While many think of the S&P 500 as an index of unchanging companies that have stood the test of time, the truth is the index is constantly in flux. The committee in charge of determining the 500 companies included in the index is constantly evaluating its members and ensuring they maintain a set of standards required for inclusion. If a company becomes unprofitable or declines in value too much, the committee will replace it with a more deserving company when it reconstitutes the index every quarter
Another instance when the committee will add new stocks to the index is when one of the companies gets acquired, delisting their stock from the market. Such was the case earlier in July, which led to The Trade Desk's inclusion in the index. Just a week later, the committee added Block (XYZ -3.39%) to replace Hess following the latter's acquisition by Chevron.
Despite a big jump in Block's stock price on the news, building on a considerable increase in its share price since the start of May, investors can still buy shares of the company at a fair price. Here's what you need to know.
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Refocusing on profitable growth
After incredibly strong adoption for both of its financial products on the consumer and seller sides during the pandemic, Block has experienced a bit of a hangover. In fact, it's seen a marked deceleration in its gross profits (a more fitting metric than revenue for the business) over the last year.
Its first-quarter gross profit growth came in at just 9% -- the fourth straight quarter of decelerating gross profits, down from 22% growth in the year-ago period. The challenge isn't isolated to Square (its seller service) or Cash App (its consumer service). Both have seen considerable slowdowns.
Management has plans to turn things around in the second half of the year. It's rolling out Cash App Borrow nationwide, based on its acquisition of Afterpay. It expects to be able to increase loan limits and reduce defaults using its wealth of consumer data and machine learning algorithms. It's also planning to increase its marketing spend, focusing on niche customers like teens and their families. Meanwhile, it continues to roll out new features and products for Square to grow revenue and improve retention.
Despite the slowdown in its top line, Block has managed to improve its profitability, boosting its earnings per share (EPS). Adjusted operating income grew 28% year over year in Q1 on the back of margin expansion.
While the step-up in marketing for Cash App will weigh on its margins, it should help reaccelerate its top line. And that's still a big opportunity for Block. Management estimates the total addressable market for Square is $130 billion and $75 billion for Cash App. While it's focused on small segments of each market, it's still underpenetrated with just $9 billion of gross profit over the past year.
While increased marketing spend will pressure profitability in the near term, the nature of Block's core businesses benefit from scale with minimal marginal operating costs. That should produce strong earnings growth over the long run.
A fair price for a fintech leader
With big opportunity ahead for the company, investors interested in fintech stocks should consider adding Block to their portfolio.
As of this writing, the stock trades for just under 30 times forward adjusted earnings estimates. As the company reaccelerates its top-line growth to double digits over the next few quarters, it should put itself on a path to sustain that pace over the long run. As long as it maintains cost discipline, it should see strong margin expansion over time as it scales. That should lead to strong EPS growth, justifying the current price.
On top of the fintech business, investors also get access to a Bitcoin business. The company generates a small amount of revenue from the spread on Bitcoin sales through Cash App. It also owns Bitkey, a self-custody Bitcoin wallet, and Proto, a suite of Bitcoin mining products and services. Management expects the latter to contribute to gross profit starting this year. Additionally, it holds Bitcoin on its balance sheet.
While Bitcoin represents a tiny piece of Block's business today, it could provide strong upside if there's broader adoption of the cryptocurrency. In the meantime, the core fintech business looks poised to bounce back from its recent downturn. While the increase in stock price reflects growing investor confidence in the turnaround efforts, there's still time for investors to buy the stock at the current price.
