XP - XP: Quality For A Cheap Price

2023-11-01 22:09:22 ET

Summary

• XP Inc. is a $10.7-billion market cap financial services provider in Brazil with a wide range of products and services.
• The company achieved significant milestones and reported increased earnings and profitability last quarter.
• I think XP Inc. is well-positioned to take advantage of expected interest rate cuts and market activity, with strong long-term prospects.
• XP's forwarding EV/EBITDA ratio is only 8.6x [-15.7% lower than TTM], which I think is very low.
• I believe XP is a high-quality company poised for growth, benefiting from a fair stock valuation and a boost in business momentum due to changes in Brazil's monetary policy.

The Company

XP Inc. ( XP ) is a $10.7-billion market cap financial services provider in Brazil that offers a wide range of financial products and services. They operate the XP Platform, which allows clients to access investment products such as securities brokerage, fixed-income securities, mutual funds, hedge funds, private equity funds, derivatives, credit cards, loans, insurance, and more. They also provide services to institutional and corporate clients, manage various types of funds, and offer investment products like real estate funds. Additionally, XP Inc. offers wealth management services and financial education courses both online and in person.

In Q2 FY2023 , XP Inc. achieved significant milestones, surpassing BRL1 trillion in client assets (+30% CAGR since IPO). They reported a 12% YoY increase in EBT and a 7% YoY increase in net income. Their focus on cost control discipline resulted in improved operating leverage and profitability. For example, XP's compensation ratio, which is calculated as "People SG&A" [salaries with taxes + SBC] divided by net sales, decreased significantly in Q2, indicating improving cost control of the business:

The revenue mix favored the retail segment, with growth in new verticals, particularly in card revenue. The return on average equity increased to 22%, which is higher than the previous two quarters but still has room for improvement compared to FY2022.

Last quarter XP Inc. experienced a recovery in capital markets activity and a positive trend in the equity capital market. The Central Bank's monetary easing also bodes well for 2H FY2023, the management said during the earnings call . Browsing through recent investment banks' papers, I came across a research note by Citi that found XP Inc. is indeed very well positioned to take advantage of expected interest rate cuts and accelerating market activity. Citi Research predicts that there is a significant potential for improvement in the company's operating figures as weaker top-line trends have been observed over the past few quarters. Although short-term results are likely to benefit from a strong handle on cost-control initiatives and additional product revenues, Citi Research believes that the market is increasingly optimistic regarding retail and issuer services top lines accelerating as interest rates continue to decrease. Citi Research is also positive about the long-term prospects of XP's business, as they believe that capital market development is a secular trend that will continue to benefit the company.

I agree with Citi Research's conclusions about the growth potential of the Brazilian end market for XP. According to Statista , digital transactions in the country should continue to grow rapidly for at least the next few years, creating a favorable environment for the fintech market.

Even though XP Inc. is growing quite rapidly and has a favorable environment to continue that growth, what I like most is how high-quality that growth is. It often happens that growth companies prioritize development speed over quality, ignoring profitability or liquidity needs, but that's definitely not XP's story: in the last quarter, the company not only grew its topline and margins but also lowered its debt-to-equity ratio and maintained a fairly high level of cash on its balance sheet. In my opinion, the company's credit risk profile only improved lately.

Many may assume that XP stock should trade at high multiples [at a premium to other representatives of the Brazilian fintech industry] given its rapid revenue/EPS growth rates and margin expansion while controlling costs. I suggest checking it out.

The Valuation

If you open Seeking Alpha's Quant Valuation grades for XP , you'll see that the stock is rated "D", which at first glance is a bad sign. However, if we take a closer look, it turns out that the company's multiples are not that big in absolute terms. Of course, compared to the Financials sector, which includes all companies (from fintechs to retail banks and asset managers), they naturally appear overvalued due to the specifics of the business. But this seems to me insufficient to call XP an overvalued stock.

I suggest we look at the big picture by comparing individual multiples to growth and profitability metrics. For example, if we take EBITDA-related metrics, we see exactly what I wrote about above: Margin is growing, YoY forwarding growth is quite high [+21.5%]; at the same time, the forwarding EV/EBITDA ratio is only 8.6x [-15.7% lower than TTM], which I think is very low.

At the same time, the company pays dividends that, assuming a constant share price and the consensus forecast for their growth, should give investors a ~4.27% yield by FY2027 , which I think is very good for a high-growth fintech company.

In addition, XP will most likely continue to buy up their shares from the market because a) their business is highly profitable and b) the share price is still in correction, which at current valuation multiples can make the current purchase price very attractive from a management perspective.

Second semester, we already mentioned in the first quarter that we would return to shareholders either through share buyback or dividends or both at least 50% of payout ratio that we did last year.

We have already returned BRL960 million in the first semester of this year and we are going to return more in the second semester. But we have not decided yet the number. So, whenever we do, we are going to announce to the market.

Source: XP's Q2 earnings call, emphasis added by the author

The Bottom Line

The company will report third-quarter results on Nov. 13, 2023, according to Seeking Alpha. Analysts expect modest growth in earnings per share, which should accelerate again in FY2024. The trend in revisions is strongly upward, despite all the macro complexities, which is a good sign.

But for sure XP Inc. stock carries various risks, including market and economic fluctuations, regulatory changes, intense competition, interest rate and currency risks, and operational challenges, particularly in the highly technology-dependent fintech industry. The firm may also face credit and liquidity risks, client behavior impact, and the potential for political instability in Brazil. Additionally, the company's performance can be influenced by market sentiment and concentration risks.

Despite the risks, I recommend investors take a closer look at XP. In my opinion, it is a quality company that has good growth potential, which should be supported by the stock's moderate valuation and an acceleration of the business growth momentum following the monetary policy turnaround in Brazil.

So I rate XP as a "Buy".

Thanks for reading!

For further details see: