Fintech, digital payments and the idea of a cashless society has been one of the more dominant themes over the past few years. These themes have led to the rise of companies such as Visa (NYSE:V), Mastercard (NYSE:MA), PayPal (NASDAQ:PYPL), Square (NYSE:SQ), Tencent (OTCPK:TCEHY) (WeChat Pay) and Ant Financial among many others. However, I believe that EMs (particularly Brazil) stands to benefit from secular growth in these industries as they have lagged behind China, Europe and the US.
The first thing we learned early on was that Brazil was a country ripe with opportunity. Not only because of its large population and developing economy, but also because of the relatively weak presence of electronic payments and simple, user-friendly technology to support modern commerce and foster Brazilian entrepreneurship... in 2000... (the) incumbent providers of payment processing services were unable to service the needs of online merchants.
I will be doing a deep-dive on PagSeguro in order to better understand its business model and how its operational metrics compare to StoneCo, its fellow Brazilian fintech company. I will also draw upon lessons from the Square story and what this may mean for PagSeguro's future growth prospects.
Brazil is a geographically vast country, of continental proportions, composed of more than 5,500 cities and 200 million people to date. According to Neoway, there are currently approximately 9 million small and medium businesses (SMBs) in Brazil who are trying to grow their businesses in the context of a high cost banking environment and the infrastructure challenges that such a vast geography imposes.
According to the founders of StoneCo, "Brazilian entrepreneurs have historically suffered from the general lack of transparency regarding the transaction fees they pay for their banking services... one of their biggest frustrations in running their business."
However, despite these inefficiencies, companies such as StoneCo and PagSeguro were only able to enter the industry after regulatory changes in 2010. Prior to these changes, there were only 2 players in the payments field - Cielo (established by Visa and 3 Brazilian banks) and Rede (issues Mastercards and supported by Citibank (NYSE:C) and Brazil's largest financial institution).
Brazil is particularly attractive as its payments market remains less penetrated and has greater growth upside than more mature economies. According to the World Bank and ABECS, electronic payments volume represented 28.4% of total household consumption in Brazil in 2016. This penetration percentage is lower than comparable measures of 46.0% and 68.6%, respectively in the United States and the United Kingdom, during the same period.
Furthermore, Brazil has a better opportunity for growth in digital payments compared to more mature economies. Only 59% of the Brazilian population above age 15 reported having made or received a digital payment, compared to 92% in the United States and 97% in the United Kingdom. Credit card penetration levels are a fundamental driver for the digital payments industry, yet, according to the World Bank, in 2015, only 32% of the Brazilian population above age 15 held a credit card, compared to 60% in the United States and 62% in the United Kingdom.
Despite the under-penetration of electronic and digital payments, there are several trends that demonstrate Brazil's near term growth possibilities. this includes increasing use of digital payments in Brazil instead of cash and checks (in 2014, the transaction volume for payment cards overtook the transaction volume for checks for the first time). Other trends include the increasing shift to conducting commerce online or through mobile devices due to growing access to mobile internet. Finally, the growing use of omni-channel commerce, expanding use of high tech POS, increasing provision of financial services by non-bank firms.
Understanding PagSeguro's Business
PagSeguro started as an online payment platform to provide the digital payment infrastructure necessary for e-commerce to grow in Brazil. Later expanded from online payments into point of sale, or POS, payments, allowing merchants to receive in-person payments and has since expanded its range of services in its digital ecosystem.
It has distinguished itself as being the only Brazilian Fintech company involved in the following five pillars:
- Multiple digital payment solutions (also StoneCo)
- In-person payments via POS devices sold to merchants (also StoneCo)
- Free digital accounts
- Issues prepaid cards to clients for spending/withdrawing their account balances - just one of their 6 cash-out methods and 30 cash in methods thus clients do not need bank accounts
- Operates as an acquirer
The entire range of services offered in the PagSeguro digital ecosystem
The main difference between PagSeguro and StoneCo appears to be that PagSeguro does not simply process transactions, their end-to-end digital platform creates an ecosystem where clients can transact and manage their cash, without the need to open a bank account.
Merchants: PagSeguro has made an effort to target the long tail market which largely consists of micro-merchants and SMEs who have been ignored or underserved by the incumbents thus are mostly unbanked. These merchants are attracted by PagSeguro's innovative, scalable and low-cost products and services which also has simpler onboarding, no paperwork and a high acceptance rate, while maintaining levels of fraud below those required by the card schemes.
With a PagSeguro digital account, merchants may transfer their revenues to a bank account but also spend it directly on the PagSeguro platform by buying online, making peer-to-peer transfers or transferring their balance to the PagSeguro prepaid card, allowing them to buy goods and services in-person and online or withdraw cash.
