PagSeguro - The Next Super App Of Brazil
Summary
- Founded in 2006, PagSeguro began its operations as a merchant acquirer providing payment processing services. Today, the company is a hybrid of a bank and a tech company.
- Located in Brazil, a country with very high cash usage and a population of 210 million, PagSeguro is a disruptive player operating in a highly penetrable market.
- PagSeguro has grown its revenue from R$1.1 billion in 2016 to R$6.8 billion in 2020, and the number of merchants using its payment processing services has grown from 1.4 million.
- Traditional incumbent players have poorly serviced 60 million people, resulting in a massive penetration opportunity for PagBank.
- PagBank is still being relatively overlooked by the market when you take a 10-year view of the business.
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PagSeguro (NYSE:PAGS) is a disruptive player in a highly penetrable market with a huge runway of growth ahead. The company operates in a sector of the market in which nearly 60 million consumers are still unbanked or underbanked.
PagSeguro's latest undertaking, PagBank, is on track to corner this sector of the market. More than 9 million consumers have opened an account with PagBank and we are of the view that PagBank could enjoy 2% market share in the Micro/SME lending space by 2030, up from 0.1% today.
I will first provide some context to the payments industry and where a Brazilian merchant acquirer like PagSeguro fits in.
Payments industry
Over the past 10 years, the use of cash has steadily declined. This is especially evidenced in mature markets as the charts from McKinsey Global Payments report (2020) show below. Technological innovation has made the process of paying "digitally", quick, seamless and convenient. Contactless payments and digital wallets have resulted in hundreds of billions of dollars in physical currency being replaced with digital spend. Thus, from a secular perspective, payment processors have been well positioned to capture this conversion over time. COVID-19 accelerated this conversion significantly as consumers around the world avoided using physical currency due to its associated health risks. Below illustrates the level of cash usage by country.
Source: McKinsey Global Payments report (2020).
As seen above, Brazil's cash penetration level is still very high which is favorable for PagSeguro as the conversion from cash to card increases over time.
Brazilian market:
Brazil is a particularly attractive country and on the brink of change driven by the following catalysts:
- Firstly, COVID-19 accelerated the digital conversion of cash to card in Brazil by 3 years.
- Secondly, recent technological advances in Brazil have led fintech companies to offer a viable digital alternative to cash that is safe, cheap, and efficient.
- Thirdly, traditional incumbent banks in Brazil have been largely bureaucratic and fragmented, falling short of meeting consumer's needs as evidenced by the fact that 60 million people are unbanked in Brazil. These 60 million people move nearly $205 billion of the country's economy per year.
Brazil's high levels of cash usage can be seen in the chart below. According to research by Morgan Stanley, card penetration in Brazil is a mere 41% versus 74% in the US. Brazilian consumers thus use cash to make purchases nearly 60% of the time. Looking forward, card expenditure in Brazil is expected to increase significantly over the next 5 years, from 40% of personal consumption expenditure (PCE) in 2020 to 62% in 2025. Payment processors in Brazil are well positioned to benefit from this conversion.
Source: Morgan Stanley Research. Word Bank, Brazil Central Bank data.
As seen in the chart below, cash is still used in a large number of transactions in Brazil that would be card based in mature markets. This high cash usage for small transactions is partly attributable to the incumbent bank's inability to service the 60 million unbanked people that move nearly $205 billion of the country's economy per year. For sake of reference, a movie ticket in Brazil typically costs R$30, and a 500ml beer costs R$7, which would fall within the first 2 bars in the below graphic.
Source: Morgan Stanley Research. BCB Survey.
Thus, a candidate for inclusion in our global portfolio would be a business in Brazil that offers the following:
- Payment processing services to the Micro and SME market who are more likely to be unbanked due to the incumbent's poor engagement.
- Attractive banking products and services never before offered to the unbanked (60 million consumers to monetize).
- Strong moat around key aspects of the business.
Investment case for PagSeguro
Similar to the disruption being caused today by disruptive payment processors like Square (SQ) in the US and Adyen (OTCPK:ADYEY) in Europe, PagSeguro has followed the same playbook in Brazil by aggressively stealing market share from the incumbent players. The incumbent payment processors in Brazil are owned by five major Brazilian banks (representing 70% of the acquiring market in 2020). These incumbent players serviced the SME space poorly and merchants were frustrated with a number of issues such as:
- The process of opening up a bank account could take weeks as merchants were required to fill in volumes of paperwork to satisfy banks' underwriting models and receive regulatory approvals. This resulted in merchants being unable to accept card payments leaving customers frustrated.
- Signing up with one of the incumbent merchant acquirers was an expensive process. Merchants were charged a fixed fee and faced hefty early cancelation fees. Additionally, hardware costs (point-of-sale machines) were prohibitively high as there was no cheap viable alternative to payment processing hardware. As a result, merchants were locked in at higher rates and lacked flexibility (which is often needed for SMEs).
PagSeguro was quick to act and alleviated a number of these headaches. Merchants can now sign up quicker and at a much more affordable rate than previously offered by the traditional incumbents. The proof is in the pudding and PagSeguro has the largest point-of-sale base in the Brazilian SME market today.
