This digital payments fintech company is growing rapidly and experiencing improving margins. It also has a lot more room to grow as the total addressable market is large and the company offers an expansive line of valuable solutions. The share price has been volatile (as high-growth stocks in general have sold off in recent months), but the business remains on a healthy trajectory, and it announces quarterly earnings today after the market closes. In this report, we review the business, competitive strengths, growth opportunities, financial health and conclude with our opinion on investing.

Overview: StoneCo (STNE)

Incorporated in 2014, StoneCo is a Brazil-based fintech company that provides retail merchants with electronic payment and short-term financing related solutions to manage their businesses across in-store as well as online channels. Its target customers primarily include micro, small, and medium-sized businesses across several industry verticals in Brazil. The company also provides services to nearly 260 integrated partners including global payment service providers, independent software vendors, and digital marketplaces, who embed Stoneco’s payment solutions into their own offerings to enhance the user experience.

In 2020, StoneCo was ranked the largest independent merchant acquirer in Brazil with a 9.4% market share as per ABECS’ 2020 TPV data. A merchant acquirer is an intermediary that provides payment acceptance solutions to merchants and also facilitates processing, clearing, and settlement of electronic transactions. More recently, the company has been expanding its product offerings through acquisitions, which are in line with its aim of creating a ‘one-stop-shop’ for its customers. Additionally, StoneCo also offers banking and short-term credit facilities as well as multiple retail management software solutions such as POS, ERP, CRM, and cash management.

The company generates revenue through payment processing fees charged as a percentage of the transaction amount or a flat fee per transaction. Through its credit solutions, it earns interest on loans or a prepayment financing fee when merchants choose to receive payment in advance. It also earns subscription and equipment rental fees for e-payment devices provided to retailers. The company owns 93 trademarks in Brazil that include Stone, Pagar.me, Mundipagg, Cappta, Ton, Equals, Buy4, and others.

StoneCo has 652,600 active payment clients as of December 2020. The company also had 114,000 additional clients for TON, a new fintech company launch by StoneCo in March 2020 to focus primarily on micro-merchants and autonomous workers. Additionally, the company had 390,000 clients using its software solutions.

Below are the company’s four sources of income:

Net revenue from transaction activities and other services: In this segment, the company derives revenue from commission and fees charged for providing merchant acquiring services such as capturing, processing, and settling transactions for merchants either online or in-store. The segment contributes 34% to total revenue.
Net revenue from subscription services and equipment rental: Here, the company derives monthly recurring revenue from rentals of electronic capture equipment, and subscription fees from its broad portfolio of software solutions and services that include business automation, reconciliation, supply chain management, customer engagement, and marketing software. This segment accounts for a 12% share of the total revenue.

Financial income: This segment accounts for nearly half of the company’s revenue. The majority of the revenue in this segment comes from working capital solutions provided to merchants whereby merchants may elect to receive early payment for their receivables in return for which StoneCo charges a prepayment fee. Prepayments are allowed only for credit card transactions. Essentially, card issuers make payments to merchant acquirers after 28 days from the actual transaction date because the credit card bill is paid in 26 days on average by the end-customer, therefore merchant acquirers make payments to merchants 30 days after the actual purchase. Instead of waiting 30 days, merchants may choose to get this amount in advance for a ‘prepayment fee’. Some sales might also be payable by customers in multiple installments which merchants may choose to receive in advance to optimizing their cash flows. StoneCo also provides credit funding to merchants for growing their businesses and charges interest in return. Repayment of these loans can be made through automatic retention of a percentage of the merchant’s sales. StoneCo’s credit portfolio was R$1.5B as of Q4 2020 and generated 2-2.5% monthly return. Nearly 90,000 merchants used its credit solutions.

Other financial income: This segment is relatively small, accounting for only 4% of revenue. It primarily includes interest earned on deposits and funds held in bank accounts.

Large market opportunity as use of e-payments remains highly underpenetrated in Brazil

The company’s long-term growth is linked primarily with e-commerce growth and increased use of electronic payments in Brazil. Both of these metrics are highly influenced by the number of internet users in the country. And as we can see in the graphic, internet penetration has increased rapidly in Brazil over the last decade to reach 70.7%. It is worth noting though that it still offers enough room for further expansion considering the 87.3% penetration in the US, 92.5% in the UK, and 91% in Canada.

Similar to e-commerce, the electronic payment market also remains underpenetrated in Brazil and promises to be a strong growth opportunity. As per the company’s F-1 filing, electronic payment volume as a percentage of total household consumption stood at only 28.4% in Brazil in 2016. This number lags 68.6% in the UK and 46% in the US. Moreover, only 17.6% of the population in Brazil aged 15+ used the internet to pay bills or to make online purchases in 2017 while the number stood at 80.7% in the UK and 77.2% in the US. This indicates a significantly large growth opportunity for the electronic payments market in Brazil.

