Description

PAGS, now known as PagBank, is super cheap ($2bn EV, 8x trough LTM EPS, 3.3x EBITDA with a net cash balance sheet) with asymetric upside of 2-4x+ if you are willing to weather significant stock volatility and the risks of investing in an emerging country (Brazil). It has been written up several times on VIC since coming public in Jan 2018 but I think now represents the best risk-adjusted entry point as the company is executing and creating significant value under the surface despite stagnant top and bottom line growth over the last 1.5 years. Discrete macro and company specific issues have negatively impacted revenue growth and earnings but those issues will soon flip the other way and PAGS should start to see significant growth again, leading to a re-rating more inline with the strategic value of the asset with over 30m consumer and merchant relationships in a developing country where there is still significant upside room for digital payments growth.

Brief History:

PAGS started out as a merchant acquirer for the underserved long-tail nano-merchant Brazilian economy. It IPO'd to generate capital in order to fund the prepayment of credit card receivables that is prevalant in Brazil. For the first few years of PAGS' public existence, the bull story was centered on growing merchants and payments TPV. Then PAGS started moving up the merchant size to acquire M-SMBS's which naturally slowed the active merchant growth, and brought with it more competition. Along the way they acquired a banking license to start offering banking solutions (free deposit account, access to investments like CD's, etc) via their PagBank neobank offering. The narrative on the strategy/bull case has thus shifted multiple times over the years, muddying the narrative for US investors that have trouble understanding the vagaries of the Brazilian payments landscape.

But to me, the strategy for the company is now quite clear, even if its not totally clear to the market. The strategy is to create a closed loop payments/financial ecosystem for merchants and consumers that allows its customers to do everything they need through a superapp. By enabling the merchant/consumer to have a one-stop shop financial portal, PAGS attracts sticky deposits into its bank to use to lower its cost of funding. The lower cost of funding is critical to grow its credit card receivable prepayment business which is the most profitable income stream for the company. And not only will they be able to grow the amount of prepayments it can fund but the spread will also naturally increase.

Since launching, PagBank has grown to over 30m accounts and the company now has over R18bn in deposits - which makes it #2 in Brazil behind NuBank at 80m+ accounts. Note that NuBank has over a $30bn market cap vs <$3bn for PAGS. Despite the momentum in PagBank and in the strategy to build out a financial ecosystem mutually beneficial for the consumer and for the company, idiosyncratic events have negatively impacted the financial results and perception of the company by investors, leaving it priced for dead, when the opposite of being a key strategic asset in Brazil is far more likely.

Below are some of the key issues impacting the company and why I believe they are more than priced in. In fact, PAGS is set to re-accelerate growth and profitability which should lead to a massive re-rating for the company over the coming quarters.

Higher Rates Set to Reverse:

As inflation started to spike post-covid, the Brazilian central bank embarked on a massive hiking cycle that brought the SELIC rate to 13.75% (from 2.00%). PAGS got caught behind in raising prices but was ultimately able to increase pricing to stabilize net financial income. To put into perspective the impact that the rate hiking had on the business, financial expenses in 2022 increased by R2.4bn or 300%, far in excess of the 47% revenue growth. Despite that, net income still  increased 12% and is expected to increase in 2023 also. The R2.4bn increase in financial expenses amounts to almost R6.00/shr vs R4.50 in 2022 reported EPS. 

The central bank has finally started easing, reducing rates by 50bps in August. Every 100bps of easing, all-else equal, is R190-200m of benefit to EBIT (higher as the funding base grows). Some of that will be offset by lowering prepayment rates to merchants (mostly M-SMB, long-tail merchants have fixed rates), but even if we assume 50% of the benefit, if rates go down by 300-500bps over the next few years, that is 300-500m of EBIT or ~R0.75-1.25 of EPS tailwind. That is just from the benchmark rate going down. 

In addition, PAGS has been consistently lowering its cost of  capital with total funding for bank deposits/CD's now at 94% of CDI. I expect that to march gradually lower as PAGS increases the amount of bank deposits (at ~75% of CDI) and reduces the amount of third-party CD's while also using its own internally generated cash flow. 

Loan Losses Fully Reserved:

PAGS made an in ill-fated foray into unsecured lending at PagBank leading to massive credit losses. These credit losses negatively impacted EBIT by ~R540m in 2022 (R1.30/shr). The unsecured portfolio is not fully reserved and PAGS is only entering into secured lending. The lending book has increased to 52% secured from practically 0% at the end of 2021. While the move to a higher quality loan book in Financial Services division should improve profitability over time, right now that negatively impacts top line growth.

