StoneCo: Remaining Positive On Long-Term Growth Opportunities Despite Negative Sentiment

Summary

• StoneCo has seen their stock pull back nearly 80% over the past year as investors have negative sentiment around high valuation and Brazilian economy risk.
• Fundamentally, the company has seen a lot of success growing their SMB and micro-merchants in addition to growing their Banking and Insurance products.
• Valuation remains attractive with the stock under $20, implying a valuation of just 20x a reasonable 2023 EPS estimate.

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StoneCo (NASDAQ:STNE) is one of the leading Brazilian financial technology companies, providing merchant and banking solutions. Over the past year, the stock has pulled back nearly 80% as the Brazilian economy has been in-and-out of pandemic-induced lockdowns. Nevertheless, STNE's fundamentals have remained quite solid as they have gained share in the micro-merchant space and have continued strong growth from SMBs. Management also remains confident in the long-term growth opportunity of their Banking and Insurance products and the recently acquired Linx revenue provides more recurring, software-like revenue streams.

Data by YCharts

Given StoneCo's unique market positioning for merchants in terms of both acquiring and banking solutions, I believe there remains a long-term growth opportunity for many years to come. Yes, this will likely have a volatile ride as the Brazilian economy and merchants are difficult to predict, plus the risks of unknown future regulatory pressures may cause some sentiment headwinds.

However, the company is well positioned across their business to capture both merchant and volume upside as the economy recovers. In addition, the rapid shift to digital commerce only helps the company's long-term growth algorithm as more merchants will be looking for digital payment solutions, both on the acquiring and banking side.

The company's valuation remains pretty attractive and with the stock now under $20, STNE trades at under 9x forward EBITDA and only ~20x potential 2023 EPS. If the company is able to execute over the next few quarters, it would not be surprising to see a potential double, or even more, in the coming 12-18 months.

Financial Review

Fundamentally, the company's recent earnings report was not worthy of another 50% cut to the stock's price. Both parts of the company's business, Payments & Financial Services and Software Solutions, reported strong metrics, though expense growth above revenue growth has caused some concerns around the longer-term operating trajectory.

Yes, there continue to be concerns around the regulatory environment, Brazilian economy, and the Brazilian Real strength. However, fundamentally it appears the company remains undervalued when looking at long-term growth potential.

Payments & Financial Services

Source: Company Presentation

When looking at the combined micro-merchants and SMBs, the company has done a great job expanding their TPV. Yes, a lot of this growth is due to the micro-merchants starting off at a 0 base and growing to R$3.4 billion during the recent quarter, though SMBs' TPV grew an impressive 70% during the quarter.

Recently, the company has provided a 2-year growth CAGR for MSMB, which I believe is a better metric to use to understand the true underlying growth trends throughout the pandemic. With this 2-year growth CAGR metric accelerating to 61% during the most recent quarter, the company has shown their ability to grow despite the numerous economic headwinds.

Source: Company Presentation

I believe the real driver of future growth is going to come from the micro-merchant space. While SMB growth will be essential to profitability, the company is investing heavily in growing their micro-merchant base and this can be seen with total MSMB client base growing nearly 300K sequentially and over 2x compared to the year-ago period.

As the Brazilian economy continues to open up and merchants return to normalcy, I believe there will be significant growth drivers over the coming quarters and years.

Source: Company Presentation

Taking a further look into their Banking and Insurance segments, we can see unit economics continuing to improve. Part of this is the benefit of an easier comparable due to the global pandemic, but this is also being driven by their improved products and solutions.

During the company's recent earnings call, management talked about the growing opportunity within their Insurance solution, which I believe remains a long-term growth opportunity in a fragmented banking market within Brazil.

Our insurance solution, though still in pilot mode, is showing encouraging initial results with 14,500 active contracts, in which we earn a fee without underwriting risk. Merchants, their families and employees have multiple insurance needs and we're working to provide them superior financial protection. This is another important step towards our goal to be the best financial operating system for Brazilian merchants.

The long-term opportunity for both Banking and Insurance remains very positive given how fragmented the Brazilian economy is. For merchants, especially SMBs and micro-merchants, it can be quite difficult for them to get their acquiring, banking, and insurance products all from the same provider. STNE provides a bundled offering that fits merchants of all sizes, which can be a real competitive differentiator in the market.

Software Solutions

While the Software Solutions revenue is quite new, the company's recent acquisition of Linx has provided a more consistent source of revenue. During the recent quarter, Software Solutions revenue stood at R$315 million, of which R$262 million was from Linx (Linx revenue grew over 15% during the quarter). I believe this revenue stream will give investors a little more confidence in not only the revenue growth potential, but the recurrence and stability as well.

Source: Company Presentation

STNE laid out some targets and ambitions for Linx (see chart above) and I believe the long-term growth story remains positive. In addition, management recently talked about how they are at the beginning of this investment and believes clients will see better results driven by the software usage.

With the acquisition of Linx in our current set of solutions for multiple retail verticals, we seek to build the best workflow tools to generate efficiency for our merchants, and help them sell more through multiple channels. We're only at the beginning of our journey in combining software and financial services to bring even more tangible results to our clients and we're really excited with the opportunities ahead.

Valuation

The stock has been down nearly 80% over the past year after trading at a high point just under $100. The combination of a premium valuation, heightened regulatory risks, and a volatile Brazilian economy has caused investors to quickly jump ship. Nevertheless, I believe this significant pullback has provided long-term investors, who have patience for volatility, to build a position at a good entry point.

Aside from the long-term growth opportunity, STNE also has the potential to be acquired, given the massive pullback in the stock. In late-December, a Brazil Journal story reported that STNE hired JPMorgan and a law firm to help the company evaluate strategic alternatives. Since that article was published, acknowledging it's only a rumor, the stock has popped over 20%.

While investors should not solely rely on speculation of a possible acquisition or corporate restructuring, I do believe it provides some level of downside protection.

Data by YCharts

Given the current volatile economic conditions in Brazil, I believe the company is producing lower profitability that their long-term potential. STNE remains heavily invested into their products and expanding further into micro-merchants and SMBs, thus are taking a near-term profitability hit in order to grow their merchant base.

The above chart shows just how much the company's forward EBITDA multiple has contracted over the past year, which is pretty similar to another Brazilian fintech company, PagSeguro (PAGS). However, given STNE is currently trading under 10x forward EBITDA, I believe the long-term profitability potential outweighs any potential future downside risk.

According to Yahoo Finance, consensus is expecting EPS of $0.70 in 2022, which results in a current 2022 P/E of just under 28x. While that definitely does not scream cheap considering the numerous risk factors, I believe the normalized EPS is much higher than $0.70.

Just a few months ago, consensus was expecting EPS well over $1.00; however, continued risks and volatile Brazilian economy has caused consensus to cut estimates. If the Brazilian economy continues to improve and STNE is able to continue to grow their merchant base, it's not unreasonable to think EPS could reach $1.00 in 2022. Even if EPS were to be $1.00 in 2023 and the stock were to trade at a 25x multiple at the end of 2022, this would imply a price target of $25 by the end of 2022, or ~25% upside from current levels.

I believe the biggest risk to STNE remains the Brazilian economy and potential future lockdowns driven by the global pandemic. If the country is not able to show continued improvement regarding vaccination and COVID case count, it could be a long, slow path towards recovery. In addition, there remains some risk with the Brazilian Real (the country's currency), which has shown to be quite volatile over time.

Also, as the Brazilian economy and technology continues to develop, we could see increased competition in the merchant acquirer and banking space. Typically, increased competition can lead to lower margins and price cuts, which ultimately hurt profitability.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.