One of the most exciting secular growth trends that investors should be paying attention to if they aren't already is the advent of fintech and digital payments businesses. The large traditional banks were too slow to incorporate technology to improve their user experiences to prevent being disrupted. And now there are numerous companies encroaching on their territory.
One such fintech pioneer, Block (SQ 0.78%), should be on every investor's radar right now. JPMorgan Chase Chief Executive Officer Jamie Dimon even said the business, formerly known as Square, "innovated where we should have."
Here's why I think it deserves a closer look as a potential portfolio addition in 2023.
Two budding ecosystems
What makes Block an impressive business is that it has two outstanding segments. Its Square unit provides financial services, software, and hardware solutions to small merchants that want to seamlessly accept card payments from customers, as well as handle payroll, invoicing, and loyalty programs, among many other services. During the most recent quarter (Q3 2022 ended Sept. 30), Square's gross profit increased 29% year over year. And the segment processed gross payment volume of $50 billion, which was up 20% year over year.
There's also Cash App, the popular personal finance mobile app targeted at individuals, which was the No. 2-ranked finance app on the Apple App Store, behind only Intuit's TurboTax. Cash App lets its users buy stocks, trade Bitcoin, send and receive peer-to-peer payments, and get debit cards.
Cash App, like Square, is posting stellar growth. Gross profit for the segment of $774 million represented an increase of 51% year over year. And in September of last year, Cash App counted 49 million monthly active users, with 18 million active Cash App Card customers.
These two ecosystems would be great companies on their own, but Block is finding ways to strengthen the ties between them. Cash App Pay lets customers make purchases at Square merchants directly with their Cash App balances utilizing a QR code. And with the addition of buy now, pay later specialist Afterpay, Cash App customers and Square sellers are further integrated thanks to the payment installment service.
NYSE: SQ
Key Data Points
Huge upside
Block's past growth has been tremendous, but there is still a sizable opportunity ahead. According to the management team, the company has a $120 billion gross profit opportunity, one that keeps increasing. Since it's continuing to expand its product offerings while further penetrating existing regions and entering new ones, Block's story is far from over.
Another upside is the resurgence of Bitcoin, which has soared 38% so far in 2023. If the top cryptocurrency's momentum continues, it could be a boon for Cash App in terms of attracting new users and getting its existing ones to add more money to the platform to buy Bitcoin.
Despite general macroeconomic weakness, Square and Cash App continue to demonstrate that they can grow in this environment. And with $7.1 billion of liquidity, compared to long-term debt of $4.6 billion, shareholders have peace of mind that the business will weather any recession in the near term.
The beauty of payments enterprises is that they can be extremely lucrative at scale. For example, just look at the two dominant card networks, Visa and Mastercard. These behemoths have pristine income statements. Visa's and Mastercard's net income margins were 51% and 43%, respectively, in their latest fiscal quarters.
And then there's PayPal, which has experienced a bit of a slowdown in recent quarters, but still generated free cash flow of $1.8 billion in the third quarter of 2022 on revenue of $6.9 billion. That translates to an incredible margin of 26%.
To be clear, with its Square and Cash App segments, Block obviously doesn't have exactly the same business model as Visa, Mastercard, or PayPal. However, Block does benefit from operating leverage. The marginal cost to process each additional transaction for its merchant base or its individual users is negligible because the network infrastructure is already largely built out. Therefore, as revenue and gross profit continue climbing in the years ahead, Block's margins will expand, and the hope is that it becomes very profitable.
At a price-to-sales multiple of 2.5 today, investors shouldn't hesitate to add this wonderful company to their portfolios in 2023.
