The first half of 2022 was unkind to fast-growing but richly valued stocks like Block (SQ -0.20%). Shares are down 76% from their all-time high almost a year ago. Chalk it up to the U.S. Federal Reserve's interest rate hikes (higher rates lower the present value of stocks) and possible economic recession.
In spite of macroeconomic issues, though, Block remains in high-growth mode and is only just beginning to unlock the profitability of its fintech platform. This stock could be a fantastic buy right now for investors who don't mind riding out some volatility in the share price.
Deepening the ties between merchant and consumer
Early in 2022, Block completed the acquisition of buy now, pay later (BNPL) outfit Afterpay in an all-stock purchase. The deal was worth $29 billion when it was announced last summer, but it ended up being worth significantly less given Block stock's decline.
Nevertheless, with Afterpay now in the fold, Block outlined some strategy at its investor day in May. It explained how it would use BNPL to increase individual user activity and deepen its relationship with merchants. Management described Afterpay as the connective tissue between Cash App (for consumers) and Square (for merchants) to create one unified "two-sided network."
You see, Cash App and Square already have lots of users, most of whom are in the U.S. But for a fintech company like Block, increasing user count is only part of the growth strategy. Once a user has been onboarded, increasing their usage of a financial product is the other part of the expansion strategy. BNPL offerings help merchants convert more paying customers. And for consumers, Afterpay's app-based marketplace increases engagement. Thus, integrating Afterpay into both Cash App and Square could increase usage, which in turn would increase Block's take from the higher rate of transactions.
Even without Afterpay, though, Block's business was doing just fine. Gross profit (revenue minus cost of revenue) grew 34% year over year in the first quarter of 2022 to $1.29 billion, and free cash flow was $188 million, compared to negative $63.3 million a year ago. Digital financial services are winning over young people, and Block is one of the preeminent players in the U.S. -- with lots of potential internationally, where the company currently has very little presence. Afterpay, based in Australia, could help accelerate this overseas expansion.
A top value among fintech stocks?
Block is still scaling up its operations, and so profit margins are being sacrificed for growth right now. However, the company is showing early signs of making some headway in this department. While free cash flow can be highly variable from quarter to quarter, the $188 million generated in Q1 was a great sign. Free cash flow was a decent (but not fantastic) 15% of gross profit. Expect this metric to ramp up over time.
Nevertheless, even as it spends heavily on acquisition integration and marketing, Block is actually doing far better in the profitability department (by free cash flow, at least) than it ever has in the past. Free cash flow (FCF) generated over the last trailing-12-month period was $965 million, which means that at Thursday's closing price, the stock trades at just under 40 times its ratio of enterprise value to FCF.
It's worth noting that net income swung to a net loss this year and was negative $76.9 million. This is primarily due to non-cash expenses like depreciation and amortization of intangible assets -- for example, charges related to acquisitions. Over time, net income and free cash flow should converge.
At any rate, the point is this isn't a value stock. But if Block can maintain its growth momentum for the next few years, it isn't an unreasonable price tag, either.
But what type of investor should pay up for Block? Here are some things to consider:
- Block is priced on the assumption it will be in growth mode for years, so only investors who plan to hold for three to five years (the longer the better) should buy.
- Since it generates thin profit margins and is valued on its growth trajectory, Block stock's price movements are far more volatile than average -- so an investor should be willing to live with wild swings in investment value.
- Block has lots of competition in the fintech space, so it should be a part of a diversified portfolio -- not just with other fintech stocks, but with stocks in different industries.
Block is a promising company that could deliver huge returns over the next decade, especially since the stock has fallen so far from its highs. However, expect this to be a wild ride along the way. Mind the risks and invest accordingly.