As per the company’s presentation, it has a total market opportunity of R$120B, indicating a current market penetration of less than 3%. Additionally, we believe that the company has a large opportunity to penetrate new geographies in Latin America and the rest of the world by leveraging its existing technology with some modifications.

Consistently gaining market share in a highly competitive industry

StoneCo operates in a highly competitive industry with a constantly evolving landscape. Its merchant acquirer and payment processing competitors include Cielo S.A., Redecard S.A., Santander Getnet, PagSeguro (PAGS), Banrisul Cartões S.A. (Vero), Adyen, and SafraPay. The majority of the merchant acquiring market is currently captured by companies that are backed by large banking institutions or their subsidiaries (e.g. Cielo, Rede, Getnet, Vero). Cielo is the largest player in the industry with a market share in the mid-30s. It is controlled by two Brazilian banks.

As we can see in the market share chart above (from Cielo’s corporate presentation), Cielo lost more than 15% market share in just 3 years and Rede has lost 3% market share while PagSeguro and StoneCo saw substantial growth in market share during the same period. This is primarily because PagSeguro and StoneCo have historically remained more technology-oriented fintech players while Cielo has remained a traditional player, lagging in digital technology and innovations desired to cope with changing industry trends and consumer behavior.

Between PagSeguro and StoneCo, we believe StoneCo has a competitive edge resulting from its broader set of offerings that enables merchants to do much more than just accept payments or meet working capital needs. The additional solutions include software to manage businesses online, manage cash flows, customer relationships, marketing, and many other workflows. Besides that, the company has been primarily targeting micro, small and mid-sized businesses that have historically remained underserved by large banks.

As Thiago Piau, StoneCo’s CEO, said in an interview:

“Starting out with payments (merchant acquiring business) 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.”

The broad and growing customer base of merchant acquiring solutions enable the company to more easily and cost effectively cross-sell its banking, credit, and software offerings due to smooth integration between different offerings. Within the same acquiring platform, merchants can contract, monitor, and repay loans, making the platform highly integrated.

From a performance and product quality perspective, the company has a Net Promoter Score (“NPS”) of 64 as per the Brazilian Institute of Public Opinion and Statistics’ (IBOPE) study performed in November 2020 which is the highest among StoneCo’s peers operating in the company’s key markets.

Acquisition strategy to help expand product suite, client base and realize synergies

StoneCo has undertaken multiple acquisitions to broaden its ecosystem and expand its client base. These include the acquisition of EdB in 2016, Pagar.me in 2013 and Equals in 2015. StoneCo also acquired 33.3% and 25% stakes in Vhsys (a business management system for micro and small businesses) and Tablet Cloud (a POS and ERP platform for SMBs), respectively in 2019. StoneCo has an option to increase its stake in both companies to 50%. Both acquisitions together provide StoneCo access to 18,000 additional software clients. Other examples of acquisitions of small software companies in 2020 include Menew (ERP and POS software for food service), Mlabs (50% stake; a social media management platform for SMBs), and Questor (50% stake, an ERP solution for SMBs and accounting offices).

More importantly, the company is all set to acquire Linx S.A for a transaction value summing up to R$6.8B (USD 1.28B). The deal has been approved by shareholders and is currently pending a nod from regulatory authorities. Linx is a leading provider of retail management software and e-commerce software solutions with 70,000+ clients. As per IDC, Linx had a 45.6% market share in 2019 in the retail management software market and a 13.7% market share in the e-commerce market. The acquisition would boost Stone’s competitive position as it adds not only various merchant specific software tools to its offerings but also adds an additional network of merchants to cross sell into. Strong integration of Linx’s offerings with StoneCo’s financial offerings would provide additional synergy benefits to the company by promoting the sale of StoneCo’s payment, banking, and credit solutions to Linx’s existing customers. Additionally, migration of customers of Linx Pay, a payment processing solution, to StoneCo’s platform would result in greater economies of scale. As per StoneCo’s recent investor presentation, it has already purchased an 18.9% stake in Linx from the open market at a price lower than the offer price.

Broadening ecosystem will lead to more customer stickiness

StoneCo’s clients have been continuously adopting multiple offerings . For example, customers opting for both software and payment solutions rose from 22% in 2019 to 30% in 2020. Merchant acquiring customers also opting for either banking or credit solutions increased from 10% in 2019 to 34% in 2020. While merchant acquiring customers opting for both banking and credit solutions rose from 0% in 2019 to 5.3% of the total payment client base in 2020. Not only does increased multi-product adoption result in greater revenue per customer, it also leads to increased customer engagement and greater customer dependency on the company’s set of solutions for managing business workflows and operations.

