StoneCo: Margins Face Headwinds, But Core Growth Continues
Summary
- The market clearly wasn't impressed with 2021Q3 earnings as StoneCo favoured client relationships rather than immediately passing on recent interest rate hikes to their product pricing.
- Funding costs increased 252%. Management also cited heavy investments in growth as reasons for why margins are well below historical levels, and expected to remain so in the near-term.
- Whereas Q2 benefitted from a mark-to-market gain on StoneCo's Banco Inter investment, this swung to a large loss in Q3. There are probably more mark-to-market losses, to come.
- Accounting for the Linx acquisition and inflation, growth is not quite as torrid as would first appear. Proforma, nominal revenue growth was only 26.4%, but 46.4% ex-credit.
- In my view, the pullback helps to offset the risks, resulting in an improved opportunity for long-term investors. I discuss some key risk factors.
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Investment Thesis
StoneCo Ltd. (NASDAQ:STNE) has seen a further sharp stock price pullback after 2021Q3 earnings revealed additional issues. These include reduced margins as StoneCo slowly adjusts product pricing to Brazil's rising interest rates, mark-to-market losses on StoneCo's investment in Banco Inter, and a continuation of elevated NPLs, with the unwinding of the legacy credit portfolio. The turbulence may have spooked international investors who are unused to the vagaries of emerging markets.
But StoneCo's core growth looks to be still intact, and while certain operational challenges won't get resolved in the immediate future, ultimately it looks like the worst will subside in subsequent quarters. Part of the contraction in margins resulted from StoneCo's investments in growth, while the slow product-pricing adjustments were a deliberate effort to prioritize growth and client relationships. Beneath the headline results is that StoneCo is aiming for bigger scale perhaps than before. I continue to be long-term bullish, even though downside risk still exists.
Recent Results Send the Stock Price Down Further, But Core Growth Intact
StoneCo's 2021Q3 results revealed additional blemishes, but it wasn't too hard to see that core growth continued. First, some of the positives:
- Strong TPV growth of 53.6% y/y, ex-coronavoucher, and a 2.1x increase in active payments clients -- note that this includes micro-merchants.
- 57.3% growth in total revenue -- however, proforma revenue growth that controls for the Linx acquisition was only 26.4%, and 46.4% excluding the credit product which was halted in Q3.
- Ex-coronavoucher, market share has continued to trend upwards.
- Improved banking and insurance ARPU, with growth of +34% and +60%, respectively.
- They continue to invest heavily in "engineering, sales, marketing, and operational teams".
- Adjusted free cash flow was roughly flat, from a year ago, at about ~$43M (R$238.5M). Annualized, this puts StoneCo's market cap at roughly ~30x adjusted FCF -- this isn't cheap, though the denominator presumably reflects recent headwinds.
On the negative side of the ledger:
- Funding costs increased 252%, because of an increase in Brazil's interest rates. Funding costs are a part of financial expenses, which went from 6.9% of revenues, in 2020Q3, to 22.5% in 2021Q3.
- The Linx acquisition has not yet been accretive to EPS, although management sees the margins as "healthy", with a lot of opportunity for synergies.
- No additional provision needed for the legacy credit portfolio, but coverage is down to 102% from 112% in Q2. Performing clients have been settling their accounts, resulting in a rise in NPLs to 48% from 35% in Q2, as the portfolio gets skewed to non-performing clients. NPLs have risen 8% in absolute terms.
- ~$239M (R$1,341M) mark-to-market loss on the Banco Inter investment. This is a non-cash charge, and the write-down amounts to a ~$90M loss (R$500M) versus the original investment in Q2. Banco Inter now accounts for about ~$354M on StoneCo's balance sheet (R$1,980M), or ~7% of the market cap.
- Brazil's inflation is close to 10%, so that should be factored into these reported growth rates. Real revenue growth, ex-credit, has then been around ~35%.
- Profitability has had a setback in the last couple of quarters, in Q2 because of the credit debacle prompted by Brazil's faulty registry system, and in Q3 because of the margin pressures from funding costs, etc.
The press release and earnings call elaborated on management's investment objectives, with the ultimate goal of being "much bigger in terms of scale". Growth avenues include:
- There's room to expand the client base. StoneCo now has an MSMB (micro + SMB) client base of 1.3M, compared to ~8M SMBs and ~20M+ micro clients in Brazil, by StoneCo's own estimates.
- This includes "investing in new fronts to serve our merchants", like integrating software and financial services and helping clients to sell through multiple sales channels.
- "When we look at Linx clients, they have approximately R$350B in annualized GMV, and we monetize only 0.3% of such value."
- "Also, those clients have approximately R$200B in annual TPV, and mid-single digits penetration with our payment solutions."
- The current credit product, which needs to be turned around, plus potential credit card and overdraft products.
