Stone Profile (NASDAQ: STNE): Warren Buffett's bet on Brazil's small businesses
In 2018, Warren Buffett’s Berkshire Hathaway, unexpectedly, invested in two Fintech companies: India’s Paytm (NSE: PAYTM) and Brazil’s Stone (NASDAQ: STNE 0.00 ). I wouldn’t dare to say I know the rationale behind this decision, but I would guess that Berkshire made bets on the digitization of payments in large emerging markets. Cash is being gradually replaced with cards, mobile wallets, and other forms of digital payments, and Paytm and Stone were well positioned to profit from this trend.
During its first years as a public company, Stone delivered impressive returns. However, in 2021 the company’s fortunes changes: its lending operations got swamped in credit losses, the Central Bank of Brazil started hiking rates, the company’s equity investments had to be marked down…and Stone posted a massive loss for the year. Stone’s shares lost almost 90% of their value, and some observers even called out Buffett for making a mistake.
However, it is too early to call Stone a flop. The company keeps growing its customer base at an impressive pace. It has broadened its product offering beyond acquiring and now offers bank accounts, payment cards, and insurance. And the company’s management is working fiercely on restoring profitability. I don’t know if Stone will be able to restore its previous glory, but this is definitely an interesting transformation to follow!
Please note that the company reports in Brazilian Reals (denoted as R$ further in the text). As of this writing, the exchange rate to USD was R$5.38.
The latest annual report of the company claims that “in 2021, 2020, 2019 and 2018, [ Stone ] was the largest independent merchant acquirer in Brazil and the fourth largest based on total volume in Brazil according to data from public sources.” You can think of Stone as “the Square of Brazil” since the company provides a similar range of services: POS software, payment terminals, payment processing, digital accounts, and working capital financing.
The company competes with bank-owned and bank-controlled acquirers, such as Rede, Cielo, and GetNet, as well as independent acquirers, such as PagSeguro. According to Stone’s data, the Brazilian merchant acquiring industry processed R$2.7 trillion in Total Payment Volume (TPV) during 2021, resulting in an 11.2% market share for Stone based on Q4 2021 TPV.
The company groups its payment clients into two segments: micro, small and medium-sized business, or “MSMBs”, and, “Key Accounts”, which includes sub-acquirers, platforms, and larger merchants serviced through the company’s subsidiary Pagar.me.
In 2018 Stone started piloting its digital banking services with the promise that it can extend the range of services offered to micro and small merchants and increase the average revenue per client. As of today, the company’s banking services are used by more than 500,000 customers and include digital accounts, payment cards, bill and PIX payments, as well as insurance.
Stone offers digital banking services and payment cards free of charge and monetizes the service by investing customer account balances into short-term financial instruments (“floating revenue”), as well as through card interchange fees. It should be noted that Stone is a payments institution, not a bank; thus, it has limited capacity to use customer account balances for lending.
Stone offers two types of lending products: working capital financing (or “prepayments”) and loans against receivables. Working capital financing is a form of short-term financing that allows merchants to receive payments from their customers faster. Thus, in Brazil merchants would typically receive payments from the acquirers in 30 days after the customers settled their credit card bills. Stone transfers the authorized payments to merchants within days, taking the credit risk that the payments will not be settled (and there will be no merchant to collect from).
In 2020-2021 Stone decided to go beyond working capital financing and started scaling its lending against the receivables (the company would lend money to a business, and retain a share of sales collected with payment terminals, as loan repayments). However, in mid-2021 they had to halt this product due to mounting credit losses. The company realized that the national credit receivables registry and its own internal processes were not ready for full-scale lending operations. The company plans to return to lending sometime in 2023.
Finally, the company offers its clients software solutions, such as Point-of-Sale software, CRM and ERP systems, as well as eCommerce, Loyalty and Marketing platforms. In 2021 the company doubled down on its software business by acquiring Linx, Brazil’s leading provider of POS software. The company estimated that it had “approximately 13% penetration of the software SAM in Brazil, which totals R$9 billion in revenue” following the acquisition.
In summary, the company generates its revenue from a) payment processing fees and payment terminal sales and leases, b) working capital financing (“prepayments”), d) interest on banking customer account balances (“floating revenue”), c) software subscriptions, and d) interest it earns by investing its own cash into short-term financial instruments.
Stone’s growth in terms of active payment clients is nothing short of spectacular. Thus, the company grew its payment client base at a compound annual growth rate (CAGR) of 92% during the 2017-2021 period, from 0.13 million clients at the end of 2017 to 1.76 million clients at the end of 2021.
