2023-07-18 08:00:21 ET
Summary
- StoneCo, the largest independent merchant acquirer in Brazil, is a promising investment opportunity due to its disruptive financial and software technologies and strong competitive moat.
- The company is poised to leverage the growing trend toward digital payments in Brazil and capitalize on the forthcoming interest rate reduction by the Brazilian Central Bank.
- Despite encountering challenges in 2021, the new leadership is dedicated to enhancing cost discipline and revitalizing its credit offering, establishing a strong foundation for future success.
- Amidst the current trading range of $11 to $13, the stock's appealing valuation offers investors a notable margin of safety, providing reassurance in case of adverse market conditions.
Investment Thesis
StoneCo (STNE), the largest independent merchant acquirer in Brazil with the backing of legendary investor Warren Buffett, presents a compelling investment opportunity for the next five years. The company's suite of disruptive financial and software technologies tailored for the Brazilian market, combined with personalized customer support through localized Stone Hubs, establishes a strong competitive moat that is difficult to replicate. Based on my conservative valuation, assuming an exit EBITDA multiple of 7.00x and a discount rate of 18.75%, the estimated intrinsic value of the stock is $18.42, providing potential investors with a favorable margin of safety. With an anticipated rate cut in Brazil and the forthcoming relaunch of the company's credit offerings under experienced management, I believe Wall Street may be underestimating the company's potential for margin expansion and undervaluing its stock price, thus making it an attractive opportunity for savvy investors.
Company Overview
Prior to 2010, the Brazilian merchant landscape was characterized by a dualistic system where merchants were obligated to possess two distinct point-of-sale ("POS") machines: one provided by Cielo (CIOXY) for processing Visa (V) transactions and another by Rede for processing Mastercard (MA) transactions. This arrangement left merchants with limited options and lacked competitive dynamics. However, the Brazilian Central Bank ("BCB") intervened in 2010, dismantling this duopoly and opening the market to competition, thus granting merchants greater bargaining power. Following this regulatory shift, merchants gained the freedom to choose between POS machines offered by Cielo, Rede, or other emerging market entrants for processing credit card transactions from both Visa and Mastercard.
Amidst this transformative environment, StoneCo was founded in 2012 by Eduardo Pontes and André Street, with a primary focus on providing payment services to clients. Over time, the company evolved its business model, expanding its scope to offer a wide range of product offerings to merchants. Today, the company aims to serve Brazilian entrepreneurs by delivering exceptional solutions at fair prices and ensuring the best customer experience. StoneCo operates within two main segments: Financial Services and Software. Within the financial services segment, StoneCo provides a comprehensive suite of offerings that include payments, digital banking, and credit solutions, which are primarily tailored to cater to the needs of Micro, Small, and Medium Businesses ("MSMBs"). On the software front, StoneCo offers an array of solutions such as POS and ERP systems for various retail and service verticals, CRM tools, engagement platforms, e-commerce capabilities, and omnichannel solutions, which enable merchants to streamline their operations, enhance customer engagement, and facilitate efficient management of their businesses.
Market Overview
The Brazilian commerce landscape has witnessed a remarkable surge in electronic transactions, replacing traditional cash and check payments with various digital methods such as credit, debit, and prepaid cards, eWallets, Pix transactions , and mobile devices. This shift towards digital payments has been fueled by factors such as the increasing adoption of e-commerce and mobile payments, as well as the accelerated growth of contactless payments during the COVID-19 pandemic. According to Statista Market Insights , the total transaction value in Brazil's digital payments market is expected to exhibit a compounded annual growth rate ("CAGR") of 16.54% between 2023 and 2027, reaching an estimated total amount of US$199.60 billion in the final year. The rising popularity of digital wallets and mobile payment apps like PayPal (PYPL), Venmo, and Cash App (SQ) has contributed to the seamless and secure execution of transactions. Furthermore, the expansion of the digital payments market can be attributed to the emergence of fintech startups and the integration of blockchain technology into payment systems, which has bolstered the overall efficiency and security of digital transactions.
