StoneCo: Building The Digital Payments Ecosystem Of Brazil
Brazilian based payments platform integrated with financial solutions and a suite of retail management software.
Acquisition of Linx expands on its platform by offering POS and ERP software to digitize Brazil’s merchants through an omnichannel.
Market tailwinds add to its opportunity to reach its large target market of SMEs where it has only penetrated 6% of the market.
Strong challenger to a market historically dominated by large banks with a revenue growth forecast of 61% in 2021.
StoneCo, Ltd. (STNE) is an integrated provider of payments and financial services for SMBs and online merchants in Brazil. It is proving itself as a strong challenger to a market historically dominated by local banks with its market share almost doubled from a year ago. The company managed to so by offering an integrated payments platform with a suite of credit solutions and retail management software, enabling a one-stop platform to do business. It also focuses on the underserved SMB market which represents 8.8 mln businesses in Brazil. The company is actively penetrating its market segments through M&A. The recent acquisition of Linx (LINX) builds on its platform with POS and ERP retail software to digitize merchants through an omnichannel solution.
Extensive Platform Enabling Digital Payments and Commerce
StoneCo started as a payment processor but has expanded to provide a wide range of value-added services integrated with its payment platforms. Besides payment acceptance, the company's offerings include prepayment of instalment receivables, credit, sales reconciliation, split transaction settlements, financial services, automation and ERP software. It aims to create an integrated, end-to-end systems provider for merchants through omnichannel solutions. At first glance, its business model appears similar to Square's (SQ) seller ecosystem. However, StoneCo has a greater emphasis on its merchant receivables prepayment which contributes half of its revenues.
Compared to other payment processors, the company derives a significant source of revenues from financial income. In addition to processing payments which are generally low margin activities, the company has a lending arm, similar to Square Capital, which provides working capital solutions in the form prepayment of merchant's receivables from payments and credit. Compared to Square, the company is more reliant on this line of business as it represents half of its revenues derived from:
Prepayment options for future expected receivables from credit card instalments and charge a discount rate on merchants
Recently introduced credit solutions to merchants which are repaid through the automatic retention of a percentage of their sales
Revenue is earned by charging a prepayment fee for prepaid receivables and fees from credit products. To fund these services, the company primarily secures funding from third-party banks, issue senior quotas by FIDCs to institutional investors, and with its own capital contributions, thereby reducing credit risk. Management claims it has very low loss rates in the mid-single digit range. Overall, this is a feature that the company has been ramping up by upselling to its merchants. Around a quarter of its customer base uses both its payment processing and credit solutions and has been rapidly growing.
Besides that, the company earns revenues from electronic data equipment rental and POS and ERP software, reconciliation, customer relationship management reporting tools. This contributes to its subscription services and equipment rental revenues which accounts for 11% of total revenues. The chart below shows a full breakdown of its revenues. The point is that the company has a fully integrated payments, credit and retail software platform which enables merchants to digitize and manage their businesses more effectively.
Massive South American Market Opportunity
Brazil is an incredibly large market processing over BRL1.8 tln in payment transaction volumes in 2019. StoneCo has nearly doubled its market share to around 14% which is an incredible feat against traditional players with the likes of Cielo (OTCPK:CIOXY), Rede and GetNet which are backed by large local banks. Market leader Cielo which is backed by Brazil's largest bank (Banco do Brasil) (OTCPK:BDORY) and Rede (Itaú Unibanco) (ITUB) has cumulatively lost share from over 70% to just 60%. Whereas newcomers StoneCo and rival Pagseguro (PAGS) continue gaining share, disrupting the industry by targeting the underserved SMBs. StoneCo is helping these businesses to digitize their payments processes as well as managing their businesses more effectively by providing working capital and retail management software solutions. There are around 8.8 mln SMBs and the company has massive potential as it has only captured 6% of that market. Another point is that StoneCo offers a more competitive transaction pricing with an average take rate of around only 1.8% compared Cielo at almost 2% and rival Pagseguro at 2.4%.
The outlook of cashless payments in the emerging Brazilian market is highly promising. Usage of cash is still predominant as it remains the preferred method of payment by 70% of consumers. Additionally, 1/3 of the population is unbanked. Based on forecasts from Statista, the percentage of digital payments transaction volumes of GDP could increase from 3.4% to 6% in 2024, a 4-year CAGR of 15%.
The huge opportunity provides Fintech companies such as StoneCo with massive potential for growth. To aid the progress, the central bank has launched an instant payment network called PIX enabling cashless payments in the form of QR and NFC. Thereby allowing StoneCo to implement these forms of payments in its platform. The government is also working on implementing an open banking framework for 2021. These initiatives are positive for StoneCo as it builds its market leadership.