They stressed that they aim to be disciplined with return on investment -- e.g., with a payback period of 11-15 months, on client acquisition.
Source: StoneCo 2021Q3 earnings slides.
Source: StoneCo 2021Q3 earnings slides.
Source: StoneCo 2021Q3 earnings slides.
Source: StoneCo 2021Q3 earnings slides.
Margins -- Lower than Usual for the Near Future as StoneCo Prioritizes Growth
Seeing as how top-line revenue growth has continued, a bigger immediate concern is net margin, which fell to 9% in 2021Q3, below historical norms -- this is expected to persist for the near term. There was some extensive discussion of this on the recent earnings call:
[CEO Thiago Piau] We have invested approximately R$120M more OpEx in the growth of our operation and in new business when compared with the third quarter of 2020. This, combined with higher interest rates, impacted our margins. And even though we started to reprice clients, managing our payback strategy with discipline, we are doing this in a way that we keep good level of growth, and don't jeopardize our relationship with our merchants, which is the most important thing given the opportunities we have.
Source: StoneCo 2021Q3 earnings call.
Source: StoneCo 2021Q3 earnings slides.
So taking this at face value, the increase in financial expenses was partly by choice, as they opted to prioritize their relationships with clients and not immediately pass-on all of the rapid interest rate increase. Some further explanation:
[CEO Thiago Piau] ...our business has some exposure to macro environment, as Rafael said, in a positive and negative way. We're positively exposed to inflation, given that it increased TPV and the software contracts are naturally adjusted by inflation. But we're negatively impacted by interest rates, as funding is a very important resource to grow our Company. The way to mitigate this negative exposure is really for products and the right pricing strategy.
So, when we scale our balance sheet, our banking solutions, we have more outstanding balance of our clients. [...] there is a lag between interest rates increase and our repricing strategy because we don't want to jeopardize the relationship with our clients and keep good level of growth...
[...] So, what we see is in the short-term, our margins are lower than the margins we had historically, right. And interest rate was going up much faster than what we thought in the beginning, and we decided to accept a little bit lower margins during a short period of time not to jeopardize the client base.
[...] We believe that's worth it in the very short term, to have margins that are lower than the historical margins that we had in order to gain much more scale and have a much stronger business model in the future.
Source: StoneCo 2021Q3 earnings call.
Just because having lower margins has started out as a strategic decision, though, doesn't mean that there couldn't be longer-lasting pressure, e.g. from competition. Analyst estimates for profitability in 2022 and 2023 have been cut by ~24% and ~17%, respectively, in the past 3 months, and even more since mid-2021.
Source: Seeking Alpha.
Country Risk -- Stagflation, Commodity Risks, Politics
Apart from the credit issues that I highlighted in my last article, much of the pushback on StoneCo has related not to company-specific issues, but to how Brazil is arguably a basket case that's at the mercy of turbulent political and macroeconomic forces. Like most SA readers, I don't live in Latin America -- admittedly, one is much less likely to have any informational "edge" on a foreign stock. But apart from the potential diversification benefits of investing in emerging markets, I expect that the extreme swings in investor sentiment can result in opportunity.
It wouldn't be practical to go deeply into all of the macro risks for Brazilian equities, here -- readers can look at the iShares MSCI Brazil Capped ETF (EWZ) for macro coverage of Brazil by SA contributors, which incidentally has been bullish, lately. See, for example, here and here. But stagflation is one of the points of concern:
- Inflation is close to 10%, unemployment fell to 12.6% in 2021Q3 from 14.7% earlier in the year, while real GDP growth expectations, according to Brazil's Ministry of the Economy, are 5.1% for 2021, and 2.1% for 2022.
- Concerns about stagflation popped up as early as April 2021, and unemployment has been above 10% during the entire time since StoneCo's IPO in 2018Q3 -- but StoneCo has continued to see core growth during that time.
- With the pandemic and global supply chain issues, there are plenty of headwinds which should eventually abate.
- Brazil was an early poster child for badly managing the pandemic, but case counts have now come down significantly.
- Arguably, the growth and innovation of companies like StoneCo is a reason itself to be optimistic about Brazil's long-term prospects.
- A key way to address the risks, obviously, is with diversification. I'd personally be content with a mid-single digit overall exposure to Brazil, which gives room to average down.
In any case, the macro risks have to be weighed against the risk-return trade-off of the specific company.
Source: Reuters.
Source: IMF.
StoneCo's "TPV and the software contracts are naturally adjusted by inflation", giving it some natural hedge. But in the last article, I had missed the exposure from StoneCo's prepayment business and funding costs. While StoneCo is looking to adjust slowly, to prioritize growth, competitors might be looking to take market share by keeping pricing low -- for example, MercadoLibre (MELI) stated that they will "strive to not have to pass on increased fee structures to consumers where possible", on spread-based business, by looking to keep funding costs in check.