Client growth came primarily from the MSMB segment in the last couple of years. As the chart below illustrates, the MSMB segment client base grew at a triple-digit rate from Q2 2021 to Q1 2022. The growth slowed down in Q2 2022, but was still impressive, with Stone surpassing the 2 million MSMB clients mark in Q2 2022. The company estimates that there are 13.5 million MSMB clients in Brazil.
Growth in the “Key Accounts” segment has been more modest. This segment includes sophisticated retailers, e-commerce, and technology companies that consume Stone’s payment capabilities via APIs. Stone groups “Key Accounts” segment clients into “sub-acquirers” and “platforms” and the company has been gradually offboarding sub-acquirers, which hinders segment growth.
In early 2022, the company surpassed the milestone of 500,000 active banking customers. Stone finished Q2 2022 servicing 526,000 customers. The growth curve is rapidly flattening out, so it will be interesting to see what the company does to continue growing this business. Stone’s banking services make sense when combined with its payment acquiring service (meaning that we should not expect the number of banking clients to surpass the number of payment clients).
The two charts below perfectly illustrate the company’s failed effort in the lending business. Thus, you can see rapid growth of credit clients and credit portfolio during the Q1 2020 - Q2 2022 period, and a no-less rapid decline since then. The company halted its lending operations and is running down its lending book. At the beginning of the year, the company’s management was optimistic about resuming lending operations in 2022, but by now the plans moved to 2023.
Total Payment Volume
As for any merchant acquirer, Total Payment Volume, or the total value of processed transactions, is the key metric driving revenue. Total Payment Volume processed by Stone grew at a compound annual growth rate of 54% during the 2017-2021 period. The company processed R$337.9 billion in TPV during the last four quarters (Trailing Twelve Months, or TTM), so the growth continues into 2022.
Over the last couple of years, TPV generated by the MSMB segment customers grew at a faster pace than TPV generated by the Key Accounts segment customers. As the result, the share of MSMB TPV grew from 60% in Q1 2020 to 77% in Q2 2022. As I will discuss later in the text, Stone charges MSMB customers a much higher Take Rate, so the increasing share of MSMB TPV is a positive contributor to the growth of the company’s revenue.
The reopening of the economy after the pandemic shutdowns played a role in the growth of the MSMB segment in 2021, but, as the chart below illustrates, the growth continues into 2022. Let’s see if Stone can deliver further growth despite the complicated comps of Q3 2021 and especially Q4 2021. The company’s management guided for R$73-74 billion in MSMB TPV in Q3 2022, which implies a 41-43% growth YoY.
We discussed above that customer growth in the Key Accounts segment is modest, and, as the chart below illustrates, the Key Account TPV has been almost flat during the last 4-5 quarters (partially driven by the above-mentioned offboarding of the sub-acquirers). I don’t think that Stone is ready to abandon this segment completely, but the management’s focus is clearly on the MSMB segment.
Stone grew total revenue at the compound annual growth rate of 58% during the 2017-2021 period. As noted earlier, there are multiple components of Stone’s revenue: a) revenue from transaction activities (payment processing, interchange fees), b) financial income (“prepayments”, floating revenue from investing customer balances, income from credit products), c) subscription services (POS software, payment terminal rental), and d) other financial income (interest on corporate cash).
If you look at Stone’s quarterly revenue, you will notice a turning point in Q2-Q3 2021 (see the chart below). Besides the organic business growth, multiple things contributed to this change. First, Stone started experiencing severe losses in its credit business in Q1-Q2 2021. Second, in late Q1 2021, the Central Bank of Brazil started aggressively hiking the interest rates (Certificado de Depósito Interbancário or “CDI rate”) to fight inflation. Third, Stone started repricing its services to reflect the higher cost of funding. And finally, the company completed the acquisition of Linx, which added R$246 million to Q3 2021 revenue.
Plotting the company’s financial income numbers on a chart perfectly illustrates this turning point (Financial Income includes interest on “prepayments”, “floating revenue”, and interest on credit products). As you can see, Financial income started declining in Q1 and Q2 2021, as Stone started occurring credit losses (credit losses decrease Financial Income through Fair Value adjustments). However, the trend reversed in Q3 2021 as Stone halted its lending operations and started repricing its services to reflect the increase in the interest rates.
Let’s discuss how the central bank’s rates (CDI rate) impacted Stone’s business. As explained above, working capital financing, or “prepayments”, is a critical piece of the acquiring business. Stone charges its clients not only for processing the payments, but also for settling the transactions faster. Therefore, when the Central Bank of Brazil started hiking rates, Stone experienced a sharp increase in the cost of funding, and had to start aggressive repricing of its services. As you can see from the chart below, the competition was driving the Take Rates down in late 2020 and early 2021, and the trend reverted in the second half of 2021.