Another point is that e-commerce could also be a positive factor. According to JP Morgan (JPM), ecommerce in Brazil only accounts for 3% of retail spending which is far below developed economies but is forecasted to grow above 4% by 2025 as internet penetration has grown to a high rate at 70%. Thus, the e-commerce industry has plenty of room to rise along with cashless payments. From its annual filing, the company claims that 51% of Brazil's ecommerce transaction volume went through its platform.
Acquisition of Linx
StoneCo is expanding its footprint retail software services with the acquisition of Linx at BRL 6.8bln. According to the IDC, the company is the largest software company for retail management systems with ERP and POS software in Brazil. It has a market share of 45% in the Brazilian ERP and POS retail software market and impressive revenue growth with a run rate of BRL1 bln on a TAM of over BR11 bln. More importantly, this deal would provide strong synergies to StoneCo by broadening its suite of retail software capabilities in ERP and POS with Linx Core. By integrating with its payments processing stack, it creates an end-to-end platform for doing business and provides upselling opportunities to its clients.
In the near-term, management would be able to penetrate Linx's client base of 70,000 and offer its payment processing and receivables prepayment service by integrating with its fintech as a service platform. This would also enable Linx's existing merchants to digitize by integrating its ERP and POS software with Stone's online payments processing tools. In the long term, management sees even greater value generation by streamlining and simplifying existing solutions that Linx develops and expanding its offerings across the SMB market which it has an established presence.
Our valuation is based on assumptions that the company continues to gain market share. While the company is gaining market share rapidly, it is still relatively small with only 14% of market share. The top three bank-linked processors still dominate with over 75% market share combined. These companies have greater scale over StoneCo and are more established. StoneCo is starting to feel the heat of the competition, with its competitors adopting their own digitalization initiatives. For example, Cielo has over 1.5 mln merchants and is adopting digital payments with its partnership with WhatsApp (Facebook) (FB) with over 120 mln users in Brazil, to enable real-time digital payments on the messaging platform.
Besides that, there is also competition from Fintech company Pagseguro which has increased its market share from 7% to 9% in 2020. It has more than 5 mln merchants using its digital payments processing platform. The payments processing company also offer digital banking to consumers and is partnered with Spotify (SPOT), Uber (UBER), Cabify and more. Overall, competitive pressures may weigh on StoneCo which would affect our market share projections and in turn revenue growth rate forecasts of 61%, resulting in a lower price target.
The company has been growing its top line aggressively with an average growth rate of 81% in the past 3 years. Revenue growth for this year however is expected to moderate but a recovery in Q3 increasing 39% YoY indicates the worst is over for the company. For the full year, the company is expected to have a market share of around 14%, rising from 8% a year ago. In 2021, we anticipate its market share to grow further as it continues winning new SMB merchants.
Based on an assumption that it achieves a market share of 17.5%, this represents a market share growth of 22% in 2021. As discussed above, the Brazilian payment processing market is projected to grow at a CAGR of 15% which is in line with market estimates. Overall, we project the company's core revenues to grow 41% in 2021 which is obtained by multiplying the market share growth rate with payments market growth rate.
Accounting for the Linx acquisition, we estimate its revenue contribution of a BRL1 bln in 2021 growing at a CAGR of 11.9% based on the forecasted retail management software market growth rate. Besides that, we estimated revenue synergies of BRL400 mln from payment processing cross-selling opportunities on Linx's customer base of 70,000 by multiplying with the average revenue per customer for StoneCo. In total, we see the company's revenue growing at 61% in 2021 at BRL4.77 bln.
Although the company is successfully growing its market share and top line, the company's free cash flow generation is still negative at -118% as it continues making investments to penetrate market opportunities. Thus, DCF analysis is not applicable to value to the stock. Instead, we apply a comparable valuation based on the payments processing industry price to sales ratio.
We selected companies involved in the payments processing industry across the globe processing over a $1 tln in transactions to obtain an industry average P/S is 23.98x.
Based on the forecasted revenue of 2021 and industry average P/S of 23.98x, our model shows a target price of $97.90 which is 16.1% above market price.
Fintech company StoneCo is a strong challenger to the payments processing market with a leading integrated payments platform. It has a rich set of financial solutions with its prepayment of receivables and credit as well as its suite of retail management software which enables an omnichannel solution. The market opportunity is massive as the company has only reached 6% of the 8.8 mln SMBs across Brazil. It is actively expanding and building up its platform to enable the digitization of commerce with its recent acquisition of Linx to complement its payments platform with POS and ERP retail management software. Although the company already is on an incredible run, the company remains attractive with a revenue growth forecast of 63%. Overall, we rate the company as a Buy with a target price of $97.90 with 16.1% of upside.