Shift4: The Orca in the Room
Exploring the issues flagged in Blue Orca's short report
Longs and shorts often love founder-led companies for the same reason:
Founders aren’t afraid to aggressively drive the company forward and challenge convention.
It’s arguably the key strength - and weakness - of founder-led companies.
Unsurprisingly, these names are prone to being battleground stocks when both sides converge and take an entrenched position on the risk and reward ahead. Who ultimately “wins” is, in my opinion, a very nuanced debate. It really depends.
For instance, Shift4 Payments (ticker: FOUR) is (in my opinion) an unresolved battleground stock where investors are still trying to risk assess the issues flagged in Blue Orca’s short report and the company’s go-forward growth trajectory.
After reading the Blue Orca’s report, and exploring the company’s filings for myself, I can certainly appreciate why both sides feel the way they do, and why they’re divided on Founder and CEO Jared Isaacman’s stewardship of the company.
Overall, while I consider the issues flagged in Blue Orca’s report regarding Mr. Isaacman’s margin loan and Shift4’s accounting practices valid concerns, I’m more actually concerned about the appropriateness of peculiarly timed insider transactions that set off my “dark arts” radar. Investors should certainly contemplate and risk assess the ramifications of a potential margin call, but I think the wildcard here is an SEC call, not a margin call.
These insider transactions are my “orca” in the room that needs to be addressed.
Disclaimer: This newsletter is not investment advice. Views or opinions represented in this newsletter are personal and belong solely to the owner and do not represent those of companies that the owner may or may not be associated with in a professional capacity, unless explicitly stated.
Summary: He’s Maverick
I already mentioned this in a prior premium write-up, but, if I was instructing the corporate governance equivalent of Top Gun school, Shift4 Founder and CEO Jared Isaacman is Maverick.
He has the moxie, vision, and instinct to be an exceptional, long-term public company steward, but some of his more aggressive maneuvers are akin to leaving your wingman to win a dogfight at the risk of compromising the entire mission. Now, many of the maneuvers he has pulled off - or attempted - are genuinely impressive, but I believe they were unnecessarily aggressive and exposes him - and the company - to material unforced errors.
For instance, on July 26, 2021 Shift4 would issue a $632.5 million convertible note, and later approach EVO Payments on September 9, 2021 with an unsolicited preliminary non-binding proposal to acquire the company for $36.50 per share via cash and stock. This was a bold decision and arguably the correct move to attempt at the time.
My concern is unsolicited bids don’t happen “out of the blue”, especially when it’s a transformative deal. There’s usually a lot of thought, debate, and pre-planning that occurs before even attempting a large, transformative acquisition offer. The intent to submit a bid is also arguably material, non-public information.
And yet, Jared Isaacman was allowed to execute a ~4.4 million share variable prepaid forward sales contract on September 7, 2021 where he received $275 million just 2 days before he made a transformative acquisition offer to EVO Payments that would require issuing a meaningful amount of Shift4 equity to fund a deal.
For background, these prepaid forward sales transactions allow insiders to hedge downside risk, share performance gains, and obtain immediate large-sum cash payments. I can only speculate, but it makes a lot of sense to me that Jared Isaacman would want $275 million in liquidity to help manage his March 2021 margin loan and ~$100+ million charitable pledge commitment to St. Jude Children’s Hospital ahead of pursuing a transformative deal that would potentially have a negative impact on the stock if EVO Payments accepted the offer.
Interestingly, PE firm (with Board representation) Searchlight Capital Partners also sold 4,250,000 shares on August 9, 2021 just one month before the EVO Payments offer was made. I don’t know when internal Board discussions began regarding pursuing transformative M&A, but this also is uncomfortably close to trading while (arguably) in possession of material, non-public information for me. It also doesn’t help Searchlight would later sell 967,600 shares in Q2 2022 via direct share repurchase by Shift4 after the company received an SEC comment letter on May 11, 2022 that would later result in and financial restatements.
