As credit rating agencies focus on the perceived risk in Block Inc.’s (SQ) exposure to consumer and small business markets, they miss the company’s innovative offerings like Cash App, BNPL, and Square Financial Services. In today’s FA Alpha Daily, we examine Block’s credit risk using Uniform Accounting and determine its true risk rating.
FA Alpha Daily:
Wednesday Credit
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In the financial technology sector, companies that focus on small businesses and consumers often face a mix of risks and opportunities.
These markets can change quickly, making them unpredictable, which leads credit rating agencies to be cautious about these companies.
However, this same environment also offers chances for innovative growth and development.
Block, Inc. (SQ) stands out in this respect. It is an innovative fintech company that disrupted the payments ecosystem.
The company’s business model is multifaceted, generating revenue from various sources, including transaction-based services, subscriptions, hardware sales, and Bitcoin transactions.
This strategic diversity plays a crucial role in reducing the company’s dependency on any single revenue stream, thereby mitigating risks.
One of the key growth drivers for Block is its Cash App, a peer-to-peer payment network.
In an era where digital payments are becoming increasingly popular, Cash App positions itself as a vital player, offering significant growth potential as it continues to attract a larger user base and higher transaction volumes.
Moreover, Block’s Square Financial Services, a state-chartered industrial bank, provides another avenue for expansion.
With the rise of fintech solutions and the increasing need for integrated financial services, Square Financial Services is well-placed to broaden its product offerings and customer base, contributing substantially to Block’s overall growth trajectory.
The Buy Now, Pay Later (BNPL) service is another innovative aspect of Block’s offerings. BNPL allows consumers to make purchases and pay for them over time, typically with little to no interest.
This service has gained popularity due to its flexibility and convenience, appealing to a broad range of consumers.
Block’s strong foothold in this domain, especially evident during high-demand shopping periods like Black Friday and Cyber Monday, underscores its ability to tap into emerging consumer trends effectively.
However, it seems that credit rating agencies often overlook these aspects of innovation and growth potential, focusing instead on the perceived risks associated with Block’s exposure to consumer and small business markets.
That’s why, S&P has assigned Block a “BB+” credit rating, indicating a high risk of default of around 11% over the next five years. This rating also places the company in the risky high-yield basket.
Based on the company’s robust financial position, Block should have a much higher credit rating.
We can figure out if there is a real risk for this company by leveraging the Credit Cash Flow Prime (“CCFP”) to understand how the company’s obligations match against its cash and cash flows.
In the chart below, the stacked bars represent the firm’s obligations each year for the next five years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
The CCFP chart indicates that Block’s cash flows are more than sufficient to meet all of its financial obligations in the future.
The chart implies that the company has a solid financial foundation and should be able to meet its obligations without difficulty in the next five years.
The company has some consistent debt maturities over the next five years. Yet, these don’t seem like a big concern for the company due to its strong cash flows.
Block has a substantial amount of cash on hand and a strong ability to generate more with its innovative solutions and growth prospects going forward. This could also help it maintain a level of financial stability, even if an economic downturn appears.
Overall, the company doesn’t seem like it’s at a big risk of failing to pay its obligations, which is different from what the credit rating agencies suggest.
Therefore, we rate Block “IG4+”, which means the company is placed among the safer investment-grade basket. This rating implies that the company’s risk of default is around only 2% as opposed to S&P’s overstated risk of default around 11%.
It is our goal to bring forward the real creditworthiness of companies, built on the back of better Uniform Accounting.
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SUMMARY and Block (SQ:USA) Tearsheet
As the Uniform Accounting tearsheet for Block (SQ:USA) highlights, the Uniform P/E trades at 22.6x, which is above the global corporate average of 18.4x but below its historical P/E of 46.5x.
High P/Es require high EPS growth to sustain them. In the case of Block, the company has recently shown a 14% Uniform EPS shrinkage.
Wall Street analysts provide stock and valuation recommendations, that in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Block’s Wall Street analyst-driven forecast is for a 32% and 38% EPS growth in 2023 and 2024, respectively.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Block’s $80 stock price. These are often referred to as market-embedded expectations.
Furthermore, the company’s earning power in 2022 was 3x the long-run corporate average. Moreover, cash flows and cash on hand are 3x its total obligations—including debt maturities and capex maintenance. The company also has an intrinsic credit risk that is 80bps above the risk-free rate.
Overall, this signals a low credit risk.
Lastly, Block’s Uniform earnings growth is above its peer averages and is trading above its average peer valuations.
Best regards,
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
This analysis of Block Inc.’s (SQ) credit outlook is the same type of analysis that powers our macro research detailed in the member-exclusive FA Alpha Pulse.