Top-line growth fueled by strong customer acquisition, increasing payment volumes, and successful cross-selling

StoneCo has delivered tremendous top-line performance in recent years with revenue growing at a 3-Year CAGR of 63% driven by successful cross-selling, a growing customer base, and total payment volum (“TPV”). Below is the trend of key top-line metrics over the last 5 years.

In 2020, StoneCo experienced more volatility due to the COVID-19 pandemic. And despite TPV growth of 63% in the year on a YoY basis, revenue grew only 28.9%, indicating a decline in the take rate. This was primarily due to the high payment volume of coronavoucher, a financial aid program by the Brazilian government, which had low take rates. Even after excluding the impact of high coronavoucher volumes, the take rate at 1.73% in 2020 was still down by 12 bps on a YoY basis. This was in part due to a decline in StoneCo’s prepayment pricing that is linked to country specific interest rates which fell from 5% to nearly 2% year-on-year, however we believe the take rate was also impacted by price wars that were triggered in the acquiring industry.

While revenue growth was lower due to a decline in take rate, it was also significantly impacted by the strong headwinds faced by retail merchants during the early wave of COVID-19. In fact, StoneCo had to lay off 20% of its workforce in May 2020 due to operational challenges. However, please note that the pandemic led headwinds didn’t last long, as demand for e-commerce solutions picked up rapidly due to enforced social distancing restrictions. With headwinds now converted into tailwinds, StoneCo expects accelerated growth in 2021 and is forecasting 40%+ revenue growth in the medium-term. And while the addition of clients is an important factor driving top-line growth, there is still significant room for revenue growth within its existing customer base. Currently, only 5.3% of clients use all three acquiring, banking, as well as credit solutions while only 30% uses both payment and software solutions. Please note that the company earns 2.5 times higher revenue from clients that use payment, banking, and credit solutions in combination, relative to clients that only use payment solutions.

Impressive expansion in margins

Net margin has increased from -12% in 2016 to 28.9% in 2020 as the company realized the benefits of high operating leverage and economies of scale. In fact, the company reached its highest net profit margin (35.7%) in the most recent quarter (Q4 2020). Below is a chart depicting the bottom-line trend in recent years.

The company has its own ‘Stone technology platform’ for performing payment processing and settlement services. The platform possesses high fixed costs due to data centers and workforce requirements. However, growing TPV processed on the platform would result in a reduction in cost per transaction which in turn would lead to some offsetting of the negative impact on profitability from the price war in the acquiring industry.

Strong balance sheet, with enough gun powder to fuel growth both organically and inorganically

StoneCo ended FY 2020 with total debt of R$6.08B, whereas its total liquidity position (consisting of cash and short-term investments) stood at R$10.6B. StoneCo is also a high free cash flow producing entity. In 2020, it’s adjusted cash flow from operations stood at R$1,109M and adjusted FCF stood at R$653.5M , up by 57% on YoY basis primarily because of strong top-line growth and expanding margins. The company’s strong cash flows and balance sheet enables it to expand its ecosystem and realize synergies by investing in lucrative acquisition opportunities.

Source: Investor presentation (*R$ in millions)

Premium valuation but well deserved

StoneCo trades at a forward EV-to-Sales multiple of 15.7 times and a forward Non-GAAP Price-to-Earnings ratio of 65.4 times. While these multiples are higher than most industry peers, the company is also experiencing industry leading growth and margins. We believe that the company has the potential grow into its premium valuations by delivering impressive top and bottom-line growth in the coming years.

Also worth mentioning, these valuation metrics have come down as the price has declined since mid February (as high growth stocks in general have sold off) despite ongoing strength in the business.

Risks:

Increased competition from larger peers: Technological innovation and improvements in offerings by a larger, more resourceful player like Cielo can lead to more competition for StoneCo. It is important to note that, StoneCo has successfully managed to gain market share from these players despite them having an upper hand during the early stages of this market’s evolution.

Conclusion

Overall, StoneCo represents an attractive long-term investment opportunity, especially after the share price decline in recent months. The company is well-positioned to expand its market share through its broad range of offerings, and it has the balance sheet and cash flows to support significant organic and inorganic growth. StoneCo announces quarterly earnings today after the market closes, and this could add significant near-term volatility, but in the long-term—this business will continue to grow and these shares will likely eventually go significantly higher.

Attractive Long-Term Upside, Earnings Announcement Tonight