Obviously, Shift4 determined these transactions were “appropriate” (they wouldn’t do them otherwise), but we know the company has acknowledged their disclosure controls and procedures and internal control over financial reporting were not effective going back to Q3 2021 when these insider transactions occurred so there’s a distinct possibility they didn’t have effective processes in place to determine if there was MNPI. That said, even if these transactions turn out to be “appropriate”, I still think the company is unnecessarily pushing the envelope and exposing shareholders to risks that don’t need to be taken.
Overall, no one starts a company and grows it into a public company without being exceptional, but I do believe Mr. Isaacman needs to clean up some of these decisions and surround himself with trusted pre-fixers to help him avoid material unforced errors going forward.
Addressing the Orca in the Room
Note: I’m writing this under the assumption you’ve read Blue Orca’s report. Also, for the sake of brevity, I’m not going to go through all my views of Blue Orca’s report and the company, and will be focusing on the key issues I think are most relevant for this write-up. Put another way, I’m really not interested in dragging this newsletter down another Illumina-esque rabbit hole.
All things considered, I do believe Blue Orca’s Shift4 short report raises valid points regarding the company’s alleged aggressive accounting practices and earnings management.
Where I differ from Blue Orca is I’m less inclined to believe Mr. Issacman’s margin loan - and the risk of a margin call - was the key driving force behind the issues and maneuvers flagged in their report. I don’t dismiss it as an influence, but I’m not sold it was the driver.
After reviewing Shift4’s public filings, I believe he likely had ample liquidity to meet his March 2021 margin loan requirements - and avoid forced selling due to a margin call - after executing a ~4.4 million share variable prepaid forward sales contract in September 2021 where he received a cash payment of $275 million.
Assuming he had an outstanding margin loan of ~$161 million (i.e. 20% LTV on 10 million pledged shares at $80.58 per share), $275 million is arguably enough capital to cover both his margin loan and his ~$100+ million charitable pledge to St. Jude Children’s Hospital.
That said, this doesn’t trivialize the potentially consequential issues Blue Orca has flagged and the negative impact it can have to outside, long-term shareholders. Yes, Jared Isaacman is the company’s largest shareholder and has been building his company for decades, but that doesn’t mean his decisions are always going to be aligned with the interest of outside, long-term shareholders.
The corporate governance isn’t great here (in my opinion) and needs to improve. Jared Isaacman should provide more transparency on his margin loan and consider proactively unwinding it. Shareholders should still be concerned about the company’s capital allocation and strategic decisions being intertwined with Mr. Issacman’s personal balance sheet and liquidity obligations.
Even if a margin call isn’t as big of a factor, the issues Blue Orca flagged can still compound into really major, existential problems if left unaddressed and/or ignored.
CEO’s Response to Blue Orca’s Report
Candidly, I have some mixed feelings about Jared Isaacman’s response to Blue Orca’s short report:
As some of you may have seen, we were the subject of a short seller’s report yesterday. Having founded this business when I was 16 and spending the last 24 years in constant pursuit of improvement, I am no stranger to critics.
We knew long before our first day at the New York Stock Exchange that operating a public company attracts critics, both fairly and unfairly. I don’t fault these cynics for trying to do their job, but they’ve got it wrong on FOUR and in many plain and obvious ways. As just a few examples:
I only purchased shares in 2022 and never sold stock on the market as it was implied. My share count diminished in 2022 as a result of stock donations to St. Jude Children’s Research Hospital.
I have never received a margin call, even when the share price was at its lowest last summer. In fact, I refinanced and reduced the size of my margin loan in December of 2022, well above the 52-week lows.
As discussed at length, insourcing distribution was a fantastic way to improve the customer experience, margins, free cash flow and the unit economic model of our new SkyTab POS product.
We are proud of our employees, partners and sales force that have helped build the company over the past two decades. I am and will continue to be the largest shareholder for the foreseeable future – and simply because I believe in our ability to keep winning. For more than two decades, our growth and audited financial results, including our free cash flow generation, speak for themselves.
