Success Of New Business Ventures Critical To Justify Current Valuation For PagSeguro Digital And StoneCo

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About: PagSeguro Digital Ltd. (PAGS), STNE
by: Carlos Macedo
Summary

It is unlikely the acquiring businesses of both PAGS and STNE will still be growing fast enough to justify a 13-15X P/E multiple in 2024 (what valuations suggest).

Support for current share prices has to come from growth generated by non-acquiring sources: banking for PAGS and software/banking for STNE.

While there is much hope, the markets the companies are entering are competitive, with established and new players. The companies’ success in merchant acquiring may not translate.

Delays in rolling out and ramping up these new ventures could disappoint the high expectations for both companies and weigh on share prices.

Editor's note: Seeking Alpha is proud to welcome Carlos Macedo as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Essential. Click here to find out more »

Editor's note: Seeking Alpha is proud to welcome Carlos Macedo as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Essential. Click here to find out more »

PagSeguro Digital (PAGS) and StoneCo (STNE) both tap into the potential of the payments and banking markets in Brazil. With the growth in revenue/client slowing, the companies are branching out to new services. Current valuation levels (2019 P/Es of >30X) already reflect at least partial success in these ventures, which, given the competitive environment in the new segments, is at best uncertain. Delays in rolling out and monetizing the businesses could weigh on shares in the near to medium term, given the high expectations already built into prices.

PAGS and STNE listed shares in the last 18 months at high multiples to support their expansion into the Brazilian payments market. The companies’ growth, combined with regulatory changes, led bank-owned incumbents to aggressively lower prices to maintain market shares, casting a shadow over the prospects for the industry. This hurt valuation for all industry participants, though much more severely for the incumbents. As it stands now, incumbents owned by banks, despite representing over 70% of the share of net income in the segment in 2018, account for roughly 30% of the implied market cap.

This discrepancy in market value is largely driven by the growth expectations for incumbents relative to newcomers. As per consensus estimates, both PAGS and STNE are expected to expand net income by over 30% a year between 2018 and 2020, while earnings for Cielo (OTCPK:CIOXY) (the only listed bank-owned incumbent) are expected to decline 20% per year over the same period. However, current market values suggest that the difference in growth would extend much further than 2020. They also start to raise the questions regarding the value of the segment as a whole, with implications for all participants.

Competitive pressures to limit merchant acquiring earnings growth in Brazil to less than 10% per year through 2024

As per the Brazilian Central bank, payments companies in Brazil (including all bank-owned incumbents and recently listed newcomers) generated R$5 billion in net income in 2018, on revenues of R$16.3 billion. These figures may be slightly understated since they only consider payment companies registered at the Central bank – though all the relevant market participants, including PAGS, STNE, Rede, Getnet and Mercado Pago) are accounted for. These results were on the back of total payment volume (TPV) of around R$1.4 trillion (based on ABECS and Central bank data), a 14.3% increase over 2017. For 2019, card association ABECS expects TPV to expand 15.7%, leading TPV to account for a historical high of 34.8% of private consumption expenditures.

Sector trends that weighed on profitability in 2H2018 – stronger price competition and more intense marketing and sales efforts – are likely to continue in 2019, particularly for the bank-owned incumbents. For instance, on April 17 Rede announced that it was not charging merchants to prepay credit card receivables for merchants that had accounts domiciled at Itau Unibanco (Rede’s controlling shareholder), a move that could save up to a third of industry earnings if broadly adopted (no one has matched Rede so far). This should weigh earnings growth for these incumbents (consensus estimates for Cielo call for 2019 net income to decline 36% yoy). For the most part, this should offset the strong gains in earnings for newcomers: as per consensus, net income for PAGS and STNE is expected to increase by 65% in 2019. Based on these offsetting trends, net income for the entire segment should expand by less than 5% in 2019.

Extending this rationale five years forward, to 2024, these offsetting trends should continue to limit overall industry earnings growth. Assuming GDP growth of 2.5% and inflation of 3.75%, along with penetration TPV into PCE expanding to 42.5%, leads to a 2019-2024 CAGR for TPV of 18%. Some price erosion (particularly in the next 2-3 years) should keep revenue CAGR at 11%. Further spending in marketing and distribution (including further POS terminal subsidization), as well as tighter margins on prepayment, should offset gains with scale and constrain 2019-2024 earnings CAGR for the segment below 10%.

Competitive pressure and tighter spreads should keep merchant acquiring net income to increase at a CAGR of below 10% through 2024 (R$ million)

Source: Brazilian Central bank, estimates

Examining the valuation divide: more than just merchant acquiring

It is likely that, by 2024, the acquiring segment in Brazil will have stabilized into a new structure, shaped in large part by the current turbulence. At that point, with penetration at levels comparable to some developed countries today, TPV growth is likely to slow, but pricing pressure from competition should also abate, leading to little change to industry earnings growth (in other words, expected earnings CAGR post-2024 should stay around 10%). It is also likely that growth for individual companies engaged in this market also converges – at least for services inherent to pure merchant acquiring (which in Brazil includes prepayment).

If so, all the companies should trade at similar multiples of 2024E earnings. Based on the calculation above for industry earnings, current share price levels would indicate a P/E ratio of 13.7X. This is much lower than the current >30X levels at which PAGS and STNE trade and the implied 20.8X 2019E earnings at which the overall segment trades, though more compatible with growth levels the merchant acquiring segment is likely to post.

