Description

Recommendation: Initiate a short position at today’s price.

Note: All figures in $BRL unless otherwise noted

Overview

Nails4 recently wrote up competitor PAGS as a long (1/25/18). I think a more robust way to play the same core themes is through a short of the largest incumbent, Cielo.

Cielo is a $20bn USD market cap merchant acquirer and payment processor in Brazil. Cielo allows businesses in Brazil to accept payment via credit and debit card. By most metrics it screens relatively cheaply --  16x earnings, 10x EBITDA, but I expect earnings to drop precipitously due to fierce competition.

Cielo is historically one half of a duopoly. Before 2010, Cielo was the only processor that could accept Visa, and Rede was the only processor that could accept Mastercard.  Post 2010, the Central Bank of Brazil broke the industry open for other competitors to accept Visa/Mastercard. Regulations in 2013 and 2015 further opened the market for competition by ending any form of exclusivity.

Despite regulation, Cielo has done fantastically well to fend off competition thus far. In fact, Cielo shares have had a total return of 373% since the end of 2010, as management built up more ways to extract more revenue from its customers, through high POS rental rates and short term financing. Today, Cielo is robbing its customers blind, with rates that would be completely unacceptable anywhere else in the world. Cielo earns 54% EBITDA margins and 40% ROEs. This leaves a profit huge opportunity for competitors willing to undercut Cielo and be a low-cost option. That competition has finally arrived in force.

Segments

Cielo has 3 core lines of business. All 3 could be cut in half or worse over the next several years.

• Renting out POS systems (est. 25% of Net Income)
  • Cielo rents out devices that read credit/debit cards. This revenue stream has tripled since 2011, as Cielo has increased average rental price by 9.4%/yr. Cielo is now heavily reliant on this annuity stream, but this has been a central point of competition.

• Collecting a spread on all transactions (est. 35% of Net Income)
  • Cielo takes a Merchant Discount Rate (MDR) on each transaction processed. Payment volumes have increased by 12% annually since 2011, but Net MDR has declined -3% annually.

• Financing pre-payment loans to customers (est. 30% of Net Income)
  • Cielo provides advances to merchants for consumers that paid in credit card or credit card installment payments. Pre-payment revenues have increased 25% annually since 2011.

1. Competition is well-equipped to steal  over half of Cielo’s customers

Cielo has left a huge opportunity available for any competitor willing to seize it. Though EBITDA margins have fallen from an out-of-this world 67% in 2010 to 54% today, they are still very high on a global basis.

Note: EBITDA Margin based on Net Revenue (derived from net MDR)

PagSeguro is a relatively new entrant into the space, arriving in 2014, and they are set to be a fierce competitor moving forward. PAGS has thus far been very happy to undercut Cielo’s massive margin, while still earning a tidy profit for itself (38% EBITDA margin). PAGS has done this by flipping the industry on its head. Instead of earning a profit renting POS systems for $130/month, PAGS sells the POS systems at cost (about 8x monthly rent at Cielo). This has made PAGS’ economic proposition highly favorable:

A “typical merchant” with sales of $440K (the average for Cielo’s merchant base), could save $4,600 per year by switching to PAGS, increasing margins by 1.0 percentage point. This would be huge for a retailer that probably runs single digit EBIT margins.

It is therefore unsurprising that PAGS has grown merchants at a dizzying rate – over 80% CAGR for the past 3 years. Meanwhile, PAGS’ customer acquisition cost has been cut in half, as PAGS has been able to rely more on common sense math and word of mouth to acquire customers. Customers can join the PAGS ecosystem 100% online, without having to speak to a single person, while Cielo’s customer acquisition strategy is primarily bank branch/salesforce driven. About 75% of PAGS’ growth so far has come from customers that had never used a POS system before, but as PAGS penetrates further you can expect that mix to shift towards increased poaching of Cielo merchants.

On top of this, because of legacy systems (merchants had to have both Cielo and Rede in order to process Visa and Mastercard), a UBS survey indicated that ~40% of merchants still work with more than one acquirer. 61% of these customers intend to cancel one acquirer.

Though I have focused on PAGS thus far, a number of other options are also extremely viable. Cielo is not particularly cost competitive with any of them.

