Block's (NYSE:SQ) stock price experienced a roller coaster ride during the pandemic. Nowadays, I believe their growth is transitioning back to their normalized rate. The competition in the POS system is intensifying; however, they have a significant runway for growth with their Cash App. They reported their Q4 FY23 on February 22 with a quite strong result. I initiate a 'Buy' rating with a fair value of $93 per share.
Square POS System Growth Strategy
Square's POS system is focusing on small businesses, and they have witnessed tremendous growth over the past few years. In recent quarters, the GPV growth has started to fall to a low-double-digit rate. Their "something for everybody" approach makes their solutions suitable for merchants at reasonable costs.
The POS system is facing growing competition, with numerous options in the market, including Clover, Shopify (SHOP), Lightspeed, eHopper, Revel Systems, and PayPal (PYPL), among others. These new POS systems offer affordable solutions for various sizes of merchants, catering to both online and offline channels. Considering the intensifying competition, I anticipate that Square's POS system growth may start to normalize. However, they should still be able to grow above the market growth rate for several reasons.
Firstly, Square has been shifting its focus more towards up-market sellers over the past few years. As illustrated in the chart below, their GPV mix for Micro merchants has decreased from 52% in FY18 to only 32% in the most recent quarter. In comparison, they have grown the mid-market GPV from only 20% to 40% during the same period.
The mix shift is crucial for Square, as mid-market merchants can generate higher margins for the company. These sellers are highly likely to utilize a broader range of Square's add-on services, including inventory management, loyalty programs, gift cards, marketing, and cash management. These additional services could significantly improve Square's net profits, as most revenue from these services drops directly to the bottom line of their profit and loss statement. I expect Square to continue deploying their sales force and technology to attract more mid-market sellers in the near future.
Secondly, Square is actively working to expand its international market presence. In Q4 FY23, Square generated $827 million in gross profits, with international operations contributing $106 million, or 12.8% of the total. The growth in the international market provides an additional growth avenue for their POS system. These services share similar IT infrastructure and overhead costs, thus it could generate very high incremental margins for the company.
Finally, Square's POS system is well-suited for omnichannel operations, capable of satisfying the needs of sellers for both online and offline checkout demands. I anticipate that Square will continue to invest more in omnichannel capabilities, aiming to gain additional market share from traditional POS service providers.
Growth Runway for Cash App
The Cash App business experienced a significant boost during the pandemic period, as the app was able to directly receive subsidy money from the government. In FY23, total Cash App revenue accounted for 67% of the overall revenue, and excluding bitcoin, it represented 23.7% of the group's revenue. Consequently, the growth of the Cash App is crucial for the overall performance of the group.
Cash App is undoubtedly innovative, but it operates in a market with several similar apps, including Wise, PayPal, and Venmo, among others. All these fintech companies have experienced notable growth in the past few years, as the market represented a blue ocean opportunity for each player.
Block is consolidating its acquired Afterpay service into their Cash App, and the Buy Now, Pay Later (BNPL) feature could strengthen the app's competitive advantage. This integration allows users to directly borrow money from the app and pay later, enhancing the functionality and appeal of Cash App.
For Cash App, I believe there is substantial growth potential in the future. Block is actively improving the monetization rate of their app, achieving 1.48% in Q4 FY23 compared to only 1.19% in Q1 FY22. The strategy for increasing the monetization rate involves offering a broader range of services and adjusting service pricing. Management has indicated a robust monetization capability, particularly within financial services and increasingly through commerce. I anticipate that the upward trend in the monetization rate will continue in the future.
Cash App has experienced significant growth in the past, but it remains underpenetrated in the market. As of Q4 FY23, they had 56 million monthly active users, a figure considerably smaller than PayPal's more than 400 million monthly active users.
Block is expanding Cash App's offerings with the Cash App Card as an additional service, and they have witnessed robust growth with 22 million cards, 40% of which are attached to their monthly active user base. These additional services have the potential to increase profitability and generate top-line growth for Cash App.
Financial Analysis and FY24 Outlook
Their growth experienced a boost during the pandemic but cooled down in FY22. Operating profits have been minimal in the past, and their cash flow generation was weakened by substantial investments in IT engineers and technology infrastructure.
In FY23, they generated only $100 million in cash from operations, which couldn’t cover their capital expenditures. However, they maintained a net cash position on the balance sheet, indicating a strong financial position.
In Q4 FY23, they reported a remarkable performance, with gross profits up 22% year-over-year. Cash App's gross profits increased by 25%, and Square as a whole was up 18% year over year. This strong quarterly performance led to a surge of their stock price.
