Description

Stoneco (STNE) is a merchant acquirer in Brasil helping SMB conduct electronic commerce across in-store, online and mobile channels. With an active client base of ~500k and total payment volume of R$129 billion, STNE is growing its top line in the high double digits, aggressively taking market share while trading for 33x TTM FCF.

On top of being the lowest cost provider, their differentiated business model is based on a closer and proactive approach to clients through on-demand customer service and their Stone Hubs (hyper-local distribution centers), allowing them to grow market share rapidly ~8% (4th largest in Brasil), up from sub 1% in 2016.

STNE generates revenue from:

1. Merchant Discount Rate (MDR) 

1. STNE generates revenue on credit and debit transactions captured through credit and debit cards, meal vouchers, boletos and other APMs.

2. POS rental

1. STNE commercializes POS equipment based on a subscription fee model, similar to incumbents (Cielo, Rede and GetNet), but different from other new players such as PagSeguro that sell the POS machine. A couple of years ago, STNE started to sell POS equipment to autonomous professionals and micro-merchants (such as taxi drivers, physical therapists or food trucks). They announced a new entry level POS called Stone Mais, being sold at 12x installments of R$11.9 (Bluetooth connection) or R$34.9 (with chip).

3. Prepayment of receivables 

1. Since the settlement period is 30 days and credit card sales in installments, Stone (as other merchant acquirers in Brazil) offers merchants the prepayment of those receivables. In Brazil, ~50% of credit card volume is made in installments and is labeled as 0% APR.

2. Since Stone doesn’t participate in a locking of receivables network called SCG, it operates more freely than incumbents like Cielo. The industry spread for this line of business is ~25bps.

3. To fund the service, Stone uses their capital or borrows from a bank. One of the primary uses of their IPO proceeds was to rely more on their own capital as funding. 

Competitive advantage: Cost

STNE is the lowest cost provider, which is usually the only consideration for merchants in Brasil (over service or technology). Stone charges on average about half of what incumbents are charging on POS rental and ~25%-40% less on MDRs for both credit and debit.

Service

Moreover, STNE has a better platform than peers as it allows for more customization. Further testament is in much higher usage of technology solutions ~27% of their customers vs sub 3% for peers. Data from our channel checks suggest that STNE’s customer satisfaction is the highest among peers with an overwhelming +80% of customers would recommend.

Stone is free to pre-pay and has no conflicts with controlling banks

Stone is not part of a receivables locking agreement called SCG (Guarantee Control System). This agreement had been limiting Cielo and Rede’s ability to pre-pay

Merchants. Cielo and Rede control the majority of the market at around ~70%.  Stone also is not owned by banks, hence they are less prone to paying incremental rebates to issuing banks and can be more aggressive in pre-paying.

Hubs

STNE’s hubs are the primary distribution model for Stone solutions to brick-and-mortar merchants. These hubs are located in small and medium sized cities, or suburban areas of larger cities, and are designed to provide hyper-local sales to SMB clients. Hubs are small offices the local team uses to prepare client routes, hold morning debriefings and external meetings, store POS equipment, etc. Each hub has about 5-12 people with the vast majority in sales, 1-3 support and one sales leader. 

The hub strategy is a key differentiator for Stone, and also an important driver in helping the company win and retain clients. Managment has stated that older Stone hubs are able to achieve ~20% market share vs 8% for STNE’s national market share. In addition, the older hubs have very little churn sub 1%. The hubs allows STNE to scale considerably while maintaining a local footprint, as shown by its declining SGA/Revenue from 26% in 2016 to 14% in 2019.

Brazil industry overview

eAcquirers earn revenues three ways:

1. Merchant discounts (fees charged by merchants based no transacted volume)

2. Service or POS rental fees (fees non-volume linked and generally linked to a POS usage or other services provided

3. Interest income (for anticipating future receivables to merchants, on sales already performed.

 At the time of inception, all large banks joined two JVs to foster credit and debit card acceptance in Brazil. In the first group Citibank, Itau and Unibanco were the sole owners of Redecard and the sole processors of MasterCard. In the second group Bradesco, Banco do Brasil and Santander owned Visanet (Cielo) and only accepted Visa. The brazilian acquiring industry is highly concentrated due to its history, and the top three players are estimated to have more than 80% of the market. 

After the IPO of Visanet and the end of brand-acquirer exclusivity in July 2010, the market started to fragment. Santander Brasil was one of the first and most successful players with ~10% market share

Brazil currently has ~7mm SMB, a number predicted to grow ~2% per year. Excluding manufacturers ~15% of the market, the total addressable market share is ~6mm (commerce and service providers). The net new additions, around 120k a year, are still a substantial market for STNE, considering new clients are more sensitive to fees.

Over the past 10 years, Brazil has grown penetration for most years between 150-200 bps per year. The Brazilian card association (ABECS) also forecasts the ratio of card/personal consumption, currently at ~35%, to grow. International peers such as US and UK stand much higher at 45% and 65% respectively. Although, the market has room to grow, the crux of the thesis is not based on secular growth, but rather STNE taking market share.

The majority of the market is in credit cards 60% vs debit cards 40%, but we see a relatively larger increase in debit card going forward. Since deregulation, the industry has seen MDR pressure from around 3% in 2008 to ~2.5% today for credit cards and a much smaller decrease for debit cards from 1.6% to 1.45%. Furthemore, in Brazil the banks have been able to preserve more of the economics as interchange fees have fallen less than MDRs. Banks used to keep ~50% of the economics of a card transaction in 2008 vs ~66% today for credit and ~58% for debit.

Valuation

1. Active merchants 

1. STNE has grown active merchants from 82k in 2016 to ~500 in 2019, up 88% last year.

2. Active merchants is a proxy of subscription services.

2. Total Payment Volume (TPV) 

1. TPV has grown from R$28 billion in 2016 to R$129 billion in 2019, up 55% last year.

2. Net revenue from transaction activities is a function of both active merchants and transactions per merchant.

3. Financial income 

1. This is derived from receivables and is the largest revenue generator ~50%, and has grown from virtually nothing in 2016 to R$1.3 billion last year. 

• It is quite difficult to make forecasts and we generally tend to buy based on a large margin of safety and strong business fundamentals. Nonetheless, the calculations above provide a general guidance and should be taken with caution.

• The current global uncertainty sparked by COVID-19 has thrown or will throw pretty much any excel model down the toilet.

• It is difficult to pinpoint a fair value for such a business, but considering the growth profile, strong business model and potential to enter other lines of business we believe the outlook is strong for STNE. 

• Our base case assumes a ~20x TTM EBIT for a current upside of 58%.

• While the upside echos STNE’s price prior to the recent sell-off, we are not anchoring our valuation on it. Rather, over the next 3 years it is not unreasonable to see STNE’s valuation reflect its fundamentals more accurately.

On a side note, Berkshire has a 5% stake in the company as of their latest 13F-HR.

Risks

We are seeing a rising churn rate in the industry as deregulation has heated the competitive landscape. Incumbents’ willingness to lower price has poured kerosene, creating a hostile environment. However, due to the nimble nature of their business and continuous market share acquisition (lowest cost provider), Stoneco should be in a better shape to weather the storm.

I don’t have a view on the Brazilian Real or the Brazilian economy but needless to say there is currency and country risk.

Catalyst

Since there hasn't been any material disclosure, we attribute the current sell-off as part of the broader market. We believe that over time investors will decouple STNE from the broader market.