StoneCo: Is the risk/reward worth it?

It isn't often that you find a company that both Warren Buffett and Cathie Wood are invested in. Jack Ma also has a stake in the company through Ant Financial. The stock reached as high as $92 and is now trading significantly lower. The question is if the risk/reward is worth an investment?

This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

This analysis will be a bit different from what you are used to read in my blog. StoneCo is a growth company. So instead of using the principles I have learned from my Phil Town workshop, I use the principles I have learned from the GOAT academy. I should also mention that most of the numbers I use in this analysis is from Finbox, which I believe is a great tool to get different numbers from various companies.

Before I start with the analysis, I should mention that at the time of writing this analysis, I do own shares in StoneCo. It is 1,36 % of my copytrading portfolio and my average buy price is $10,3. I also own shares in both Berkshire Hathaway and Alibaba, which have stakes in StoneCo. Nonetheless, I will keep this analysis unbiased.

StoneCo is a Brazilian company that was founded in 2012. They describe themselves as a provider of financial technology solutions that empower merchants and integrated partners to conduct electronic commerce seamlessly across in-store, online and mobile channels in Brazil. In short, they have designed a cloud-based technology platform that helps clients to connect, get paid and grow their business. They also have banking services, while piloting insurance services that seems to be off to a good start, while their credit business and investments in the Brazilian Banco Inter haven't gone their way, more about that later. Their business model "The StoneCo Model" revolves around a client centric culture, which is quite interesting. It means that they open so-called Stone Hubs in different parts of Brazil, these work as local operations close to their clients, these all have integrated teams of sales, service, and operations support, which makes it possible for StoneCo to serve their clients in person in the matter of minutes or hours, and not in days as with some of their competitors, which is a competitive advantage, as their customers are small business owners. Furthermore, as they provide all these services to their customers, which are small business owners, StoneCo is building a switching moat, as it will be time consuming and difficult to switch provider.

Their CEO is Pedro Zinner. Pedro Zinner is new in the role as CEO, as he became the CEO on April 1st, 2023. However, it isn't new to StoneCo, as he served as a board member at StoneCo before taking the role as CEO. Prior to becoming the CEO at StoneCo, Pedro Zinner was the CEO at Eneva S.A., which is one of the leading power generating companies i Brazil. Pedro Zinner also has experience from companies such as Painaiba Gas Natural, Vale mining, BG Group and Banco Icatu. He holds a BA in Economics from Pontificia Universidade Catolica do Rio de Janeiro and a MA of Business Administration from Chicago Booth Graduate School of Business. Pedro Zinner has more than 25 years of experience in strategy, risk management, and finance, through his former positions. He has been recognized for the transition of Eneva, which took a company that was o the verge of bankruptcy to become one of Brazil's major energy providers. We don't have much information on Pedro Zinner, and we have no results in StoneCo to judge him by. I do like his vast experience and his results in Eneva but at this stage, management is an unknown at StoneCo.

I believe that StoneCo already has a moat that will grow stronger moving forward, as they will get more customers. Unfortunately, I don't have much information about the management, which is something that neeeds to be monitored. Later I will do a discounted cash flow model to calculate a price for StoneCo but before I do so, let us just have a look at some key financial metrics.

Down below we see some key financial metrics. Revenue continues to grow nicely each year, which is always nice to see. Gross profit margin is continuously high, but it is worth noticing that while gross profit margin was higher in 2022 than in 2021, it is lower than in 2020. It is the same pattern we see in Operating margin, EBITDA margin, and EBIT margin. Nonetheless, the margins are still high, so it isn't something that I'm concerned about. 2021 stands out and management has previously acknowledged that they didn't execute as they should have in 2021, and it is good to see that they are back on track in 2022. It is also worth noticing that despite margins increasing in 2022, StoneCo still haven't returned to being a profitable company. It is something that I would like to see in 2023.

