Block (SQ): Bitcoin Business negative for profits to come

Shopping in the meta verse

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blocks (NYSE:SQ) including Facebook’s parent company Meta Platforms (META) formed an odd duo in 2021 when both companies decided to change their names to broadly reflect crypto and the Metaverse, the double hype of the time. It wasn’t entirely clear at the time that the market for crypto would collapse less than a year later. In fact, for most of 2021, the zeitgeist was one of euphoric spirits and a retail boom, with bubbles appearing in everything from SPACs to NFTs. It was truly an era of easy money, and when it ended, it did so with a bang.

To be fair to Block, the name change should also reflect the wider range of businesses. These included Jay-Z’s music-streaming platform TIDAL and Australian buy-now-pay-later firm Afterpay, which was acquired in an all-stock deal for $29 billion. Essentially, Block’s triumphant move to crypto, BNPL, and music streaming came at the height of market sentiment. In fact, Afterpay’s larger competitor, Klarna, recently completed a downward round that saw its valuation cut from $45.6 billion to $6.7 billion, down 85%.

San Francisco-based BNPL competitor Affirm, with its partnership with Amazon (AMZN), is down 89% from its all-time high to $5.29 billion. Block undoubtedly paid too much for Afterpay, which is now becoming a liability with rising interest rates and a global economy on the brink of recession.

Big writedowns are likely to come

A write-down occurs when an entity decreases the carrying amount of an asset when its fair value falls below its carrying amount. While Square’s balance sheet ended its most recently reported fiscal 2022 second quarter in relatively decent shape, with cash and cash equivalents of just under $5 billion offset by total debt of $5.3 billion, the company had a company value of almost 12 billion US dollars. This accounted for 41.5% of the company’s total assets and is mainly made up of the surplus from the Afterpay buyout.

How much is Afterpay worth now? In a blunt comparison to its peers and the broader e-commerce sector, the company would likely currently be trading in a valuation range of $2.9 billion to $5.8 billion on the Australian Stock Exchange if it were never acquired. That number would be lower if revised down for the 30% premium over the market price paid by Block.

Data from YCharts

This leaves an expected impairment of at least 80% of the current goodwill in sight. While that would be a non-cash charge, it would cause shareholders’ equity to fall 57% to $7.3 billion. Coupled with an apparent deterioration in Block’s cash position due to negative cash burn from operations of $114.6 million, the impairment would become even more acute.

Data from YCharts

The uncertain macro backdrop is already weighing on Block’s common stock as the company’s underlying financial profile is expected to decline. To be clear here: BNPL is glorified subprime lending. It allows mass-market consumers to take advantage of various financing options to spread the cost of their purchase at checkout. This is an inherently risky proposition given the specter of a recession.

The current BNPL cohort was formed after the 2008 global financial crisis under regulations that encouraged the proliferation of non-bank lenders. They have not been tested in a recessionary environment characterized by falling real incomes, high inflation and rising interest rates. As a result, Block could find that Afterpay’s consumer credit performance is deteriorating and that the company may need to take large writedowns on its portfolio if risks aren’t managed well. Crucially, managing these risks would mean the company would materially back out of underwriting for what is currently a large portion of its active customer base. This would significantly slow BNPL’s growth and create less synergy with Afterpay’s ongoing integration with the Cash app and the Square seller ecosystem. This was recently extended to the UK and Canada.

Chase the hype and find out

Block’s growth is negative, with revenue for the most recent reported quarter coming in at $4.41 billion, down 5.8% from the year-ago quarter. This was due to a slowdown in the low-margin bitcoin trading business, which accounted for 56.6% of the company’s revenue in fiscal 2021 and had a gross profit margin of less than 3% during one of the liveliest bitcoin bull markets in years. Bitcoin trading is an inherently volatile and unstable business, with cryptocurrency exchange Coinbase (COIN)’s revenue falling 64% year over year in its most recent reported quarter.

Block is expected to realize negative gross margins on its bitcoin business this year as the fickle retail trade that led much of the initial trading boom has dissipated with the collapse of most speculative trading phenomena in 2021. There could be more pain The majority of developed economies are forecasting to slip into recession next year as elevated inflation forces a new hawkish Fed into a series of rate hikes. Block pays at the top for Afterpay. Bitcoin, its biggest revenue driver, will now weigh on revenue for the foreseeable future. Shares could very well drop into the $40 area against this backdrop. However, the market remains volatile and upside risks remain if there is a significant reversal in the Fed’s current hawkish stance. This is the most relevant short-term risk for a bear position.


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