About Hindenburg Research#

Last week, Hindenburg Research took aim at Dorsey in his latest business venture. These folks make money by shorting companies they believe are operating fraudulently, and then they release reports detailing their findings. They were fresh off the back of their harsh report on Adani, which led to the companies owned by Asia’s richest man losing over a hundred billion dollars in market cap.

Introducing Block Inc. (Formerly Square)#

Hindenburg released a similar report about Dorsey’s new company, Block Inc. The company hasn’t been doing great since Hindenburg bet against them.

Block Inc., formerly known as Square, is a financial technology conglomerate. It owns companies you’ve likely heard of:

• Square: This is an easy-to-use payment processing and banking software designed for small businesses.
• Tidal: This is a music streaming service that was originally founded by rapper Jay-Z. Block acquired it in 2021 for 300 million dollars in cash.
• Cash App: A mobile payment service. It lets users send and receive money, trade stocks, and even invest in crypto. The key thing here is it does all this without actually being part of the banking system at all.

Block’s Stock Performance and Hindenburg’s Prediction#

Block Inc. had a market cap of over 100 billion dollars in 2021. That means it was actually worth significantly more than Twitter, even at the high price Musk paid for it.

Today, its value is 60 percent less than its all-time peak. Hindenburg is arguing that it will fall by a further 65 percent to 100 percent because of what they see as flaws in the business. Yeah, that doesn’t look good.

Revelation 1: Inflated User Numbers and Easy-to-Create Fake Accounts#

The first problem they found is that Cash App doesn’t have nearly as many users as the company is reporting. This is because fake accounts are too easy to make.

• Why it’s easy: Since Cash App isn’t technically a bank, it doesn’t have the same identification requirements to open an account.
• Why users matter to investors: Investors love user growth. For a networked platform like Cash App, having more people use it makes the platform exponentially more valuable. Cash App’s main feature is sending money directly to other Cash App users, so its value increases with every new user. Other network companies like Facebook, Uber, and Twitter spend a lot of resources getting new users. (Uber needs riders and drivers; Facebook needs friends to connect; Twitter… well, that last one’s a bit different because some billionaire “edged lord” got forced to buy it by the SEC). The point is, investors and companies building a network are willing to pay a lot for user growth, even if the business isn’t profitable while they’re doing it.
• Block’s Claimed Numbers: Cash App told its investors it had 80 million active users who had made at least one transaction in the last year. This would be roughly 25 percent of all people in the markets they operated in. Fintech companies make much more money per user than social media sites, so 80 million users and growing is a very impressive result for a service less than 10 years old.
• Employee Rumors & Estimates: Hindenburg heard rumors from company employees that people were making duplicate accounts for themselves, with some individuals having hundreds of Cash App accounts. Former employees estimated that 40 to 75 percent of accounts were fake, involved in fraud, or were additional accounts tied to a single actual individual.
• Hindenburg’s Test: To see how easy it was to set up a fake account, Hindenburg created Cash App accounts for Elon Musk and Donald Trump. These accounts were automatically approved! Within minutes, they were able to successfully exchange funds. An investigator at the firm was also able to order a Cash App Visa card under the name of Donald J Trump. (Hindenburg wanted to make it clear the staff member’s real name is not Donald J Trump).

Security and verification are often sacrificed for ease of use when building an app. But this becomes a real problem for Cash App, its investors, and the authorities when Hindenburg revealed why people were making so many accounts. (Here’s a hint: it wasn’t just to make user numbers look good for investors).

Revelation 2: Aiding and Abetting Criminal Behavior#

So, the reason people are making so many Cash App accounts is the second major issue Hindenburg raised: the business is aiding and abetting criminal behavior.