Before we continue to the discounted cashflow model, I would like to investigate the risks and potential of StoneCo. One risk is that some of their business decisions haven't gone their way. I wrote earlier about their investment in Banco Inter and their credit business not performing as you would like. They had to write off BR$1,2 billion on their investment in Banco Inter due to share prices dropping. StoneCo sold their remaining shares of Banco Inter in February 2023. Previously, they also had to pause their credit business, as due to malfunctioning of the registry system, which resulted in losses. Stone Hubs could be a risk. Stone Hubs seem to be a great idea, as it gives StoneCo a competitive advantage, but they are also expensive, as you need employees. If in Brazil we see labor cost rise, as in the rest of the world, it could make Stone Hubs a very expensive way to attract new customers. Right now, the payback period for each customer they get is 11-15 months, and it could get longer with higher labor costs. High interest rates. While StoneCo is protected against inflation, as their payments business captures a rate of nominal transactions, and the software business has inflation adjusted contracts, it is another story for higher interest rates because funding is an important resource to grow their company. Previously, StoneCo decided not to transfer these extra costs of higher interest rates to their customers, to keep a good relationship. As a result, it did hurt their margins. Hence, they will need to find a balance through the right pricing strategy, which will keep margins high and customers in house. Brazil's economic environment. Like most other countries, Brazil has a high inflation. Furthermore, their GDP growth are expected to slow down, and we we have high unemployment. StoneCo do not expect to expand into other countries in the next couple of years, meaning they will be largely affected if the Brazilian economy underperforms.

There are also lots of potential for StoneCo moving forward. Large room to grow their client base. StoneCo currently has 2,5 million customers, if you combine their small and midsize business (SMB) and micro clients. StoneCo estimates that there are 8 million SMB's and over 20 million micro clients in Brazil. It means that StoneCo has a lot of room to grow, if they can get their hands on those customers. Brazil switching to digital payments. Unfortunately, the latest numbers I could find through the World Bank is from 2017 but they still show the enormous potential for digital payments in Brazil. In 2017 electronic payments volume in Brazil represented 28,4 % of total household consumption compared to 46,0 % in the U.S and 68,6 % in the UK. 27 % of the population in Brazil, aged 15 or older had a credit card, compared to 65,6 % in the U.S and 65,4 % in the UK. 17,6 % of the Brazilian population aged 15 or older had used to internet to pay a bill or make a purchase, compared to 77,2 % in the U.S and 80,7 % in the UK. These numbers have undoubtedly increased in Brazil since 2017 but it must be expected they are still well behind the other countries. Integrating the acquisition of Linx into their software solutions. StoneCo acquired Linx in 2020, and we still haven't seen the effect of the acquisition yet. However, the integration of Linx into StoneCo is on the right path and StoneCo's software segment reached an EBITDA margin of 16,2 % in Q4 2022, which is the highest since StoneCo acquired Linx. Management has high hopes for software and has previously stated: "We're only in 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 about the opportunities ahead". In the next paragraphs I will go through my calculations to find the intrinsic value of StoneCo.

I have now investigated the financials, risks, and potential of StoneCo I will now look at the price by doing a discounted cash flow model. To do so I will need some numbers that you can see below. The numbers are the 2022 numbers, which I could find at Finbox. However, the perpetuity growth rate and the discount rate are numbers I have come up with myself. The reason I chose 3 % as perpetuity growth rate is that it is usually a between the historical inflation rate of 2-3% and historical GDP growth of 4-5%. I decided to go with 3 %, which is in the middle. The chosen discount rate of 12% is because it is usually between 9-12%, and due to the current market conditions, I decided to go with the highest. Remember that all the numbers made in these calculations are in millions.

I also need to determine how much EBIT, Depreciation & Amortization and Net Working Capital will evolve over the next couple of years. I decided to go with an EBIT growth of 20 % over the next years, which is in line with the analysts' expectations at 21,5 % according to Finbox. I believe that Depreciation and Amortization will grow at the same rate at 20 %, while I keep Net Working Capital flat over the next five years. I haven't found a smart way to share my spreadsheet here but once I made my calculations, I found the intrinsic value of StoneCo to be $27,8.

Having investigated StoneCo I find the company interesting. There are some uncertainties regarding management because the CEO is new, but I feel comfortable in in vast experience. StoneCo does not expect to expand outside of Brazil anytime soon, which means that when investing in StoneCo, you are dependent on the Brazilian economy, and you need to have the stomach for that. However, it is also one of the reasons that the investment case of StoneCo is intriguing, as the transition to digital payments in Brazil is lacking most western countries, meaning that a company like StoneCo could see significant growth. I don't know if it is a risk per se, but I would like to see StoneCo turning profitable again. I just feel better investing in profitable companies. Finally, investing in emerging market stocks is going to be a rollercoaster ride and you will need to be able to stomach that if investing in StoneCo. All being said I think that the risk/reward in investing in StoneCo is worth it if you can get the stocks below 50 % of intrinsic value at around $14. However, I will personally keep the position relatively small.

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