When investors go long a stock, they are aiming to profit from when its price increases. This is the more common type of investing, as it has high upside potential and the worst-case downside is usually just losing all your investment (unless you used leverage).
However, it is also possible to go short on a stock. Short sellers aim to profit from a stock falling in price. Often times, stocks can remain overvalued for a long period of time, and thus some short-selling firms aim to create their own catalyst. This is often done in the form of a short seller report.
Short seller reports aren't your typical "oh, this company is financially weak" claims, as in this age of information, investors have already thouroughly scrutinized any public information. Instead, short seller reports dive extremely deeply, make bold claims and try to reveal any shocking anyformation that may harm the business’ reputation. These reports often have emotion seamlessly tied throughout the report in order to provoke fear in investors to sell the stock.
Recently, one stock that has come under fire by short seller Hindenburg Research is Block Inc. (SQ, Financial), the company behind Square and Cash App. Is it time for investors to panic about Block, or is the short seller report taking things too far? Let's dive in.
Business overview
Block Inc. (SQ, Financial) is a leading fintech company that has worked to create "ecosystems" of its products. Its first product was the popular Cash App, which now has over 50 million monthly transacting users. Cash App enables people to send money to friends as well as trade stocks and even cryptocurrencies. Block's strategy is to layer on as many services as possible in its applications to increase user interaction, payment volume and “stickiness."
The company's second major ecosystem is Square. This is a segment which provides point of sale services to small- and medium-sized businesses. Not only does it provide a valuable tool to these businesses, it also collects data on its SMB transactions, cash flow, etc. and then uses this for personal offers and loan underwriting. SMBs are known to be an underserved market from a credit standpoint, and Block aims to solve that problem.
Block also closed its acquisition of Afterpay in early 2022 for a staggering $29 billion. Afterpay provides "Buy Now Pay Later" services to its customers.
The short seller case
On March 23, 2023, Block was hit with a short seller report by Hindenberg Research. The short-selling company is famous for cases including Riot Platforms (RIOT, Financial) and Nikola (NKLA, Financial). Its report against Nikola was particularly powerful, as it revealed that the company had pushed its trucks to move them in demonstrations, as they weren’t actually functionial yet, so the company was lying to investors. Since that report in the third quarter of 2020, Nikola’s stock has plummeted by over 94%.
However, this short seller report on Block caused the stock to decline by just 20%, so that immediately serves as a signal to me that the market is skeptical on the short seller's allegations.
The main thesis of the report alleges Block has overstated its monthly transacting users, as a large portion of its accounts are duplicates and related to fraud/scammers.
In the report, Hindenburg analysts showed how easy it was to create multiple accounts under popular celebrity names such as Elon Musk and Donald Trump. These accounts could then be used to mislead people and commit fraud. On a smaller scale, this could be used to impersonate an account for someone the victim knows and thus benefit from transfers.
I agree that duplicate accounts do seem to be an issue for Block, but scammers are a common part of just about everything these days. Interviews with former Block employees for the Hidenburg report indicate 40% of accounts reviewed had duplicate parameters such as email, phone, etc. However, what the report fails to clarify is the three former employees interviewed used a very small sample size. However, it is undeniable that the duplicate account problem is worse for Block because of its easy sign-up where a user just needs to give their email address and phone number, unlike a traditional bank account.
I personally believe this is a solid tactic as it allows the company to frictionlessly onboard users. However, since the fake accounts thing has come into the spotlight, it needs to step up its security from nonexistent. The good news is, when I looked at the app recently, I discovered it is now asking for a full social security number to sign up. Therefore, it is pretty clear Block understands the issues and is taking steps to fix them.
Another point the Hidenburg report makes includes the fact its Cash App inflows are slowing. This is correct; the company reported a rapid 54% increase in inflows to $179 billion in 2021 and just ~13% growth in 2022 to $203 billion. However, the short seller report failed to explain the context for investors. In 2020, ~$814 billion was given in the form of stimulus check alone, and even more free money was poured into the U.S. economy from things like government bailouts of big corporations, cheap and forgivable loans to small businesses, near-zero interest rates, etc. Therefore, greater inflows would be expected. In 2022, we saw a high inflation, rising interest rate environment (as a direct result of easy-money policies), which has of course squeezed the everyday consumer. This has resulted in an impact for all financial companies, not just Block.
Another claim made in the report was that Block’s Cash App is particularly favored by criminals as its product is featured in a variety of rapper music videos which reference using the app to pay for the proceeds of crime. For example, in a song called “Cash App” by rapper 22Gz, he states “I pay them hitters through the Cash App." I admit these lyrics are fairly shocking, but it's quite a leap of logic to infer from this that Cash App is some sort of crime accessory. Songs talk about things like guns, crime, etc. all the time. It is more a part of the culture to sound “cool” as opposed to the reality. Rappers also regularly talk and endorse brands from Grey Goose Vodka to the Maybach or Bugatti luxury cars. I don’t believe statements like this have any place inside a reputable short seller report or investing thesis.
Recent earnings
Block reported a solid 14% year-over-year growth in revenue for the fourth quarter of 2022 to $4.65 billion. In addition, its Cash App gross profit increased by a rapid 43% year over year to $2.6 billion for the full year of 2022. Therefore, despite the tough economic environment, the company is doing fairly well.
Valuation
Hindenburg believes Block is overvalued as it trades at a price-to-tangible-book-value ratio of approximately 13, which is higher than other fintechs such as Upstart (UPST, Financial) and SoFi (SOFI, Financial), which trade at price-to-tangible-book-value ratios closer to 2.1 and 1.6 respectively. This is a good point, but I believe this metric is an obscure point which only really makes sense for banking stocks, not a growth stock.
I personally prefer to use the price-sales ratio when valuing growth stocks. Block has a price-sales ratio of 2.2, which is 69% cheaper than its five-year average.
The GF Value chart estimates a fair value of $229 per share for the stock, which is below its price as of this writing. The chart does warn of a possible value trap due to onging net losses and declining earnings. However, I believe this was mainly driven by a series of one-off and non-cash expenses as well as unrealized changes in the value of stock investments, as adjusted Ebitda was down just 5% year over year for 2022.
Guru investors such as Ray Dalio (Trades, Portfolio)'s Bridgewater Associates and Ron Baron (Trades, Portfolio)'s Baron Funds own shares of Block, which is a positive sign.
Final thoughts
Block is a leading fintech company that has helped millions of Americans (including those unbanked) to get easy access to financial services. It even played an important role in getting stimulus checks to unbanked Americans in 2022.
A short seller report is never a good sign, but I believe many of the points made inside the Hindenburg report are taken out of context and sensationalized in order to spur selling in the stock. Block has denied the claims, calling them “factually inaccurate,” and aims to work with the SEC to explore legal action against Hindenburg.
The good news for investors is that Block should now need to provide full disclosure on its fraud rates and greater transparency on its financials. Ideally, I would like to see a full report clarifying which parts are accurate while debunking other claims, as there definitely seems to be some truth to Hindenburg's report, even if parts of it are misleading.