• Standard Rules for Banks: Normally, banks have to follow Know Your Customer (KYC) and Anti-Money Laundering (AML) laws. These are just called AML/KYC in the industry. These laws exist to make it harder for criminal organizations to access the banking system. They put the responsibility on the bank to know their customer’s identity and source of income. That’s why large transactions might get delayed by your bank, and why you need lots of paperwork to open a checking account.
• Cash App’s Loophole: Cash App has all the functionality of a bank. If you go to their website, it says you can “send, spend, bank, and buy stocks or Bitcoins.” But notice there’s an asterisk next to the word “bank,” because that’s not what Cash App really is. It’s just a payment processor, like Venmo, PayPal, or Zell. Since it’s not technically a bank, it doesn’t have to meet the same AML/KYC standards.
• Resisting Requirements: Although the USA Patriot Act requires financial institutions to collect taxpayer identification numbers (like your Social Security number), and prepaid cards like Cash App’s were determined to fall under the same customer ID rules as bank accounts, Cash App Management resisted this requirement, according to multiple former employees.
• Minimums for Accounts: To create a Cash App account, someone only needs to give their phone number or email address, a zip code, and their name.
• How Criminals Use It: Criminals have taken advantage of this by using Cash App to receive payment for illicit substances or services and to run scams.
• More Findings from Hindenburg’s Test: When Hindenburg created profiles for Donald Trump and Elon Musk, they saw hundreds of other Cash App accounts existed under the names of well-known businessmen. These accounts had unique identifiers called cashtags, like Trump approved donation and Elon Musk crypto. These were obviously set up to scam unsuspecting people who might want to donate to the former president’s campaign or think Elon Musk will double their money.

Look, if aiding and abetting criminal behavior on a massive scale wasn’t enough, the company should be shut down just for creating the term “cashtag.” Society would be better off without them.

• Dorsey’s Pride in “Cultural Impact”: Jack Dorsey is a big fan of hip-hop music, which probably led him to acquire Tidal. But he has also made and publicly bragged about the cultural impact of Cash App at JPMorgan investor conferences. Why? Because it showed up in the lyrics of so many rap songs. Dorsey told the audience in his 2021 presentation, “We have a very mainstream customer for Cash App and the evidence is this… the number of hip-hop songs that include the phrase Cash App or even named Cash App is pretty incredible. I think it’s over one thousand or two thousand right now.”
• Hindenburg’s Counterpoint: The average person at a JPMorgan investor conference probably isn’t that impressed by rap lyrics anyway. But Hindenburg argued that Dorsey shouldn’t have been proud of this “cultural impact” at all, because most of these songs describe the role of Cash App in facilitating criminal activity. As part of their report, Hindenburg even included a playlist of songs mentioning Cash App.

Revelation 3: Culture of Ignoring Problems#

The third problem Hindenburg identified was the company culture of turning a blind eye to the issues of fake accounts and illegal activity.

• Why They Ignored It: The company didn’t want to ask too many questions because it clashed with their goal of “frictionless banking,” as described by Block’s CFO.
• What Employees Revealed: Former employees revealed through leaked photos that Cash App’s client relationship management software was able to identify individuals using multiple accounts. But what did Block do? They would only blacklist accounts, not the actual people, making it easy for bad actors to just get back on the platform with a new account.
• Company Incentives: The company has an incentive to overlook fraudulent accounts because it lets them report higher user numbers and lower per customer acquisition costs than their competitors.
• Making Money from Crime: Fraud and illicit transactions also make Cash App a lot of money. Cash App charges a fee for every instant transaction. Illicit transactions are usually larger than friends splitting a restaurant bill. A large share of Cash App’s revenue allegedly comes from illegal activity.
• The Risk of Stopping It: If they properly cracked down on that illegal activity, they would have to explain to their shareholders where all those customers and all that revenue went.
• Legal Risk: The proceeds of crime could be taken back from the company if prosecutors ever decided to go after them.

Revelation 4: Failing to Profit Even From Fraud Against the Platform#

The fourth problem Hindenburg brought up was that even though Cash App allowed so much fraud to happen through their app, they weren’t even able to make any money off it.

