Lately, the market has been enamored with artificial intelligence stocks, and some other areas have suffered. One of them is fintech, and two of the biggest players have had some pretty miserable years. Both Block (NYSE: SQ) And PayPal (NASDAQ:PYPL) are down more than 10% this year, but still have solid results.
Fintech stocks were all the rage on Wall Street a few years ago. Now they are an afterthought. This usually represents the best buying opportunity as other investors have strayed from simple investments like Block and PayPal. That’s exactly what I see, but there are a few things to consider before taking a position on these two.
Block, formerly known as Square, divides its business into two operating segments. The first is Square, the enterprise-oriented product that provides payment processing and banking services to its customers around the world. Second is Cash App, which started as a peer-to-peer payment service that allows users to purchase stocks Bitcoin and do their banking.
Since both of Block’s services could have some impact on the cryptocurrency, Block wants investors to focus on gross profit, or income, after product costs. This is generally a smart strategy for investors, because a company can grow revenue quickly but potentially subsidize that growth with lower margins, which will ultimately hurt the company.
Both Square and Cash App posted solid results in the latest quarter, with gross profit up 18% for Square to $888 million and for Cash App up 37% to $968 million. It may surprise some investors that Cash App is a bigger part of Block’s business than how it started with Square, but it’s indicative of how important this app has become to many users.
Unfortunately, Block’s operating costs have continually increased, preventing the company from becoming profitable. Operating expenses rose 19% in the second quarter, which is still less than gross profit growth. This could be the main slowdown, as Block posted an operating profit a few years ago.
Because Block proved they could do it once, I’m confident they can do it again. But the short-term mentality of many investors has caused them to abandon ship on Block stock. As a result, the shares can be purchased at what I consider an incredibly attractive valuation.
Investors shouldn’t expect Block to return to the more than 10x revenue value it achieved between 2018 and 2021, but 1.6x is almost nothing to pay for a company integrated into the payments infrastructure. Block looks like a screaming buy here, and investors should use the short-term weakness to build a long-term position.
PayPal is in a slightly different place in the fintech world. While it has an app that rivals Cash App (Venmo), it also acts as a digital wallet and offers payment processing for some customers through the Braintree product. The main obstacle for many investors is PayPal’s slow revenue growth. In the second quarter, PayPal’s revenue grew only 7% and expects 8% growth in the third quarter. That’s not much growth for a growth stock, so many investors headed for the exit.
But the problem with that statement is that PayPal itself is no longer a growth stock. Now it looks more like a value stock because the main part of the investment thesis has become stock buybacks and earnings growth.
Thanks to simple year-over-year comparisons, PayPal’s earnings per share (EPS) has grown rapidly, rising 414% in the second quarter. These are permanent gains thanks to improvements in operational efficiency and have given PayPal the cash flow to buy back a lot of shares. Management repurchased about $1.5 billion worth of stock in the second quarter, but after deducting stock-based compensation costs, that number drops to about $1.1 billion.
During the second quarter, PayPal had an average market cap of $76 billion, meaning PayPal bought back about 1.5% of the company in one quarter. That’s an incredible rate of buybacks and will boost long-term shareholder returns even if PayPal only grows in the high single digits.
But the market hasn’t adopted this strategy, and as a result the stock looks dirt cheap by traditional valuation metrics.
Regardless of whether you use current or forward-looking earnings, PayPal stock has never been cheaper. While the new CEO, Alex Chriss, will have to prove himself, he has been given the keys to a machine that practically runs itself.
If PayPal sees any new business success, the stock is at such a low starting point that it could explode higher at any time. As a result, I think buying PayPal now is a genius investment move.
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Keithen Drury has positions in Block and PayPal. The Motley Fool has positions in and recommends Bitcoin, Block, and PayPal. The Motley Fool recommends the following options: Short December 2023 $67.50 on PayPal. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.