Description

Background

SQ has been written up 5x previously on VIC (June ‘21, March ‘21, June ‘19, July ‘18 (short), and November ‘16); but given the carnage in the Fintech / growth market with SQ trading at 30x ‘23E EBITDA & 22.1x / 26.7x ‘24E EBITDA / EPS, and the current catalyst path we can underwrite an 18% 3-year IRR from current levels. Given the previous write-ups/general familiarity will keep the background concise. 

Block is one of the most well positioned FinTech companies with two synergistic ecosystems (i) Square (formerly Seller) & (ii) Cash App that reside at the nexus of numerous macro tailwinds including cash to card digitization of SME’s, payments broadly,  B2B and embedded financial services, eCommerce, consumer finance, and crypto. 

Square

Square offers a cohesive commerce ecosystem that consists of 30+ distinct software, hardware, and financial service products that helps sellers across a diverse range of industries (e.g., services, food-related, and retail businesses) and sizes (e.g., sole proprietors to multinational businesses) start, run, and grow their businesses, monetized via a combination of transactions, subscriptions, and service fees.  Square’s software offerings consist of their online, point of sale, developer platform, CRM, and team management products, which are integrated to enable a holistic view of sales, customers, employees, and locations. They have vertical specific offerings for retail & restaurants, as well as appointment-based businesses. They offer online checkout, a customizable digital invoicing solution, and virtual terminal enabling all of their customers to have omnichannel capabilities. Square’s developer platform offers a suite of payment & commerce API’s and SDK’s to support in-person, online, and mobile payments, the ability to create and manage orders, subscriptions, product catalog, loyalty programs, gift cards, and more, all of which can integrate into existing accounting, CRM, and ERP software tools. 

Since Square acts as both the merchant of record for the transaction as well as the payment service provider (PSP) they are responsible for settling funds with the seller, and help manage transaction risk loss on behalf of their merchants. This has enabled them to offer a suite of financial service products including managed payments, instant transfers, high yield business savings & checking accounts, Square Loans (formerly Square Capital), and Square Payroll.

The team is executing on a growth algorithm at Square focused on (i) Upmarket expansion (and churn reduction), (ii) International Expansion,  (iii) Additional features supportive of share gain (e.g., B2B AP tools, insurance, tax preparation, Square Checking, Square Invoices), and (iv) Square Loans.  In 2022 the Seller ecosystem will  generate $150B+ in GPV across “millions” of merchants, with a net take rate of 1.1%, gross profit margins of 90% (on net-revenue), and EBITDA margins of 30%. Over time management has guided to 40%+ EBITDA margins for Seller (by 2025E). 

Cash App

Cash App provides an ecosystem of financial services that allows individuals to store, send, receive, spend, and invest their money. They finished 2022 with 44M MAU across the US & Europe, as the number one finance app in the iOS App Store & Google Play store,  and the number four app overall based on US downloads.  

The Cash App growth algorithm is focused on (i) Growing MAU’s (ii) Growing Engagement, and (iii) Increasing Inflows. They have executed well on this strategy with weekly active users steadily growing as a percentage of MAU’s (⅔+), new products including the ability to send fractional stocks & BTC to friends, payroll, instant deposits, and tax returns, while re-engaging former users via Cash Card Boost offers, in-app notifications, re-download campaigns, and new functionality from the Afterpay Acquisition. They are currently generating $60+ in gross profit per user across 49.0M MAU’s with 12% EBITDA margins, and should be able to drive GP/user to $75+/user with EBITDA margins in the 30%+ range (management’ long-term guidance is 35%+). 

Upside Optionality

Beyond the core business today Block has several call options that are ascribed $0 value in the current stock price including:

The potential to become the largest payments network in the world outside of Visa & Mastercard with a difficult to replicate moat and multiple shots on goal

Closed Loop P2P/P2M

What began in 2009 as an “iPhone dongle”, has morphed into two separate ecosystems consisting of 49M MAU on one side, and millions of merchants responsible for $200B+ in GPV on the other side; they continue to evolve & expand the breadth of the individual ecosystems (as evidence below), but perhaps most importantly, the connection of those two ecosystems can create one of the largest closed-loop payment networks in the world. The ability to effectuate “on-us” payments between Cash App Users & Square Sellers has already been rolled out with a renewed emphasis on Cash App Pay. On the P2P side, in 2021 Block launched the ability for US & UK users to send cross-border payments between each other instantly, using real-time exchange rates with no fees.  Block has a history of tuck-in M&A (Credit Karma Tax, Stitch Labs, TIDAL, Caviar), and now larger M&A (Afterpay). One of the main justifications of the Afterpay acquisition was to connect the two disparate ecosystems, and help scale internationally. Given the carnage in the crypto ecosystem there will likely be the opportunity for tuck-in M&A in key remittance corridors. 

B2B

The B2B payments TAM is $125T (of which cash & check represent $38T, with ACH representing $84T). As Block continues to innovate with Square Checking, Invoices (ACH), and banking for SME’s, while leaning in with Square Loans they are incredibly well positioned to capture some of this B2B payment volume. They have data on their merchants, their vendors, and their customers, and more and more frequently core ERP information, while already involved in the flow of funds. As they activate the ILC license granted, it’s not a stretch to see them lean into AR/AP with an emphasis on

Open Networks

Visa & Mastercard pride themselves on being “open networks” and have noted that while we’ve seen domestic closed loop systems work (e.g., UPI, PIX) and quasi-domestic digital wallets gain share (e.g., AliPay, WeChat Pay), over time they all need to be interoperable with more open systems such as the card networks. This is largely the view that SQ has taken in their approach to delivering financial services, as the Square ecosystem is an open platform with hundreds of third party integrations and extendable API’s & SDK’s. 