However, PagSeguro's success as a merchant acquirer is only half the story and it is PagSeguro's more recent transition into a completely new area that excites us most. This new area is banking and its latest undertaking, PagBank.
Established less than 24 months ago, PagBank is already the 3rd largest digital bank in Brazil, and the exponential growth in its client base is expected to continue.
Will PagBank succeed? We think so. Let us dig a little deeper into the investment case.
It is important to understand how the Brazilian consumer buys products and services to contextualize how PagSeguro has disrupted payments.
In Brazil, consumers expect the merchants (not the banks, which is the case ROW) to grant them credit when making a purchase. The purchase amount is then paid off interest-free in multiple monthly installments. This is the case for 60% of all credit card transactions in Brazil.
Thus, a merchant will make a sale and only receive the revenue after the respective monthly installment has been paid. This has created working capital nightmares for merchants as they may only receive full settlement up to 6 months later.
PagSeguro was quick to identify the issue and began offering merchants a receivable prepayment option for a fee. Under this option, PagSeguro settles the receivable due to the merchant on behalf of the consumer and the underlying receivable is then owed to PagSeguro by the credit card issuers. PagSeguro charges a finance fee in the form of a discount to the lump sum receivable. The merchant is paid the amount of the receivable less the prepayment fee.
PagSeguro learnt that merchants were more concerned about their cash flow needs than they were about paying a fee for early settlement. This created a win-win as the early prepayment of receivables created a working capital alternative for merchants whilst also generating incremental income for PagSeguro.
Will PagBank succeed? We think so. Let us dig a little deeper into the investment case.
It is important to understand how the Brazilian consumer buys products and services to contextualize how PagSeguro has disrupted payments.
In Brazil, consumers expect the merchants (not the banks, which is the case ROW) to grant them credit when making a purchase. The purchase amount is then paid off interest-free in multiple monthly installments. This is the case for 60% of all credit card transactions in Brazil.
Thus, a merchant will make a sale and only receive the revenue after the respective monthly installment has been paid. This has created working capital nightmares for merchants as they may only receive full settlement up to 6 months later.
PagSeguro was quick to identify the issue and began offering merchants a receivable prepayment option for a fee. Under this option, PagSeguro settles the receivable due to the merchant on behalf of the consumer and the underlying receivable is then owed to PagSeguro by the credit card issuers. PagSeguro charges a finance fee in the form of a discount to the lump sum receivable. The merchant is paid the amount of the receivable less the prepayment fee.
PagSeguro learnt that merchants were more concerned about their cash flow needs than they were about paying a fee for early settlement. This created a win-win as the early prepayment of receivables created a working capital alternative for merchants whilst also generating incremental income for PagSeguro.
PagSeguro used to finance these prepayments using debt that had been extended to it by banks, often at very unattractive rates. As the charts below from The Financial Times illustrate, Brazilian banks have historically charged extremely high interest rates and the spread between the retail lending rate and the central bank rate is amongst the highest in the world.
Source: Financial Times.
To aggravate matters further, the major banks have historically had 70% market share in the merchant acquiring space.
Source: JPMorgan estimates. Company data, ABECS.
Thus, PagSeguro has been at the mercy of these banks for financing even though it may not be in the banks' best interest to do so because of the threat posed by PagSeguro to their subsidiaries. This is exactly what happened in 2016 and no mercy was shown. The major banks stopped offering PagSeguro finance, rendering the company unable to offer its prepayment service to its customers.
This catalyst made PAGS realize three things:
- PAGS' reliance on the banks for working capital finance was unsustainable given the banks inherent conflict. In the longer run, the banks would always navigate a way to squeeze them out.
- Through its merchant acquiring business, PAGS possessed important data of its clients. It would be able to more effectively underwrite receivable prepayments, funding these prepayments at a lower rate (cost of deposits vs cost of funding from traditional banks), and would also be able to better absorb default losses.
- PAGS well understood the Micro/SME market and the challenges the unbanked and underbanked were facing. The inception of PagBank would not only support the existing business, but represent a new market with a TAM 17x that of the merchant acquiring business.
Source: PagSeguro company website.
PagBank set out to build a compelling two-sided network (acquirer on one side and a bank on the other) with a mission to disrupt and democratize financial services in Brazil, which was up to then a concentrated, underpenetrated, and high interest rate banking market.
In less than three minutes and 100% online, merchants and consumers can open up a free PagBank digital account with a wide range of offerings, operating as a regular checking account.
Let's look at a number of practical synergies that PagBank has realized for the group:
- PagBank notices a consumer having excess cash sitting in his/her digital account. PagBank advises clients to earn interest on his/her balance by investing in one of PagBank's Certificate of Deposit (CD). PagBank uses proceeds from CD to finance prepayment of receivables for their merchants.
- If the receivable prepayment made to a merchant is relating to a PagBank customer, PagSeguro will have the ability to recoup the amount directly from the customer (instead of from the issuing bank) and have full insight into the customer's ability to make repayments.
- PagBank will generate an additional revenue stream on 3rd party transactions by acting as the card issuer for consumers.