PagSeguro derives its revenues from 3 sources. Firstly, it earns from the sale of its POS devices. Secondly, it earns from charging a transaction fee as it helps merchants process payments. As seen below, for a transaction of 100 BRL, it earns around 3.2-5% as a transaction fee. Thirdly, it earns from advancing merchants their money that would have been paid in installments, a common practice in Brazil. This is a high margin segment of their business as they are able to charge a 42% rate, a small amount compared to the incumbents.
I believe that PagSeguro is similar to Square in several very important ways - in that it genuinely helps micro-merchants. Firstly, the sign-up and onboarding process is hassle-free which is line with the goal to gain as many new users as possible. PagSeguro has a 100% online onboarding process, without paper and with a very quick turnaround. Furthermore, customers such as micro-merchants benefit greatly as they do not need a bank account to join the Pagseguro ecosystem. Compare this to the traditional payment processor model which required a detailed application, a phone call audit, and an expensive equipment purchase and/or lease.
Secondly, like Square, PagSeguro provides business owners with business intelligence features that they never had before. What’s the most popular drink on the menu? The busiest day? And other data that lets small business act more like big business.
Consumers: Ordinary consumers can also create a free PagSeguro account to pay merchants but also the option to save their card details on PagSeguro's digital wallet solution and to make and receive peer-to-peer payments. PagSeguro's offerings are hence not just limited to businesses but also to consumers. Its digital wallet solution is one of the three most popular digital wallet solution in Brazil (provides the same service as Apply Pay, Samsung Pay and Android Pay).
Understanding StoneCo's Business
StoneCo is a Brazilian provider of Fintech solutions that allows merchants and integrated partners to facilitate electronic/digital payments seamlessly across in-store, online, and mobile channels through a website or inside of a mobile application. To put it simply, this allows its clients who use StoneCo's technology to get paid quickly and easily. They also provide digital product enhancements such as split-payment processing, multi-payment processing, recurring payments for subscriptions, and one-click buy functionality for its clients.
Like PagSeguro, it earns its revenues from the same 3 channels. However, unlike PagSeguro it focuses on merchants who have larger businesses. Furthermore, unlike PagSeguro, it has a large staff of sales and customer service personnel who are hired all over Brazil in order to provide a customer-oriented business model.
Example of a StoneCo POS being used for a digital payment transaction
Comparison Of Operational Metrics
In terms of revenue, PagSeguro is the clear winner. Despite having a larger revenue base (>3x in 2017), PagSeguro had a higher revenue growth rate in 2017 of 121.66% vs. StoneCo's 74.27%. This looks set to continue into 2018 with Yahoo Finance aggregating revenue growth estimates to be over 150% YoY for PagSeguro as compared to the slightly over 100% growth for StoneCo.
Interestingly for PagSeguro, its largest revenue segment has always been revenue from transaction services. Encouragingly, in 2017, it became the highest growth segment for PagSeguro (155% YoY), a stark contrast from 2015 when it had the lowest growth (67%) among the different business segments. According to management, this was a result of "a continued increase in our customer base and TPV" and this looks to be the main revenue driver for PagSeguro going forward as well.
Revenue from sales are revenues from the sale of PagSeguro's POS devices to its merchant clients. Financial income comes from the PagSeguro feature which allows for payments in installments thus allowing PagSeguro to earn a certain percentage.
On the other hand, StoneCo's biggest revenue segment is Financial Income with revenue from transaction activities a distant second. StoneCo's financial income is generated by fees charged for the prepayment of clients’ receivables from credit card transactions. Some merchants allow cardholders to elect to pay for purchases in multiple installments. StoneCo (like PagSeguro) allow merchants to elect early payment of single or multiple installment receivables, less a prepayment fee.
While there are differences in the importance of certain business segments when comparing PagSeguro and StoneCo, all of their business segments are correlated with Total Payment Volume (TPV). In both of their earning results, growth in business segments were largely attributed to the increase in TPV. Hence, continued high growth in TPV is essential to sustain high top-line growth for both companies.
Interestingly, despite having a first mover's advantage, PagSeguro is lagging behind StoneCo in terms of TPV that they process though they are catching up. However, PagSeguro's higher revenue despite having a lower TPV means that they're better at converting payments processed into revenue. This can be seen in their higher take-rate (total revenue/TPV) of 4.9% (Q3 FY18) as compared to StoneCo's take-rate of 1.87%.
PagSeguro's higher take rate as well as significantly higher transaction revenue implies that PagSeguro charges a higher fee for each transaction. While this means a higher revenue stream for PagSeguro, this has not stopped it from enjoying high TPV growth rates as it closes the once wide gap with StoneCo.