We plan to have a detailed discussion of our Q1 operating results and financial performance in two weeks. For those betting against us, keep in mind May 4th is just around the corner.
Starting with the positives, I do commend Jared Isaacman for his proactive and generally high-road response. There are some jabs in his response, but they’re not over the top. I also like - and currently buy into - his belief that the company can keep winning. That seems genuine to me.
Where I have “mixed” feelings is, aside from directly addressing and refuting the margin call issue, he (in my opinion) doesn’t really address the other major issues flagged in Blue Orca’s report.
Long-time subscribers know I tend to read company press releases a *bit* differently from most folks, and pay a lot more attention to what’s not being said and/or talked around.
The response (in my opinion) doesn’t really address the allegations of aggressive accounting and earnings management, and I found it peculiar he would say the audited financial results “speak for themselves” given the company had to restate their audited financials following an SEC inquiry. Frankly, if he had a good and compelling response to these issues, I expected to see it in this letter so the absence of a more direct rebuttal is a bit of a flag for me.
Finally, I consider the following statement a “fact that isn’t entirely truthful”:
[I] never sold stock on the market as it was implied. My share count diminished in 2022 as a result of stock donations to St. Jude Children’s Research Hospital.
I’ve already discussed Mr. Isaacman’s stock donations to St. Jude and how his $100+ million charitable pledge was essentially a personally liability which needed to be paid. Consequently, while he “never sold stock on the market”, he arguably paid his “charitable liability” in stock in lieu of selling shares and giving cash to St. Jude. At the end of the day, the stock needed to get sold, but it was St. Jude doing the selling instead of Jared Isaacman.
Interestingly, when he executed variable prepaid forward contracts in September 2021, it was mentioned a portion of the $275 million received in the transaction would be used to “make charitable donations while also allowing him to maintain voting and dividend rights in the stock”:
Mr. Isaacman, through the SPV, entered into the variable prepaid forward contracts in accordance with his family financial plan, to provide current liquidity and continue to make charitable donations while also allowing him to maintain voting and dividend rights in the stock and units, as well as the ability to participate in future stock price appreciation up to the respective forward cap prices, during the term of the contracts and thereafter if the SPV settles the variable prepaid forward contracts in cash.
If a portion of the $275 million he received was originally intended to meet his charitable donations (presumably to St. Jude), why did he end up donating stock instead? Did he retain that capital, and donated stock, instead, to ensure he’d have liquidity to avoid selling pledged shares and meet margin loan requirements?
If that’s the case, it intuitively makes sense to me why he’d be inclined to donate ~1.6 million shares vs. selling a comparable amount to meet his margin loan requirements since disclosing 2022 stock gifts would be delayed until February 2023 when the Form 5 is filed vs. 2 business days for a Form 4 filing selling stock. There would be arguably less impact on the stock price by facilitating sales through stock donations due to delayed disclosure of the gifts and removing the need to disclose “related party” repurchases via block trade.
Speculation: Was Strategic M&A the Key Driver?
In addition to having $275 million in liquidity, another reason why I didn’t think a margin call was a driving factor in the issues flagged in Blue Orca’s report is Shift4’s aggressive accounting practices go back to Q3 2021 when the stock was $80+ per share and (in my opinion) well before a margin call would realistically be a top-of-mind issue that would influence decision-making. Consequently, this leads me to believe something else was driving these “envelope pushing” decisions.
So if a margin call wasn’t a major factor - and that’s a big “if” since we don’t know how large his margin loan actually is - what else could potentially compel Shift4 and Jared Isaacman to allegedly engage in aggressive accounting practices and proactively try to support the stock price?
I can only speculate, but I think strategic M&A was a major driver of these decisions.
We know Shift4 approached EVO Payments in September 2021 regarding a transformative acquisition, which is also the oldest 10-Q filing the company communicated to investors could not be relied upon due to their incorrect accounting treatment of customer acquisition costs. It makes sense to me that they’d potentially be aggressive with their accounting practices to “support the stock price” around the time they were looking to do large stock-funded deals. With EVO turning them down, the company would subsequently announce the acquisition of Finaro, largely funded with stock, and pursue other acquisitions.
