When financial technology (fintech) company Block (SQ 2.48%)went public in 2015, back when it was known as Square, it explained its business in its registration documents like this: "We started Square in February 2009 to enable anyone with a mobile device to accept card payments, anywhere, anytime." The company had a square-shaped credit card reader that plugged right into smartphones and tablets.
Block has more hardware devices today, and many people think of these devices when thinking about the company. However, through the first three quarters of 2023, the company has only generated $125 million in hardware revenue. This means that hardware sales are a measly 0.7% of its $16.1 billion year-to-date revenue.
On the other end of the spectrum, revenue generated from Bitcoin (BTC -0.42%) accounted for 43% of Block's year-to-date revenue -- its largest revenue source. But surprisingly, the purpose of this Bitcoin revenue stream isn't dissimilar to its hardware revenue stream, as I'll explain.
How are fintech hardware and Bitcoin alike?
Gross profit compares the cost of an item against its sales price. Let's say someone makes a pizza with $5 of ingredients. If they sell that pizza for $10, their gross profit is $5.
For Block's hardware, it has a negative gross margin -- the hardware costs more to make than the sales price. The company's 2% gross margin for Bitcoin is better, but it's still not a big money-maker.
Why go to all the effort of making hardware and processing Bitcoin transactions if you aren't going to make money off of it?
Block views fintech hardware as a way to expand its merchant customer base with its Square ecosystem, and it views Bitcoin as a way to increase its consumer customer base with its Cash App ecosystem. It's not uncommon for companies to willingly lose money on customer-acquisition strategies in order to make money down the line from something else. That's what's happening here.
For both Square and Cash App, Block generates transaction-based revenue, as well as subscription and services revenue. And these are higher-margin propositions.
For transaction-based revenue, Block's gross margin is about 42% -- not too shabby.
For revenue from subscriptions and services, Block's gross margin is even better, at 81%. And what's exciting is that, through the first three quarters of 2023, this revenue segment rose an impressive 33% from the same period of 2022, making it Block's fastest-growing revenue stream.
Over the long term, this can be significant. As the chart below shows, gross profit growth has outpaced revenue growth over the past three years, which is what you want to see.
What this means for Block stock
The obvious takeaway should be that Block is a much more complex, multifaceted business than meets the eye. Anyone trying to build an investment thesis for this company has their work cut out for them -- there's a lot to account for.
A less obvious takeaway is that investors need to be careful when trying to evaluate Block's financials. There are some low-profit efforts directed at customer acquisition, which can be good. Customers can generate high profits for the company over the long term.
Therefore, growth of Block's merchant base and Cash App user base may be some of the most important metrics for investors to monitor.
Tracking growth in the merchant base isn't the easiest task -- Block often doesn't share a number. However, tracking payment volume (the dollar value of processed transactions) is a close proxy. There are promising signs here, with payment volume for the Square ecosystem rising 11% year over year to $55.7 billion in Q3.
In the Cash App ecosystem, things are a bit easier to track, and it's also encouraging. Block's Cash App had 55 million transacting active users in September, which was up 11% from the same month in 2022.
As Block's merchant base and base of Cash App users grow, expect the company to generate more transaction and subscription revenue. And these revenue streams can boost the company's gross profit even more, which could make Block stock a good one to buy.
Bringing this full circle, it all starts with Block's low- and negative-margin businesses: hardware and Bitcoin. As merchants look for ways to digitize their businesses, Block has all the tools. And as people look for fintech solutions to manage their cryptocurrency, investments, and banking all in one place, Block again has almost everything.
Low-margin services open the door to better things, and that's why the future is bright for Block.