The Latin America Mobile Payment Market, according to Mordor Intelligence , is expected to register a CAGR of 24.5% during the forecast period from 2022 to 2027. Market players are focusing on integrating mobile payment solutions with advanced technologies and biometrics to enhance security and efficiency, thereby driving market growth. The increased number of online transactions and the thriving e-commerce sector are also expected to strengthen the market. Furthermore, access to banking services in Brazil has continuously improved. A three-year survey shows that the share of respondents without access to a banking account decreased by 14 percentage points between 2017 and 2021. At last, the decline among the youngest respondents was particularly notable, with the share of unbanked individuals aged 15 to 24 decreasing from 53.3% in 2017 to 20.5% in 2021.
As this trend continues, I think revolutionary Fintech companies such as StoneCo can benefit from recognizing the vast potential of the digital payments market in Brazil. While there are an estimated 13.9 million MSMBs in the country, only a fraction of them, around 2.526 million, are currently utilizing StoneCo's products (according to their most recent 20-F Filing). In their most recent Earnings Call , management claimed that their company's MSMB Total Payment Volume ("TPV") was able to grow at 24.5%, while "the industry was growing 10.7% in the first quarter." With the increasing shift towards e-commerce and the need for robust digital infrastructure, I believe StoneCo is well-positioned to capitalize on the expanding market and cater to the growing demand for digital payment solutions in Brazil.
Erroneous Execution
StoneCo's Q3 2021 Earnings Release
In 2021, StoneCo faced major losses in its credit offering due to challenges related to the Brazilian faulty registry system and the company's inability to accurately assess the financial risks associated with card receivables used as collateral in Brazil. Under the previous "Transitory Rules" system, non-compliant card acquirers and sub-acquirers allowed merchants to shift their card transactions to new acquiring services, effectively bypassing collateral guarantees with players like StoneCo. When the market transitioned to the New Regulatory Framework, implemented on June 7, 2021, issues were further exacerbated. The initial technical implementation of the registries did not enable lenders to register guarantees on future receivables associated with potential new commercial relationships, creating a loophole in the collateralization process. As a direct consequence of these challenges, StoneCo's credit business experienced substantial losses in 2021, resulting in a huge decline in financial income. The company's financial income dropped from R$326.6 million in the second quarter of 2020 to R$40 million in the second quarter of 2021. Additionally, StoneCo's non-performing loans ("NPLs") without principal payments increased from 35% in the second quarter to 48% in the third quarter of 2021. These adverse developments led StoneCo to make the decision to completely shut down its credit offerings in the latter half of 2021. If you want to analyze the situation further, you can also take a look at two articles written by Northern Reflections on Value and Heisenberg View .
In 2021, StoneCo made a significant investment error by committing up to R$2.5 billion (approximately US$471 million) in newly issued shares of Banco Inter (INTR), financing it with 2028 bonds carrying a yield of 3.95%, primarily denominated in USD. The purpose behind this investment was to strengthen the partnership between StoneCo and Banco Inter, leveraging the product and payment technology capabilities of both companies, as well as tapping into Inter's funding capabilities to enhance efficiency in StoneCo's working capital offerings. StoneCo acted as a cornerstone investor, acquiring shares at a fixed price of R$57.84 per share. Unfortunately, I believe this investment resulted in an estimated total loss of R$2.09 billion for StoneCo, severely impacting its bottom line. Furthermore, StoneCo faced a comprehensive income loss of R$207 million due to foreign exchange exposure resulting from swap contracts used to hedge their inaugural bond issuance. Although StoneCo fully liquidated its position on February 1, 2023, the bond's value remains subject to exchange rate risks since it was issued in USD. As of July 8, the bond was trading at $0.7799 on the dollar, rebounding from a low of $0.6575 in February ( according to data from Macroaxis ). It is worth noting that despite multiple requests from analysts since the Q3 2022 Earnings Call , StoneCo's management has not taken any action to repurchase these bonds.
