Risk/Reward Rating: Negative
Square pulled out all the stops in announcing its second quarter earnings five days earlier than scheduled in a surprise Sunday press release. The surprise earnings release was accompanied by a large acquisition announcement. The company announced it was buying Afterpay for $29 billion in an all-stock deal, valuing Afterpay at an extraordinary 42x sales and 492x EBITDA (earnings before interest taxes depreciation and amortization). It should be noted that Afterpay was not profitable in 2020 on a GAAP basis (generally accepted accounting principles). The company offers a buy now, pay later (BNPL) app that has gained some market traction in recent years and saw big gains during the COVID pandemic.
It should be noted that paying such a historically extreme valuation for a business has traditionally been a red flag in the stock market. It often suggests the buyer is being overly aggressive in their assumptions or is not confident in their own organic growth potential and thus feels the need to buy growth at any cost. Only time will tell in the case of Square and Afterpay.
On the business front, Square reported healthy growth for the second quarter. Given the effects of COVID in 2020, using 2019 as the base year provides a more meaningful perspective on the underlying trends for Square. The company breaks out two broad business categories: Cash App Ecosystem and Seller Ecosystem.
Revenue in the seller ecosystem grew at 23% per year over the past two years (this segment was hurt by COVID due to the lockdowns and closure of many smaller businesses). On premise business grew at 19% per year over the past two years and the online seller business grew at 28% per year. These numbers are generally inline with industry competitors such as PayPal after adjusting for the relative size differences.
Revenue in the cash app business grew at 258% per year the past two years. The cash app business includes gross Bitcoin sales as revenue which distorts this figure materially to the upside. For example, Square only keeps 2% of Bitcoin sales on average. Therefore, categorizing 100% of Bitcoin gross sales volume as revenue is economically misleading from an investment standpoint.
From an investment perspective, Square essentially serves as a Bitcoin middleman and generates the equivalent of a 2% commission on Bitcoin sales. To put the 258% per year revenue growth rate of the cash app segment in context, Bitcoin gross revenue has increased a total of 3,171% over two years and accounted for 64% of Square’s total reported revenue year-to-date. This amounts to $6.2 billion in reported revenue in the first half of 2021, of which Square kept $129.6 million in gross profits. It should be noted that Bitcoin sales declined by 27% in the second quarter versus the first quarter as the price of Bitcoin collapsed. Bitcoin faces many regulatory and market tests going forward creating a cloud of uncertainty which is compounded by recent sharp losses experienced by Square’s Bitcoin customers.
On the valuation front, Square reported GAAP earnings of $.34 per share for the second quarter and $.42 for the first six months of 2021 (excluding a gain on the sale of their DoorDash stake and a write down of the value of their in-house Bitcoin holdings in Q2 2021). On a non-GAAP basis, the company reported earnings of $.66 per share in Q2 and $1.07 per share for the first six months of 2021. Giving the company the benefit of the doubt, using non-GAAP estimates, Square is currently valued at 142x 2021 non-GAAP earnings estimates and 130x 2022 estimates.
The larger non-GAAP earnings numbers are mainly the result of excluding material stock-based compensation expense. For example, Square reported $298 million of cash flow from operations in the first six months of 2021, of which stock-based compensation expense amounted to $265 million (a non-cash expense).
Square used $66 million of the $298 million of cash flow in the first half of 2021 for capital expenditures and $170 million to invest in Bitcoin for its own investment purposes. Given that Square views Bitcoin as a long-term business capital investment, free cash flow after subtracting these capital expenditures for the first six months of 2021 was $61 million.
At the current share price, using the diluted share count, Square is valued at $144 billion. If we assume the acquisition of Afterpay closes, which will be paid for with Square stock, the current valuation is approximately $176.6 billion. This is a massive valuation compared to the underlying cash flow generation of Square as outlined above: 240x annualized first half cash flow and 1182x annualized first half free cash flow. Square generated $1.96 billion of sales excluding Bitcoin revenue in the first half of 2021. Annualizing these sales plus Square’s Bitcoin gross margin (net Bitcoin sales), Square is trading at 35x sales.
All told, Square is growing at a healthy clip, however, the current valuation remains extraordinary from a historical market perspective when compared to Square’s economic results. The current valuation fully accounts for the growth potential for the foreseeable future. Furthermore, the fintech and payments industry is one of the most competitive segments in the world today, suggesting that outsized returns are likely to be competed away. The signal sent by paying an extraordinary price for an acquisition raises another reason for caution. When the risks and uncertainty surrounding Bitcoin are added to the mix, the risk for new Square investors appears to heavily outweigh the potential rewards.
Technicals
Technical backdrop: Square’s stock is trying to stage a breakout above the all-time highs reached during the speculative peak in February 2021 in the $283 area. The stock has become extremely extended to the upside since the COVID crash bottom of $50 in March of 2020. From a long-term perspective, the 50-month moving average (brown line on the 10-year monthly chart) stands at $106. Additionally, a bearish flag has formed on the monthly chart and is extended to the upside.
Square 10-year monthly chart
The 5-year weekly chart tells a similar story with the stock attempting to break above the weekly top in the $283 area in February of 2021. The 50-week moving average (brown line on the 5-year weekly chart) stands at $215. This level is also the weekly support zone that was broken in May of 2021 and was forming the shoulders of a potential head and shoulders top pattern prior to the recent rally.
Square 5-year weekly chart
Zooming in to the 2-year daily chart reveals a similar story as the weekly chart. The story is one of an attempted breakout to new highs after selling off two months ago and setting up a potential head and shoulders top. The key level of support that was briefly broken in May of 2021 is at the $200 area and now serves as a line in the sand. The 200-day moving average is at $223 (grey line on the 2-year daily chart).
Square 2-year daily chart
Technical Resistance: The current level which is near all-time highs.
Technical support: $225 to $235 area which is the 200-day and 50-day moving average, respectively. Next lower support looks to be $215 which is the critical weekly support area and $200 which is the critical daily support level.
Price as of report date 8-2-21: $276
Square Investor Relations Website: Square Investor Relations
All data in this report is compiled from the Square investor relations website and SEC filings, and where applicable publicly available information regarding consensus earnings estimates.