hapabapa/iStock Editorial via Getty Images

hapabapa/iStock Editorial via Getty Images

Last week Block (NYSE:SQ ) reported its Q1 2022 earnings, generating over 44% year-over-year (YoY) growth excluding bitcoin. The company’s gross profit growth was 34% for the quarter and Block’s Square Sellers ecosystem continues to see strong gross profit growth as Block continues to increase the value of its platform for its Sellers by offering services like Payroll, expense management, and now integrating Afterpay’s BNPL tool, which leads to more volume for Square merchants. Block ultimately benefits when it processes more volume, which is partially Afterpay, which saw its merchant base increase by 10% last quarter.

We continue to build tools and services to help sellers make more sales.

What sets us apart from every other company, whether they be focus on sellers, individuals, buy now, pay later because we have all of it in 1 ecosystem. They all connect together.” - Jack Dorsey, Block Head

Block’s other ecosystem, Cash App, continues to grow organically, even while facing tough comps. This quarter, Cash App saw its strongest month of active users with monthly actives transacting 21 times on average.

Block is building a full-fledged payment ecosystem for both merchants and consumers. Block's ecosystem is designed to be more inclusive to both consumers and merchants by enabling everyone to fairly participate and access the economy. Now with Afterpay on board, Block will leverage its ability to offer consumers credit to accelerate gross profit growth by better engaging consumers through Cash App and driving more sales at Square Sellers. This quarter was informative for understanding Afterpay’s progress since the acquisition was completed on February 1st, while there’s much more for Block to unveil at its Investor Day on May 18th.

Cash App was all about Trust, Families, Afterpay, and Bitcoin this quarter. Ultimately, Cash App is focused on driving user engagement and offering value-added financial products that enable consumers to send outflows and participate in the economy. Since Block has billions of merchants, it benefits from higher profits when Cash App users spend at Square Sellers since Block is entitled to fees from processing both the issuing payments, on behalf of consumers, as well as acquiring the payments, on behalf of the merchants.

Rolled out new optionality for teens to deposit paper money into their Cash App at participating Walmarts and Walgreens, for a $1 fee

Trust - Introducing FDIC insurance for all Cash App cards in April

Block is just beginning to integrate Afterpay into Cash App

More than 10M Cash App users have bought Bitcoin since Cash App launched the service in 2018.

Cash App introduced Bitcoin transactions on the Lightning network which enables people to send and receive Bitcoin by makings transactions “instant and free”. Bitcoin transactions previously took as long as 10 minutes.

Launched the ability to send funds between the U.S. and the U.K. which will inform its next moves for international growth. Block will also use M&As to expand internationally, leveraging what it has learned since its acquisition of Verse, a Spanish P2P payments app, in June of 2020.

Let's talk about some of the drivers. First, we saw our strongest monthly engagement on Cash App in March as monthly actives transacted 21 times on average across our ecosystem during the month. This is driven by strong adoption of our banking products including Cash App card. Cash App Card was one of our fastest-growing monetization streams, with gross profit growth in the first quarter of more than 50% year-over-year despite strong growth in the prior year period and more than 170% growth on a three-year CAGR basis.

Second, we saw our highest quarterly inflows ever into Cash App with growth on both a quarter-over-quarter and year-over-year basis. Inflows per active declined slightly on a year-over-year basis given significant government disbursements in the prior-year period but increased quarter-over-quarter. Direct deposit has been a growing mix of inflows and we've seen particular strength from recurring paycheck deposits, which were up more than 2.5 times year-over-year in March.

Increased adoption has been a key driver of volume here. In March, we reached approximately 1.5 million direct deposit monthly actives. And while we've been increasing adoption across our monthly active base, we believe there is still so much opportunity ahead as we bring awareness to our direct deposit capabilities.” - Amrita Ahuja, Block CFO

This quote from Block’s CFO highlights the growth in Cash App, even facing tough comps considering the government disbursements in Q1 of 2021, but more importantly it highlights that Cash App is seeing strong engagement in inflows and well as outflows. This is critical because Cash App generates revenues when users spend money using their Cash App Card or deposit money into their Cash App, which is monetized through fees.

Cash App saw its strongest levels of monthly engagement as active uses transacted on average 21 times in March, while inflows were also an area of strength. Cash App Card gross profits grew more than 50% in Q1, while Block recently increased its fees on instant deposits to 0.5%-1.75% from 0.5%-1.5%.

I think a lot of it comes back to what we've shared around our inflow framework. These three key drivers of monetization win in Cash App.

First growing our active base. As of the end of December, we had over 44 million monthly actives. We continue to grow that quarter-over-quarter in Q1 and month-over-month into April. Second inflows, we have continued to grow. We had our strongest inflow quarter ever in Q1. And that's on the back of growing product adoption as well as growing engagement as we noted in our remarks and as you noted strongest engagement month in March with 21 transactions during the month on average across our monthly base.

