Block (SQ2) is a diverse technology (software and hardware) company engaged in solving the complex financial needs for both sellers and consumers. The global banking system is being reshaped as barriers of entry are removed, primarily through technology of which Block is a major disruptor and innovator.
Block began in 2009 providing point of sale (POS) software and hardware for merchants to quickly accept card payments remotely. Since then, the company has rapidly grown its business through its launch of the Cash App in 2013, initially as a means of providing peer-to-peer (P2P) payments, which has evolved to include a range of other banking products and financial services.
Network effects. Peer-to-peer transactions have powerful network effects as every time a customer sends or requests money, Cash App can acquire a new customer or reengage an existing customer. Block has enhanced the efficiency of peer-to-peer transfers by streamlining the onboarding process for Cash App, enabling customers to sign up in minutes. Cash App is currently only available in the US and the UK although there are plans to expand internationally.
Product innovation. Block continues to generate customer demand and retention through new product launches and offerings, driven by its data collection, allowing it to focus on products that customers want and need to further entrench its offerings into its customers ecosystems. Existing customers using Block products continue to grow and their needs expand, leading to increased adoption of other products and insight tools, creating valuable long-term customers, generating higher returns for little incremental investment.
Investment View
We rate Block a Buy. Block has an incredible growth opportunity ahead and has less than <3% penetration into a large addressable market of just under US$200b, albeit it remains a competitive landscape. Block trades on an above market multiple, where any significant changes to its growth trajectory and earnings outlook would see increased volatility.
The current macro climate poses some risks to the short-term growth of the company, which heavily relies on retail sales and consumer spending, albeit this is slightly offset by recurring subscription revenue and other Cash App revenue channels. We are comfortable that the long-term growth opportunity offsets any short-term volatility. Better than anticipated cost control at the 4Q22 results, could be a near-term catalyst re-rate the share price.
Business Overview
Block was initially established in 2009 as a single-product company enabling small businesses and merchants to accept card payments through their mobile phones, and was originally called Square, after the shape of the portable card reader attachment. It was founded by Jack Dorsey (who remains the CEO, and who also co-founded Twitter in 2006) and Jim McKelvey (who now sits on the board). The ecosystem has grown with new product offerings targeted at increasing the efficiency of doing business for its customers. Block significantly expanded in 2013, launching the Cash App with a peer-to-peer (P2P) payment offering, which has since evolved into an ‘all-in-one’ financial product. The app now features equity and bitcoin investing, a Cash Card (debit card), Boost (discount and rewards product), tax submission and refund capabilities, as well as direct and cross-border payment functionalities. Cash App currently boasts over 80m annual active users in the US and the UK.
In January 2022, Block completed its acquisition of Afterpay Limited, an Australian "buy now, pay later" (BNPL) provider. The acquisition allows Block to integrate both of its Square and Cash App ecosystems, by enabling its sellers to offer the BNPL function and by seamlessly offering Afterpay on the Cash App, driving demand and customer retention. We provide more insight into the different ecosystems in more detail below.
There are several other smaller segments to the business which are currently less material, however, provide future optionality. This includes Spiral and TBD, which aim to improve the bitcoin ecosystem through open-source development and reducing the transaction times. Block has also mentioned plans to offer bitcoin mining software to make mining more accessible, although no further information has been released. In 2021, Block acquired a majority and controlling stake in TIDAL, which seeks to empower artists through a creator economy and ecosystem.
Figure 1: Overview of the Block ecosystem
The company splits its divisions into the two main separate ecosystems, Square and Cash App. For 3Q22 as of 30 September 2022, the split of gross profit between the two was almost 50/50, with <1% coming from the other projects and TIDAL. Gross profit growth has been exceptionally strong historically and is forecast to continue growing at high rates over the coming years. Whilst growth rates will likely slow as the company matures, the embedded network effects and brand recognition will lead to higher levels of profitability as the business continues to scale its products and earn additional revenues as its users grow and utilise more of the product suite. Note that in the chart below, we have opted to show gross profit rather than revenue, as the company is required to report total trading volume of bitcoin as revenue. Block then subtracts the cost of goods (essentially being the cost of the bitcoin) and the gross profit becomes the margin that Block keeps (which has historically been c.2.5%).
Figure 1: Gross profit by ecosystem
Figure 2: Gross profit growth
Square Ecosystem
After solving the initial problem of accepting card payments remotely, the focus shifted to building out a product line to assist any seller in generating more sales and managing finances. Traditionally, sellers would use an array of products for different purposes, such as a specialised email marketing provider, a specific POS system or a fintech for a loan. Square seeks to be able to replicate all the required functions through its offerings, building a ’one stop shop’ and empowering its clients to succeed. Square also offers product integration with clients preferred external solutions.
Technology has been the key driver for its product expansion and the company continues to heavily reinvest in its R&D capabilities. The more Square products that a customer is using has been shown to increase customer retention as the products become entrenched within their business. Square operates a ‘freemium’ model, where the initial base level software comes free with signing up to using its payments systems, which is monetised through transactions and payments (which typically start at 1.9% per transaction). Square however offers a multitude of additional software and hardware products, which enable sellers to gain more data driven insights or offer loyalty programs as examples, and generate stickier customers and revenue for Square, creating a win-win scenario.
