Under pressure. Since reporting its 2Q23 results, the SQ2 share price has been under pressure and underperformed key globally listed peers. As the business continues to show strong operating momentum, we believe the share price dislocation and cheap PER provides an opportunity for long-term investors to add a quality growth company to portfolios.
Margin improvement underway. At a recent conference, Block reiterated that it had seen ‘incremental efficiency gains’ in recent months, in-line with expectations for profitability to continue improving as management focus on cost control. Whilst there was limited other ‘new’ information, Block focussed on its Square business, solidifying its confidence that it can grow earnings throughout the cycle, driven by rolling out new software product features and expanding upmarket and overseas.
Upgrade cycle continues. Looking at the incremental margin efficiency gains over the past few quarters, we can clearly see operating leverage flowing through the business. Furthermore, Block has historically beaten and upgraded its EBITDA guidance over the last few quarters. We expect this to continue, driving an earnings upgrade cycle.
What recession? The US retail sales data continues to reflect underlying resilience in the US economy and consumer spending. The Square ecosystem is particularly leveraged to retail and restaurant spending, which is the index we prefer to track. Further, we have seen a recent uptick in the US consumer sentiment surveys, which have dramatically improved since the lows in June 2022 after the rapid interest rate hikes began. We expect continued improvement albeit gradual as the interest rate environment normalises.
Bargain hunting. Block is currently trading on a 12m forward PER of just ~24x, well below its historical average. Given the earnings outlook of nearly 30% growth pa for the next 3 years, Block is trading on incredibly low growth adjusted multiples. We also believe given the improving earnings trajectory that Block deserves to be on a higher multiple.
Investment View
Block is clearly continuing to execute on its strategy and comments from management around profitability discipline should continue to provide positive momentum to the stock. We believe that the recent sell off provides long-term investors the opportunity to add a quality growth stock to portfolios. The current 12m forward PER of ~24x is well below historic averages, and well below key peers. Management have reiterated that it continues to identify and extract operating efficiencies, as evidenced by improving incremental margins, and we expect this strong profitable growth focus to remain.
At the 2Q23 result, the July exit run rate of 21%yoy was below expectations, however we believe further efficiencies could lift the overall margin, offsetting any potential slow down in top-line growth. The July month also has some specific items such as revised interchange economics and some pricing economic changes in Cash App. We expect the company to continue providing conservative guidance and beating throughout the year and retain our BUY recommendation.
See our thesis in key charts below:
Figure 1: Block has materially underperformed other key e-commerce technology peers calendar year to date
Figure 2: Block has historically beaten and upgraded its EBITDA guidance for FY23. Share price has not followed the upgrades
Figure 3: Incremental margin improvements evident
Figure 4: Retail Sales resilient, Consumer sentiment turning
Figure 5: PE de-rate has been severe. ~24x is too cheap
Figure 6: Share price not tracking forward EPS trajectory
Figure 7: Block remains inexpensive on forward multiples when compared to peers
Risks to Investment View
Softer retail sales through Block platforms from rising interest rates impacting consumers. Increased competition leading to market share losses or potential discounting. Regulatory and legislative risks impacting growth potential as well as potential fraud and money laundering risks. Dual class share voting structure, with Dorsey owning 45%+ of voting rights and potential key person risk. Geographic expansion risk with potential overinvestment and execution risk.
Recommendation
We retain our Buy recommendation.
