Description

Summary:

PagSeguro is a very high growth and disruptive payment enablement business in Brazil. The closest analog is Square in the U.S. Their core market are micro, small, and medium businesses in Brazil, who are under-served by the giant acquirers Redecard and Cielo. Pagseguro has found a way for these tiny businesses (who do very little volume) to accept cards and other electronic payments at an acceptable cost. There is currently very little competition. Pagseguro is growing ~100% YOY with rising margins. 

We pretty much never do IPOs but I think an exception needs to be made for this one. I think this is an early stage compounder.

Industry / Business Overview:

The Brazilian merchant acquirer industry is totally ossified and dominated by three players, each of whom is affiliated with a mega-bank. Together, Redecard, Cielo, and Getnet have 90%+ market share. These companies are rather complacent and lazy. MDRs are extremely high. Their margins are also very high. Card penetration is low as cash predominates in Brazil. Card penetration among smaller merchants is de-minimis due to the high cost of acceptance.

There is a tailwind though. Digital payment volumes are steadily growing as a % of total payments. I expect this to continue for the foreseeable future.

PagSeguro’s business model works for these tiny merchants (average payment volume per merchant is only USD$4000 per year!) because:

• They have developed a super low cost payment terminal. The larger acquirers rent their terminals out at a huge charge. PagSeguro allows their merchants to buy their terminals for the equivalent of 4-6 months of rental fees from Cielo or Rede. For these companies, terminal rental fees are a very large piece of EBIT and they are loathe to disrupt their own business model. For tiny merchants, the terminal costs are very substantial compared to their revenues.

In addition, their MDRs are similar to large acquirers. So all in all, it's a very attractive solution for SME merchants to adopt.

• They have a low CAC. Their parent company is UOL which is a large media conglomerate in Brazil. They get free advertising from UOL. PagSeguro acquires customers solely through digital channels (GOOG, FB, UOL, YouTube, etc) rather than on the ground sales force. Merchant onboarding is done 100% remote as well. Amazingly, their CAC is actually FALLING.

• They seem to be able to offer a “digital account” which is like a light digital banking app. This allows merchants, even unbanked ones, to manage their business payments / receivables. 

• They have come up with a clever ecosystem via issuing prepaid debit cards, which allows micromerchants without bank accounts to accept card payments, and then use the card at other merchants, or cash out at an ATM.

• They require their customers to enroll in their “prepayment” program for installment payments at an effective interest rate of 2.99% per month. (Believe it or not, this is considered a modest rate of interest in Brazil). Finance income is extremely important to the business model. I can go into more detail on this later, but Installment Payments are a idiosyncratic feature of the Brazilian market.

This model is finding a lot of traction with small merchants. Right now, they have 2.6 million individual merchants as customers. In contrast, Cielo, which processes probably 25x their volumes, has 1.6 million individual customers. 75% of PAGS’s merchants who use the “basic” POS system have never accepted card payments before. There is very little overlap between the PAGS customer base vs everyone else, including MercadoPago.

In 2017, customer count doubled year over year, and TPV went up 140%. Average payment volumes per merchant went up 30% (mostly due to accepting a greater variety of payment schemes, not because of mix). Due to operating leverage, earnings before tax went up substantially more. So all in all, this is a firm on a very strong trajectory.

Today, PagSeguro has about 2%-3% volume share in Brazil acquiring. They think that can go to 10% in the medium to longer term.

Lastly, 80% of volumes are offline, and 20% are e-commerce. (The ratio is the inverse of MELI’s MercadoPago).

Now, you may also be wondering about the differences between this and Square. The key difference is that merchant acquiring is just a better business in Brazil -- higher MDRs, more financing revenues, less competition. PAGS also has some good customer acquisition channels. So even at a low volume of TPV, PAGS is substantially profitable. This is very much unlike Square in its early days.

Long Term Growth

In general, merchant acquiring at scale has been a pretty solid business to be in worldwide. The business tends to be sticky from a relationship front, and scale is very important. 

The long term growth trajectory seems clearly positive. They are building a very big lead in the micro/small merchant space, and it’s a business that the larger acquirors are not interested to pursue given their higher cost structures and pricing. PagSeguro’s TPV is also 5x that of MercadoPago, who is probably the closest competitor.

They are also busy building an ecosystem – e-wallet, QR codes, working capital lending, etc. The loan in the LT is to deepen engagement with the micro merchant customer base, or even expand into the consumer arena (Venmo-like, also P2P lending). 

In general, we are comfortable that this business has some serious innovation / technology chops. In 5+ years, PAGS could look quite different from today.

Financing Business

Brazil has a really weird dynamic where many items can be bought on installment – which is essentially a short term interest free loan extended by the merchant to the consumer. This habit dates back into the hyperinflation years, and has been pretty much assimilated into the retail landscape. It's important to note that it's the CUSTOMER who chooses whether to pay on installment, and customers have all the incentives to do so.

About 1/3 of PagSeguro’s TPV is on installment. PagSeguro essentially takes the present value of that installment stream, discounted at 2.99% per month, and pays the merchant upfront. Then they collect the full value over time from the bank. There is limited credit risk (because the bank is the ultimate counterparty, and the large Brazilian banks actually have better credit ratings than the government).

The financing works out to be 42%/yr. But that’s considered modest in Brazil, as alternative sources of financing to these small merchants are in the triple digits, along with credit card rates. (These merchants are treated like retail customers by the banks). Thus, so far, there’s been little push back from merchants. In the LT, one risk is that the rate compresses.

The downside of this business of course is that it’s capital intensive. PagSeguro has been somewhat capital constrained. With the IPO proceeds they will become self funding. This is a decent use of cash because of the high ROIs offered.

Financing Risk

The Brazilian government is considering legislation to change the way card settlement works. Essentially, right now banks get a giant float from cards because they don’t pay the merchant for 30 days after the charge is incurred. The Brazil government wants to reduce that to 2 days. It's unknown what effect this might have on PAGS and all its peers. For example, their MDRs might need to be adjusted. Their financing business may also be affected, because the discount period they use might be shortened by 28 days. This legislation is still being debated and there is no telling what the government will ultimately do, however. The banks understandably are lobbying hard against it. This discussion has been ongoing since 2006 and there's been no change, because it's really bad for banks and the lobbying has been intense.

My personal feeling is that since PAGS has full control over the gross MDRs, they'll be a net loser if the reform happens but it won't be a massive blow. As long as they continue to execute, they'll be okay in the long run. I'll leave you guys to make up your own minds, but I think this is the biggest near term risk.

Key Points of Uncertainty:

• Ultimate TAM and growth. Can they keep up this blistering pace? Will this online CAC model peter out and force them to build on the ground sales to reach more merchants? Will CACs increase if more people attack digital channels?

• Competition – will the large acquirers wake up? What about MercadoPago? Will Amazon make a payment play?

• Execution – a lot to be done… These guys have a big opportunity but need to execute against it. Can they strengthen the ecosystem? Can they get people to adopt their wallets? Can they move towards ubiquity in small merchants? Can they eventually move upmarket to compete with Cielo (they do not want this today)?

• Regulatory risks

Valuation

By my estimates, PAGS trades for a mid-30s PE multiple for 2018. Growth is really fast obviously and there's ongoing operating leverage. If growth continues anywhere near current pace, the multiple gets reduced very quickly in 2019-2020... 

Catalyst

None. As long as it keeps growing it's fine.