3 Red Flags for Block's Future

Block's (SQ -2.58%) stock plunged nearly 80% over the past 12 months as the fintech giant disappointed investors with its dismal growth rates. Rising interest rates exacerbated the pain by crushing higher-growth tech stocks.

Some investors might be tempted to buy Block after that steep decline, since it now trades at less than two times this year's sales. However, investors should evaluate these three red flags before pulling the trigger.

Image source: Block.

1. Block's big Bitcoin bet

Block rolled out Bitcoin trading on the Cash App in early 2018, but that decision was a double-edged sword. On one hand, it generated a lot of fresh revenue, attracted new users to the Cash App, and diversified its business away from Square's seller-oriented services.

But on the other hand, Block's higher mix of Bitcoin's lower-margin revenue reduced its overall margins while increasing its exposure to the volatile cryptocurrency market. The pros seemed to outweigh the cons during the pandemic, when Block's skyrocketing Bitcoin revenue temporarily offset the slower growth of Square's merchant-dependent services.

However, those tables turned as Bitcoin's price plunged from its all-time high of about $65,000 last November to about $20,000 today. As a result, Block's declining Bitcoin revenue completely offset the post-pandemic recovery of Square's seller-oriented services -- as well as the growth of the Cash App's other non-Bitcoin services -- in the first half of 2022:

Data source: Block. YOY = Year over year.

Therefore, Block's near-term revenue growth will remain tightly tethered to Bitcoin's unpredictable price -- but the market's demand for the top cryptocurrency could remain tepid as interest rates continue to rise.

2. The inflationary headwinds

Meanwhile, rising inflation could make it more difficult for Square's seller-oriented services to recover. While higher inflation could boost the average value of each payment and its service fees per transaction, it could also cause consumers to make fewer discretionary purchases.

Block didn't directly address inflation at all during its latest shareholder letters or conference calls. Instead, it spent a lot more time talking about Bitcoin, its newer Cash App features, and its recent purchase of Afterpay. That's pretty odd for a company that relies heavily on the spending and investing power of the average consumer.

By comparison, PayPal Holdings' corporate finance VP Gabrielle Rabinovitch said the digital payments company was "closely monitoring the impact of high inflation on economic growth, consumer demand and sentiment, as well as broader global macroeconomic indicators" in its latest conference call in August. Rabinovitch also said PayPal would take an "appropriately prudent approach" in navigating the "complex" market.

3. Overpaying for Afterpay

Block's acquisition of Afterpay, the Australian buy now, pay later (BNPL) service, for $29 billion in January raises another bright red flag. That deal valued Afterpay, which is still unprofitable, at nearly 30 times its 2021 sales.

When Block agreed to buy Afterpay last year, the BNPL market was still on fire. Affirm's stock hit a record high of $168.52 last November, which valued the BNPL provider at $47.4 billion -- or 36 times the sales it would actually generate in fiscal 2022 (which ended this June).

Therefore, Block likely believed that Afterpay deserved a similar premium. But today, Affirm is only worth $5.8 billion, or three times the sales it's expected to generate in fiscal 2023. Affirm's stock crashed as investors fretted over its slowing growth and staggering losses.

So if Block had only waited for a few months, it could likely have acquired Afterpay at a much lower price. Instead, it paid an unnecessary premium for a deeply unprofitable business. Block expects Afterpay to rack up $750 million in operating expenses for the full year -- compared to analysts' expectations for an operating loss of $713 million for the whole company -- so it would likely have remained profitable if it had simply ignored Afterpay. 

BNPL services might initially seem resistant to inflation, since higher prices could encourage shoppers to split up larger purchases. However, they could also crumble quickly if those shoppers fall behind on their payments.

Block will remain in the penalty box

Block isn't doomed yet, but analysts expect its revenue to decline 1% to $17.6 billion this year with a net loss of $699 million -- compared to a net profit of $166 million in 2021 -- as it integrates Afterpay. Block's downside might be limited at these levels, but it will stay in the penalty box until Bitcoin's price stabilizes, it demonstrates that the Afterpay acquisition wasn't merely a pricey knee-jerk reaction to the BNPL trend, and its business is resistant to inflation.