Key Drivers & Catalysts
Despite past missteps, StoneCo's current share price presents an enticing valuation for investors as the company's new management is actively turning the company around and solidifying its competitive moat. The one thing I believe that differentiates StoneCo away from its incumbent competitors is the company's client-centric and mission-driven culture that focuses on revolutionizing traditional industry practices and outdated technologies, all with the goal of delivering solutions and services that far exceed the basic fulfillment of client needs. In my opinion, the traditional models that sell payment acceptance solutions through bank branches often fall short in providing a satisfactory client experience for business owners. Bank sales representatives, lacking specialized knowledge in payment acceptance solutions and new technologies, struggle to effectively address merchant point-of-sale needs.
In StoneCo's CEO Letter to Shareholders 2019 , these incumbent players typically utilize "anti-competitive actions" through their bargaining power to maintain merchant loyalty by linking the use of POS machines to discounted credit lines or checking account services. In contrast, I believe StoneCo differentiates itself by offering a comprehensive suite of financial and software services with a personalized customer support through localized Stone Hubs, which further reinforces it as one of the best end-to-end platforms for merchants. By focusing on improving the client experience, empowering businesses with cutting-edge solutions, and providing them with personalized fast-paced support, I believe this strategic approach will position the company as a preferred partner for merchants seeking innovation and a comprehensive suite of services in the long-term.
As can be seen in those two charts above, the StoneCo has achieved an impressive growth in the Brazilian TPV market share, nearly tripling it from 4% in 2017 to around 11.20% in 2022, even though the company has deprioritized its sub-acquiring volume. In my opinion, this success can be attributed to their unique advantage of offering both financial services and software solutions, placing them in a favorable position compared to competitors. Unlike legacy institutions that solely focus on financial solutions, StoneCo's integrated approach enables them to provide comprehensive and tailored solutions to merchants. The combination of StoneCo's financial services and software solutions yields powerful synergies since the financial services segment can offer strong growth and monetization opportunities, while the software solutions segment continues to enhance customer stickiness and generate valuable data to optimize financial service offerings, which ultimately creates an endless feedback loop that reinforces the company's competitive advantage. With the completion of the Linx acquisition in 2021 , the company has further strengthened its position by providing merchants with seamless adaptation to the complexities of the omnichannel world. By integrating Linx's digital solutions with StoneCo's fintech-as-a-service platform, I believe merchants can gain the ability to effortlessly connect their physical offline operations to various digital commerce channels, including their own websites, online marketplaces, and social media platforms.
As StoneCo continues its growth trajectory and expands its distribution network and set of solutions, I anticipate significant benefits from its self-reinforcing network effects. By reaching a larger number of merchants through its expanding network, StoneCo can offer a broader array of solutions and attract more consumers who value convenient and secure payment options. As the merchant network expands, I think it will become increasingly valuable for other merchants to join, creating a virtuous cycle of growth. In fact, this is evident in the remarkable growth of their total active clients, which has surged from 83.50 thousand in 2017 to 2.818 million as of 2023, representing a staggering 33-fold increase within just six years.
While their client base expands, I anticipate a potential decrease in TPV per client over time as the company focuses on serving micro merchants, a segment often overlooked by legacy institutions, since they typically have higher take rates. By catering to a variety of merchants, I believe the company can establish stronger relationships and gain valuable insights into their needs and preferences, which will ultimately allow management to enhance their solutions and further differentiate themselves in the market. In my view, the combination of StoneCo's diverse offerings, expanding market share, and focus on underserved merchant segments solidifies its position as a potent disruptor in the industry.
Banco Central Do Brazil Author's Contribution
According to my statistical analysis, there seems to be a strong positive correlation of 84.74% between the Selic rate and StoneCo's financial expenses. This relationship is logical considering the company's reliance on selling receivable rights to fund its working capital and credit solutions, which are tied to commercial relationships with banks and investment funds. As the Selic rate increased, financial institutions demanded higher discount rates, resulting in a large surge in StoneCo's financial expenses. In 2021, StoneCo faced a huge challenge as it was slow to pass on funding costs to merchants, while its credit portfolio suffered setbacks. Consequently, the average take rate dropped to 0.91% in Q2 2021 (excluding the credit business effect, it would have been closer to 1.81%). According to their 2021 Q4 Presentation , the company adopted a proactive commercial strategy focused on larger SMBs despite the increase in funding costs, deferring to pass these higher costs to their clients until November 2021.
