Description

PagSeguro (PAGS) is Brazil’s largest payment processor for micro merchants. After coming public about

a year ago a combination of macro uncertainly, industry specific competition issues, and unforced errors

from the management team has led to the stock trading down 50% from its peak to $21.25. We believe

the stock more than doubles from here to a target of $45 as the market realizes that the majority of

these issues have been solved and buying PAGS at 13x 2020 earnings for 30%+ revenue growth is a

bargain. For a basic business description PAGS was written up about a year ago on VIC and has

slideshows on their IR page for reference.

A brief overview of our thesis:

 Firstly, we’re posting this now b/c there have been a few pieces of incremental information over

the past week (STNE pre-announcement, Cielo conference call) that we believe aren’t being

reflected in the stock price……always tough to say why but our desk is being told there are a few

larger holders trying to move stock which can sometimes create interesting entry points

 PAGS is an early stage Square (SQ)

         o They focus on micro merchants which are underserved by larger competitors

         o Sales distribution is digital which has proven to be far easier and more effective than

            “feet on the street”, having following SQ since the IPO its clear this was the most

             important dynamic the early bears missed and one of the key reasons large competitors

             had trouble keeping up

         o In the medium term the digital ecosystem will be the more important driver of the

            customer experience instead of core payment processing (digital wallet, payroll,

            inventory management, lending, etc), again, for those who follow SQ revenue growth

            accelerated in a meaningful way once they launched their lending/capital program,

            incidentally PAGS will be launching similar programs starting in Q1 2019

        o Nobody else focuses on their customers, primarily b/c they are expensive to serve but

           mostly due to the fact that they lack a bank account, PAGS solves this with their digital

           wallet

 The Brazilian macro situation was resolved positively with the election of Jair Bolsonaro in

October (views on his social beliefs are another story…)

        o Since the run off results the Ibovespa is up 20% and was the best performing stock

           market in the world last year

        o Buying economically sensitive businesses in Brazil now is the equivalent of buying

           similar stocks in the US right after Trump was elected

        o This can already be seen in consumer spending data which has accelerated 200-300bps

           since September to +6-7% in Q4

 As of this morning it looks like the major competitive fears from the rhetoric produced by Cielo

are set to improve

       o The CEO got on the conference call and said pricing wouldn’t get any worse

       o Most bears were hoping that they really would follow the scorched earth policy that

          they talked up over the past two quarters

       o Its also worth noting Stone (STNE) pre-announced inline to slightly better revenues and

          take rate last week which likely de-risks PAGS Q4 to an extent and debunks the thought

          that larger guys could gain back share simply by cutting price (they did….and it didn’t

          matter)

 The stock is very cheap

      o Revenue growth will be mid-30% in 2019 and we are expecting +25% in 2020

      o The balance sheet is net cash (and they self-fund receivables)

      o Yet the stock trades at 13x 2020 earnings and 7.5x EBITDA, compare that to STNE

         (arguably more susceptible to competition since they focus on larger customers) that

         gets 19x earnings and 14x EBITDA, or Square, which is unrealistic, but if you want to

         dream it gets 66x earnings and 55x EBITDA

     o Even FDC got taken out for a better multiple!

 In the very short term we have been told but a few trading desks that a large holder needs to

get out of a bunch of stock, we believe this has been weighing on it since the beginning of the

year

Given that, here’s why the stock has been so ugly:

 It started with Goldman giving management an early release on their lock up in June

      o Since they didn’t pre-announce any Q2 numbers despite only having 15 days left in the

         quarter the roadshow did not go over very well

      o They said that they were worried about market disruption due to the election, turns out

          they were right

      o Signed a one year agreement to halt stock sales

 This was followed by the macro disruption management was worried about

      o Brazil has a budget issue mostly due to onerous pension obligations and early in the

         election campaign it seemed that the far left candidate, Fernando Haddad, was

         comfortably ahead, this lead to the Brazilian Real going from 3.60/$ to 4.20/$, since

         PAGS is an ADR this obviously matters, along with the economic repercussions

 Competition

     o Rede/GetNet were the first to respond to share losses from newer players with price

        cutting actions in Q4 2017/Q1 2018 but the public markets really took notice when Cielo

        got vocal on their Q3 call last fall, this caused PAGS/STNE analysts to fret about potential

        downsides to take rate/profitability

      o But similar to SQ vs FDC, PAGS/STNE are actually offering a better and simpler mouse

         trap compared to the larger players who source most of their business from the bank

         channel (again, see FDC….), it isn’t all about price

      o And even if it was all about price the cuts that were made basically brought them down

         to the level of PAGS/STNE since they had been undercutting to gain share for some time

      o As mentioned above, this afternoon Cielo indicated that the price cutting was unlikely to

         get worse which should provide more comfort that the bottom is close to being reached

 Regulation

     o No discussion on the Brazilian payments space would be complete without it, and we

        will admit it is a legitimate risk, its just not one we see turning into reality anytime soon

     o For brief background, about 1/3 of credit purchases in Brazil are done via installments,

        most of which are for 1-6 month periods, these installment programs originated during

        periods of hyperinflation but have stuck around b/c they are actually cheaper for the

        consumer than bank loans even though APRs approximate 40%+

     o PAGS self-funds these loans and they make up 45% of net income, this is declining and

        was more than 60% a few years ago

     o We think the chances of the central bank attempting to phase these loans out is small

      They actually make up 6-7% of GDP if they were removed it would cause an

         immediate consumer recession

      Bolsonaro’s finance minister, Paulo Guedes, is a free market proponent and has

         signaled he doesn’t intend on large changes within the payments system, similar

         to sentiments echoed by central bankers

      The market would adapt by charging higher processing spreads over the

         medium term

      When the payments system was converted from a large bank oliogopoly to a

         free market in 2012 the whole idea was the allow for more competition and

         players like PAGS to enter, these smaller players would not be able to compete

         as effectively if the regulations were changed

Conclusion

      The Brazilian payments industry has both secular and cyclical legs

      PAGS is best positioned to penetrate the micro merchant segment of the industry, we think it

         will be a 20% grower for years to come

      Competitive fears are over blown and data points over the past week confirm this (STNE pre-

        announcement and Cielo’s conference call)

      Launches of merchant capital programs, payroll software, and other

Catalyst

 -Q4 earnings