Block's Adjusted Profit Jumps, But Hidden Costs Raise Questions

Block (XYZ) reported third-quarter earnings that beat its own guidance, with gross profit rising 22% year over year to $3.24 billion. The company also raised its full-year outlook for the third consecutive quarter, sending shares up about 8% in after-hours trading.

The standout performer was Cash App, which saw gross profit jump 27% to $2.07 billion. Square's gross payment volume grew 14% to $76.4 billion, with U.S. payment volume growth accelerating to 10%. Management attributed this to field sales reps and reseller partners winning over sellers still using older systems.

Operating income rose 5% to $428 million, but adjusted operating income surged 92% to $923 million. This divergence is largely due to February's staff cuts, which reduced product spending while gross profit continued to climb.

However, the adjusted figures exclude $435 million in contingency, restructuring, and other charges—mostly accrued legal costs. This marks the third straight quarter of large legal charges, and the company did not specify the nature of the legal matter.

Additionally, transaction and loan losses rose 66%, three times as fast as gross profit, driven by growth in Cash App Borrow and Afterpay lending. While loan fees are included in gross profit, the losses are recorded as an operating expense below the gross profit line.

The impressive adjusted profit growth is a testament to Block's cost-cutting efforts and the scalability of its business. However, the widening gap between adjusted and GAAP results raises transparency concerns. The $435 million in legal charges, which are excluded from adjusted figures, are real costs that impact the company's financial health.

More importantly, the rapid growth in loan losses—up 66%—outpaces gross profit growth significantly. This suggests that Block's lending products, while contributing to revenue, carry substantial risk. If losses continue to climb, they could erode profitability and strain the balance sheet.

Management claims lending margins have held steady, but investors should scrutinize this metric in future quarters. The growth in Cash App Borrow and Afterpay lending is a double-edged sword: it drives engagement and revenue but also exposes Block to credit risk, especially in a potentially weakening economy.

The legal charges are another overhang. Three consecutive quarters of large accruals without disclosure of the matter creates uncertainty. Until the nature and resolution of these legal issues are clear, investors may apply a discount to the stock.

Overall, Block's operational momentum is undeniable, but the quality of earnings is questionable. The market's positive reaction to adjusted figures may be short-lived if these costs persist.