StoneCo: This Turnaround Is A Turning (NASDAQ:STNE)

Introduction

This is my third article on StoneCo (NASDAQ:STNE). Let’s see if my timing is better this time! Whilst I originally purchased StoneCo around its IPO price of $25 many years ago, and enjoyed its wild ride to around $80, I sold at this moment as the price was rather ridiculously optimistic on its future prospects. All was good until this point. As the price started crashing after peaking past $90, as it dipped below $50 I started accumulating a position again. And so this continued as it dropped below $10.

At this stage, I should ask if I have simply made a mistake. Whilst my average cost price is once again in the mid 20s (the irony of life!), I find myself still attracted to a number of factors surrounding this company. Let me touch on them in this article.

Recent Results

Past articles I have written on StoneCo discuss the issues the business has been through over the last 2 years, so I shall not repeat them here again. Let’s focus initially on recent Q3 2022 results. My main highlights are:

• I’m excited when the take rate increases from 2.09% in Q2’22 to 2.21% in Q3’22 (1.66% in Q3’21), and the business still increases market share. That is a good quarter.
• When at the same time revenue in the financial services business line increases 71% y/y, it’s a great quarter.
• Digital banking increasing number of clients, deposits and average revenue per active client (ARPAC), as this continues scale benefits will grow.
• Software remains a little disappointing for me. Growth and margins seem to have evolved little from when Linx was an independent entity. What value add is being developed by StoneCo being its owner? Seems for the moment, scale benefits and economies of scope are relatively muted.
• The company is increasing profitability, with EBT margins now approaching 10%. Also, management is rebuilding creditability after missing guidance and estimates repeatedly during 2021. So far in 2022 they have beat earning estimates twice, and been in line once. We are now starting to see earning revisions move upwards, rather than downwards. Momentum fundamentally and sentiment wise seems to be turning positive.

Moving Forward

We have always valued StoneCo highly for its owner operator culture, and its obsession with client satisfaction. This has not changed over the years, though we do believe management pushed themselves to become involved in too many different projects at the same time, which led to a few balls dropping. This appreciation, and the greater focus on execution (which historically I must admit has been good overall, if not overly ambitious) may be behind the recent announcement of the transition in leadership, with Thiago Piau to become a Board Member and Pedro Zinner to become CEO. We see Thiago still committed to StoneCo, but in a higher level role focused on developing key strategic and financial initiatives. The company has made the transition from a startup unicorn to an established business. Often this requires a change in leadership as the top person shifts from being a visionary to being a builder/executer.

Regarding financial results moving forward:-

• We see EBT margins shifting from sub 10% to the 15-20% level as financial expenses as a percentage of sales normalise around or below 30% as inflation and interest rates normalise (currently financial expenses are 37.5% of revenues, they made up 22.5% of sales in Q3’21).
• We see the new credit product being released soon, creating a new source of revenue that complements their payment solution and the current banking offering.
• We will be closely monitoring the software business trying to ascertain if the original strategy of bringing more StoneCo customer to the software platform is working. This should reduce the acquisition cost of a client, and should be visible through an improving operating margin and stronger growth. No evidence of either at this stage.

Valuation

Let me paint some broad strokes here. A business generating an EBT margin around the 15-20% range experiencing GDP like growth in most macro environments would trade around 2 – 2.5x sales. StoneCo currently has sales with an $800 million run rate, whilst trading at a $3 billion market cap @ $11.53. Hence, a no growth StoneCo should trade around $2 billion.

Hence, the current valuation is priced 2/3 by current earning power, and 1/3 on future growth. If we assume in 5 years time, StoneCo would grow at GDP, this suggests the market is pricing around 6% growth per annum until then. Considering at the moment sales growth year on year is >50%, this seems rather conservative.

We believe at the current price, the market is ascribing almost no value to the potential growth being profitable. We think this is creating an exciting investment opportunity, and sufficiently discounts country risk and a prolonged period of higher than average interest rates.