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  • Writer's pictureAbacus Research

Betting on operating leverage: Buy SQ

The next big theme - ends up at Square

In our eyes, FB and CRM are showing the market what the next big theme is. A recognition that growth is slowing and hence a focus on profitability of the business.

Zuckerberg just had to mention it for the stock to jump (it was just too cheap, plus there was a capex issue, which is easier to solve), whilst CRM needed to prove it to some extent. Wow did it just show some serious intent!

We have worked on both CRM and META in the last month, but felt we could not publish on either – why?

  • Because predicting operating margin expansion is a finger in the air sort of exercise. It is really frustrating as everything turns out to be a guess, until management either guides to it or produces it in quarterly numbers.

However, given the macro backdrop, we doubt that expanding margins will be a short-term phenomenon.

Both FB and CRM are maturing companies, the pivot makes sense, there is no easy excess growth avenue in the world today plus you will not get paid for it anyway, hence a refocus on operating margin / efficiency is the only reasonable option, others are following.

Just to highlight the scale of the change

After almost a decade of growth there is lots of fat to be cut. The excesses in the world of tech will be proven to be huge – the $25bn in capex a year on the metaverse that META wanted to spend. idiotic. There are loads of other examples that don’t matter now, they are the last cycle.

  • CRM just guided to FY24 (Jan yr end) Non GAAP EPS of $7.12-$7.14 vs the street at $5.80 a few days ago.

  • At the Sept 2022 analyst day CRM guided for Op margins of 25%+ by FY26. It is now targeting for a non-GAAP operating margins of 30% in Q1 FY25.

  • Plans to decrease stock-based compensation to <9% of sales from 10.5%.

  • CRM has disbanded its M&A committee. I.e. no more deals and the focus is on integration and cost cutting.

How are we going to make money from this theme?

Conclusions:

  1. We are at the beginning of the theme, thus holding on to or buying FB and CRM seems to be a good bet to us.

  2. We have written up PINS, UBER, which fall under this theme and think they are worth your time and have ~50% upside.

  3. Find other stocks that are early in this transition, but the business is high quality. This is where SQ comes in.

Predicting operating margin expansion is incredibly tough at this point, some managements will excel, others will not, but perhaps it doesn't matter, anchoring is so highly prevalent in estimates - given the last 10 years we are certain that op margins are conservative in anything that vaguely looks like a growth company.

  • The thing that we think it is safe to bet on right now is that direction of travel is higher.

SQ Conclusion

Both of Block's businesses have organic growth > 10% as a minimum. Both businesses have high fixed costs and are likely at maturity to have ~50% of GP converted into EBIT.

  • Given the level of self service and automation, this should be a highly scalable model, with super high margins in the long run.

  • From what we can see the 'Rule of 40' is a reasonable target for this business.

Hence our conclusion is that IF management is serious in its comments the potential is there for huge EPS growth over the next 3-5 years. With EPS in 2025 of $3.50+ as a reasonable target, plus incremental leverage from any ecommerce or consumer tailwind.

We see 50%+ upside in the shares over the next two to three years if management can execute on this plan.


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