Block, Inc.: I Don’t Get The Optimism (NYSE:SQ)

Shares of Block, Inc. (NYSE:SQ) have had an interesting run over the last few years.

Enjoying a huge wave of optimism in the bull market of 2021, those feelings quickly disappeared as the challenges of 2022 entered the fray. Reaching into the $40s last fall, the stock has about doubled since then on a new wave of optimism.

Not long after this rally, founder Jack Dorsey related his vision for the future in a very special letter to shareholders and in Q4 earnings. Yet, I find myself asking more questions. Ultimately, the $52 billion price for Block is one that I am struggling to justify as a long-term investor, and I thought was worth a review.

A Perplexing Market Cap

Long-term investors have to decide if a given market cap is a reasonable, present value for a company’s future earnings. What one means by “earnings” depends on the company, but for one like Block, I’m talking about free cash flow. Let’s take a look at the company’s financial history.

Even though revenues steadily grew through this period, we don’t get a very consistent picture with regard to FCF. If you do the math, though, Block generated a little over $1.1B in cash during the decade from 2014 – 2023. The company does give us a better idea of the current level of FCF:

Looking at the items it resolves (and I think these are fair), Block’s adjusted FCF comes to about $515M.

The current market would have us believe that that business is now worth $52B. That’s a Price/FCF multiple of 100. Yes, “that business” has come a long way. Initially being Square services and the Cash App, it had to spend money to acquire customers (that $5 referral promo) and mainly earned transaction-based fees. It later added Bitcoin (BTC-USD) services. It made other acquisitions (key among them Tidal), so it has more diversified revenue streams than in the past.

Still, with all those pieces, we’re talking $52B for $515M of FCF. Something needs to grow their cash flow.

Ecosystem and Banking

Let’s review some important trends that management shared. We start with improvements among sellers through Square.

Square is gradually bringing in larger customers, indicating that it is gaining higher-quality customers in this segment.

Similarly, cash inflows on the Cash App are up almost 5x from where they were five years ago. These are signs of a scaling business that can and is growing. Crucially, though, with its growing size among different lines, management believes the key to growth is through the Square ecosystem. Quoting their 2023 Form 10K (pg. 8):

Our Square ecosystem consists of more than 30 distinct software, hardware, and financial services products that provide cohesive Commerce, Customer Relationship Management, Staff Management, and Banking capabilities.

“Ecosystem” is a word that gets used a lot in the business world now. Back in 2014, it was something of a novelty to hear. That Amazon (AMZN) had developed its own retail ecosystem was amazing. Disney (DIS), meanwhile, pulled off an ecosystem in IP franchises and entertainment media. Eventually, however, we have to realize that not everyone just gets to have an ecosystem or that some are overusing the term.

Block has multiple segments that provide some synergies with each other, yes. Businesses have had this feature for a long time. In my view, a real ecosystem is when a business has both the scale and vertical model to operate with self-sufficiency. This means they not only fund everything with their own operations, they avoid having to borrow to get anywhere, and they don’t even have to think too hard about competition. They are internally focused and intrinsically driven.

I want to highlight what Dorsey has said about banking, though. In the shareholder letter, he stated:

In the same way that peer-to-peer (P2P) payments was a gateway to the Cash App Card, we see the Cash App Card as a gateway to our customers adopting Cash App as a primary banking solution.

After noting the numbers that suggest the possibility, Dorsey added:

So how do we capture this opportunity? It starts with earning our customer’s trust.

Trust is the kryptonite. The shift from providing electronic payments to being a bank is a big one. It’s also not an ecosystem to do that. At this point, having an account balance and a card to process payments (with some adjacent services) is your standard bank. I’m skeptical that Block can compete against established banks.

Seen above, Square doesn’t even dominate in its home court. Zelle does, and who owns Zelle? Some private company called Early Warning Services, LLC, which is collectively owned by the big banks.

You need qualified personnel in the regulated industry that is banking. Yet, Dorsey doesn’t seem keen on expanding the crew, explaining in the shareholder letter:

We’re under our 12,000 people cap. This constraint forces us to prioritize more impactful work, which we believe will lead to growth. We’re going to operate under this cap until we feel it’s holding us back, which is likely years out, and continue to look critically at our organization and priorities.

One notorious feature of digital payment apps from even the beginning is their poor customer service. If Block wants to make it in banking, they need to attract large deposits, but people with that amount of money are going to be hesitant if they have a problem and can’t easily talk to anyone about it.

Years ago I could not get something refunded to me on PayPal that shouldn’t have processed, even though I was quick to address it. There was essentially no customer service to remedy my situation. My response? I stopped using PayPal altogether. When I went to my local branch, I had no problem getting the matter handled in minutes with a banker. I still use that bank.

Customers care about what happens with their money. Cash App was built on millennials splitting the bill for dinner or chipping in for gas. A bank has a lot more going on, and I’m not convinced that Block appreciates what kind of step this is and how tight the competitive squeeze will be.

Ecosystems certainly don’t work like that.

Share-Based Compensation

Even if we could set aside these strategic and operational concerns that impact what is a fair market cap, we still have to remember that shares of SQ are what’s on the table. Their value, as pieces of ownership, are what matters. With that said, there’s a very concerning trend of shareholder dilution through stock-based compensation to employees.

If there’s been one area of this company that has had truly meteoric growth, it’s SBC. Assisted by this, shares outstanding rose from 154.6M in 2014 to 615.8M in 2023

For 2022 and 2023, SBC has been over $1 billion annually. While Block was kind enough to give us an improved idea of 2023’s FCF, 2023’s SBC is more than double that. Even if the fundamentals of Block improve exactly as Dorsey and the current market around SQ hope it will, it begs the question of how a long-term investor would benefit if they are being diluted at faster rate than the yearly cash generation.

Somewhat related, Block has a few billion in long-term debt due in the next fear years. Most of it is low interest, so maybe it can be refinanced at a favorable rate later, but these are also convertible issues, and they could add to the dilution as well. Principal repayment will naturally compete strongly against current FCF levels, even if conversion doesn’t happen. It’s not a big issue, but it’s one more thing on top of a picture I already don’t like.

Conclusion

Given these issues, I don’t see how I can do a Discounted Cash Flow model to provide a valuation for SQ. Such calculation relies on practical growth assumptions. It’s hard to say what that looks like as Block tries to assert itself as a bank, which I consider to be a risky and ambitious step. There’s no indication that it can or will grow its cash generation enough to make a P/FCF seem reasonable.

Potential dilution from share-based compensation and convertible debt also complicates how much stake in those future cash flows an individual share of SQ would ultimately have.

Long-term investors deserve a firmer handle than an investment in SQ represents. Without a valuation and room to determine a margin of safety, it’s not actionable. Until the situation with Block’s FCF, its growth, and share dilution more clearly and compellingly present an attractive opportunity, I can’t consider SQ a Buy.