Block: Overvalued, More Impact From Consumer Credit Cycle (NYSE:SQ)

Investment Thesis

Block, Inc. (NYSE:SQ) has strong technological support for a vast platform combining sellers and consumers. However, we see recent weaknesses in its operations. Moreover, the acquisition of Afterpay has left Block, Inc. with more exposure to the consumer credit cycle than before. We examine the data and deem SQ stock overvalued.

Company Overview

Block, formerly known as Square, is a credit card payment processing company that serves individuals, small business sellers, vendors, and multi-national businesses with hand-held devices and digital platforms, along with other more complex financial solutions. The company was founded in 2009 and is headquartered in San Francisco. It has two reportable segments: Square and Cash App.

Strength

Block strives to build a multi-channel, multi-form payment system that combines physical devices, digital platforms, and complex financial solutions into one ecosystem. The company caters to both consumers and merchants and hopes this integration of both sides could drive lead generation for merchants and consumer engagement. On the consumer side, it has Cash App, and on the seller side, it has Square.

In its Square ecosystem, Block provides over 30 different distinct software, hardware, and financial services products. It even provides a developer platform with payment and commerce APIs and SDKs to enable external developers to integrate with the Square ecosystem. In its Cash App ecosystem, customers can store, spend, send, receive and invest and tax prep their funds seamlessly all in one platform. The integration of the two sides comes from a commerce effort that Cash App customers can pay at a subset of Square sellers in person or online by simply scanning the QR code or tapping a button on the phone at check out. This effort seems to be still in the experimental phase as it is not available to all of its clients.

Due to its ability to provide more complex solutions, Block has attracted mid-market sellers, who generate more than $500,000 in annualized gross payment value(GPV). This segment of customers accounted for 28% of Square’s GPV in 2019, 30% in 2020, and 37% in 2021. This is a nod to its multi-channel and multi-functional ecosystem’s development, as clients with large volumes need a more comprehensive processing platform.

Overall, with the innovative integration of various functions onto one platform, Block has been able to drive growth and expansion of profitability. Its 5-year cumulative total return has greatly exceeded the general tech sector and the broader market.

Weakness/Risks

Several weaknesses stood out from the last few quarters. Block’s operating expenses have been rising persistently while the earnings from operations are deteriorating to negative.

Block added about $1.4 billion of consumer receivables from the acquisition, and by Q3 last year, it had about $1.25 billion on its balance sheet, compared to none in 2021.

And the first nine months of 2022, the operating expenses were 60% more than in the same period in 2021. If we parse through the recent quarter’s data, the “transactions, loans, and consumer receivables” were the largest contributor, most of which was from Afterpay.

In fact, besides the consumer receivables impacting the operating cash flow, there is also an item called “Warehouse Funding Facilities (WFF)” that made a large impact on its cash flow from financing activities. This WFF is what Afterpay had in arrangements with financial institutions in Australia, New Zealand, the U.S., and the U.K. collectively; they are dubbed WFF. They are financing and originations for consumer lending that are secured against respective consumer receivables. Again, it loops back to the consumer receivables. In the latest quarter, cash flow from both operating and financing declined substantially, and only from investing is trending higher, which usually was in negative territory in the past.

The timing to acquire Afterpay in early 2022 to get into the BNPL (“Buy now, Pay later”) business is perhaps a bit wrong-footed, as consumer credit started to turn sour since the credit tightening cycles began. Some of the key consumer credit delinquency rates have been rising recently. If the trend persists, it could pressure the company’s cash flow and balance sheet to make Afterpay a successful integration into its business. If this lending condition doesn’t improve, it will be an obvious drag on its cash flow.

Also, since Afterpay is a multi-national company, its payments and receivables also involve foreign currency transactions. Block’s foreign currency translation adjustment increased substantively on the losses side in 2022. For the nine months ending in September, the forex adjustments were almost negative $1 Billion.

Last but not least, Block’s bitcoin revenue inevitably declined, from about $8 billion to $5.3 billion in the first nine months of 2021 compared with the same period in 2021. Overall, although its gross profit margin held steady, the free cash flow margin and net margin were compressed.

And its EBITDA has been trending downward on a TTM basis.

After the acquisition of Afterpay and stepping into the BNPL business, Block will be more closely affected by the consumer credit cycle than previously being a pure payment processing company, which relies more on processing volume. Its consumer credit exposure will make a more pronounced impact on its cash flow.

This is only some part of the whole story. We can see its weakness in earnings actually started before the acquisition. We think Block has some more loose ends that need to be tightened in its operation and integration of the overall platform and system.

Financial Overview

Valuation

We take into consideration of the analysis above and use our proprietary models to assess Block’s fair value with a ten-year projection forward. In the bullish case, Block has a weaker year in 2023 but bounces back in the next year, while eventually bursting into explosive double or triple digits growth in its cash flow; it was valued at $63.23. In the bearish case, Block takes more time to integrate various parts of its system and encounters slower consumer credit expansion in the near term, but still manages to grow into triple-digits; it was valued at $34.24. In our base case, Block needs to overcome its weaker cash flow in 2023 but successfully integrates Afterpay into its overall system with a higher growth rate later and generates free cash flow in the billions; it was valued at $40.70. We think its current price is very rich and not pricing in enough risks both in the near term and in the longer term.

Conclusion

In general, we like the direction Block, Inc. is trying to build the company into, with a comprehensive ecosystem and innovative technological support. However, its vast system needs better integration, or there will be more operational expenses and costs than desired. In the near term, due to its recent acquisition of Afterpay, Block, Inc. also needs to navigate a weaker consumer credit cycle that has already affected its cash flow. We think Block, Inc. stock is overvalued and will recommend a sell at this point.