All told, over 50% of Cielo’s merchant customers and payment volumes would be well-advised financially to switch platforms over the next several years

2. The customers poised to leave are by far Cielo’s most profitable

The economics of switching to PagSeguro make the most sense for small and mid-sized business (i.e. payment volume <$1m BRL). For these businesses, renting the POS systems is a meaningful drag on profitability, and they don’t need any of the handholding that larger organizations might want.

The big issue for Cielo, is that these are exactly the customers that it cannot afford to lose. The MDRs for small businesses can be nearly twice as high as the MDRs for large enterprises. If Cielo loses its bottom 25% of payment volumes, I estimate it could lose 33% of transaction revenues. Losing 50% of volumes would cost 63% of transaction-based revenues.

Perhaps more importantly, Cielo risks losing its entire financing business (30% of profits). Brazil has a unique quirk whereby many items are sold on installment over several months. This is essentially interest free financing provided by the merchant to the customer. Merchants can choose to wait for the full amount to slowly roll in over several months, or take financing provided by Cielo (or any merchant acquirer). The financing provided by merchant acquirers comes with a cost that can equate to ~40% APR. While this seems startlingly high by western standards, it can actually be quite reasonable for SMEs who have limited access to financing, and debts that are typically held for less than 60 days. In comparison, personal loans in Brazil averaged 127% APR, while revolving credit lines for small businesses average 264% APR in 2017.

But while taking short term financing can make a great deal of sense for small businesses, taking a 40% loan does not make financial sense for larger, more financially savvy organization, when the SELIC (overnight rate) is ~7%. It is doubtful that many organizations with POS sales > $300k BRL rely on short term financing at such high interest rates. According to UBS surveys, just 41% of merchants prepay receivables. Thus the smallest 50% of Cielo customers likely account for nearly all of the financing business (~30% of profits).

Losing 50% of customers/payment volumes could cut profit by more than 80%

3. MDRs in Brazil are still 2-5x higher than the rest of the world

The rest of the world is a very informative comp to what normalized end game for this industry should look like. Cielo has historically operated with 60+% EBITDA margins, but competition should (and has) brought this down. Even the largest acquirers in the world (First Data and World Pay, 12.7x and 7.9x larger by payment volume) earn EBITDA margin of ~45% while Cielo is at 54% today. Without clear barriers to entry, global markets have pushed down MDRs to compete, and the Brazilian market has a long way to fall.

Net MDRs should decline 50% or more, offsetting any growth from continued card penetration in Brazil

4. Other Negatives

• Regulation – The BCB has talked for years about reducing the number of days that it takes for merchants to receive credit card payments from D+30 days to D+2 days. This would bring Brazil on par with the rest of the world. This will likely substantially reduce the amount of short-term financing required by merchants. This also would likely squeeze net MDRs/increase interchange, as banks are no longer getting ~28 days of free float.
• Shift to Ecommerce – Mercado Libre has become a dominant ecommerce platform in Brazil, and an increasing shift towards retail done on the platform would increasingly benefit Mercado Libre’s own payment platform Mercado Pago.

Valuation

Cielo still trades closer to a monopoly multiple than the now-disrupted franchise that it currently is.

As it stands today Cielo is massively uncompetitive with available options. If Cielo chooses to stay the current course, earnings could be slashed by 80%.

Of course, Cielo could course correct and decide to slash MDRs, sell POS systems at cost, and become competitive on price. Indeed, this may be a preferred outcome in the long-term, however it is difficult to imagine management voluntarily gutting their annuity stream from POS system rentals (25% of net income) and significantly decreasing MDRs. Even in this “best case” scenario, Cielo will need to slash its margins to match something close to PagSeguro’s 38% EBITDA margin, and pray this does not trigger a race to the bottom. Recall that EBITDA margins in Brazil are still far higher than they are in the rest of the world.

Assigning a 40% EBITDA margin to Cielo’s revenue today implies a 26% decline in EBITDA. Applying an 8x EBITDA multiple to this implies 46% downside in the medium term.

Food for Thought…

Another way to think about value in this business is to consider enterprise value per volume of payment processed/acquired. By this metric, Cielo is substantially more expensive than global comps, which gives a sense of just how badly Cielo exploits its customers relative to global players. POS Rental and Pre-payment financing simply don’t exist as profit centers elsewhere, and MDRs are still fantastically high in Brazil. As competition and regulation continue to take hold, I expect this multiple to contract rapidly.

Catalyst

Continued competitive pressure and further regulation