PagSeguro's Bullish Thesis
Part1: High growth in TPV and active clients
I will start with a quote from Habour Spring Capital's Q2 Letter outlining reasons for its long position by explaining how the company up-ended the existing merchant acquiring business model. The first aspect of my bullish thesis is hinged on how PagSeguro can continue to achieve high growth in active clients and TPV.
(1) offering cheap equipment; (2) allowing merchants to purchase devices and pay no ongoing rental fee, unlike the offering of competitors; (3) creating a viral, self-service model which required little to no customer service; (4) advertising the product broadly to kickstart adoption.
I agree with Harbour Spring Capital's view on PagSeguro's competitive advantage in the merchant acquisition business which I believe allows them to charge a higher transaction fee while maintaining high growth in its number of active clients and TPV. This in turn will allow it to enjoy high revenue growth (as long as take-rate remains stable) and improve margins as it enjoys scale thus lessening the impact of various fixed costs.
PagSeguro's potential in growing TPV is shared by management who believes that as it currently only controls about 4% of market share, it "still has a long way to go."
The increase in TPV and active clients will not only have a positive effect on top line growth but also improve margins as certain fixed costs come down (as a percentage of sales). Selling expenses as a percentage of sales have fallen from 24.98% in FY2014 to 7.94% in the most recent quarter. Margins have also improved and stabilised, operating margins were at 12.12% in FY14 but have improved to 27.56% in FY17.
Continued margin expansion can be expected in the future due to PagSeguro's asset-light model. PagSeguro's focus has been on mobile and online which is also reflected in its distribution and onboarding process. Everything is completed online hence it is a very scalable model. Furthermore, unlike other technology companies which spend a lot on advertising and marketing, PagSeguro has largely depended on brand awareness (through its parent company UOL) and word-of-mouth. For example, Q1FY18 saw a 107% increase in revenue but only a 30% increase in marketing and advertising revenue.
I believe that PagSeguro will continue to see high growth in its financial income segment through the provision of early payment of installment receivables. This was said by management in its F1:
Micro-Merchants and SMEs have historically faced difficulties accessing early payment of installment receivables from the incumbent payment processing providers in Brazil. In addition, when they provide the feature, the incumbents often require customers to request early payment on a transaction-by-transaction basis. Furthermore, conventional funds generally involve high interest rates in Brazil. According to the Central Bank, at September 30, 2017, when the SELIC, the Central Bank’s overnight rate, rate was 8.15%, financial costs were 127% per annum for a personal loan, 321% per annum for overdraft credit for a private individual, 339% per annum for overdraft credit for a business, 332% for revolving credit for a private individual and 264% per annum for revolving credit for a business. In comparison, we offer our early payment of installment receivables feature for merchants at a rate equivalent to 42% per annum. Given these comparatively low interest rates, we believe there is a large market opportunity for our early payment of installment receivables feature.
Part 2: Well-developed ecosystem to increase stickiness and customer loyalty and well positioned to offer new value-added products and services.
The second aspect of my bullish thesis on PagSeguro, especially relative to StoneCo is the breadth of the PagSeguro ecosystem and its continued innovation to increase stickiness of its products and customer loyalty.
PagSeguro's wide product offerings include a market leading e-wallet solution, cards that allow you to spend money inside your PagSeguro account, bill payments and other software systems for merchants. These provide a powerful network effect that can not only entrench SMBs over other offerings but also provide incremental monetization opportunities. The incredible breadth of its product offerings have led some to compare PagSeguro favourably to Alipay (NYSE:BABA).
Some of its more popular value-added services among existing clients includes the ability for PagSeguro merchants who are largely unbanked to use their PagSeguro accounts to pay the bills and top up their phones.
An example of its plans to continue expanding its value-added products and services can be seen in the recent Q3 earnings call with regards to the provision of loans to merchants.
Recently, we launched our lending products, PAGS Capital... On average, PAGS’ charge rates almost 3x lower than banks. We are seeing against that and for now, this brought up (our) margin through our financial results and we expect it to increase stickiness in the loyalty of our merchants.
This is where Square's path could be an example for what is to come for PagSeguro and the possibilities for its lending products. Square's lending products under Square Capital was launched in 2014. Since its launch, the loan volume has increased tremendously, more than 4x since Q2'15 demonstrating the huge demand for cheap loans for micro merchants and SMBs.
Pagseguro has also been at the forefront of innovation among Brazilian fintech companies. This includes its development of its own QR code payment solution for its clients (mostly micro-merchants) in the vein of Alipay and WeChat Pay in China. It has already gradually been rolled out to merchants and management "believe[s] QR code payments will be an important complement to our portfolio of products as a new alternative to foster the adoption of electronic transactions in long-tail."
Finally, PagSeguro's extensive digital ecosystem allows it to differentiate it from its competitors as acknowledged by management. "By being only a payment solution, only the MDRs and prepayment, at some point, you cannot differentiate from your competitors. So what we have in mind is to have a more robust digital account where the merchants can come to us, they can have payments and they can also use additional services."
