Description

XP is Brazil’s leading technology-driven financial service platform that is growing and gaining share from traditional banks. XP offers the broadest range of investment products at more competitive prices and has developed strong relationships with over 11k independent financial advisors (IFAs) over the past several years since its IPO in 2019. The stock is now lower than the IPO price despite having grown assets and earnings at a double digit CAGR. A premium multiple should return as the effect of macro pressures and recent elevated expenses abate.

Revenue breakdown:* (1) Brokerage commissions (34%)  

 (2) Asset management fees (26%)  

 (3) Issuer fees (24%)  

 (4) Insurance brokerage, educational, distribution etc. (16%) .  

Q2 Revenue breakdown by channel:  Retail (77%), Institutional (12%), Issuer Services (5%), Digital content/other (5%). Revenue is predominantly generated in Brazil with 3% generated in the US.

Missed street expectations have created opportunity 

The last two quarters have not been clean. The reaction seems disproportionate. Consensus 2022 EPS estimates have come down approximately 8% from Dec 21’ while the stock has declined over 30%.  The market has clearly taken away the premium multiple and is betting that growth will stall for the foreseeable future.  What happened?

Q12022’ :  Retail revenues contracted  11% QoQ  which led to  weaker operating  leverage and  margin pressure. EBITDA margin of 31.4% down from 32.9% in 2021 Q1.  Retail revenue yield declined materially as much as 21bps sequentially to 1.15%, the lowest level historically.  Capital markets activity was the main culprit as January was particularly weak.  The issuing business is still under pressure but recovered from January lows during the rest of Q1 and into Q2.

Q22022’:  Issuer activity picked up from January lows as well as overall retail revenue and the revenue yield also ticked up but the EBITDA margin ticked down again as expenses were particularly high concentrated in bonuses, data processing and salaries as XP invested heavily in new hires.  The street clearly mis-modeled this dynamic.  XP hired 2000 employees over 2021 mostly in the internal advisory business but believes this has a 1 yr payback. Managment indicated on the call that headcount growth will decelerate going forward.  To make matters worse, the company showed cash flow using a different metric than Q1 which made previous comparisons difficult and rattled some holders.  The IR team clearly needs to improve their communications.

Secular share gains continue

XP locked up a sizable position (11,300) of the Independent Financial Advisor network. Many of these Advisors are exclusive to XP for a 10 yr period starting in 2020.

This was a large upfront investment (100mm quarterly amortization) that should secure their position and growth in the market for some time.

Xp offers 800 products versus a fraction of that for Itausa and Bradesco.  Fees are generally lower than competitors across most of the product groups.

Xp has gained mindshare with smart investments in its brand through increased financial education and events like Expert .  NPS is a solid 76.

Tuck in M&A solidifies XP's market position. Recent examples include Banco Modal and equity interests in Asset Management firms that give XP clients access to products unavailable in Brazil.

Targeting different channels with tailored brands: XP investments-mid-high net worth , Clear-power traders, Rico-millennials/digital native

Diversification has been effective

Increased fixed income activity given higher rates has muted the effect on earnings from lower equity which will likely have more than quadrupled since the IPO by year end 2022 despite a tougher macro backdrop and much higher interest rates.

New products in credit card (300k+ ) cards and insurance have grown to 10% of quarterly revenue albeit need more scale to hit profitability.  Credit products are linked to brokerage accounts so they are to a large extent secured and likely will not cause any large credit loss issues.

Itausa Ownership selldown continues

Itausa has indicated it expects to sell its stake below 10%. The decision stems more from the bank’s own capital management plans (the XP stake does not get equity treatment and therefore artificially depresses their CET1 ratio).  Although an overhang, the sale is no reflection of XP prospects.

Itausa recently announced the sale of 6.5mn XP class A shares October 4, 2022, or 1.2% of XP’s total shares.  Their stake is now at 51mm or 9.2% of the shares outstanding. 

They sold a 1.4% stake for R1.2bn in December 2021, a 2.1% stake for R1.8bn in March 2022, a 1.3% stake (7mn shares) for R665mn in July 2022 and a 1.2% stake (6.5mn shares) for R660mn in October 2022.

This all implies potentially another 10.5mm shares will be sold in 2022 given comments in March they planned to sell 24mm shares this year

There has been interest from several parties in buying all or a portion of whatever stake Itausa sells.  General Atlantic, one of the original VC investors that sold a stake on the IPO in fact bought back almost $100mm after the stock decline in the wake of the Q2 report.

Excess Capital understates ROE and implies potential for capital return

XP has approximately R7bn in excess capital, an implied 28% Basel capital ratio.  The peer group is closer to 15%. ROE, which has declined as have margins of late, is still well in excess of peers but is likely understated given the excess capital and certainly has upsides as margins recover.. 

In May 2022, XP announced a R1B share repurchase on the Class A shares but there is certainly room for that to expand. On the Q2 conference call, they also

mentioned the prospect of buying unlisted B shares back from Itau (8.3mm owned).

Inside Ownership

90% of net worth of management is in the stock

Attractive Valuation

XP went public in 2019 at $27 (over the indicated range of $22-25) and was heavily oversubscribed .  At that time.AUC was approximately R400B.  At the end of 2022 it will be north of R900B, or a 33% CAGR.  Much of the decline in the stock from the IPO ($40’s down to $30’s) period can be attributed to the increase in Brazilian interest rates (Selic has gone from 4.5% to 13.6%) exacerbated by the aforementioned earnings missteps. Higher rates hurt capital markets activity and investors are less likely to look for more sophisticated products (mutual funds and hedge funds) which XP offers.  As rates ease, the secular growth rate should accelerate and the multiple will likely expand.

The stock currently trades at a historically low 11.6x 2023e EPS for a growing business (temporarily subdued) gaining share with a higher than average ROE as

seen in the table below. XP's long term growth are also above average.

Risks

High interest rates persist in Brazil

Operating leverage does not materialize

Increased regulation affects exclusivity agreements

* Based on most recent six months

Catalyst

Potential cleanup of remaining Itausa stake

. 

Interest rates peak and start to decline

Increased growth from tuck-in M&A

Election results create more favorable Brazilian market sentiment