StoneCo Stock: A Ballsy Bet on Brazilian Businesses
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Imagine working in a department where your goals were impossible to meet, your actions created division amongst employees, and every competent individual regarded your function as useless. No, we’re not talking about human resources, we’re referring to the diversity, equity, and inclusion (DEI) functions that ought to be getting trimmed, oh, right about now that the bear market has started.
If DEI did their job properly, every organization would be staffed with the exact proportion of people that make up this planet. An organization of 1,000 people would need to scour 85 different countries to start hiring diverse folx – one Cuban, two Rwandans, three North Koreans, four Yemenis, and the list goes on. They’d also need 187 Chinese, 181 Indians, 43 Americans (with appropriate racial breakdowns), and 28 Brazilians.
As the seventh most populous country on this planet with 215 million people, Brazil is as corrupt as Indonesia and rich as Russia. It’s the largest fintech market in Latin America (fifth in the world), with about 700 startup companies. One of the opportunities these fintechs are trying to capture is providing B2C payments platforms for the 30 million small to medium businesses that drive a good chunk of the Brazilian economy. One of these fintech players is StoneCo (STNE).
About StoneCo Stock
Short-term share price movements should be taken with a grain of salt, but sometimes you can’t help but wonder what happened to a stock. Below we’ve circled what StoneCo’s basic financials looked like in 2018, the year they had their initial public offering which was priced at $24 a share and saw participation from Warren Buffett himself.
After shares breached $90 a share in early 2021, things hit the skids fast. Over the past rolling year, shares of StoneCo have lost 86% of their value (compared to a Nasdaq loss of 21% over the same time frame) with shares trading around $8.50 giving the company a market cap of $2.6 billion. The rapid fall in share price is at least partially attributed to the company’s small business credit offering which was wisely paused in mid-2021 around concerns about businesses being able to pay back their loans.
In credit, we ramped up our offering quickly, but did not manage it well.
StoneCo
StoneCo’s SMB Business
There are 30 million micro, small and medium-sized enterprises (MSMEs) in Brazil, accounting for 30% of the country’s GDP. StoneCo has managed to land nearly 2 million of them as clients who utilize the company’s payments platforms. One payment product provided by StoneCo is TON, a point-of-sale (POS) terminal that merchants can purchase at price points that vary based on the fees they’re willing to pay. The higher the fees, the less the terminal costs.
Not only are the hardware products financed by StoneCo, but the transactions can be as well. In other words, a merchant might allow their customers to pay in installments – up to 12 monthly installments – and StoneCo accepts these payments and returns the money to the merchant minus an interest rate which can range from 12% to 25%. Merchants can also borrow against their receivables which is referred to as “collateralized credit, backed by card receivables” and it’s about as risky as it sounds.
Less than three years ago StoneCo started offering credit to businesses and dispensed around $647 million worth of loans. The below chart shows how dramatically the value of that loan portfolio has been dropping. (Forget about the currency conversion, just compare the top number – loans outstanding – to the bottom number – money they expect to get back.)
The good news is that StoneCo has nearly recovered the entire $647 million in outstanding loans and may realize a small profit on that venture. The bad news is that they showed investors just how risky it is to offer credit to small Brazilian businesses and their customers.
We’ve always felt buy-now-pay-later (BNPL) is a horrible idea because it doesn’t take into account the consumer’s credit score or ability to pay back the loan. In America, companies are not required to do any due diligence before extending BNPL credit. Now imagine extending credit to individuals in an emerging market like Brazil which only began putting together a credit scoring system in place a decade ago. The complexity only increases when you add other stakeholders like merchants and banks. StoneCo’s stock may have plummeted because credit was supposed to be a critical component of the value they expected to realize from businesses.
The company believes that this is still possible and attributes the problem to regulatory changes and – wait for it – the Rona. It’s all detailed in a paper they published – The New Dynamics of Registration of Receivables in Brazil – on the root cause of their credit crisis. They’ve now hired a Head of Credit and expect to resume their credit offering with improvements that include “personal guarantees” and “better risk monitoring.”
Banking for Brazilian Businesses
Offering banking products to small businesses sounds like a “do good while doing good idea.” Remember the adage? Sell to the poor, live with the rich, sell to the rich, live with the poor. However, the reality is that operating in emerging or frontier markets comes with its own set of risks and challenges. The biggest problem is that small businesses don’t have a lot of money to begin with. StoneCo reported 510,000 banking clients with deposits of around $380 million – about $736 per business. Each of these clients generates an average of $6.28 in revenues per month for StoneCo which seems quite high. That’s probably because StoneCo has now thrown insurance products into the mix so it’s difficult to say what’s really happening with their banking business. An article by Bloomberg several months back talked about how higher interest rates are creating problems for StoneCo and their competition.
Let’s not forget that the fintech market in Brazil is extremely competitive, and local banks and/or the government could certainly use legal/regulatory means to thwart the competition. The outrage machine doesn’t work so well overseas, and in some places, it’s culturally acceptable to play dirty. We question how profitable StoneCo will be given they operate in a highly competitive market, a concern that other analysts have raised.
