Block (SQ): Bitcoin Business negative to income to come

Block (NYSE:SQ) including Facebook’s parent Meta Platforms (META) formed a strange duo in 2021 when both companies decided to change their names to reflect the crypto and metaverse, the dual hypes of the time. It was not entirely clear then that the crypto market would collapse less than a year later. In fact, the zeitgeist for most of 2021 was characterized by spirits drunk on euphoria and a retail boom that saw bubbles pop in everything from SPACs to NFTs. It really was an era of easy money, so when it ended, it did so with a bang.

In fairness to Block, the name change was also intended to reflect the larger 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. Initially, the triumphant spin into crypto, BNPL and music streaming was done by Block at the peak of market sentiment. In fact, Afterpay’s larger competitor Klarna recently completed a downward spiral that saw its valuation cut from $45.6 billion to $6.7 billion, a decline of 85%.

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

Large write-downs are likely to follow

An impairment occurs when a company reduces the book value of an asset when its fair market value falls below its book value. Therefore, while Square’s balance sheet was in relatively decent shape at the end of its most recently reported fiscal 2022 second quarter with cash and equivalents of just under $5 billion offset by total debt of $5.3 billion, the company had goodwill of just under 12 billion dollars. This made up 41.5% of the company’s total assets and is mainly formed from the profit from the acquisition of Afterpay.

How much is Afterpay worth now? Using a stark comparison with its peers and the wider e-commerce sector, the company would likely trade on the Australian Securities Exchange at a value range of between $2.9 billion to $5.8 billion if it was never acquired. This number would be less if adjusted lower for the 30% premium over the market price that Block paid.

This takes into account a probable impairment of at least 80% on the current goodwill. While this would be a non-cash charge, it would see equity realize a 57% decline to $7.3 billion. Furthermore, when aggregated with what appears to be a deterioration in Block’s liquidity position on the back of negative cash burn from operations of $114.6 million, the decline would be more acute.

The uncertain macro backdrop is already weighing on Block’s common stock as the company’s underlying financial profile appears to be declining. To be clear here, BNPL is glorified subprime lending. It allows mass market consumers to use different financing options to spread the cost of their purchase at the checkout. This is an inherently high-risk bet against the specter of a recession.

The current BNPL cohort was founded in the wake of the 2008 global financial crisis following regulations that encouraged the proliferation of non-bank borrowers. They have not been tested in a recessionary environment characterized by falling real incomes, high inflation and rising interest rates. Therefore, Block may find that Afterpay’s consumer credit results deteriorate and that they have to realize large installments on the portfolio if the risk is not managed well. Critically, handling these risks will mean that the company significantly withdraws from underwriting a large segment of its active customer base. This will significantly slow BNPL growth and see less of the synergies realized with the ongoing integration of Afterpay with the cash app and the Square merchant ecosystem. This was recently extended to the UK and Canada.

Chasing the hype around and finding out

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

Block looks set to realize negative gross margins on its bitcoin business this year, as the volatile retail trade that fueled much of the initial trading boom has dissipated with the collapse of most speculative trading phenomena seen in 2021. There may be more pain to come with the bulk of the developed world is projected to fall into recession next year as rising inflation forces a newly hawkish Fed into a series of rate hikes. Block paid at the top for post-payment. Bitcoin, its biggest revenue driver, is now set to be a drag on revenue for the foreseeable future. Shares could largely fall into the $40 range on the back of this. However, the market remains volatile and upside risks remain if there is a felt pivot of the Fed’s current hawkish stance. This is the most relevant short-term risk for a bear position.