Block (SQ): Earnings negative bitcoin business ahead

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Blocking (NYSE: Sq), including Facebook parent Meta Platforms (META) formed an odd duo in 2021 when both companies decided to change their names to broadly reflect the crypto and meta universe, the twin ads of the weather. At the time, it wasn’t entirely clear that the crypto market would crash less than a year later. Indeed, the zeitgeist for most of 2021 was characterized by euphoric animal sentiment and a retail boom that saw bubbles in everything from SPACs to NFTs. It really was an era of easy money, so when it ended, it did so with a bang.

To be fair to Block, its name change was also intended to reflect the broader range of businesses. This 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, the triumphant spin in crypto, BNPL and music streaming was done by Block at the height of market sentiment. Indeed, Afterpay’s larger competitor Klarna recently completed a round of declines that saw its valuation drop from $45.6 billion to $6.7 billion, an 85% drop.

San Francisco-based BNPL rival Affirm with its partnership with Amazon ( AMZN ) is down 89% to $5.29 billion from its all-time highs. Block undoubtedly overpaid for Afterpay, which now appears to be a liability amid rising interest rates and a global economy on the brink of recession.

Big write-offs are likely to come

A write-down occurs when a company reduces the book value of an asset when its fair market value falls below its book value. Consequently, while Square’s balance sheet was in relatively decent shape at the end of the last reported second quarter of fiscal 2022, with cash and equivalents of just under $5 billion offset by total debt of $5.3 billion, the company had a reputation of just under $12 billion. This forms 41.5% of the company’s total assets and is mainly formed from the surplus from the Afterpay buyout.

How much is Afterpay now? Using a rough comparison with its peers and the wider e-commerce sector, the company is likely to currently trade on the Australian Securities Exchange in a valuation range of between $2.9 billion and $5.8 billion if it is never acquired. That figure would be smaller if adjusted lower for the 30% premium over the market price Block paid.

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Data from YCharts

This assumes a likely impairment charge of at least 80% on current goodwill. While this would be a non-cash charge, it would cause equity to realize a 57% drop to $7.3 billion. Additionally, when combined with what appears to be a deterioration in Block’s liquidity position amid a negative cash burn from operations of $114.6 million, the impairment will become more acute.

Diagram
Data from YCharts

An uncertain macro backdrop is already weighing on Block common stock as the company’s underlying financial profile looks set to decline. To be clear here, BNPL is a glorified subprime. It allows mass market consumers to use various financing options to spread the cost of their purchase at the point of payment. This is inherently a high-risk venture against the specter of recession.

The current cohort of BNPL was founded after the 2008 global financial crisis following regulations that encouraged the spread of non-bank lenders. They have not been tested in a recessionary environment characterized by falling real incomes, high inflation and rising interest rates. Consequently, Block may find that Afterpay’s consumer credit performance deteriorates and that it has to realize large-scale write-offs on its portfolio if risks are not well managed. Critically managing these risks would mean the company substantially withdraws from underwriting a currently large segment of its active customer base. This will significantly slow BNPL’s growth and see fewer synergies realized with Afterpay’s ongoing integration with Square’s cash app and seller ecosystem. This has recently been extended to the UK and Canada.

Chase the noise around and find out

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

Block looks poised to post negative gross profits from its bitcoin business this year as the volatile retail trade that drove much of the initial trading boom has dissipated with the collapse of most of the speculative trading phenomena seen in 2021. It may there is more pain to come with most of the developed world forecast to slip into recession next year as rising inflation forces the recently hawkish Fed into a series of rate hikes. Block paid at the top for Afterpay. Bitcoin, its biggest revenue driver, is now expected to hinder earnings for the foreseeable future. Shares could very well fall into the $40 range on the back of this. However, the market remains volatile and upside risks remain if there is a tangible pivot to the Fed’s current hawkish stance. This is the most relevant short-term risk for a bearish position.

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