In addition, higher interest rates made it more attractive for Stone clients to hold their money in their banking accounts. Thus, as you can see from the chart below, banking client balances ballooned from R$862 million in Q2 2021 to R$2.3 billion in Q2 2022. Stone earns a margin on those account balances (“floating revenue”), which is reflected under the “Financial income” position in the financial statements.
Stone turned profitable in 2018 and reported profit before taxes in 2019 and 2020. However, in 2021 things turned south and the company reported a R$1.45 billion loss before taxes. Two things happened: a) the rising rates increased the company’s cost of funding, and b) the company had to mark losses on its investment in Banco Inter (as well as pay interest on the bond it issued to finance this investment).
As can be seen from the chart below, Stone’s operating expenses fluctuated between 60% to 76% of the total revenue during 2020 and early 2021; however, those rapidly escalated to over 100% of the revenue in Q3 2021, as the Central Bank of Brazil started raising rates.
Financial expenses, relative to the revenue, grew from single digits in early 2020 to 41% in Q2 2022. The increase was partially driven by higher TPV and “prepayments” volumes, but the main impact came from the rising rates and higher cost of funding. As I noted earlier in the text, the company cannot use customer balances to fund lending; and thus, has to rely on external funding and its own capital.
In addition to the rising financial expense, Stone had to mark down its investment in Banco Inter (positive bars on the chart below indicate a mark-down). Brief history: in May, 2021 Stone acquired a 4.99% stake in Banco Inter, a banking challenger boasting over 20 million customers, for R$2.5 billion. The company issued a $500 million bond (that’s 500 million in U.S. Dollars) to fund the transaction. Thus, starting from Q2 2021 the company started marking this investment to market, as well as paying interest on the respective bond issue.
If we exclude the mark-to-market adjustments (and the interest on the issued bond), then the total operating expenses were almost equal to the company’s revenue during the last four quarters (i.e. 98% of the revenue in Q2 2022). Thus, the company continues to reprice its agreements to boost revenues and optimize its costs to return to profitability. The topics of repricing and operational efficiency dominate the earnings calls, and I expect this to continue into 2022 and 2023.
Net Income (Loss) and Adjusted Net Income
2021 was a difficult year for the company, as it went from a Net Income of R$837 million a year earlier to a Net Loss of $1.38 billion. On an adjusted basis, the company remained profitable posting an Adjusted net income of $203 million for the year. As you can see from the breakdown below, the main adjustment is the Mark-to-Market on Banco Inter investment and the cost of the bond that the company issued to finance it (R$1.38 billion in total).
The chart below perfectly visualizes the turn of fortunes that Stone experienced last year. The company continues to post Net losses in 2022 on a non-adjusted basis; however, those losses are primarily driven by the Mark-to-Market impact of Banco Inter investment (R$323 million in Q1 2022, and R$527 million in Q2 2022).
In Q2 2022 Banco Inter listed its shares on NASDAQ, and Stone sold part of its stake as part of the process (Stone sold a 1% stake receiving R$180.6 million. The company paid R$500 million for this stake in May 2021). As the result, the company will not adjust Net income with bond expenses going forward.
Things to Watch in 2022 and Beyond
MSMB segment growth. The MSMB segment is the main driver behind customer and TPV growth. As the company has already crossed the milestone of 2 million MSMB customers, I would expect that posting further growth will become harder. The earnings calls suggest the management focus is on the MSMB segment, but we should not exclude the possibility of the company refocusing its efforts on Key Accounts in case the growth stalls.
Repricing efforts. As per the management’s comments, the company will continue repricing efforts which should boost revenues and improve profitability. The company’s performance will also be impacted by further actions of the Central Bank; though, it is not clear whether we should expect further hikes or a rate cut. For Stone, rate increases are double-edged swords that help the company boost revenues, but at the same time increase the cost of funding.
Banking services and lending. The company is planning to return to lending, but I doubt this will happen before 2023. Predicting the direction of interest rates is a wild guess, so even if the company is ready for the relaunch from the product standpoint, I would expect them to wait until there is better visibility into the funding environment. I would also expect the company to evaluate options of becoming a bank, so it can use customer deposits to fund lending.
Restoring profitability. The company used to be profitable in a low-interest rate environment. Let’s see if the company manages to restore profitability with the current funding rates, or if it has to change its business model.
Stone is a great illustration of how quickly a fortune of a Fintech company can change, especially, if it involves lending. 2021 was a rough year for Stone, but I am hopeful that the company’s management will manage to turn things around. In any case, it will be interesting to follow their progress!
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Source of the data used above: Investor Relations
Disclosure & Disclaimer: despite rocky performance in 2021 and 2022, I own shares in most of the companies covered in this newsletter, as I am extremely bullish on the long-term transformation in the financial services industry. However, none of the above is or should be considered financial advice, and you should do your own research.