Let's talk fintech today – more specifically, Square (or Block) vs PayPal. Initially I felt like these were direct competitors. But the more I learned about Block (I already researched PYPL here), the less I thought of it a true competitor. So, I'll focus my discussion around Block, to start.
The Potential Opportunity
The stock is down more than 60% off its highs, in the past six months. Meanwhile, analysts are either really bullish or have zero clue as to how to value this thing! The average price target is $230 per share... which represents a 125% upside from here. So, this business will be a challenge to value, but let's start by understanding the various business segments.
Block, is a MUCH more complicated business than PayPal. It has a lot of moving pieces. But, at a high level, it has two main operating segments – Seller & Cash App. They are essentially two separate ecosystems that do intersect at some level.
The Seller Ecosystem (i.e. Square) is a one-stop solution for merchants (mostly small businesses) to start, run and grow their business using both software and hardware. So, for example, there is the Point of Sale system, Appointments, Square for Restaurants, APIs for online checkout, hardware, risk management, and other financial services.
The Cash App Ecosystem provides individuals with financial products and services, much like a bank – but, obviously, mobile first. Services include banking, investing, spending, and of course Bitcoin.
There are also the recent acquisitions of AfterPay and TIDAL. TIDAL is a very small part of their business, so I'll be excluding it from our valuation analysis. AfterPay is an interesting one that integrates with Block's services, and valuing that can be challenging – as you might remember from our Affirm valuation, as the BNPL model is yet to be proven.
Gross Payment Volume (GPV)
Block's non-financial key performance indicator is GPV – which is essentially the volume of transactions that occur in the ecosystem. Every company might have a slightly different variation as to how it's calculated, but as you may recall PayPal was evaluated by TPV or Total Payment Volume.
Although not formally stated as a KPI, Bitcoin plays a HUGE role in the success and future of Block, imo. In fact, the name change to "Block" kind of makes this obvious. Founder and CEO Jack Dorsey left Twitter (where he was also a co-founder) to go full-time on Block, because of his obsession with Bitcoin. I say obsession, because he's what we call a "Bicoin maxi" in the world of crypto. I don't know where he stands in the borderlines of crazy and genius, but he's deeply invested in Bitcoin adoption – which is consistent with the direction of Cash App, and its investments in Bitcoin. I do think they are doing something way ahead of the curve by implementing Bitcoin micropayments using the Lightning Network on the Cash App. However, I'm also not convinced that the future of the Lightning Network would be on a centralized app... something doesn't add up. But, THIS is what YOU need to decide on before investing into Block (imo). We'll revisit this point, but for now, let's move on to the valuation.
As a reminder, all valuation sheets are available to premium members of The Hawk Letter and Discord. I highly recommend you join, to make your own assumptions and investment thesis :)
To start, we take a look at GPV and notice the growth rate declined significantly in 2020 (due to COVID), where it only grew 6%. This tells me, right away, that a lot of the volume for Square must take place with physical retail businesses as e-commerce stores were COVID beneficiaries. Based on the metrics provided, we can see that the Seller ecosystem generates about 90% of the calculated GPV. But, Cash App is a growing piece. We also see that most of the transactions are from smaller businesses – which were significantly more impacted during COVID... and I'm still questioning their recovery.
The total percentage of revenue from GPV is increasing, because of the increasing Bitcoin revenue. So, the GPV metric is becoming a less corelated or diluted by Bitcoin – which has been contributing 50% to revenues.
Before we get excited (or nervous) about Bitcoin revenues, we need to understand the revenue recognition here which (in my eyes) is a bit misleading. Rewind to 2020, where Cash App purchased about 8,000 BTC for $220M. This essentially funded the bitcoin operation, which users are now able to buy, sell, and send BTC from. There are no gains reported from BTC (due to accounting principles), but the carrying value can be impaired with a reduction in price. Either way that's not hitting the top line. So the top line number of Bitcoin, is essentially GPV because Block "owns" the bitcoin and carries that risk/reward of ownership. Whereas someone like PayPal uses third party to facilitate crypto transactions, it doesn't hit their top line like this. It becomes evident when you see the Bitcoin gross margins are roughly 3% – which is the "true" net revenue in my eyes. So, I will stick to earnings as my main valuation metric.
Assuming the Seller segment, can continue to grow 20% CAGR and CashApp at 30% (though the potential here can be much higher)... I just don't know or feel comfortable forecasting Bitcoin the bull case here ...at current margins, they're still growing net income at 30% CAGR. Although this is much lower than analyst forecasts (which concern me), that's very impressive. I'm also fully ignoring TIDAL and AfterPay from this valuation for simplicity.
Based on my DCF analysis, and normalized price ratios, I still see a 30% upside to Block.
Risks vs. PayPal
There is a ton of uncertainty and risk in our assumptions. The biggest being, Bitcoin and valuations. The risk in Block, in undeniably larger than PayPal. Not only because of the Bitcoin, but valuation as well.
I've re-assessed the worst case scenario for PayPal – which means giving it a historic Visa and Mastercard valuation (not even current inflated ones) – and I get the same upside as Block. I just don't understand why PYPL is being hated, and I do believe it's undervalued. CEO Dan Schulman thinks the same, since he bought roughly $1 million worth of stock last Thursday.
The upside, however, with Block can be huge since PayPal is no where near as ahead of the curve on Bitcoin adoption.
My conclusion, to make it clear, is that there is more margin of safety in PayPal given its valuation. It's a no brainer if you're looking for more safety. However, if you're looking for a more aggressive investment and believe in the future of Bitcoin, then Block is a better option. But, I will urge you to think about whether the future utility of Bitcoin (and the Lightning Network) would be on a centralized Cash App. That's why I find it hard to make that bet. I also think that Block has a lot going on, including Bitcoin risk – which I much rather own myself. AfterPay should be reported on the next earnings report, and you have to assess that business. Do you believe in that BNPL is a sustainable business model? For me, there's just too many risks with Block, although I really like what they're doing. It just doesn't fit in my portfolio right now, and I'd much rather use that allocation within crypto or DeFi. I do, however, own PayPal and will look to add at these levels. I hope that helps! Let me know if any questions or feedback :)
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