Shares of fintech company Block (SQ -1.57%) are down nearly 80% from their all-time highs, and they're down roughly 1% year to date as well. Some of the stock's more recent troubles can be attributed, in part, to a short report from Hindenburg Research in March. The report outlined a long list of potential reasons for a 75% downside in Block stock, spooking investors.
Of course, Block's management promptly rebutted some of Hindenburg's claims. And several weeks later, the company reported financial results, showing promising progress with the business. Has fear from the short report created a buying opportunity for long-term investors?
The biggest allegation lobbed at Block
To be fair, even as a Block shareholder, I share some of Hindenburg's concerns. I wouldn't argue against the short research firm's critiques of Block's acquisition of Afterpay, the high valuation of the stock, and the seemingly hyperbolic explanations of fairly common fintech capabilities from management.
Investors will never find a risk-free stock. It's important to assess risks and decide whether a company is still worth investing in. For me, Block has been a buy despite some of its risks.
However, the biggest allegation from Hindenburg toward Block, in my opinion, relates to the company's Cash App ecosystem. At the risk of oversimplification, Hindenburg believes that management has inadequate safety controls over Cash App, which is an invitation for bad actors. These bad actors create multiple accounts to hide their illegal activity, artificially inflating Block's numbers.
Here's why this allegation carries massive implications: The Cash App ecosystem is arguably the most important part of Block's business.
To illustrate, Block generates the majority of its gross profit from two business segments: the Square ecosystem for merchants and the Cash App ecosystem for consumers. In 2022, 49% of the company's reported gross profit was attributable to Cash App. And it was growing much faster than the Square segment, with 43% year-over-year gross-profit growth compared to 30% growth for Square.
Block has grown revenue and gross profit at an impressive pace. SQ Revenue (TTM) data by YCharts.
Block's management already responded to Hindenburg about its claims regarding Cash App.
Management reported 51 million monthly active accounts in December (it has since reported 53 million actives for March) and admits that some users have multiple accounts. However, it says that 44 million accounts have verified identities and that 39 million have provided Social Security numbers, meaning these are unique users.
Moreover, according to Block's management, 97% of the money coming into the Cash App ecosystem is tied to accounts with verified identities.
I believe this is extremely reassuring when it comes to Block's Cash App ecosystem. Therefore, I don't believe this risk is as big as alleged in the short report.
How Block is getting better
Block was growing and profitable from 2019 through 2021 before swinging to a massive net loss of $541 million in 2022. Needless to say, the market wanted to see Block get its expenses under control in 2023. And in the first quarter, the company showed marked signs of improvement.
For context, Block's revenue can fluctuate wildly due to its Bitcoin services. Block co-founder and CEO Jack Dorsey believes in the world's largest cryptocurrency, and Block has consequently developed Bitcoin services that contribute to revenue but are designed to earn little to nothing in gross profit. Therefore, looking at gross profit growth instead of revenue growth does make sense for Block investors, since some of its revenue doesn't contribute to its gross profit.
In Q1, Block's gross profit was up a robust 32% year over year. However, importantly, the company's operating expenses were only up 13%. Because of this, Block was able to shrink its net loss of $207 million in the first quarter of 2022 to a net loss of $19 million in Q1 2023.
Encouragingly, Block's management reduced corporate overhead and also cut back on sales and marketing. That said, it still spent money where it counts: on product development. Product development expenses were up 37% year over year, giving us hope that the company will roll out new products and features that can allow it to continue growing.
Also, Cash App is more important for Block than ever. In Q1, Cash App's gross profit of $931 million represented 54% of the company's overall gross profit. And it was up 49% year over year. In other words, Block's biggest gross-profit machine is also its fastest-growing segment.
Looking at the big picture, Block is growing fast, expenses are coming back under control, and there's hope for future growth. Some might still question whether Block's management is telling the whole truth about its business, and if that's you, then you should simply avoid the stock. However, I believe this business can still create a lot of long-term shareholder value, which is why I still own it.