Also, and this is very, very speculative, I think the company may have seriously considered and/or attempted to sell themselves, especially around July 2022 and December 2022, which may have played a role in their allegedly aggressive accounting practices.
First, it makes more sense to me the company would allegedly try to inflate their adjusted EBITDA and cash flow numbers - especially Q4 2022 - via aggressive accounting to optimize for M&A takeout multiples vs. trying to manage earnings to avoid a margin call.
I focus on the periods around July 2022 and December 2022, because Shift4’s share repurchases stop in July 2022 for the remainder of the year despite approving an additional $50 million to their share repurchase program on June 15, 2022 and still having ~$45 million remaining in their authorization which would later expired on December 31, 2022. It doesn’t appear to me the stock was trading at levels in 2H 2022 that would warrant a pause due to valuation. Also, Mr. Isaacman doesn’t gift shares to St. Jude in the months of July 2022, October 2022, and November 2022. Potential M&A talks in July 2022 may have also contributed to Shift4’s delayed August 2022 reply to the SEC regarding their accounting practices, and didn’t respond - as required - 10 business days after the SEC’s June 21, 2022 letter.
Further, Jared Isaacman’s December 2022 public comment that the company could go private again might not have been an isolated comment and may have been influenced by strategic takeout talks. If he was serious about taking the company private, I think there’s less incentive to be as aggressive on Q4 2022 earnings and propping the stock as alleged by Blue Orca.
Again, this is complete speculation on my part, but Shift4 was (privately) a “darkhorse” takeout target of mine for PayPal with Jared Isaacman as a long-shot CEO successor. Recall, I covered Paypal last year in October 2022 and discussed why I believed the company was signaling CEO succession before it was officially announced in February 2023, and posited the company could find their next CEO via acquihire.
The periods I think PayPal might have seriously considered a deal - and possibly talked to CEO Jared Isaacman - was in July 2022 when Paypal paused their share repurchases and adopted an inducement equity plan (i.e. M&A friendly), and in December 2022 when they once again paused share repurchases. I know this is a bit of a stretch, but I don’t think it’s unreasonable to believe Mr. Isaacman spoke with PayPal given the two companies did announce an expanded relationship in March 2023, and those deals are usually discussed/negotiated over months. PayPal CEO is a big step up, but I don’t doubt Jared Isaacman would believe he’s an excellent candidate for the CEO role, and capable of impressing the Board into seriously considering him.
That all said, I think a strategic takeout is currently off the table, and believe M&A is the one area where Blue Orca’s report potentially has the biggest impact on the company over the near-to-medium term.
The issues raised in their report might not necessarily scare away public shareholders and how they value the company, but I wouldn’t be surprised if caused strategic buyers and sellers to pause and take extra cautious when evaluating the value of Shift4’s equity from a dealmaking perspective. It might even eliminate the company from M&A consideration until they “clean up” to avoid the possibility of other unknown surprises and/or issues.
Potential Issue: Peculiarly Time Insider Transactions
One issue that doesn’t seem to be actively discussed that I’m concerned about are Shift4’s insider transaction activity:
There are multiple insider transactions that (in my opinion) look uncomfortably similar to “insider trading” on material non-public information.
Investors should certainly contemplate and risk assess the ramifications of a potential margin call, but I think the wildcard here is an SEC call regarding insider transactions, not a margin call.
For example, Jared Isaacman was allowed to execute a ~4.4 million share variable prepaid forward sales contract on September 7, 2021 where he received $275 million just 2 days before Shift4 made an unsolicited preliminary non-binding proposal on September 9, 2021 to acquire EVO Payments. This deal would have required issuing a meaningful amount of Shift4 equity to EVO shareholders to fund the deal and would potentially have a negative impact the stock price:
On September 9, 2021, EVO received an unsolicited preliminary non-binding proposal from Party A, a potential strategic acquiror of EVO, whereby Party A proposed to acquire EVO for a purchase price of $36.50 per share via a mix of cash and Party A’s stock, subject to a number of contingencies, including initiating and completing due diligence and the negotiation of definitive transaction documents. On September 9, 2021, the closing sale price of EVO’s Class A common stock was $25.67 and the closing sale price of Party A’s common stock was $80.52.
