Investment Case: StoneCo Ltd.
A Disruptive Payments Business in Brazil
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Hello friends,
Welcome to everyone that signed up during the past week! Today, we will be going through an investment case for one of our portfolio companies, StoneCo (STNE). If you missed our first investment case for Alibaba, click here! The below analysis is for informational purposes only and not intended as financial advice.
Business Overview
StoneCo (STNE) is a Brazilian payments business that empowers small and medium sized merchants to conduct electronic commerce across in-store, online, and mobile channels. The company was founded in 2012, starting with payment processing technology alongside a POS terminal. The business has since expanded to provide banking and credit products, along with workflow software solutions through a series of acquisitions. The broad and growing customer base of merchants enabled the company to cross-sell its banking, credit, and software offerings due to smooth integration between different products. This business strategy has been successfully executed in the U.S. by Jack Dorsey’s Square, and we believe that Stone is on a similar path, albeit with more bumps in the road.
Stone has a massive market opportunity in their home country of Brazil. Brazil’s POS terminal market is expected to grow at a CAGR of 17.8% through 2028, with highly favorable trends in smartphone penetration, digital payments and e-commerce. In recent years, card transactions have been taking greater share of overall payments, with the share of cash payments falling from 52% in 2017 to 30% in 2021. We believe that these digitization trends will continue in the years ahead, providing a significant tailwind for Stone and other fintechs in the region.
While Stone reports earnings through two operating segments (financial services and software), we find that the business generates revenue in 5 distinct methods:
Merchant Discount Rate (MDR)
Stone charges a fee to merchants for processing transactions through their POS device. This take rate is currently 2.21% of total payment volume (TPV).
POS Sales
Stone commercializes POS equipment through either rental fees or sales. They offer multiple products and pricing options to better fit their customers specific needs.
Prepayment of Receivables
Since the settlement period for credit card transactions is 30 days, Stone offers merchants the prepayment of those receivables. In order to fund this operation, Stone either uses their own cash or borrows from a bank and collects the spread between their carrying rate and the fee charged to merchants.
Banking, Insurance, and Credit
Stone offers working capital loans to their SMB segment. These loans are collateralized by card receivables. (i.e. they lock the receivables in the POS to ensure repayment of the loan). The company uses the transaction history from their merchants POS device to underwrite loans and has taken a conservative approach as macro conditions have been volatile in Brazil. We anticipate credit to be a larger percentage of total revenue once macro conditions normalize.
Software
The company has a vast portfolio of smaller workflow SaaS products they’ve either built or acquired over the years. For example, they’ve acquired Linx in 2020, the largest retail ERP software in Brazil with 45% retail share, to strengthen their software offerings. Their SaaS products address integral business functions such as customer relationship management (CRM), marketing engagement tools, and omnichannel solutions (OMS). Stone is currently the only player that has a substantial software offering when compared with their payment acquirer peers.
Why we like the business:
We find that Stone’s offerings have the potential of creating a self-reinforcing ecosystem that can allow the business to gain significant operating leverage as it scales. The business, while still in the early stages, has already shown the operating leverage inherent in its business model, as seen through their costs declining as a percentage of revenue. In general, we like businesses that can grow multiple revenue streams simultaneously, as this growth tends to compound once the business reaches sufficient scale. This is especially true, when growth in one segment reinforces growth in another, creating a flywheel effect.
Stone follows what is commonly referred to as a “Land and Expand” strategy, popular among software companies. The theory is that a merchant starts with the payment terminal to accept card transactions. After some success, the merchant then looks to increase sales and profitability by using Stones software tools. Seeing positive results, the merchant then looks to expand their business, requiring capital loans to fund this expansion. While all these business functions are occurring, Stone is generating proprietary data that can be used to improve their offerings. In this sense, Stone is attempting to create a one-stop shop for merchants and act as a business partner to their 2.5 million active clients.
As Thiago Piau, Stone’s founding CEO, said in a 2020 interview,
“Starting out with payments was just a Trojan horse, a way of striking a relationship with the Brazilian business owners…Our main strategy now is to offer all the other services banks offer those clients and ultimately yank them out of the banks.”