If current market caps for listed acquirers already captures this medium-term outlook, then the current share each company has of the segment market cap should be equivalent to the company’s share of 2024E net income. This means that, for PAGS, 2019-2024 earnings CAGR would be 17.0%, and for STNE, it would be 20.8%. However, it also means that, for Cielo, 2019-2024 earnings CAGR would be -9.4% (even though consensus forecasts have Cielo’s earnings flat in 2020 after a sharp decline in 2019).

It is unlikely that Cielo’s earnings decline at a CAGR of nearly 10% (or 50% in absolute terms) through 2024. At R$2.1 billion in 2019 as per consensus estimates, earnings are already expected to be down nearly 50% from peak levels in 2017. Considering that Cateno, the company’s payment processor partnership with Banco do Brasil (OTCPK:BDORY) that is unaffected by the current turbulence in the acquiring market, generated R$500 million in earnings for Cielo in 2018 that would likely expand at overall segment rates in the next five years, this would leave Cielo’s acquiring operations earning roughly R$400 million in 2024 (compared to R$2.8 billion in 2018).

More likely than this very negative outlook for Cielo, share prices for PAGS and STNE already factor in a fairly positive outlook for the companies’ recently announced non-acquiring initiatives.

The key to PAGS’s entrance into banking is monetizing clients

On May 15, PAGS launched a marketing campaign for PagBank, the company’s digital banking initiative. PagBank offers a free bank account that allows users to receive their paychecks, top up prepaid mobile phones, make or receive transfers and pay bills, in addition to requesting loans. The account can be opened in three minutes and accessible primarily through a smartphone app. The PagBank account is connected to each user’s PAGS merchant acquiring account and charges fees for more than five transfers a month, withdrawals at an ATM, and card usage abroad. While the features are, for the most part, similar to those offered in PAGS’s already existing payment account, PagBank makes them available to non-merchant acquiring clients.

This digital banking segment in Brazil is becoming increasingly competitive, and PagBank adds another sizeable player to the fracas. The features of the PagBank account are fairly comprehensive but fall short of those offered by other digital banks such as Banco Inter or Nubank. That said, the tie into the merchant acquiring account offered by PAGS creates a captive market and should ensure some stickiness.

Ultimately, PAGS’s goal should be to increase the revenue generated per client, which PagBank helps to accomplish by adding additional services that can generate revenue. This is particularly important because revenue per average client for PAGS has been relatively stable for much of the past 12 months (likely driven by a combination of lower pricing on POS terminals, change in mix towards smaller merchants, and the slow adoption curve for new merchants). However, as many of the new banks in Brazil are discovering, adding clients to a free digital banking service is relatively easy (albeit somewhat costly, given advertising spending). Monetizing these clients is more challenging – a challenge PAGS will have to overcome to justify current valuation levels.

STNE’s three-pronged approach of software, credit, and banking depends on continued client growth

As highlighted in the company’s 4Q earnings call, STNE is pursuing three avenues for non-acquiring growth.

  • Software. STNE continued to launch and deploy software to its clients, emphasizing Collact, VHSYS and Tablet Cloud during its 1Q earnings call. The company provided examples of how these offerings are helping its clients run their businesses, increasing traffic and profitability, not to mention stickiness to STNE’s own merchant acquiring services. This has been one of the company’s differentiating factors from the start, and it sees a R$9.5 billion addressable market.
  • Credit. STNE sees a R$75 billion addressable market in credit to SMEs. The company is rolling out the product, earning a fee to redirect loans to partner banks that take on the credit risk (partly aided by information on receivables provided by STNE).
  • Banking. STNE has already opened thousands of accounts in banking product, which is aimed exclusively at its clients. The product allows account holders to make transfers and pay bills/taxes and comes with an open banking API (in preparation for the open banking regulation currently being prepared by the Brazilian Central bank).

Much like PAGS, STNE is entering new markets that are partially defined by competition. Retail software in Brazil is dominated by Linx and Totvs, which have a combined market share of over 70%. Most of that is focused on larger merchants, giving STNE a clear entry path, but competitive pressures should intensify as technology becomes more widespread. For credit and banking, the competitors become large incumbent banks and new digital entrants, all of which are seeking to improve their position.

However, STNE makes it clear that these additional products are geared towards the company’s client base, not third parties. As such, expanding the client base becomes even more important. Growth in net adds has been decelerating in the last two quarters, in large part as a result of the higher base of comparison (the number of net adds per quarter remains solid). But the competitive environment is becoming increasingly more complex, particularly as incumbents start to erode STNE’s initial price advantage. For these new offerings to drive results and provide support for the company’s valuation, STNE needs to continue to add new clients at a strong pace.

Conclusion: Success of new ventures not assured, could hold back shares

Without these new initiatives to drive revenue growth, earnings growth for PAGS and STNE would move closer to overall levels for the segment (so close to 10%). Current multiples are not compatible with that level of growth, indicating that investors are already building in some success in their outlooks. However, the markets targeted by the companies in their new initiatives are competitive with many established players and hungry newcomers. More importantly, the companies’ impressive success in developing their merchant acquiring businesses may not extend to these new ventures. While the outcome is still some years into the future, delays in ramping up the business could make PAGS and (especially) STNE more exposed to the underwhelming trends in the acquiring business and keep both shares from performing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.