For background, a variable prepaid forward sales contract allow insiders to hedge downside risk, share performance gains, and obtain immediate large-sum cash payments so it’s a bit alarming that Jared Isaacman would be “hedging” shares ahead of a pursuing a material stock-funded acquisition that could negatively impact the stock price.
We get a glimpse of this potential negative impact when Bloomberg reported on November 16, 2021 that EVO Payments rejected Shift4’s bid without any mention of offer price, and Shift4’s stock traded down ~9% to $66.00 per share on November 17, 2021. This price reaction gives some credence to the idea Mr. Isaacman’s “hedging” transaction might have been influenced by the risk of a declining stock price if their EVO bid was accepted.
According to the SEC, insider trading policies should also apply to hedging transactions:
Insider trading policies will apply to hedging transactions involving the company’s securities as they do to transactions in the company’s securities generally. For example, a company’s insider trading policy will prohibit executives from purchasing put options on the company’s stock while in possession of material non -public information. Because the prohibition on insider trading is of general applicability – i.e., not limited to hedging transactions specifically – the Final Rule should not be interpreted to require disclosure of a company’s insider trading policy irrespective of whether the policy specifically refers, by way of example, to hedging transactions. (Source: Clearly Gottlieb)
Further, PE firm (with Board representation) Searchlight Capital Partners would sell 4,250,000 shares on August 9, 2021 one month before the offer was made. We don’t know exactly when internal Board discussions began regarding pursuing transformative M&A, but this transaction still appears uncomfortably close to trading while in possession of material, non-public information to me, especially when the company issued a $632.5 million convertible note on July 26, 2021 that may have been informed/influenced by a desire to pursue a large deal in the near-future (i.e. EVO Payments bid).
Both Jared Isaacman and Searchlight are mentioned in the company financials as having significant influence over the company, including control over decisions that require the approval of stockholders. Pursuing a transformative acquisition like EVO Payments would require their approval, and they collectively “unloaded” ~8.7 million shares via stock sales and forward sale contracts when the stock price was in the $80s prior to making an unsolicited preliminary non-binding proposal to EVO. The optics that both parties might have had informational awareness that they were working towards an offer and were managing the economic impact of a potential transaction doesn’t look great.
While EVO Payments declined Shift4’s acquisition offer, the SEC has noted “an acquisition need not be more likely-than-not to occur for it to be material” to investors, and emphasizes the importance of the process used to determine the existence of MNPI. I believe an argument can be made Shift4’s intent to submit an unsolicited preliminary non-binding proposal was MNPI and the company potentially lacked the proper process to determine this was MNPI.
Keep in mind these transactions occurred in Q3 2021 and during a period where Shift4 already acknowledged their disclosure controls and procedures and internal control over financial reporting were not effective. Consequently, I believe there’s standing for the SEC to investigate whether or not Shift4 had an effective process in place to determine the existence of MNPI when these transactions occurred.
Also, it also doesn’t help Searchlight would later sell 967,600 shares in Q2 2022 via direct share repurchase by Shift4 after the company received an SEC comment letter on May 11, 2022 which would later result in financial restatements and possibly contributed to the CFO resigning. Both the appropriateness of the sale and repurchase are a concern to me since Q2 2022 is another period the company acknowledges procedures and internal control over financial reporting were not effective, and potentially shows there was indeed an “ineffective” process in place to determine MNPI.
Overall, I’m not sure what the fallout would be, but I do believe it’s sensible for shareholders to risk assess the possibility of an SEC investigation and the ramifications to the company and stock if it’s determined these transactions occurred while in possession of MNPI.