Since then, StoneCo's management team has been strategically increasing the overall take rate for MSMB clients while deprioritizing sub-acquirers in key accounts due to their low profitability and volatile nature. Some investors may express concerns about maintaining such a high take rate in the prepayment business, as competitors are likely to lower their rates to aggressively acquire new clients when the central bank cuts interest rates. However, the forthcoming relaunch of StoneCo's credit business in the second half of 2023 presents a promising opportunity since the credit business has historically commanded higher take rates compared to the prepayment business. Therefore, I believe the company will be capable of maintaining a competitive take rate in the future, even if competitors offer more attractive pricing. During the 2023 Q1 Earnings Call , Vice President Rafael reinforced this perspective, noting that new revenue streams like banking credit are expected to "contribute more and more to take rates over time," alongside pricing in acquiring and other fronts. With its robust portfolio of sticky business solutions for merchants and the ability to charge competitive rates through credit offerings, I believe StoneCo is well-positioned to achieve a competitive take rate.
More importantly, the company stands to benefit from lower financial expenses as it actively seeks ways to reduce funding costs, which can further benefit from the expectation that the central bank may initiate rate cuts as early as August 2023 since the latest report shows that the Brazilian inflation rate has already reached 3.16%. Considering these factors, I believe the prospect of StoneCo maintaining a competitive take rate, leveraging its credit solutions, and realizing reduced financial expenses serves as a compelling catalyst for investing in a high-growth company that offers limited downside.
Finally, I firmly believe that StoneCo has a potential to optimize its margin and achieve further operational efficiencies as it continues to mature and benefits from the upcoming rate cut. The management team has demonstrated their ability to recover the bottom-line margin, with a notable improvement from 2.06% to 8.73% over the past five quarters, which followed significant losses incurred from rising financial expenses and setbacks in the credit business. According to their 2023 Q1 Earnings Release , the company has successfully reduced their cost of services as a percentage of total revenue by 700 basis points, from 32.6% to 26.6%. Moreover, their selling expenses accounted for only 14.4% of total revenue, compared to 18.5% the previous year. Despite the central bank's efforts to increase interest rates throughout 2022, StoneCo's financial expenses as a percentage of revenue reached a peak of 41.43% in Q2 2022 but gradually declined to 34.06% in Q1 2023.
Furthermore, I like to note that StoneCo's management has recently adopted a more accurate approach by including share-based compensation as a real form of expense, acknowledging its impact on long-term shareholder value and reflecting it in the calculation of adjusted net income. Under the leadership of Pedro Zinner, who successfully turned around performance at Eneva by prioritizing cost optimization and productivity enhancements, I have increased confidence in StoneCo's ability to achieve operational efficiencies and become a more sustainable company. With Zinner's expertise, I believe that there is still potential for further operational leverage in StoneCo's business, paving the way for continued growth and improved financial performance.
Capital Structure
With a strong net cash position of $522.97 million Reais, StoneCo possesses substantial financial resources to fulfill its short-term and long-term debt obligations. Based on my interest expense calculations, the company is expected to allocate approximately $338.22 million Reais towards interest payments in the next 12 months. Even under my bear case scenario, StoneCo would generate over one billion Reais in EBIT, ensuring sufficient coverage for its interest expenses. While the company's current financial condition may not be optimal, it does not indicate a significant financial crisis.
Financial Valuation
Author's Contribution Author's Contribution
According to my estimate for the bull case scenario, StoneCo's intrinsic value could be worth anywhere between $18.67 and $33.48, assuming an exchange rate of 5.50 for the BRL/USD and a discount rate of 18.75%. Revenue is expected to grow at an average rate of 19% throughout this period, driven by:
- A fully relaunched credit solutions business, which will contribute to most of the financial income and higher take rates.
- A significant rise in utilization of StoneCo's banking solutions, coupled with a steady increase in total payment volume (TPV), which will help drive most of the growth in transaction services (assuming other players will continue to act rationally and not undercut prices considerably).