• Not All Professional Crime: Not all the fraud was organized, professional criminal activity. Much was actually low-level fraud against the platform itself. Think of people buying stuff online and then claiming they didn’t get it to get their money back.
• Hard to Monitor: Monitoring these claims to figure out if they’re real is difficult and expensive.
• Past Policy: At one point, Cash App would automatically refund any disputed charge under $25.
• What Employees Saw: Former employees who worked in Cash App’s customer service department said they would start to recognize the same people. These individuals would order food every day using Cash App and then charge back the money. The employees also said most of these people were “eating much better than they were” – all at Cash App’s expense, because it was the company that ended up paying.

Revelation 5: Capitalizing on Pandemic Relief Fraud & Insider Selling#

The fifth key point made by Hindenburg is how the founders capitalized on pandemic relief fraud to make themselves billions.

• Pre-Pandemic Threat: COVID-19 was a major threat to Block’s business. Before the pandemic, over 65 percent of Block’s revenue came from Merchant heavy transaction fees from Square, their business-focused payment processor. With small businesses shut down across the country, Block faced a collapse of its main revenue source.
• The Response: In response, the company shifted its focus to Cash App’s potential use in distributing pandemic relief.
• Dorsey’s Actions: One day before the CARES Act was even signed into law, Dorsey tweeted that Block was ready to help distribute government money immediately, focusing on customers who didn’t have bank accounts. His tweet said, “The technology exists to get money to most people today even those without bank accounts US Government let us help”.
• The Result: Around 11 million people activated the direct deposit feature on their existing Cash App accounts or set up new deposit-enabled accounts within weeks of Dorsey’s tweet. This helped Block report strong metrics at a critical time.
• What Became Clear Later: It later became clear that those new users fell into two groups:
  • People who desperately needed the money as quickly as possible.
  • People stealing other people’s identities to get the stimulus money.
• Why Identity Theft Was Easy: This was possible because of Cash App’s loose identification policies.
• Suspect Transactions: Suspect transactions at Cash App’s partner (likely related to the fraud) exceeded those of JP Morgan and Wells Fargo, despite those banks having four to five times as many transaction accounts.
• Insider Selling: The positive news about user growth and new revenue was enough to push the stock price up to all-time highs. This is where Dorsey and other insiders took the opportunity to sell off billions of dollars worth of their stock to investors who didn’t know what was going on and wanted to buy into the “bank of the future.”
• Dorsey’s Specific Sales: Dorsey himself made 25 insider sales between November 2020 and October 2021, while the stock was trading for as high as $277 a share.
• Damning Detail: What’s even worse is that during this time when the company was reporting success to shareholders, not a single insider purchased any shares.
• Stock Price Drop: Before the Hindenburg report was released, Block stock was already trading 74 percent lower than its highs. After the Hindenburg report, it’s more like 85 percent lower.

Revelation 6: Overvaluation and Potential Downside#

The sixth and final problem highlighted in the Hindenburg report is the “real nail in the coffin.” They claim Block is overvalued and could decline significantly.

• Hindenburg’s Argument: Despite issues like slowing revenue, current unprofitability, warnings about future unprofitability, and signs that Cash App is stagnating, investors have given Block valuation multiples that assume rapid growth.
• Valuation Metrics (Block): The company trades at an EV to EBITDA multiple of 60x and a 2023 Forward Price to Earnings (P/E) ratio of 40x on adjusted earnings.
• Comparison (PayPal): In comparison, Block’s competitor PayPal trades for an EV to EBITDA multiple of 16.6x and 15.1x adjusted 2023 earnings.
• The Downside: Hindenburg argues this suggests a 62% to 72% downside for Block if its valuation metrics were more in line with its peers like PayPal.
• Investor Expectations vs. Reality: Investors usually want a company to make money or grow fast (preferably both). Investors were okay with Block’s slower earnings in the past because it had so many users coming in, so they expected earnings to grow later. But now, their user growth is slowing, and they are still not earning nearly as much per share as other companies doing similar things.
• Report’s Closing Thought: This section of the report ended with a line saying, “we are entering a period where the endless hype and unrealistic valuations of past years are beginning to face the financial reality of higher interest rates.”