Shares of Block (NYSE:SQ) have experienced downward pressure since early FY2022, largely attributed to a slowdown in top-line growth resulting from various factors such as pull-forward demand, reduced B2B spending, and increased competition. While Block stock performance has been relatively muted, with only a 2% aftermarket rally following decent Q1 FY2023 results, there are reasons to remain optimistic. Despite the stock’s YTD return lagging behind major indices, recent upside momentum driven by declining CPI data suggests a potential turnaround. While the company’s fundamentals have deteriorated over the past year, efforts to improve margins and drive earnings growth in FY2023 are encouraging. Additionally, the recovery in cryptocurrencies, including Bitcoin, could provide a boost to Block’s gross profit. With these factors in mind, the outlook for the stock appears favorable, and the worst may be behind us.
Understanding Near-Term Challenges
The recent decline in Block’s stock price and its limited upward momentum may raise questions for investors. However, it’s important to recognize that the company has maintained an impressive 34.4% compound annual growth rate (CAGR) in adjusted EBITDA from FY2019 to FY2023E, indicating a strong performance despite the recent downturn.
Challenges arose both from macro and micro perspectives in FY2022. Block experienced a significant decline in transaction-based revenue due to slower growth in gross payment volume (GPV). The point-of-sale (POS) industry became increasingly competitive, with major players like Apple Pay expanding their market share. As a result, adjusted EBITDA growth declined by -2.2% YoY in FY2022, leading to a -41.5% YoY decrease in adjusted EPS. This demonstrates the stock’s vulnerability to valuation impact.
Additionally, key margins such as adjusted EBITDA margin, adjusted net income margin, and free cash flow (FCF) margin reached their lowest levels since FY2017, further contributing to the stock’s decline. From a macro perspective, the increase in the federal funds rate to combat high inflation in FY2022 put pressure on high-growth stocks with deteriorating fundamentals like Block. This likely contributed to the significant sell-off witnessed by the stock.
However, as long-term investors, it is crucial to look beyond near-term headwinds and focus on the company’s secular growth catalysts. The accelerated digital transformation resulting from the pandemic has led to increased reliance on fintech transaction products and services by merchants and customers.
Integration of Square Ecosystem and Cash App
Block’s Investor Day in 2022 highlighted significant changes in the company’s business model. While payments revenue accounted for the majority of gross profit in 2015, the largest revenue stream has since shifted to software and integrated payments, banking, and international operations. During the Investor Day, Block emphasized the integration of Afterpay into its ecosystem, aiming to establish a connection between Square and Cash App. This integration is expected to enhance customer acquisition and improve the lifetime value to customer acquisition cost (LTV/CAC) ratio in the long term.
While the integration of Afterpay may temporarily impact margins, management remains optimistic about future synergies and benefits associated with the deal. Cash App’s margins currently lag behind those of Square, primarily due to higher variable expenses such as peer-to-peer processing, risk loss, and card issuance costs. However, there has been a notable improvement in Cash App’s margins, with a strong expansion from 17% in FY2021.
The Cash App ecosystem has shown remarkable growth, with a 61% YoY increase in FY2022. Instant Deposit and Cash App Card have played a significant role in driving Cash App’s gross profit, achieving an impressive 43% YoY growth. The introduction of savings accounts and the Cash App Card has further contributed to monetization expansion in the long term.
Margin Improvement in FY2023
Despite the challenges faced in FY2022, positive signs are emerging for Block. The adjusted EBITDA margin has rebounded from its recent low, indicating a positive trend. The company exceeded revenue and adjusted EPS expectations in Q1 FY2023 and raised its outlook for adjusted EBITDA in FY2023. The expected expansion in Cash App margin, as mentioned during the earnings call, should contribute to overall margin growth. These developments suggest a potential recovery in profitability in the current fiscal year. Consistent earnings growth and expanding margins would instill confidence in investors, even amidst a slowdown in top-line and gross payment volume (GPV) growth.
Block Stock Valuation Considerations
In terms of valuation, Block currently trades at a higher multiple compared to PayPal (NASDAQ:PYPL) based on its FY2023 adjusted EBITDA outlook. The EV/adjusted EBITDA FY2023E multiple for Block stands at 32.7x, while PYPL trades at 10.5x. Similarly, Block’s forward price-to-earnings (P/E) ratio of 42x exceeds PYPL’s 14.3x, despite Block’s strong rebound in adjusted EPS. While Block may not be considered a value stock at present, its higher multiple can be justified by its greater growth potential and strong outlook for margin expansion compared to its peers.
Moreover, the recent decline in inflation, as indicated by the June Consumer Price Index (CPI) report, could serve as a catalyst for high-valuation growth stocks like Block. Lower inflation expectations and a favorable outlook on long-term interest rates resulting from a potential soft-landing scenario in the US economy could support Block’s valuation.
In Conclusion
Despite experiencing a significant decline in stock price, Block exhibits positive signs of recovery with anticipated margin and profitability improvements in FY2023. Cash App’s strong growth, coupled with Block’s potential for top-line growth and margin expansion following a cyclical downturn, justifies a higher multiple compared to its peers. The June CPI report, indicating lower inflation expectations, further contributes to the positive outlook for high-valuation growth stocks like Block. Therefore, considering the recent muted price action, this may be an opportune time for long-term investors to consider Block stock as a potential investment.
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