As a result of Jack’s leadership, Block is leaning into Bitcoin & the Lightning Network (“LN”). In order for merchants to adopt a new payment scheme they need to have consumers willing & able to utilize it, and for consumers there needs to be ubiquitous merchant acceptance, which is why these are so difficult to create. Given the two sided ecosystem that Block has already built, the roll-out of Cash App Pay for merchant adoption, SQ’s software as the system of record, and the integration of LN into Cash App, SQ could be the most important company in the first truly global “open-loop” network beyond Visa & Mastercard. The LN is still incredibly nascent and efforts around TBD have had limited disclosure. LN operates via a hub & spoke model dependent upon liquidity in relevant payment channels, which SQ could become a key routing hub in. SQ’s focus on  building infrastructure for LN, contributing liquidity, and connecting B2B, B2C, and P2P payment flow over LN could be a vital factor in its success. 

Patents

SQ has shown a history of  product innovation and a look through a number of Square patent filings & job postings could be meaningful revenue drivers in the future which are not factored into our existing underwriting or consensus estimates including Cash Network, Customizable Payroll, Intelligent Item Financing, etc… 

• Cash Network- This Cash Network would enable SQ to keep fund flows within their closed-loop ecosystem. 

• Employee Customizable Payroll Processing- SQ discussed a system where an employee could designate their own payroll preferences, including a customized payroll period which could be different for each employee (the merchant would be able to dictate payment frequency limits).  

• Intelligent Item Financing- This is described as a supply chain finance solution where SQ (or third party FI’s) could offer loans directly to merchants after they have purchased items necessary to run their business. 

• Facilitation of Crypto Payments- They filed a patent in November of 2021 which outlines the functionality for integrating a payment processing platform and payment making platform for “differentiated payment allocations using cryptocurrency”. The system described in the patent would allow a merchant to accept payments split into portions of both cryptocurrency and fiat currency, with the fiat currency being deposited directly into the merchant account, and the cryptocurrency being deposited into an associated crypto wallet. 

• Cryptocurrency Network & Merchant Payments- SQ has previously obtained patents for a cryptocurrency payment network enabling individuals to buy and sell cryptocurrencies through Cash App, but on October 27, 2020, the USPTO approved Block’s application for a Payment Network for Security Assets. The patent describes a network and process that enables a consumer to make a payment to a merchant (via Cash App) with securities (cryptocurrencies, stocks, etc.) rather than fiat currency

• Wearable Payment Device- This patent describes the temporary assignment of payment data to a wearable payment object (shown as a wristband) which can then communicate with merchant POS and payment systems to make payments. The patent specifically names festivals and markets as events that would qualify as use cases for the product. This contemplates events such as concerts and music festivals, where wristbands could be distributed with embedded RFID chips linked to the individual’s payment information (or Cash App information, synergistic with the TIDAl acquisition and the desire to “empower creators & provide them with new revenue streams,” 

• Physical, Logical Separation of Balance of Funds-  allows users to create sub-accounts for specific spending categories (e.g. restaurants, clothing, groceries, etc.). Instead of having to open separate accounts, users can manually or automatically create sub-accounts which will deposit a pre-set amount of funds in the specific account for budgeting purposes. This is very much in-line with the concept of self-driving money / autonomous finance we continue to touch on with wallets

• Multi-Merchant  Loyalty- Square would utilize merchant characteristics, such as geographic location and merchant category, to group “complimentary” Square merchants to form multi-merchant loyalty programs. Consumers would then have the option to enroll in the multi-merchant loyalty programs at the time of purchase at any Square merchant participating in a multi merchant loyalty program. The patent does not provide details on whether the loyalty rewards would be funded by the merchant, Square, or a combination of the two. However, the patent does indicate both the potential to automatically enroll Square merchants in the multi-merchant loyalty programs as well as the potential for opt-in programs, with automatic enrollment signaling the possibility that Square could intend to fund at least a portion of the rewards.

Given management’s historical track record, these call options coupled with potential upside around (i) International Expansion (ii) Enterprise eCommerce via a bundled sales approach (iii) Afterpay revenue synergies, affiliates & Afterpay Ads, (iv) New Payment flows, (iv) New software solutions to facilitate global hiring / payroll, (v) Consumer Credit, and (vi) M&A (potential international expansion), are all not “priced in” to the stock at current levels.  

Valuation

SQ currently trades at 32.5x / 41.0x ‘23E | 22.4x / 27.0x ‘24E EV/EBITDA & P/E. We have them growing earnings at a 45% 3-year CAGR driven by Cash App MAU’s expanding to 60M at a $65 gross profit / user with 15% operating margins, and seller GPV going from ~$200B in ‘22 to $380B in ‘25E as they continue to move up-market / international with 400bps of EBITDA margin expansion (below management guidance) 

Catalyst

While there's no hard catalyst, SQ has seen Cash App gross profit per user go from $5 in 2015 to $25 in 2019 to $60 today while growing MAU's from <5.0M to 49.0M over that time period, and with the growing attach rate of Cash App Card, focus on Boost/every day spend, increased disclosures and product should highlight how undervalued the asset is within SQ today. Seller is continuing to lean into embedded finance offerings and will be able to reap the benefits of the ILC license over the next two years as they can start to operationalize that. They are in the midst of closing the two ecosystem, leaning into Cash App Pay, and should be a consolidator of sub-scale global fintech assets to expand their geographical footprint & capabilities.