Huge news came out in financial technology land this week when famous fraud investigators and short-sellers Hindenburg Research released a report on Block (NYSE: SQ). The research group is alleging that Block is willingly facilitating fraud through its popular Cash App service, inflating user metrics, and seeing deteriorating lending results through its buy-now-pay-later (BNPL) subsidiary Afterpay. Hindenburg also believes the stock is generally overvalued.
Block immediately responded to the report alleging it is "inaccurate and misleading" and that it is exploring legal action against the firm.
Are these short-sellers right about Block? Or is Block right that it is a bunch of nonsense?
What Hindenburg is alleging
The Hindenburg report is long and complex, but it generally is making four major allegations against Block:
- Block has knowingly let fraudulent and criminal accounts thrive on Cash App. These include scam artists, drug dealing, and even paying for murder. Hindenburg provides numerous examples of hip-hop artists describing the Cash App as an easy way to pay for drugs and hit men.
- Due to the rampant amount of spam accounts and fraud, Block has misled investors by overstating the true number of unique users on the Cash App by as much as 75%.
- Its Afterpay acquisition is going terribly. In 2022, the segment lost $357 million, with customer delinquencies growing from 1.7% in 2021 to 4.1% in early 2022.
- Its skirting of regulatory rules on interchange fees is flimsy and at risk of getting regulated away. Interchange fees make up a large portion of Block's overall revenue.
All these lead Hindenburg to believe there is major downside in Block stock, even with shares already falling 55% in the last year.
What investors should worry about
Let's work backward through this list to see what could end up being material to Block shareholders. The interchange fee loophole is a concern, as it makes up a large portion of Block's business (third parties estimate it made up 35% of 2021 Cash App revenue), but this is a problem for a ton of financial technology companies and should have already been known by any shareholder. Hindenburg is not unearthing anything new here.
The deteriorating BNPL numbers were also something any investor who read Block's earnings reports could see. The acquisition has gone terribly and could be a huge headwind for Block for years to come. While definitely a reason why Block's stock has tumbled in the past year, like with the interchange fees, this is nothing new that Hindenburg discovered.
My biggest concern would be with these (potentially) inflated user numbers at the Cash App. Block has touted Cash App's monthly active users (MAUs) for years, with its reported number hitting 51 million at the end of 2022, up from just 1 million in 2015. A lot of investors are counting on these new Cash App MAUs to drive growth for Block as they adopt all the app's products. If 75% of these monthly transacting users are fraud, spam, or fake accounts, future revenue growth at Cash App might be much lower than investors expect.
As regards to criminality, no financial product is going to be perfect in keeping crime away from its service. You don't ban hammers if one person uses the tool for murder.
But it looks like there is evidence that Block has knowingly let criminals and fraud thrive on its Cash App. If this gets proven in court, there could be huge fines and/or sanctions coming from the U.S. government. Obviously, this would be terrible news for shareholders.
Should you sell your shares?
I believe there were numerous reasons to sell Block before this short report was released. The company has spent irrationally on Bitcoin and other cryptocurrency products, with no regard for return on invested capital (ROIC) and has made terrible acquisitions like Afterpay and Tidal. (Tidal is a subscale music streaming service that hemorrhages money.) It has heavily diluted shareholders (shares outstanding are up 50% in the last five years), with little to no profits to show for it.
SQ Shares Outstanding data by YCharts.
Now, it looks like Hindenburg has unearthed even more concerns that could derail Block's business. If any of these major allegations have merit, Block stock will likely fall much further from here. That makes Block shares hard to own right now.
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Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Bitcoin and Block. 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.