Part 3: Growing with its merchants and consumers
PagSeguro has often been compared with its American counterpart - Square which while similar has a more mature business. One takeaway from Square that is especially relevant to PagSeguro has been the development of Square's merchants' business. Starting out as micro and small businesses, they are able to grow their businesses over the years and Square has benefited as it processes more transactions and its clients use more of their different products.
I believe that this process has already begun as average spending per active merchant has increased significantly since FY14. Calculated as TPV/active merchants, average spending has increased from 7,991 BRL in FY14 to 13,785 BRL and should only continue to increase as merchants utilise PagSeguro's entire suite of products to grow their business.
Furthermore, just like Square, I believe that while its current target users are micro-merchants and SMBs, there is potential for it to expand to larger merchants. For example, Square recently announced the launch of its Square platforms for restaurants which provides more than just payment processing.
Finally, an area of great untapped potential for PagSeguro is its consumer offering. While PagSeguro currently has products for individual consumers, it is currently focused on acquiring new merchants and business owners thus there are only metrics for number of active merchants. However, it is inevitable that PagSeguro will take a similar path as Square with its Square Cash App. Square's Cash App recently overtook PayPal's Venmo app in terms of popularity and use.
Forbes explained that its popularity is due to the fact that "Square's payment processing service is now used by over two million merchants, giving their Cash App real-life exposure and value to millions of consumers. On the other hand, Venmo is almost purely a peer-to-peer payment system, with a much smaller footprint among merchants." Hence, as PagSeguro continues to acquire merchants, I believe that its consumer offering will become more popular.
Getting consumers onboard is only the first step. Where PagSeguro can learn from is Square's plan to introduce new bank-like products for ordinary consumers. This was emphasised by then CFO of Square, Friar, "Anything you do today with a bank account, you should look to the Cash App to begin to emulate more and more of that." This includes services such as the ability to invest in stocks or a savings product. It already offers users the option to invest in cryptocurrency in 2017. Like PagSeguro, Square has stated that it is targeting the 30 million underbanked American consumers. If Square has managed to so successfully appealed to the under and unbanked Americans, this bodes well for PagSeguro where Brazil has 55 million unbanked (27% of the population).
Risks associated with PagSeguro:
I believe that the biggest risk associated with PagSeguro is competition. Despite focusing on the niche long-tail market of micro-merchants, there is a long list of competitors who are trying to eat at PagSeguro's market share.
The biggest victim of increased competition has been PagSeguro's hardware sales. Revenue growth from sales peaked in Q1 FY17 at 170% YoY growth and has actually declined YoY for every quarter in FY18 thus far. This has been a result of PagSeguro having to decrease price of its various POS devices as a result of competitive pressure. For example, its competitor (Cielo) is selling its POS device for 2 BRL/month, which has forced PagSeguro to lower its prices to 5 BRL/month.
Revenue from sales used to make up 26% of total revenue (FY16) but this has declined to 9% as of the recent quarter. Management has also said that this will continue to trend down into the low single digits.
More importantly though, I believe that the increased competition has hurt the take rate (calculated by taking total revenue - revenue from sales / TPV) over the years. The take-rate was at 7.51% in FY14 and has steadily declined though it has largely stabilised in the 5 - 5.50% range from FY17-FY18. I believe that due to the increased competition, PagSeguro has been forced to lower the various transaction costs which explains why transaction revenue and financial income revenue has not risen as quickly as TPV growth.
First, a comparison between StoneCo and Pagseguro. Using research done by fellow Seeking Alpha contributor, CVC Research who indicated that in October 17, "[StoneCo] is also being priced at a 75% premium to PAGS in terms of EV/S and a 150%+ premium in terms of P/E based on CY18."
On the other hand, PagSeguro and Square appear to be valued similarly with regards to its Price to Sales (NASDAQ:PS) Ratio as seen below. This would suggest that PagSeguro actually trades at a slight premium to Square, surprising given that PagSeguro demands a great Equity Risk Premium considering its business is in Brazil, an inherently riskier country than the US.
However, when one examines other valuation ratios, PagSeguro's ability to convert revenue into profit and free cash flow gives it a clear advantage over Square. I am confident that PagSeguro can be a multi-bagger and compounder in the next few years though it is possible that it sees a much more volatile path in the next few years.
With regards to metrics, I will be keeping a close eye on whether it can continue to sustain its high revenue growth - in particular transaction revenue and financial income revenue. Furthermore, I am interested in seeing if PagSeguro can continue to stabilise its take-rate while increasing active merchants and average revenue per active merchant.
Disclosure: I am/we are long PAGS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Will continue to add on dips