Figure 6: New product launches
Figure 7: International expansion
Increased integration across Square’s product suite allows for greater collection of data on customers and consumers, allowing Square to have greater customer insights for product development. Further, Square is more easily able to determine applications for lending and provide financial assistance where needed, providing a valuable competitive advantage compared to other neo banks and traditional lenders.
Square has turned its attention to moving up the food chain, from its initial focus on micro sellers (<$250k turnover) and small medium businesses ($250k-$1m), towards mid-market ($1m-$100m) and enterprise customers ($100m+) which given their respective higher processing volumes, will see increased revenue for Square. Sophisticated product innovation and omnichannel software solutions are key to unlocking the higher value segment, which is the next key focus. Other growth channels involve expanding the offering internationally, which Square has already had high levels of success.
Figure 4: The square ecosystem overview
Cash App Ecosystem
The Cash App was conceptualised on moving money between people instantly and grew rapidly through social networks and word of mouth. The ecosystem has rapidly evolved to provide users with many other traditional financial services. The product line continues to expand, increasing its total addressable market opportunities, with a view to being the central financial product for its users. This is reinforced by Cash App being awarded the #1 finance app in the app store for 5 years in the US (note it is currently only available in the US and the UK). The performance of the business is linked with the number of inflows into the ecosystem, which is the key focus for product development.
Figure 5: Cash app money flows
Some of the recent innovations include enabling users to invest into stocks and bitcoin. Stock trading through Cash App does not derive income for Block, with the US retail market structure offering brokerage for free, however it is seen as loss-leader acquisition channel. Bitcoin however does generate revenue, where it derives income based on a margin of the total amount traded. Cash App currently does not offer any other cryptocurrencies. It is worth noting that the company is required to report total trading volume of bitcoin as revenue, and the cost of goods essentially being the cost of the bitcoin. This distorts and largely inflates the revenue line for the business, with the company only actually keeping the gross profit margin (which has historically been c.2.5%).
The app has been marketed at a younger, tech savvy generation, with the split of users being c.34% Generation Z and c.38% Millennials, translating into a US market share of c.20% for Generation Z and c.17% for Millennials. This provides a strong foundation for future growth and increased penetration of younger generations growing up utilising the product. Generation Z/Y are expected to generate c.47% of total retail spend across the US, UK, and AU by 2030, from c.31% now. Cash App however does have a healthy user base of Generation X and Baby Boomers, with their higher respective incomes adding a valuable source of revenue for Block.
Cash App has been able to expand its product line and increase its average annual gross profit per active user over 4x since 2017 from $5 to $47 in 2021. Block has been able to continually innovate new ways to monetise the product, as well as attract new users, generating a significant scale benefit for the business. Further, Cash App boasts a market leading cost of acquiring new customers (CAC) especially when compared to neo banks and traditional retail banks, which typically have much more significant costs in acquiring customers. This demonstrates the benefit of the network effects and Cash Apps ability to scale, providing confidence in the successful execution of the international expansion plans.
Figure 6: Cash app annual gross profit per active user ($US)
Figure 7: Cash app cost of acquiring new customers
The focus for Cash App moving forward is on higher user engagement (more inflows and products per user), commerce, credit, bitcoin and the global expansion. As Block has plenty of lending experience through its Square ecosystem, it has since launched a lending product on Cash App which allows customers to borrow up to $200. Over 1m cumulative active users have been registered to use this feature. The borrow and future integration of Afterpay is a useful tool to entice younger generations, which typically do not have traditional credit cards.
Afterpay
The acquisition of Afterpay was primarily to drive demand via the Square and Afterpay seller combination, to build the commerce engine into Cash App, and to assist with the global expansion. The Afterpay business model generates a c.1.9% gross profit margin per transaction net of processing costs, in return for the seller receiving high repeat usage, new customer acquisition and higher transaction values.
Afterpay currently has over 4m users in Australia and New Zealand, over 13m in North America, and 3m across the United Kingdom and Europe. In the US, one third of Afterpay users are Cash App active users, whereas only 6% of Cash App annual actives are Afterpay active consumers, providing huge opportunity to grow via the Cash App userbase.
Afterpay has over 150,000 sellers on its system, with a significant number of Square customers utilising Afterpay since the acquisition and integration. Half of Afterpay’s volume processed is in the enterprise segment (over $50m annual revenue), this provides Square with a clearer avenue into this segment which it has yet to properly penetrate (but intends to as its product offering evolves).
Significant Market Opportunity
The Square ecosystem represents a c.US$120b gross profit opportunity globally. This is broken down into 3 sections:
- $81b, US commerce opportunity,
- $16b, US banking opportunity,
- $25b, International opportunity.