And then finally, the third variable around monetization rate. This is effectively how much we charge on the inflows that come into our system. And as you know, we've been able to drive value across the products that we have and been able to flex pricing on some of them even more recently. So that's the broader framework that really moves Cash App, where we've seen strong growth and traction even in the midst of a dynamic macro environment and strong health in the base of our customers on Cash App.

You also layer on top of that that we have some newer products that are just beginning to ramp whether it's reaching out to families whether it's driving inflows through direct deposits whether it's things like Cash App Pay or in the longer term the opportunities to build an integrated commerce platform with Afterpay, we see a significant opportunity here to continue to drive growth through our Cash App platform.” - Jack Dorsey Q1 2022 earning call.

Cash App is an important component of future growth at Block, while Afterpay represents an ideal platform to leverage as Cash App expands the utility of its platform. Cash App will expand its offering of financial products by giving Cash App users the option to borrow money for purchases in addition to making instant payments from one’s Cash App balance.

We will hear more about Afterpay and what’s in store for Cash App at Block’s upcoming investor day presentation on May 18th. Dorsey mentioned on the call that Block is “just getting started” when it comes to integrating Afterpay.

Cash App drove more than 350k leads to Afterpay sellers during the first quarter, which indicates the opportunity that Afterpay has to benefit from capturing sales at Square Sellers, creating synergies for Block. During the quarter, Square Sellers ecosystem saw strong gross profit growth, up 41% YoY while revenue was up ~42% to $1.44B.

Mid-market Sellers demonstrated overall strength as Square’s gross profit was up 47% for this GPV mix while overall GPV was up ~32.5%, during a quarter that it faced headwinds due to Covid-19.

For Square for the month of January and February, we expect gross profit growth of 45% year-over-year or 28% on a two-year CAGR basis. We experienced a moderation in gross profit growth for both our Cash App and Square ecosystems in January before growth improved in February. We believe the moderation in January growth was driven in part by the impact of the Omicron variant as both businesses were more impacted in regions with pronounced increases in COVID cases.” Block Q4 2021 Earnings call

Strong gross profit growth continues to be a story that’s developing within the Sellers ecosystem as we highlighted after Block’s previous earnings. Square also released a new Square Stand during the quarter that offers businesses an easy-to-use terminal that offers Square’s full platform of features.

Block continues to distribute the Square Sellers ecosystem through offering new hardware, as well as expanding to new regions. Square recently launched Square Loans in Canada and Afterpay’s international merchant base is also a good opportunity to expand the distribution of the Square Sellers ecosystem. As Block rolls out its platform in new regions, it will look to offer its full suite of services whether Square Loans, Square Marketing, or Square On-Demand Delivery.

So global expansion remains our top priority for Square and also for Cash App. And with Square with regard to Square, we have three approaches. Number one, we invest in brand and product awareness to drive a broader understanding of our product capabilities to sellers within each one of the markets. Number two, we focus on reaching product parity across all of our markets. And what this means is that, we have all the products that we have in the United States, ideally we're launching them everywhere in the markets that we're currently in as well. So that when Square loans is in one market, it's also in all the markets that we currently exist in.” - Jack Dorsey Q1 2022 earnings call.

Revenue excluding Bitcoin: $2.23B up 44% YoY

Gross Profit Q1(2022): $1.29B up 34% YoY

Seller Ecosystem gross profits: $661M up 41% YoY ($619M excluding Afterpay)

Cash App gross profits: $624M, up 26% ($582M excluding Afterpay)

Afterpay gross profits: $92M (in February and March only)

Net Income: $204M, which was elevated due to the acquisition of Afterpay and offset by $42M of the one-time deal and integration-related expenses, $31M of amortization of acquired assets, and $66M of one-time SBC, while offset by an unrealized gain of $50M in Equity; and excluding these items, net loss was $114M.

For Block’s next quarter, analysts' EPS estimates are $0.17 per share, according to Seeking Alpha’s Block earnings estimates.

Ended the quarter with $6.9B in available liquidity, ($6.3B in cash, cash equivalents, restricted cash, and investments in marketable debt securities, $600M available to be withdrawn from its revolving credit facility, as well as $1.6B available to be withdrawn under its warehouse funding facilities, to support BNPL loans).

Afterpay - 144,000 merchants, up 68% YoY; more than 20M annual active consumers on the platform, up 37% YoY

Based on guidance from management and Block’s TTM gross profits when including Afterpay, of ~$5.4B, we’ll use 32.5% growth to account for the demand for Cash App, demonstrated by the strength in inflows and outflows, as well as elevated growth in gross profits among the Square’s Sellers ecosystem.

Fwd 12 Mo. Free Cash Flow (45% of gross profit)

Now, let's use the L.A. Stevens Valuation Model to determine what Square's worth today. Here's what it entails:

In step 1, we use a traditional DCF model with free cash flow discounted by our (shareholders) cost of capital.

In step 2, the model accounts for the effects of the change in shares outstanding (buybacks/dilutions).

