NKLA - Block: Hindenburg Attacks Jack Dorsey

2023-03-23 13:25:04 ET

Summary

• Hindenburg released its latest target: Block. The Jack Dorsey-led company has come under a series of allegations, including fraud and criminal activity.
• The forensic research firm presented a detailed account of how Block could have overstated its Cash App growth user metrics by between 40% to 75%.
• Also, it "embraced" fraudulent accounts and criminal activity on its platform to drive user growth and SQ's stock price during the pandemic.
• We believe Jack Dorsey & his team could potentially face an investigation by Block's regulators, as it's hard to ignore the claims in Hindenburg's report.
• While some investors could be drawn into buying the dip, we urge patience and caution now. Investors should have zero tolerance for fraud by management. Wait for more clarity first.

Hindenburg has found a new target after it recently hammered the Adani Group, led by Indian billionaire Gautam Adani.

Investors new to Hindenburg Research should know that it prefers to be known for its " forensic research " rather than a hedge fund. However, it uses its own money to bet against stocks of companies that the company thinks are "man-made disasters" that are "bound to blow up."

As such, the firm looks to "speed up the process" while taking advantage of such calls with short-selling positions.

Founder Nathan Anderson's passion is to "find scams." For its latest target, Anderson's firm released a scathing report on Block ( SQ ), concluding a two-year investigation.

Accordingly, Hindenburg alleged that the Jack Dorsey-led company facilitated the following:

Fraud against consumers and the government, avoided regulation, mislead investors, and dressed up predatory loans and fees as revolutionary technology. - Hindenburg Research report on Block

Hindenburg's release led to a nearly 20% decline in SQ stock in pre-market trading. However, the stock has recovered somewhat, as dip buyers came in to defend against Hindenburg's attack, taking the sting out of the pre-market decline. As such, the stock is down about 12% from yesterday's close as of writing.

Hindenburg's primary target in the report relates to its Cash App. Keen investors should know that Block's Cash App is the company's critical growth driver, which saw a massive uplift during the pandemic.

Even though growth slowed in 2022, it still posted a 51% YoY growth in revenue in Q4'22 (excluding revenue from bitcoin and Afterpay). As such, it easily surpassed its Square segment, which posted a 10% YoY growth in revenue (excluding revenue from Afterpay).

Hence, Hindenburg's focus on Cash App makes sense, as analysts see it as a critical growth driver for the company to sustain its growth valuation.

Morningstar highlighted in its report that "Cash App's performance compared with peers has been relatively strong, suggesting it is positioning itself to be a long-time leader in the space."

However, Hindenburg's thesis is that the growth in Cash App has been overstated massively. The research outfit stressed:

Block's Cash App platform has 51 million monthly transacting active users, but former employees estimate that 40%-75% of accounts they reviewed were fake, involved in fraud, or were additional accounts tied to a single individual. - Hindenburg

That's a massive overstatement, if it's true. Block posted 51M in monthly transacting active or MTA users in 2022, up 16% YoY. However, it was a massive slowdown from 2021's 22% growth and 2020's 50% surge.

Therefore, Hindenburg's thesis is that Block "cooked" its numbers to drive MTA growth and painted an "illusion" to drive its stock price.

Moreover, the firm accentuated Block's claim of "disruptive" technology, and claims of "magic" designed to fool investors into thinking that the company holds a significant moat when it doesn't.

Worse still, if Block had overstated its user metrics substantially, as highlighted by Hindenburg, the thesis is that SQ could be massively overvalued.

Hindenburg argued that, given the discrepancies in Block's business model, its reported metrics, and its findings, it believes that SQ should trade much lower, with a potential downside of "65% to 75%" from yesterday's (March 22) closing price.

That suggests a fair value of about $22. But, for now, that view is not shared by Morningstar, which assigned it a fair value of about $104.

InvestingPro also indicated a blended fair value of about $99. We see it closer to about $55 to $60. Hence, there's a fair amount of uncertainty regarding its fair value.

However, if we consider Morningstar's valuation, it should be clear that Cash App plays a significant role, as it highlighted:

We expect growth in the Cash App side to be stronger and for this area to be a more critical growth engine. Excluding bitcoin revenue, we project Cash App revenue to grow at a 23% CAGR over the next 10 years. - Morningstar

We believe the most critical risk emanating from the report is the association with criminal activity. Hindenburg highlighted:

Block has embraced criminals, making it easy for bad actors to mass-create accounts for identity fraud and other scams, then extract stolen funds quickly. Even when users were caught engaging in fraud or other prohibited activity, Block blacklisted the account without banning the user. Block reported a pandemic surge in user counts and revenue, ignoring the contribution of widespread fraudulent accounts and payments. - Hindenburg

Hence, we believe an investigation from Block's regulators could be in store, as Hindenburg has proved its credentials in the past with Nikola's ( NKLA ) founder and also hedge fund Platinum Partners.

Anderson even claimed that he would only stop digging for dirt unless corporate fraud is gone, as he articulated:

If there's ever a time that I feel that most of the corporate fraud in America has been eliminated, then I'll probably announce that I'll go grow tomatoes or something. - NYT

Dorsey is his target now; we think this could be just the beginning. So while we are not selling our holdings now, we are not adding either.

Berkshire Hathaway ( BRK.A ) ( BRK.B ) CEO Warren Buffett reminded investors in his recent annual letter that he has zero tolerance for misconduct by management. He said:

When large enterprises are being managed, both trust and rules are essential. Berkshire emphasizes the former to an unusual - some would say extreme - degree. Disappointments are inevitable. We are understanding about business mistakes; our tolerance for personal misconduct is zero. - Warren Buffett annual letter 2022

We ask investors to do the same until we get more clarity. So don't buy the dip yet, even though it may look alluring.

Rating: Hold (Reiterated).

Important Note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice.

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