The company’s current market share is less than <3% of the addressable market, and it continues to take share as well as evolve the potential total addressable market. Square has initially focussed on the Micro and Small Medium Business (SMB) markets, however, has been continuing to focus on the more lucrative Mid-Market and Enterprise opportunities. The opportunity to expand into new regions and penetrate larger retailers provides a significant runway for future growth, with the recent launch into Spain and offering loans to Australasian customers being recent examples of growth initiatives.
The Cash App ecosystem represents a c.US$70b gross profit opportunity in the US. This is broken down into 3 sections:
- $28b, “Sending” – Community (P2P),
- $40b, “Spending” – Financial services and cash card,
- $3b, “Investing” – Bitcoin and consumer trading.
The above estimates do not include the development of new products as well as the international expansion opportunity, where Cash App has less than <3% penetration into the US opportunity alone. Acquiring new customers becomes easier as the user base expands, with word of mouth and network effects leading to increased adoption with less marketing effort. The acquisition of Afterpay should help accelerate adoption and customer retention, as well as potentially expanding the total addressable market opportunities.
Valuation Considerations
With the volatility in interest rates largely impacting higher growth stocks, Block has seen a marked share price decline over the 2022 calendar year. Block has never traditionally been a ‘cheap’ stock and has largely been valued on longer dated methodologies such as discounted cash flows, although a near-term multiple based valuation is useful in a macro-driven market.
Over the last 5 years, Block’s average forward PER was close to 100x. Whilst we don’t believe the average PER of over 100x is sustainable long term, we believe the current PER is too low given the growth rate and industry dynamics. We note that the company reports in $USD and therefore currency can play a large role in the volatility of the $AUD denominated stock.
Figure 8: Trading below average P/E
Figure 9: Same for EV/EBITDA
Block’s multiple far exceeds that of the broader market, however when put into context with its forecast earnings growth rate, the higher multiple can be justified. By FY24, the earnings grow into a much more reasonable multiple of c.27x. This is at an EPS growth rate of c.36%pa, compared to a forecast 3%pa for the S&P500.
Figure 10: Block’s earnings growth justify an above market multiple
It is difficult to find an exact peer, given that competitors either focus on a Square competitor product, a Cash App product, or a BNPL offering. The closest and most relevant peer with the highest correlation is Dutch listed Adyen, which offers a similar product suite to Square. On a PER basis, it currently trades slightly above Block, closer to 50x, although trade on a similar EV/EBITDA ratio of 32x.
Figure 11: Tracking with Adyen
Figure 12: Upside valuation potential
Most share prices of growth stocks are highly correlated with the consensus earnings per share over the long-term. The chart below shows the share price against the forward eps, which up until 2022 showed a relatively strong correlation. For the gap to close, either consensus need to lower its forecasts for earnings growth, or the share price needs to rally. We would expect a modest combination of the two over the next few years, with earnings estimates largely not pricing in a potential recession risk to Block’s earnings, and the market not factoring in Block’s full ability to grow earnings outside of the cycle. The risk/reward looks favourable based on the chart alone, although we note that a potential extended macroeconomic slowdown would likely have an impact on earnings.
Figure 13: Block’s (SQ.US) share price against estimated forward eps
Given that the Square’s ecosystem revenue is largely derived from retail transactions, it is important to understand retail sales trends. Data provided by the US Census Bureau has tracked retail sales since 1992. The uptrend over time is clear and understandable as both prices rise with inflation, and overall volume growth increases with population. This long-term trend will continue to support a baseline level of growth for Block, albeit at levels well below its current growth trajectory. Post Covid, there has been a spike in inflation and retail volumes, leading to an above trend figure. We expect this will moderate in the short-term as inflation normalises, which may imply some potential near-term disruption to the total payment processing volume for Square. The impact will be largely offset by increased customer acquisition and increased product usage per customer, however an extended downturn could have a meaningful impact on growth, earnings, and valuation.
Figure 14: Retail sales above trend ($USb)
Figure 15: Post GFC retail sales trend ($USb)
Investment Thesis
We rate Block a Buy. Whilst we acknowledge the short-term volatile macroeconomic climate and potential impact to consumer spending from rising interest rates, the longer dated opportunity for Block to become entrenched as a key player in the global financial ecosystem remains robust. The strong track record of product innovation and a sound management team provides us confidence that the company will continue to drive growth and execute a successful international expansion. The growth opportunity is ample, with Block only being <3% penetrated into its total addressable market.
Network effects are powerful in customer attraction and retention, with Block boasting market leading CAC, allowing it to reinvest into product innovation, rather than marketing, providing further future competitive advantages. With the acquisition of Afterpay, Block has a tremendous opportunity to integrate both of its ecosystems, retaining customers on both platforms, as well as drive customer acquisition through new channels.
The recent weakness in share price over the last year provides an opportunity to purchase a high-quality company at a much more attractive valuation. Consensus FY24 EPS of US$2.67 may be too conservative as the company rolls out globally and continues to take share as well as potential cost-out programs. We would not expect Block to revert to its long-term average PER although, however there remains ample valuation upside potential. We note that the company reports in USD and therefore currency can play a large role in the volatility of the $AUD denominated stock.
Risks to Investment View
