Hindenburg's big short & the Block Inc. red flags identified by Plato

Overnight, prominent short seller Hindenburg Research, released a 97-page report compiled over two years claiming the $44 billion payment processor, Block Inc. facilitates fraud. 

“The magic behind Block’s business has not been disruptive innovation, but rather the company’s willingness to facilitate fraud against consumers and the government, avoid regulation, dress up predatory loans and fees as revolutionary technology, and mislead investors with inflated metrics," said Hindenburg.

Australians will know Block Inc. as the acquirer of Australian buy now, pay later company, Afterpay Ltd. for $US29 bn. in January of last year.

Block’s market value finished the day down some US$10 billion. 

In January, Hindenburg Research took aim at the Adani Group, again claiming widespread fraud. Over the ensuing month, more than $US135 bn. was wiped off the Adani Group companies market value.

Plato Investment Management uses modelling incorporating 100+ red flags in the investment process across our portfolios (including the Plato Global Alpha Fund and Plato Australian Shares Income Fund) to identify companies that are likely portfolio landmines (or short opportunities when it comes to Global Alpha). 

Just as with Adani, SVB, and CSFB, the warning signs were there when it came to Block, with at least eight red flags identified by our model prior to the Hindenburg reporting, ensuring Block was blocked form our long book.    

The below chart showing the 12 month forward performance of companies with different numbers of red flags globally since 1998. As you can see, there are stark performance outcomes when a company has six or more red flags. 

Performance of Plato Red Flags, Global, 1998-2022

The Block Inc red flags identified by Plato

Red Flag 1: The CEO is also the chairman of the board

CEO and co-founder Jack Dorsey is also the chairman of the board. This power concentration is present in many historic frauds, for example, Kenneth Lay at Enron, Bernard Ebbers at WorldCom, Dennis Kozlowski at Tyco International.

Red Flag 2: Related party transactions

Related party transactions are a feature of almost every corporate fraud, particularly in the payment processing sector. For example, Wirecard AG, in one of Germany’s largest ever frauds used a complex web of related party transactions through the Philippines to conjure revenue out of thin air.

Red Flag 3: Large growth in debtor days

This often indicates a deterioration in the financial strength of customers.

Red Flag 4: Increased capitalisation of intangibles

In information technology companies, this is an often used technique to defer expenses and inflate current profits.

Red Flag 5: Very high earnings manipulation score

Plato uses proprietary models to identify companies that are aggressively manipulating earnings. Block Inc. has one of the highest scores out of the 10,000 companies that we track.

Red Flag 6: Large divergence between GAAP and non GAAP earnings

Companies often report non-GAAP (generally accepted accounting principles) earnings alongside GAAP earnings. At best, this allows companies to strip out non-recurring items, at worst it allows companies to mislead the market. In the case of Block Inc., the non-GAAP FY22 EPS was $1.00, while the GAAP EPS was a not so rosy -$0.93.

Red Flag 7: Very high share issuance

This is often a sign of a company under financial strain and more likely to cut corners. It is also a common characteristic of a company that is growing aggressively by issuing shares to buy other companies (for example, Afterpay which itself made no profit).

Red Flag 8: Insider share sales, and no insider buys over last two years

No matter how much research stock analysts undertake, there will always be an information asymmetry, with company insiders always knowing far more than those on the outside. When insiders are selling and not buying it is usually a pretty strong signal that storm clouds are on the horizon. When the CEO completes 25 separate insider sales when the stock is at an all-time high as Dorsey did, it is a fair bet a hurricane is imminent.

Learn more about the Plato Global Alpha Fund 

Dr David Allen is Plato Investment Management's head of long/short strategies and portfolio manager of the Plato Global Alpha Fund.

Discover more about the Fund and access global investing insights from the Plato team here.