Between the increase in financial expenses from higher rates and the writeoff of the entire unsecured lending book, you could make the argument PAGS' normalized EPS was closer to R8.00-10/shr in 2022 vs the reported 4.50. That would put the stock trading at <6x EPS. Cheap no matter the country or volatility.

Debit/Prepaid Interchange Cap:

Effective April 1, prepaid and debit card interchange rates were capped. This negatively impacted revenue growth beginning in 2Q23, specifically in the Financial Services division (the bank, or issuing part of the ecosystem). While headline revenue growth was slowed because of this, the impact was negligble to the bottom line as the lower fees positively impact transaction expenses in the Payments business. As this negative impact rolls off, PAGS should naturally see higher growth rates more inline with the core growth.

Merchant Portfolio Shift:

PAGS has made a concerted effort starting in 2022 to not chase unprofitable growth. The result of this strategy shift, along with the move upmarket into MSMB, has negatively impacted the active merchant count. Active merchants peaked in 4Q21 at 7.7m (vs 6.8m 2Q23). Since this is a key KPI (and the key KPI when the company came public), investors fear that PAGS is losing share, as they admitted in 4Q22. 

What the market is missing is that TPV per merchant has been growing 15-28% the last few quarters. PAGS got rid of a significant amount of nano-merchants that comprises only a small amount of TPV. Despite the shrinking merchant base, TPV has actually continued to grow each quarter. 2Q23 was a slow macro quarter and TPV grew a meagre 4%, with transaction revenue in Payments actually declining -1%. Management noted on the 2Q call that the merchant count was expected to start growing again in 3Q and that TPV was +8.5% for the first 45 days. Growth is reaccelerating as the positive impact of higher quality merchants that do more TPV starts positively impacting the mix. 

While total TPV is still growing, transaction revenue has lagged that growth due to the take rate declining for the last 3 quarters. This is expected to continue to naturally decline as the portfolio shifts to larger clients, but the combination of higher TPV per client, slightly growing merchant base, partially offset by lower take rate, should still generate double digit transaction revnue growth. I see transaction revenue returning to a double digit growth rate in 2024, with 2Q23 the trough.

PIX:

Management noted that PIX may be taking share from debit card growth. PIX has been discussed at length on VIC and while it is a risk, it doesnt appear to be the death knell that many orginally expected when the central bank rolled it out. As interest rates decline, consumers will be more apt to start using credit again, positively impacting the take rate in the business (both through the MDR and higher prepayments). In addition, PAGS actually benefits from PIX usage as it is one of the 40+ different money/moneyout options in PagBank.  PIX is worth watching, but at the current valuation it is more than priced in.

Valuation:

PAGS has a strong balance sheet and has been repurchasing shares. Despite the markets belief that PAGS is another fintech shitco, it generates cash flow and is a widely used and valuable platform with significant scale that is worth far more than the $2bn EV it is currently priced at. The stock is currently valued a 3.3x EBITDA, capex is declining as a % of EBITDA due to the efficiency of moving upmarket on the merchant side, and on an EPS basis it is valued at just 8x (vs 30x+ only a few years ago). PAGS is also currently valued at just 1x TBV. Perhaps the rebranding to the Pagbank vs PagSeguro may force the market to value the company as a bank on TBV, but even if they do, given the ability to generate significant growth and returns, PAGS should be valued much higher than it is, especially in the context of NuBank at $30bn and XP at $12bn.

I believe PAGS has materially more upside than downside with potential for >4x return. If the ompany achieves its vision of really building a financial superapp ecosystem with ever-lower funding costs, both earnings and the multiple can balloon here, leading to a homerun. Either way, I think the downside risk is not material, barring some headline news around prepayment discount rates or a massive decline in the Brazilian economy. The 2nd derivative for all the key drivers of revenue and earnings growth are turning upward and that should yield a higher stock price.

My bottoms up build, which assumes a -50bps quarterly decline in the SELIC rate starting in 1Q24 (to ~9.25% by end of 2025), 7.4m merchants at end of 2025, declining take rate, HSD growth in TPV/merchant, and modestly positive Financial Service EBITDA, yields ~$2.00 of EPS in 2025. Adjusted EBITDA margins should get into the high-20% range (from cyclcial lows of 18-19% in 3Q/4Q22).

Catalyst

 - Continued interest rate declines, lower funding costs exc interest rates, higher deposits and more PagBank features, headline growth reaccelerating in 3Q23 and into 2024.