Notably, their Adjusted Free Cash Flow for FY23 was $515 million, a substantial improvement compared to negative $346 million in FY22. This indicates significant progress in their cash flow generation.
For FY24, the company is guiding gross profit of at least $8.65 billion, up at least 15% year over year. For the adjusted operating income, Block is anticipating at least $1.15 billion, for a 13% margin, a significant increase from $351 million in FY23.
Their FY24 profit growth guidance makes sense to and there are several factors to consider for FY24.
As indicated in the earnings call, their stock option expenses will start to normalize as they reduce headcount. In addition, they anticipate their share-based compensation expense to decrease slightly quarter over quarter in Q1 FY24. They plan to cap headcount at the 12,000 level, which is 1,000 less than the current level. The capped headcount is expected to save on stock-based compensation expenses. Notably, they spent $1.27 billion on stock-based compensation in FY23.
Additionally, I anticipate the Cash App monetization rate increasing over time, directly boosting profitability, as incremental costs are minimal. Block has been strategically increasing their monetization rate through pricing. They are providing some free services in their Cash App, and some coming with fees. I foresee they continue to add more services and features to their Cash App to increase the monetization rate.
Considering these factors, I agree with their full-year guidance for another year of strong margin expansion in FY24.
Acquisition of Afterpay
They acquired Afterpay in 2022, and together with Square, Block can now offer sellers a 'buy now, pay later' (BNPL) service at checkout. I believe the deal makes strategic sense as it broadens Block’s service offering, making their products more attractive to both sellers and consumers. Block has spent several months integrating and restructuring Afterpay's business, and they are consolidating it into their Cash App division going forward. I anticipate that BNPL could assist Cash App in increasing its monetization rate and active user base. As they indicated over the earnings call, Block will further integrate Afterpay into their Cash App, and leverage Cash App to distribute their Afterpay services in 2024.
Valuation
I anticipate the growth rate of their Square POS business to gradually moderate to single digits over time due to heightened competition in the market. Additionally, I predict that Cash App will continue to deliver growth exceeding 30% in the near term, followed by a deceleration to mid-teen growth. Considering their business mix, I forecast an overall growth rate deceleration to around 8% by FY32.
It is worth noting that Block repurchased $156 million of its own shares in FY23, the first time in their history. They still have $843 million in funds available and authorized for repurchases. The moderate share repurchase would ease the pressure of outstanding shares growth. In FY23, their diluted shares outstanding grew 6.1% year-over-year. With the reducing stock-based compensation and some shares repurchase, I estimate the shares count would grow 3% in FY24.
As discussed earlier, I anticipate a significant margin expansion for the company as they enter a harvest period. This expansion is expected to be driven by operating leverage, capped headcount, pricing strategies, international expansion, and an increasing monetization rate of their Cash App. I calculate that their operating expenses growth would be around 1.8%-2% lower than their topline growth, thus generate significant margin expansion for the company.
The valuation model incorporates a 10% discount rate, 4% terminal growth, and a 25% tax rate. The discount rate and terminal growth rate are in line with all of my valuation models. With these parameters, the fair value is calculated to be $93 per share as per my estimate.
Key Risks
Bitcoin related revenue: The Bitcoin-related business accounted for over 43% of the group revenue in FY23, and Jack Dorsey is a staunch believer in Bitcoin. Given the inherent unpredictability of Bitcoin's price and transaction volumes, it's challenging to foresee the future trajectory accurately. While integrating Bitcoin transactions into Cash App makes sense, it does increase the volatility to the company, considering the unpredictable nature of the cryptocurrency market.
BNPL might not be that successful: BNPL gained significant popularity when the service was initially introduced, with the perception that it would capture a substantial market share from traditional credit cards. However, over time, BNPL companies may not appear as attractive as initially thought. Major credit card companies have started to support BNPL-related services, indicating that it is challenging for BNPL firms to completely replace credit card networks. Instead, they have often become partners, highlighting a shift in the dynamic between the BNPL providers and credit card network players.
Conclusion
I believe Block is concentrating on margin expansion and will persist in driving double-digit top-line growth. Considering the perceived undervaluation of the stock, I am initiating coverage with a 'Buy' rating and assigning a fair value of $93 per share.
This article was written by
Lighting Rock Research
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I am a growth-oriented investor, conducting fundamental research. Long-term focus, independent thinking. I prefer companies with deep moats and high recurring sales growth.Disclosure: Hunter Wolf and I are working in the same investment team. I am writing here independently.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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