It's been an exceptional start to 2020 for StoneCo (NASDAQ:STNE), with the company up 7% out of the gate to add to its triple-digit return in 2019. The company has trounced the performance of its benchmark, the Mobile Payments Group (IPAY), and is one of the few IPOs to debut in 2018 to put up a 50% or better return. This is helped by the fact that the StoneCo has strong earnings growth, unlike the majority of unprofitable IPOs we've seen debut over the past 18 months. Besides, the company's revenue growth rates are exceptional, with industry-leading 66% growth in revenue over the past year. While investors have undoubtedly done well with the stock, it's finally beginning to get expensive at a revenue multiple of nearly 21. Based on this, I believe any further strength above $44.00 is an opportune time to book some profits.
Buttonwood Financial made an exceptional call on StoneCo in Q3 of last year, initiating a market outperform rating with a $44.00 price target. Thus far, the projected move has played out near perfectly since the recommendation, with the stock now sitting a stone's throw away from the price target. StoneCo reported massive growth in active clients for Q3 2019, up 82% year-over-year to 428,900. The company has also benefited from industry-leading take rates, with take-rates up 60 basis points on a sequential basis to 1.91%, a new quarterly high. Finally, revenue growth hit a new record at $161.1 million for Q3 2019, and new all-time highs in revenue are expected to keep coming in FY-2020 based on forward estimates.
While all of the above is excellent news, the stock is beginning to get expensive, with the stock now trading more than 10% above the average current price target of $40.20, and at a revenue multiple of over 20x, based on ~$588 million in trailing-twelve-month revenue. The other issue is that we're beginning to see some material deceleration in revenue growth rates, with quarterly revenue growth of 60% or higher being a thing of the past. This is not an ideal combination for a growth stock, even if it's a market leader like StoneCo, and this could make it tough for the stock to get through its old highs at $45.60. Let's take a closer look at the company's growth metrics below:
As we can see from the below chart of annual earnings per share [EPS], StoneCo has seen incredible growth, with annual EPS soaring from $0.13 in FY-2016 to estimates of $0.72 for FY-2019. These are outstanding numbers, with EPS more than quadrupling in three years, and the potential for another year of triple-digit EPS growth for FY-2019 ($0.37 vs. $0.72) if StoneCo can beat estimates. When it comes to growth stocks, few boast this type of earnings growth, and therefore StoneCo checks all the boxes from an earnings trend standpoint.
If we look forward to FY-2020 estimates, the company is expected to put up yet another year of strong double-digit growth with forecasts for $1.02 in EPS. Therefore, while the company may look a little expensive at a trailing-twelve-month earnings multiple of over 60 currently, it is not expensive at all when factoring in the potential for earnings of $1.02 next year. While there's no guarantee they will hit these estimates, this would reduce their earnings multiple to 40x, a very reasonable valuation for a company growing earnings at 40% per year or more.
If we move over to quarterly revenue growth rates, however, there are some pretty meaningful signs of deceleration here. As we can see in the chart below, StoneCo's quarterly revenue growth rate peaked at 83% in Q4 2018 and has slowly meandered down to the 55% level as of the Q3 2019 report. While revenue growth hit a record high of $161.1 million, the quarterly revenue growth rate registered a sequential deceleration of 1400 basis points (69% Q2 to 55% Q3). This drop-off in growth rates is what I would consider a material deceleration. It doesn't help that this is expected to continue into Q4 2019 and FY-2020.
I like to use a two-quarter average for revenue growth rates (white line) as it helps to smooth out any lumpy quarters and better dictates the overall trend. As we can see from the above chart, this deceleration is not a one-quarter anomaly (blue line) but is part of a pattern of meaningful deceleration. When it comes to StoneCo, this deceleration is not a quarterly one-off, but instead an evident slowdown in sales growth going forward.
While the prior deceleration was occurring above the 50% revenue growth rate and still allowed the company to hold a title as a hyper-growth company (50% revenue growth or higher), it is beginning to look like StoneCo is heading well below 50% revenue growth into FY-2020. Based on estimates for Q4 2019 revenue of $193.0 million, we are likely to see yet another sequential deceleration, with year-over-year growth expected to come in at 41%. This would mark the second quarter in a row of more than 1000 basis point deceleration in revenue growth rates. In addition, we will likely see the first sequential deceleration of more than 1000 basis points on the two-quarter average revenue growth rate (48% to 62%).
If we look out further to Q1 2020 and Q2 2020, forecasts are currently sitting at $196.4 million in revenue, and $212.4 million, respectively. This figure would translate to 42% growth in Q1 2020 and 39% growth in Q2 2020 and would drag the two-quarter average revenue growth rate down further to 40.5% by Q2 2020. This is a massive deceleration from where it sits today at 62%, and therefore, the company is going to put up colossal beats to prevent deceleration. As it stands currently, StoneCo will need to report revenue of $206.3 million in Q4 2019 to avoid another quarter of material deceleration. While anything is possible, this figure is $13.0 million above the current analyst forecasts of $193.0 million, and it will require a miracle to beat these estimates.
To summarize, while annual EPS growth is growing at a robust pace and revenue growth rates are at industry-leading levels, StoneCo itself is seeing material deceleration due to lapping such challenging prior-year comps. This is not ideal, as revenue growth is the lifeblood of any new growth company, and it becomes more challenging to trounce earnings estimates when revenue growth is suddenly decelerating at the current pace.
A material deceleration in growth rates alone is not always enough to derail a growth stock, but it can be an issue when combined with an expensive valuation. When it comes to StoneCo's current revenue multiple of over 20x, this is what I would consider being very expensive. Despite Square (SQ) and PayPal (PYPL) being the prior leaders in the Mobile Payments group, they never got near a revenue multiple of 20x. In fact, PayPal topped out at 9.0x price to sales, while Square topped out at 14.5x. Based on this, StoneCo is quite expensive at a current revenue multiple 30% above the peak of Square's revenue multiple.
Finally, from a technical standpoint, StoneCo is running up towards a prior strong resistance level, and an area where the stock saw strong distribution in the past. As we can see in the below daily chart, StoneCo has strong resistance at $44.15, and recorded three distribution bars in this area in early 2019, before plunging over 50%. While I would not expect the same nasty reaction on this resistance test, given that the stock has built out a solid base, I do believe that the stock will have a difficult time getting through its old high of $45.60.
For investors looking to add StoneCo to their portfolio, or increase exposure, I do not believe now is the ideal time to do so. The stock may have incredible growth and is clearly a market leader, but the valuation is no longer attractive at current levels. Therefore, I would view any rallies above the $44.00 level as an opportunity to take some profits, and I believe buying closer to support would be a much better use of capital than chasing at current levels. StoneCo may have a nice looking technical setup as it approaches its prior highs, but paying up to 20x price to sales for any growth stock, especially one with deceleration on the horizon, rarely pays off.
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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.
Additional disclosure: DISCLAIMER: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.