watering 46% year over year. This was driven by Product development expenses, which increased to $548 million up 52% year over year. Overall, this expense is not a major issue as the company expanded its headcount to include more of those people in data science and engineering. Its Sales and marketing expenses increased by 19% year over year to $485 million. While G&A expenses increased by 48% year over year to $395 million. The G&A growth was again driven by headcount related to finance, legal, HR to support the Afterpay platform. Block generated Adjusted EBITDA of $327 million, which increased by a rapid 40% year over year, which was a positive.

Earnings Per Share [Normalized] was $0.42 which beat analyst expectations by $0.19. Without any adjustment, the company reported negative EPS of -$0.02, which still beat analyst expectations by $0.24 as analysts were expecting a great loss of $0.26.

Solid Balance Sheet

Block has a solid balance sheet with $6.5 billion in cash, cash equivalents, restricted cash and short-term investments. The company does have long-term debt of $4.5 billion, but only $460 million of this is short-term debt (due within the next two years), therefore it is manageable.

Advanced Valuation

In order to value Block, I have plugged the latest financials into my advanced valuation model which uses the discounted cash flow method of valuation. I have forecasted a 15% revenue growth rate for next year, which is slightly slower than the prior 18% rate, given the macroeconomic environment. However, moving forward into years 2 to 5 I forecasted a slightly higher (but still conservative) 16% growth rate.

In order to increase the accuracy of the valuation, I have capitalized the company’s R&D expenses which has boosted its operating margin to 2.48%. In addition, I am forecasting this operating margin to expand to 15% over the next 7 years, as the company’s investments start to pay off and operating leverage begins to take hold.

Given these factors I get a fair value of $105 per share, the stock is trading at $60 per share at the time of writing and therefore is ~44% undervalued.

As an extra data point, Block trades at a Price to Sales ratio = 1.89, which is 75% cheaper than its 5-year average.

Risks

Recession/Lower Payment Volume

The high inflation and rising interest rate environment have caused many analysts to forecast a recession. Inflation increases input costs for consumers and businesses alike, this usually results in a slowdown in consumer spending and thus means lower payment volume for Block. The good news is recessions tend to be cyclical by nature as the economy bounces back, so will the consumer.

Longer term the company is focused on “balancing growth and profitability” as they aim to moderate expense growth. According to management, the Cash App should be a key area where operating leverage will be seen in 2023.

Final Thoughts

Block is a fintech powerhouse that has come out of the pandemic a much stronger business. Its two growth engines (Cash App and Square) are performing well and its Buy Now Pay Later application is starting to gain traction. The stock is undervalued intrinsically and therefore could be a great long-term investment with strong future growth prospects.