In order for Stones ecosystem to work, they must be able to retain customers to increase customer lifetime value. As the payments business in Brazil is highly competitive, Stone needed to differentiate themselves from their peers. They have largely accomplished this through what they refer to as their “Hub Strategy”. Stone’s hubs are the primary distribution model for brick-and-mortar merchants. These hubs are located in small and medium sized cities, or suburban areas of larger cities, and are designed to provide hyper-local sales and customer service to SMB clients. Stone claims to have the best customer service in the market through this hub strategy as it allows them to deliver products cheaper and faster to clients, while having the ability to resolve customer issues face-to-face. This results in a higher NPS (64) when compared to their peers.
Interest Rate Optionality:
As a financial services business, Stone is heavily impacted by interest rates. The interest rate in Brazil (referred to as the SELIC rate) has increased from 2% at the start of 2021 to 13.75% in 2023. This rapid increase in interest rates hurt Stones business in two ways. Firstly, it dramatically increased the funding costs for their prepayment operations as evidenced by their gross margins falling during this period from ~82% to ~62%. Secondly, their existing credit portfolio experienced a dramatic increase in NPLs, causing Stone to temporarily pause credit entirely. As credit was the most profitable segment of their business, this announcement caused Stones stock price to collapse.
As seen in the U.S., it is not uncommon for the rapid rise of interest rates to uncover structural problems in the banking and credit sectors. Management took responsibility for this issue, claiming that they were too aggressive in providing credit to small businesses with inadequate underwriting and risk management procedures in place. While management deserves blame for this misstep, it must be noted that the global pandemic put excessive stress on small businesses throughout Brazil and a faulty registry system added to the difficulties of credit underwriting. Stone is now well underway in relaunching their credit business in 2023 and is expected to begin ramping this business toward the end of the year.
The good news is we believe that interest rates have peaked in Brazil, as inflation has been falling since June 2022 and is currently at its lowest level in 2 years. Once the central bank starts cutting interest rates, we see Stones business benefiting from increased economic growth for their client base, lower funding costs in their credit segment, and a greater appetite for risk assets.
Inflation Rate in Brazil.
Valuation:
At the time of writing, Stone currently has a market cap of $2.7B. This is backed by a Net Asset Value of $2.47B as audited by EY, or 91% of the market cap! We find this surprising for a business that is growing revenues above 35% year on year while maintaining operating margins close to 40% and is free cash flow positive. The company currently trades at their lowest multiples historically for sales, book, and earnings. As such, it is fair to say that the market does not believe in the prospects that we have laid out in this write-up. Only time will tell who is correct and with business results like their most recent, we don’t mind waiting.
Using a DCF model with decelerating revenue growth over the next 10 years and a WACC of 25.41% to account for country and currency risk, we arrive at a market cap of $4.7B or $15.07 per share. This would indicate Stone is currently undervalued by ~60%
When analyzing Stone’s valuation on a relative basis, we produce a similar result. The peer group for comparison include PAGS 0.00%↑ , Cielo, and NU 0.00%↑ . Focusing on the metrics of Sales, EBIT (Earnings before interest and taxes) and FCF, we arrive at the respective average multiples of 2.38x sales, 7.74x EBIT and 15.64x FCF, giving us a blended relative valuation for Stone of $16.02 per share.
Catalysts for share price appreciation:
· Reacceleration of credit
· Interest rate cut
· Improving margins
· Growth in the Brazilian Economy
· The continued digitization of the Brazilian economy
Thanks for reading! We hope you enjoyed the analysis. If you did, please feel free to subscribe and share with a friend.
Much appreciated,
Jack Beiro, MBA
JB Global Capital
The information contained herein represents the author’s opinion and is for informational purposes only. Nothing in this newsletter should be construed as legal, tax, investment, or financial advice. No opinion expressed by the author should be construed as a specific inducement to make a particular investment or follow a particular strategy. The author may hold positions in securities mentioned in the newsletter and may buy or sell securities at any time. The author may express opinions based on information he considers reliable, but no guarantee or warranty is made with respect to such information’s completeness or accuracy, and the author is under no obligation to update or correct any information provided. Please consult your own financial or investment advisor before acting on any information provided herein.