Block Stock: Brace For Maximum Pain (NYSE:SQ)

Let’s face it, the macro situation is horrible right now. Everyone’s accounts are getting hit hard, unless you have been net short. While we have hedged about 7-8% of our portfolio which has stemmed the bleeding to a large degree, we are still getting hit. The market has been punished hard. It has been tough. Inflation has crushed the average consumer and the Fed is responding with much higher rates. In turn, tech names have been squeezed hard, and the broader market just seems to fall day after day. Some stocks have been crushed. One example of a stock that has been crushed is Block (NYSE:SQ), despite growth still occurring. It is actually coming down to a valuation level which is still stretched but much more reasonable than in the past. The main concern in the market is the Fed is pushing rates so high that we will overdo it and lead to a deep recession. We have been in the camp of a mild recession, but if inflation data does not improve, we could be in for a moderate recession. If this happens, and unemployment really jumps, the consumer will simply have less money to spend. However, we still believe in the company and suspect a rally in the stock into year end. We are in the worst few weeks for the market historically, and have been pounded with negative news. Let us discuss.

Recession will hurt

Recession of any kind is a huge risk to Block as it hurts small businesses as consumers tighten their belts to be able to afford the essentials. Moreover, inflation causes input costs for small businesses to go up. If this continues, and we get into a bad recession Block could feel a pinch on that. We know that the entire landscape has worsened but Block operationally continues to do what it needs to do to support small businesses, while offering different services to customers. Crypto has been a pain, as the bitcoin on the balance sheet has weighed heavily. While we cannot predict where bitcoin goes, any turn down in the economy will be short-lived. Long-term, we are believers in Block.

The bears have won in the short run, but this is a long game. For now, you must brace for maximum pain. Covered call selling has been an excellent strategy to offset the immense pain, but it is only dressing the wound. The pain is real right now.

Long-term opportunity

However, the company is doing a lot of good things, and this is an opportunity to own this disruptive name if you are willing to own it long-term and leg into it. We have been in and out of this name. We have made great money on the rises, but have been stop-lost thrice now on the way down. At these levels we are now investors. Of course, in the near term, this is speculative in nature just given the action. It has really been an excellent trading stock, both long and short. For those looking to buy the stock consider selling puts on this recent big downturn as premiums are very high with a VIX over 28. Trading is what we do, but it is hard at times, and so we are currently looking for investment opportunities.

We think investors should consider owning Block. There is upside here long term in our opinion, but Block has work to do, and there could be more pain ahead. We could see why many may wish to wait for the bottom, but this climate is where investors will make great money long-term. Buying on the massive declines in this bear market. The company is operating well but has started to be hit hard by the inflation pressures and pressure on crypto, as we saw in the recently reported quarterly earnings.

The company for many quarters had long seen revenue expansion, but now that growth has stalled. We went from significant expansion, to contraction. In Q2, revenue was $4.41 billion and this was a decline of 5.8% year-over-year. Despite the fall of 5.8%, this was a beat versus consensus estimates. What we are happy about is that the company has seen improvement in profit. All lines of business are still performing well and overall, gross profit was $1.47 billion, which was up 29% year-over-year. Further, transaction revenue grew, showing no signs of a slowing economy at least through the first half of the year. When Q3 is reported we will be closely watching for these same figures.

Big transactions fuel Block’s revenue

Revenue from transactions was $1.48 billion rising 20% year-over-year, while gross profit was $600 million, up 10% from the year ago quarter. Transactions fueled much of the revenue. These numbers show the strength of the expansion the company has enjoyed, despite a terrible macro situation. Transaction volume is key and they surged from a year ago. Square processed $52.5 billion in GPV up 23% year-over-year.

On top of that, services-based revenue increased to $1.09 billion jumping 60% from last year. Further, gross profit was $882 million, up 56% year-over-year. This is really good news, but we will closely be watching for signs of cracking in Q3. The rate hikes have a delayed impact. But will it really slow things like the amazing Cash App? Well it may.

Make no mistake about it, Cash App was a great innovation that users love. Cash App generated $2.62 billion of revenue in Q2 and $75 million of gross profit. big decrease of 21% from last year. This is a trend that is likely to continue for the next few quarters as people adapt to the new climate. There is also a lot of competition from similar apps. The moat is not there. Bitcoin has also been a pain. Bitcoin was weak but volatile in Q2. The volatility helps with trading revenue, but the company has a good amount of exposure to Bitcoin on its balance sheet. In Q3 bitcoin has also been weak so we can expect pain when Block reports. As Block owns a lot of bitcoin, the stock continues to trade somewhat correlated to the price of bitcoin over time. But the majority of the business is still transaction-based. Bitcoin saw $1.79 billion in revenue, down 34% from last year. If adjust for the bitcoin, declines Cash App revenue was up 21% to $732 million.

The decline is all bitcoin driven, even offsetting gains from buy now and pay later. After a series of downgrades here and here, and a neutral initiation from Marqeta on buy now pay later slowing, we think it is a good contrarian time to buy, as they are expanding into Canada with this feature. Small business is beginning to feel the pinch a little bit with the inflation pressures, but the consumer remains strong. Growth is present, but if economic trends continue the way they are, Q3 could see pain.

The company needs to control operating expenses which were $1.68 billion, rising 66% year-over-year and this led to net losses in the quarter. Net loss was $208 million, while EPS was a loss of $0.36, all on a GAAP basis. Adjusted EBITDA was cut in half to $187 million. while adjusted EPS was $0.18. So overall, the stock is still around 60X earnings. It is getting better, and the company could earn about $1 a share this year if things do not collapse into the holidays. If the consumer is pinched, we could see more buy now pay later, not less.

Final thoughts

A rally in Bitcoin would sure help. An inflation report showing disinflation could spark a massive rally. We believe that the company will grow much larger in the next few years as long as the economy does not go deeply into recession. If it does, it will be a tough few quarters. Long-term, shares can be bought into more weakness.