In step 3, we normalize valuation for future growth prospects at the end of the ten years. Then, using today's share price and the projected share price at the end of ten years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.

Forward 12-Month Free Cash Flow [A] (a conservative estimate)

Average fully-diluted shares outstanding [B]

Free cash flow per share [ C = A / B ]

Free cash flow per share growth rate (conservative estimate)

Discount Rate (Our "Next Best Alternative")

L.A. Stevens Valuation Model

L.A. Stevens Valuation Model

As seen above, Block is worth ~$365 per share today, undervalued by nearly 80%, accounting for future dilation. In order to determine Block's projected return, we simply grow the above free cash flow per share at our conservative growth rate, then assign a conservative multiple, (i.e., 32.5x) to it for year-10. Thereby, we create a conservative intrinsic value projection by which we determine when and where to deploy our capital.

L.A. Stevens Valuation Model

L.A. Stevens Valuation Model

I rate Block a strong buy at $83 as Block is expected to be worth ~$1,426 per share by 2032 and generate a ~33% CAGR over this period. This would put Block’s market cap at more than $900B by 2032 which we find within reason given that Block is rewriting financial infrastructure, not only in the U.S. but globally while it’s still in its early days. By this time, the company anticipates that the Afterpay asset will generate nearly $12B in revenue and over $5B in adjusted EBITDA.

We're really excited about Afterpay and where it goes. We're still extremely early into this integration. This is the biggest thing our company has ever done. And obviously, it definitely distracts a lot but we've managed to perform through it.” - Jack Dorsey Q1 2022 earnings call.

Afterpay is a major opportunity for Block as Afterpay brings a consumer credit offering to the Square and Cash App ecosystems, but it represents an obstacle as Block needs to revamp Afterpay’s underwriting with similar machine learning tools that are used for Square Loans. Instead of underwriting businesses and opening opportunities for SMBs, Block will open up opportunities for consumers by extending them credit. Prior to the acquisition, Afterpay’s underwriting was weaker than its industry peer Affirm. Here are the Block CFO’s comments regarding Afterpay.

Turning to Afterpay. In April we expect GMV to be up 15% year-over-year or 70% on a three-year CAGR basis. And we expect revenue and gross profit growth to come in below this driven by a mix shift to newer markets. On a gross profit basis, Afterpay's GAAP results are impacted by expenses related to the amortization of intangible assets which was a $9 million impact to cost of sales in the first quarter and is expected to be $12 million on a quarterly basis going forward. This is not an operational expense, but rather a GAAP purchase price accounting adjustment for the acquisition.

Losses on consumer receivables were 1.17% of GMV during the first quarter which was consistent with the second half of 2021. We continue to see healthy consumer repayment behavior with 95% of installments paid on time. We're focused on unlocking the combined potential with our integration. In addition to the launch of buy now pay later for Square online sellers, we see a broader opportunity to bring Afterpay to more of our Square ecosystem in the coming quarters.” - Amrita Ahuja Q1 2022 earnings call.

Block is fine-tuning Afterpay’s underwriting, as we expected was necessary. Block is generating 15% GMV growth out of Afterpay, which is lower than peers, but this is to be expected as Block develops the necessary underwriting and machine learning capabilities as it looks to offer consumers the capability to instantly borrow funds through Cash App. This represents a huge opportunity moving forward, but also a risk, especially as the industry has lots of competition between the fintechs and incumbent financial institutions. Afterpay’s losses on loans were in line with its historical losses, while Block is also beginning to leverage the vast amounts of data across its two ecosystems when it comes to underwriting consumers from the Cash App platform. Underwriting is a risk for Block, but Block’s known to utilize machine learning in its underwriting since its earlier days in the Square Sellers ecosystem, while Block’s CEO recognizes that Afterpay is critical for Block’s long-term success.

Overall, this was a solid quarter for Block, but Block has a lot of work ahead of itself as it continues to expand the utility of its two ecosystems by enabling businesses and consumers with more tools to make commerce easy. This quarter Block proved that its Square Sellers and Cash App ecosystems are still growing organically, but there’s a massive opportunity for Block if it successfully integrates Afterpay into its ecosystems, especially Cash App.

I still rate Block a strong buy at this depressed valuation, as the long-term vision is well intact and the company’s strong financial position, with plenty of liquidity.

Thanks for reading and happy investing!

This article was written by

I am a Research Associate at Beating The Market, we strive to identify tomorrow's disruptive companies that will generate life-changing returns. At Beating The Market, I work with Louis and Ahan to help people invest in the stock market and find the next Apple, Tesla, or Facebook. We do this by utilizing BTM's Crucial Characteristics and identifying companies using the "Zero-to-One" exercise in thinking when evaluating these companies.

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Disclosure: I am a promoting contributor for Louis Stevens' Marketplace service, Beating The Market.

Disclosure: I/we have a beneficial long position in the shares of SQ, AFRM either through stock ownership, options, or other derivatives. 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.