Bigger picture, my hunch is that investor anxieties about emerging market risks can be a self-fulfilling prophecy whereby many investors start with less familiarity of the macro-situation, and any unexpected turbulence is more likely to prompt dramatic reactions. This can necessitate a longer-term horizon and the inclination to start small and average down. I'm also generally optimistic that Brazil is not actually heading towards collapse -- those who disagree will want to steer clear, obviously.
Valuation -- A Cheap Growth Stock?
As I stated last time around, StoneCo was not inexpensive leading into the latest earnings results, though valuation had to be considered in the context of the strong double-digit core growth. With forward EV/Revenues and EV/EBITDA now at 5.7x and 22.3x, respectively, it's still not bargain-basement cheap, but seems moderately priced considering the growth prospects. Note that other fintech and Brazilian equities have seen a pullback, but StoneCo's plunge is particularly notable.
To rationalize this kind of plunge in just a few weeks, one would expect that long-term prospects for sustained growth and margins are suddenly much weaker than they were, at the time of the 2021Q2 earnings. This is true for margins in the next few quarters, probably, but management commentary in 2021Q3 hasn't seemed to suggest much difference in how they see the business, longer term, except for going after bigger scale.
Still Plenty of Risks to be Aware Of
Although I am basically optimistic about StoneCo's long-term prospects, there are still plenty of further risks to be aware of, in addition to market sentiment which could always send the stock price down further:
- Execution risks, e.g. with resuming credit disbursements, banking products, and integrating the Linx acquisition.
- Additional provisioning could be required if NPLs increase further. The credit portfolio has R$816M of performing loans in excess of the loss provisions, versus R$3.0B in cash and equivalents.
- Further mark-to-market losses on investments.
- Further increases in funding costs.
- Brazil's 2022 elections.
- The industry could face some POS shortages, as a result of the global microchip shortage. Note that PAX Global Technology (OTCPK:PXGYF), which came under short-seller scrutiny recently, is only one of StoneCo's six POS suppliers -- the POS run on StoneCo's proprietary software, with dedicated cybersecurity, and StoneCo saw no evidence of security breaches.
- Many macro risks that were already alluded to, in the country-risk section.
- Other risks that I could have overlooked.
Investors have a couple of obvious risk factors that they can keep an eye on, before the next earnings results. One is Banco Inter's stock price, which ended 2021Q3 at R$46.65 -- it has since fallen further, to ~R$33 as of Thursday, which would currently imply an additional ~R$580M mark-to-market loss (~$103M). But this is small, in relation to StoneCo's market cap.
Another is Brazil's base rate (CDI), which is the overnight rate on interbank deposits. I didn't find a series for the CDI, but I'd assume this will be driven by the federal funds rate, the Selic interest rate -- we can see the steep climb from 2% in 2020Q3, to 6.25% as of 2021Q3, and 7.75%, today. Given that StoneCo is slow to pass on funding cost increases, the rate of change is probably the important aspect -- hence we can see why margins will be under pressure in Q4, and perhaps beyond.
Source: Banco Central do Brasil.
If things do go according to management's plan of bigger scale and some recovery of margins, though, I'd have to imagine that there could be multi-bagger potential here, over the coming years. That will be even more the case if near-term market turbulence sends the stock price into the low $10s or even the single digits.
One of the lessons of the past couple of decades is that tech companies with a long growth horizon can eventually deliver outsized returns. StoneCo appears to have the ability, motivation, track record, and opportunity to do this in Brazil -- one's views could come down to faith in management's ability to navigate the competitive and macroeconomic terrain, time horizon, and risk tolerance.
Final Thoughts
Investing in emerging markets is not for everyone. A stock price pullback can be a blessing in disguise, though readers will obviously have to decide for themselves if that's the case, with StoneCo. The extra layer of risk isn't just from the emerging market itself -- there is bound to be more uncertainty on the part of international investors, making them susceptible to getting spooked more easily, adding further to the volatility, versus a North American stock. StoneCo's credit product issues and reduced margins have provided just the fodder for investor anxieties.
But underlying some of StoneCo's short-term operational weakness has been management's deliberate intent to pursue long-term growth and bigger scale. For U.S.-based companies, this would often be met with investor enthusiasm. It could take some fortitude to navigate the volatility, but it looks like StoneCo still presents an opportunity for long-term oriented investors with a high risk tolerance.
Please let me know your thoughts and feedback in the comments, below.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of STNE, PAGS, MELI 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.
I'm not a financial adviser/advisor, and this article is only intended to express my own perspective. I could have overlooked key facts and/or risks, and my views could change at any time, not least because of new information that might become available. The suitability of an investment depends on your own personal circumstances and risk tolerance. You are responsible for your own due diligence and investment decisions.
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