- Transactions that take place within PagSeguro's two-sided network, the MDR fee does not need to be shared between various intermediaries, resulting in a more profitable transaction.
Risks
Macroeconomic conditions:
In April 2020, Standard & Poor's downgraded Brazil's public debt rating outlook from positive to stable. Fitch reported that the spread of COVID-19, the drop in commodity prices, tighter external funding conditions, and failing domestic financial asset prices will weaken economic growth in Latin America substantially in 2020 and carry through into 2021. Brazil's sovereign credit rating (BB-) is currently below investment grade by the three main credit rating agencies and consequently the prices of securities issued by Brazilian companies have been negatively affected. A prolongation or worsening of the Brazilian 2020 recession and continued political uncertainty could lead to further ratings downgrades which would likely cause the trading price of PAGS' shares to decline.
Competition:
Brazil is a feeding frenzy for fintech disruptors. Players including Stone (STNE), MercadoLibre (MELI), and Nubank (unlisted) have strong presence in the region and could impair PagSeguro's growth trajectory. In particular, Nubank (with 40 million customers at June 2021) poses a threat to PagBank's ability to penetrate the lower LSM market, a demographic which Nubank has already enjoyed much success.
Valuation:
Book assumptions:
We have been long PagSeguro since July 2020. Our view is that the market has taken too short an investment horizon when assessing the potential of PagBank. According to Banco Central Do Brasil (Brazil's central bank) the size of Micro & SME lending market in Brazil was R$ 851 billion at the end of 2020. With a loan book of R$ 612 mln, this represents less than 0.1% market share.
As at FY20, PagBank revenue only accounts for 8% of its total revenue. Management has provided guidance for a PagBank revenue target split of 30% (off a large base) by 2024. Thus, management plans to aggressively roll out PagBank. With significant experience in servicing this segment of the market, we believe that PagSeguro has the "known how" to grow their book aggressively and could enjoy 2% market share in the Micro/SME lending space by 2030.
This 2% target is achievable considering current metrics of PAGS'. At FY20, PAGS had 7.8 million merchants, 1.2 million (15%) of whom are eligible for WC loans. We have confirmed this with PAGS' management. If one assumed an average ticket size of R$4000 and 1.2 million eligible merchants, this translates to a loan book of R$6.3 billion, which is in line with 2024 target.
To take this 1 step further and imagine a scenario where all of PAGS' current 7.8 million merchants were eligible for WC loans, that would translate to a book of approximately R$30 bln, implying a current book greater than my 2030 terminal year forecast in my base case. Certainly not beyond the realm of possibility considering that PAGS already has a strong user base which is growing.
Revenue splits:
We see a monetization opportunity not only in the PagBanks' lending operation, but also in its card-issuing operation.
Margins:
We forecast improving margins through the 10-year investment horizon. Our terminal margin assumptions are similar to those currently enjoyed by larger players in the industry.
Multiple:
We value PAGS using a normalized EBITDA multiple. We apply a country-specific multiple of 13.5 for Brazil. This takes into account the country's nominal inflation, nominal risk-free rate, real return, and its equity risk premium. This translates to a discount rate of 9%. We apply a premium to this multiple according to the size of each segment to account for business model-specific risk. We thus apply a blended 16.5 EBITDA multiple to 2030 earnings.
Model cover sheet:
Conclusion
PagSeguro is a disruptive player in a highly penetrable market with huge runway ahead. The company has an attractive two-sided network and has the potential to become the Super App of Brazil. We rate the company as a buy with a price target of $78.8, implying 36% upside from current levels.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of PAGS either through stock ownership, options, or other derivatives. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (29)
PagSeguro stock slumps for second day on regulation that could cap key feeseekingalpha.com/...
• Consolidated total payment volume1 (TPV) of R$125.0 billion in 3Q21, up 85% y/y
• Acquiring total payment volume2 (TPV) of R$66.8 billion in 3Q21, up 49% y/y. Ex-Coronavoucherup 58% y/y
• 12.2 million PagBank active users3, growth of 1.0 million in 3Q21July 20, 2021 - PagSeguro Digital Ltd. announces 2Q21 all-time high operating metrics.
• 11.2 million PagBank active users1, growth of 2.1 million in 2Q21;
• Consolidated total payment volume2 (TPV) of R$101.4 billion in 2Q21,up 151% compared to 2Q20;
• Acquiring total payment volume3 (TPV)of R$56.3 billion in 2Q21,up 89% compared to 2Q20.
I prefer PAGS to STNE;1) STNE is still more expensive (admittedly its price has come down quite a bit).
2) Less attractive customer acquisition strategy (software solutions).
3) No benefit of a two-sided network.
4) Our view is on PAGS' ability to penetrate the Micro/SME lending market (which STNE doesn't really engage in, at least not to the extent PAGS' does). I prefer PAGS to MELI:
Meli, again, has a slightly different model but I do like their customer acquisition strategy (similar to Rakuten (4755) in Japan which I am writing a report on next). Meli focuses on online through their ecommerce market place where as PAGS' is almost entirely brick-and-mortar.