Block Stock: It Hurts (NYSE:SQ)

So we have covered Block, Inc. (NYSE:SQ) stock a few times over the last year. Each time we have found reasons to be bullish on the company’s prospects, but the Street has been unrelenting in its punishment of this stock up until about a month ago when the broader tech market began to rally. But short of this rally, the stock may have continued to suffer.

Now, take a look at the macro situation. It has been tough. Inflation has crushed the average consumer. They simply have less money to spend. This, in turn, hurts small businesses as consumers tighten their belts to be able to afford the essentials. Moreover, inflation causes input costs for small businesses to go up. If this continues, and we get into a bad recession (we are already in one technically since GDP has contracted two quarters in a row), should you give up?

Well, the entire landscape has worsened and worsened, but Block operationally continues to do what it needs to do to support small businesses, while offering different services to customers. Crypto has been a pain, as the bitcoin on the balance sheet has weighed heavily. While we cannot predict where bitcoin goes, any turn down in the economy will be short-lived. Long-term, we are believers in Block.

The bears have won in the short run, but this is a long game. The company is doing a lot of good things, and this is an opportunity to own this disruptive name if you are willing to own it long term. Of course, in the near term, this is speculative in nature just given the action. It is really an excellent trading stock, both long and short. You can do well with a buy-write strategy, or by selling puts on the big downturns. Trading is what we do, but it is hard at times. Getting in and getting out can pad returns. But investors, you have been absolutely crushed. It is a long-term game, but for now, it is tough.

We think you can still own Block, and, frankly, we like fintech. There is upside here long term in our opinion, but Block has work to do. This was reflected in the just reported quarterly earnings.

Block’s Q2 top and bottom lines

The company had long seen revenue expansion, but now that growth has stalled. While it was expected, it is kind of surreal to see the revenue growth simply stop. We went from significant expansion, to contraction. In Q2, revenue was $4.41 billion and this was a decline, yes a decline, of 5.8% year-over-year. While revenue was down, it was expected to decrease from last year. That said, despite the fall of 5.8%, this was a beat versus consensus estimates. While the revenue number was disappointing to a degree, the company has seen improvement in profit. All lines of business are still performing well and overall, gross profit was $1.47 billion, which was up 29% year-over-year. Further, transaction revenue grew.

Revenues from transactions grow

Despite the overall revenue fall, revenue from transactions was $1.48 billion rising 20% year-over-year, while gross profit was $600 million, up 10% from the year ago quarter. These numbers show the strength of the expansion the company has enjoyed, despite a terrible macro situation. Transaction volume is key. This is really important to understand. That said, volumes were better than expected, surging from a year ago. Square processed $52.5 billion in GPV up 23% year-over-year. Services-based revenue increased to $1.09 billion jumping 60% from last year. Further, gross profit was $882 million, up 56% year-over-year. Very solid. With a questionable economy, this is really good news.

Cash App is a winner

Cash App has driven so much growth for Block over the years. It was a true innovation. There are a lot of “me too” type payment services, but Cash App is one of the more dominant. Cash App generated $2.62 billion of revenue in Q2 and $75 million of gross profit. This was one of the revenue sources that led to big declines on the top line. This $2.62 billion was a big decrease of 21% from last year. It’s worth noting that the price of Bitcoin was a bit weak in Q2. The volatility helps with trading revenue, but the company has a good amount of exposure to Bitcoin on its balance sheet. As Block owns a lot of bitcoin, the stock continues to trade correlated to the price of bitcoin. However, the bulk of the business is still transaction based. Bitcoin was good for $1.79 billion in revenue, down 34% from last year. If you back out bitcoin, which has been horrible, Cash App revenue was up 21% to $732 million. The decline is all bitcoin driven, even offsetting gains from buy now and pay later.

Overall we like the trends, but small business is beginning to feel the pinch a little bit with the inflation pressures. That said, small businesses are still contributing heavily to Block’s revenues. Growth is present, but if economic trends continue the way they are, Q3 could see pain.

Block stock can rally especially if the company generates real profit

These high revenue growth, little to no earnings names have been crushed. For Block, revenue is clearly in growth mode and the company is actually earnings positive. Block must expand earnings for valuation to improve. This is the biggest positive of the quarter, gross profit is expanding. But operating profit still lags. The stock has fallen tremendously, which artificially improved valuation, and makes it a speculative buy. But margins, and of course expenses, are key to watch.

While gross profit is solid, operating expenses are very high, and they even rose this quarter. They rose so much the degree of increase outpaced the revenue gains. Operating expenses were $1.68 billion, rising 66% year-over-year and this led to net losses in the quarter. Net loss was $208 million, while EPS was a loss of $0.36, all on a GAAP basis. Adjusted EBITDA was cut in half to $187 million. while adjusted EPS was $0.18. So overall, the stock is still around 100X earnings. Much less expensive than earlier in 2022, but still very pricey. Other valuation metrics suggest the stock remains attractive. On a price to sales basis we are at 2.70 which is attractive, and the price to book is 2.73, also mildly attractive. Ultimately, we need earnings to grow.

Forward view

As we look ahead to the year, we now expect $0.85-$1.05 in EPS; this puts the stock at a still pricey but more reasonable 100X-81X FWD EPS. Yes it is expensive. Perhaps the best thing for the stock would be if bitcoin rallies hard. If that happens, so will the stock. Small business is doing well despite feeling a pinch. Buy now pay later has helped. We would really like to see operating expenses come down, or be better controlled, to ensure better net income. That will be key to watch.

We believe that the company will grow much larger in the next two years as long as the economy does not go deeply into recession. Long term, it may take time, but shares can be bought. More preferably, you can trade in and out and make serious coin if you are diligent.