A report published last week by short seller Hindenburg Research exposes key problems with Block Inc. (SQ, Financial). According to the short seller's two-year investigation, the company has committed numbers fraud on back of accounts created by scammers, avoided regulation, dressed up predatory loans and fees as revolutionary technology and misled investors with inflated metrics.
Is the Hindenburg report valid? Like most short seller reports, it has some facets that are rooted in truth, though claims do need to be taken with a grain of salt. The report specifically targets Block’s Cash App platform, which generated over $10 billion of the company’s $17 billion in revenue during 2022. That’s a big deal. There are 51 million users on Cash App, though the Hindenburg report claims a significant portion of these "users" are fake/scam accounts.
About Block
Formerly known as Square, this financial technology company provides payment and point-of-sale solutions for small and medium-sized businesses in addition to its Cash App. The company was founded in 2009 by Jack Dorsey, who is also the co-founder and former CEO of Twitter.
The company offers hardware products such as Square Register, an all-in-one point-of-sale solution; Square Terminal, a versatile payment device and receipt printer; Square Stand, which transforms an iPad into a payment terminal or complete POS system; and Square Reader for contactless and chip payments, compatible with EMV chip cards, NFC payments and card transactions through iOS or Android devices.
The good
Block has rapidly expanded in the payment processing industry over the last decade. It was the first to really use mobile tech and reinvented the checkout process. The company utilizes its brand value to attract various demographics and businesses to its ecosystem where it charges a fee of nearly 3% per transaction. Aiming to outperform established competitors, Block focuses on delivering a superior user interface and implementing a strategic ecosystem approach. It worked until competitors started to get better hardware too.
Block's merchant-focused business model enables the company to attract and retain smaller merchants that are unattainable for other companies. Essentially, Block's initial success stemmed more from broadening the market rather than taking share from existing participants. To scale, Square has been moving beyond its micro merchant base, with roughly two-thirds of its payment volume coming from merchants generating over $125,000 in annual gross payment volume. Square has likely reached a point where it has cost advantage over any new competitors and switching costs are high enough to provide a solid economic moat.
Compared to Shopify (SHOP, Financial), a similar fintech innovator, Block is much larger, much more profitable and still trades with a lower market capitalization. And, despite negative growth last year, Block and Shopify had very similar five-year average growth. I think that’s more of a reflection on how overpriced Shopify is than anything; however, there is an argument that Block should be at least on par, if not garner a much higher valuation. Shopify’s market capitalization is $62 billion, while Block’s is $38 billion. Block generated $6 billion in gross profit on $17.5 billion in sales over the last 12 months, while Shopify booked $2.7 billion gross profit on $5.6 billion in revenue. Yet, Block is priced at two times sales and two times book with Shopify priced at 10 times sales and seven times book!
The bad
Hindenburg believes that Block has wildly overstated user counts and has understated its customer acquisition costs. The research firm stated that former employees claimed that 40%-75% of accounts they reviewed were fake, involved in fraud, or were multiple accounts under single individuals. Could these former employees just be out to trash talk their former employer? Sure, but it's hard to image that would take on such a huge risk if there wasn't an easy way to back up their claims. It’s also hard to see the positives in some of the aspects of this report.
“We turned our accounts into 'Donald Trump' and 'Elon Musk' and were easily able to send and receive money. We ordered a Cash Card under our obviously fake Donald Trump account, checking to see if Cash App’s compliance would take issue—the card promptly arrived in the mail,” reads the report. “Congress passed a law that legally caps 'interchange fees' charged by large banks that have over $10 billion in assets. Despite having $31 billion in assets, Block avoids these regulations by routing payments through a small bank and gouging merchants with elevated fees.”
More importantly, Block has not been able to achieve financial consistency on the bottom line. However, analyst consensus estimates from Morningstar (MORN, Financial) call for the company to grow earnings at substantial rates in the next few years. Whether this rosy outlook will actually come into fruition, with the Cash App making up a large portion of the company’s financial performance, remains to be seen. If Hindenburg is right, Block could lose a large chunk of its profit center from these fraudulent accounts once it is made to implement stricter identity controls.
Risk versus reward
Just because the Cash App is being used for fraudulent activity, doesn’t mean that the company has turned a blind eye to this fact. While the Hindenburg report raised a number of examples along those lines, the evidence seems anecdotal and not necessarily evidence of widespread issues in my opinion.
The biggest risk is that Cash App users and Square merchants simply move on to something else. Venmo and PayPal (PYPL, Financial) are very competitive with Square. Also, starting and building a business is becoming costlier. There is a balance between rising prices and consumer demand. As prices rise, Block takes in more from its merchants, who can charge more to customers, but if prices rise too much merchants will look to find cheaper options or simply go out of business.
Currently, Block has a forward price-earnings ratio of 40 based on next year's earnings estimates, but it is at least cheaper than Shopify. Payment processing is not as much of an open field as it used to be. The reward does not seem large enough yet for the risk of missing earnings or revenue projections or if regulators start clamping down on Block’s Cash App business.