Domingos Falavina of JP Morgan was asking the hard questions last earnings call when he challenged the company’s ability to achieve the margins that a market leader might hope to attain. At one time, StoneCo had margins of 40%, and now they’re running at a loss. Mr. Falavina estimates that StoneCo has an 11% market share, and the leader has 25%. If StoneCo can command a leadership position, they’ll be able to dilute their fixed costs away and increase margins. Otherwise, they’ll need to cut costs, perhaps by trimming some of the 15,000 employees on their payroll. The company’s response talked about pricing increases, focusing on more profitable clients, and the emergence of banking services (roughly 75% of StoneCo’s two million clients aren’t using their banking offering yet). That’s assuming that the emerging market they’re operating in doesn’t throw any more curveballs.
Investing in Emerging Markets
It seems unlikely Mr. Buffett or many of the bullish StoneCo analysts have spent enough time in emerging markets to understand just how difficult it is to do business in these environments. Over several months spent scouting startups in Indonesia, we observed aggressive payments companies attempting to capture clients by subsidizing meals. Nearly every restaurant in your average Jakarta mall had a sign from one or more fintech companies offering large discounts on meals if you downloaded their app. The survivor ended up being the firm with the deepest pockets, with the prize for the winner being questionable. What was the quality of accounts captured once all the fraud was filtered out? This is a country where multiple people can occupy the same identification number. In Jakarta alone, up to five different databases store people’s identification information which leads to duplicates and misinformation. This raises several important questions.
- In a highly competitive market, just how much money should be spent trying to lure customers away from competitors to capture market share?
- If the ground truth for identification is faulty government databases, or relatively new credit scoring systems, just how prone is the system to fraud and deception?
We’ve gone a bit off track here, but the point is that we find the BRIC countries – Brazil, India, China, and Russia – present far more risk than we’re willing to take. Technology is risky enough in developed markets, but when you throw in corrupt governments, cultural differences, entrenched religious beliefs, volatile currencies, and exceptionally crafty criminals, success becomes more luck than skill. StoneCo has hinged the entire success of their business on a single country/market and that’s a risk we’re not willing to take.
Conclusion
Ever since we exited our position in Ali Baba we’ve been avoiding China as an investment thesis, primarily because of the risk surrounding VIE structures. It’s plain to see there’s tremendous opportunity to be realized in places like China, Indonesia, and Brazil, but you need to have boots on the ground to properly vet these opportunities. Any firm that derives their success solely from a single country is risky, even if that’s a developed market like the United States or Germany. That’s just one of many reasons why we’ll be avoiding StoneCo stock.
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Joe, thank you for your thoughts relate to STNE and emerging markets. During the irrational exuberance of the tech companies I was not interested in STNE, but now with the huge drop I decided to go long.
Well, I have a bit of advantage, although my boots are not anymore in the ground, they used to be. In fact a big chunk of my retirement income depends on the investments that I have in Brazil.
I fully agree with your “nice” comments about emerging countries, and of course Brasil is not different. Been able to follow the economy and a bit of the politics, definitively helps.
Few comments. Brasil started the interest increase much earlier then other countries, and it is already possible to see some effects over the inflation. Of course we need to be alert all the time, we usually say that in Brasil even the past is uncertain.
BNPL is not new in Brasil, you can use credit card and pay in installments almost anything (not the minimum payment of the total invoice, you can choose the number of installments for every specific purchase) and has been is this way for decades. No financial institution went down because of this.
Thank you very much for sharing your thoughts on this Joao. Wow, so BNPL is actually a cultural feature in Brazil? That’s remarkable. We were having a hard time understanding where StoneCo went wrong on the loan side. They talk about “collateralized credit card receipts” which means they loaned money against a merchant’s receivables. Really had a hard time seeing how that went pear-shaped. The paper they published wasn’t all that clear, but we would deduce that businesses fell on hard times and many went under. They talk about how “acquirers” were also creating problems and we’re not familiar with those intricacies. Perhaps only a native investor – one with some level of sophistication – might be able to navigate this investment opportunity safely and truly understand what’s happening. In our previous conversations I recall you mentioning your exposure to Brazil so you sufficiently understand the opportunity enough to calculate risk vs. reward. “Even the past is uncertain.” Hah!
Superb piece, Joe! I you laid out well all the “negative intangibles“ that I was having trouble wrapping my arms around. I have a small position at $7.75, which I will be selling today. Also putting Brazil off-limits. There is no need to wrestle with these headaches when there are more than enough great opportunities in the developed world. Thanks very much.
Thank you for the feedback Ken. Plenty of readers/subscribers have said they’ll continue to hold StoneCo so it’s all about your own personal tolerance for risk. For us it’s just too tough to follow and risky for the reasons we pointed out. Really glad you found this piece useful! More people were interested in this company that I thought – Joe
ARK: “Shares of StoneCo traded up ~16% on Friday after the company reported third-quarter results that surpassed expectations , with revenue up 71% year-over-year, total customers up 71%, and total payment volume (TPV) up 26%”