- The introduction of new software solutions, which will enhance the company's overall product offerings and increase customer stickiness.
EBIT margin is expected to continue expanding throughout this period as the company achieves operational leverage, with cost of services and financial expenses being diluted over time. This is due to a more interest rate-friendly environment, OpEx discipline, and higher margin from the credit solutions business (Note: My way of calculating EBITDA and EBIT is slightly different than the company's. I do not count the majority of financial expenses as a form of interest expense, but rather as the discounts charged to the company for the sale of its receivables, thus simply representing the cost of doing business. I believe this approach more accurately reflects the current state of the company, as StoneCo's EBITDA calculation approach essentially adds back all financial expenses, which can inflate the adjusted EBITDA margin).
In the base case scenario, I estimate that StoneCo's intrinsic value falls within the range of $13.15 to $23.69, assuming an exchange rate of 6.00 for the BRL/USD and a discount rate of 18.75%. The average projected revenue growth rate over the specified period is around 17%. While slightly less optimistic than the bull case scenario, this still reflects a good growth trajectory. I expect a slightly more competitive environment to put downward pressure on prices, which could impact revenue growth to some extent. However, the company's operational leverage, though slightly reduced compared to the bull case, will still play a significant role in offsetting any potential revenue losses arising from increased competition.
In the bear case scenario, my estimated stock price for StoneCo ranges from $9.11 to $16.57. This estimation assumes an average revenue growth rate of 15%, an exchange rate of 6.50 for the BRL/USD, and a discount rate of 18.75%. Despite the company's efforts in exercising OpEx discipline, my bear case scenario accounts for an elevated level of financial expenses and cost of services, which further reflects the potential challenges StoneCo may face in managing its expenses in a competitive market environment. In my opinion, there is a possibility of escalating competition among acquiring companies and financial institutions in Brazil, which can lead to price wars and put pressure on StoneCo's pricing power and profitability. Nevertheless, considering the recent trading range of $11 to $13 for the stock, the current price provides a significant margin of safety in relation to my bear case scenario. In other words, this indicates that even in a pessimistic scenario, the stock price still offers substantial downside protection.
Risks
In my opinion, competition poses the biggest threat for StoneCo's business model since they may offer more attractive pricing, potentially pressuring the company's fees, revenues, and profit margins. To maintain market share, the company may need to reduce fees and provide customized pricing options, impacting revenue generation. Deprioritizing sub-acquiring clients may also affect overall client base and revenue. As a result, StoneCo must manage costs to mitigate competitive pressures and maintain profitability in a dynamic market.
Furthermore, Brazil has a history of high inflation rates, which has negatively impacted its economy and capital markets since they also lead to increased interest rates and debt service costs for companies such as StoneCo. In addition, the depreciation of the Brazilian Reais against the U.S. Dollars can also ruin long-term value creation for U.S. investors. Restrictive macroeconomic policies, including high interest rates, have limited credit availability and hindered economic growth. For example, Brazil's official interest rate rose from 2.00% in December 2020 to 13.75% in December 2022. As a result, I believe investors should be extremely careful since these external factors can significantly affect the stability, operations, and profitability of companies operating in Brazil.
Summary
In conclusion, I recommend an overweight rating on StoneCo's stock, anticipating that it will outperform the market in the next five years. The company's extensive range of tailored financial and software solutions for Brazilian merchants, complemented by personalized customer support through localized Stone Hubs, establishes a formidable competitive moat that is exceedingly difficult for potential competitors to replicate. In my opinion, StoneCo is poised to seize the expanding digital payments market in Brazil, driven by the surge in e-commerce and mobile payments. With the guidance of a capable management team, the company is actively transforming its operations, optimizing margins, and enhancing operational efficiencies. The imminent relaunch of its credit business, coupled with the prospect of reduced financial expenses as the BCB lowers interest rates, provides a significant catalyst for future growth. Considering my estimated intrinsic value of $18.42, the current share price offers a substantial margin of safety and an enticing long-term opportunity for astute investors to capitalize on.
For further details see:
From Missteps To Triumph: Why StoneCo's Comeback Story Is Worth Investing In