Lyndon Stratford
Investment thesis
PagSeguro (NYSE:PAGS) is a pioneering disruptor in Brazil’s payment landscape that has grown its share from 1% to 11% in the span of 7 years. The company specialises in servicing small merchants and is diversifying its growth strategy to SMBs as well. Total Payment Volume (TPV) per merchant has grown 5x over the past four years while the company’s processed TPV has grown 25-fold over the same period to BRL 354 billion. I believe this is a well-run business, generating industry-leading margins, has a clean balance sheet and has a long runway of growth from secular tailwinds as well as company-specific drivers expanding its total addressable market. The market is under-appreciating the potential of a turnaround in the economic conditions as well as the long-term potential for Average Revenue Per User (ARPU) for this business. All things considered, I believe there is a wide margin of safety at these levels.
Introduction to the business model
PagSeguro, a leading financial technology entity headquartered in São Paulo, Brazil, has strategically positioned itself as a comprehensive facilitator of electronic transactions, catering to a diverse clientele ranging from individual consumers to businesses. Central to its offerings is its robust online payment processing suite, which encompasses everything from sophisticated payment gateways tailored for e-commerce platforms to agile mobile payment solutions. Complementing this is the company’s array of Point-of-Sale (POS) devices, designed to cater to varying merchant needs, enabling seamless card transactions in physical retail environments. The firm’s emphasis on innovation and technology has not only ensured its offerings remain state-of-the-art but has also allowed it to capture a significant share of Brazil’s fintech market, particularly among micro-merchants and small businesses, a segment often underserved by traditional financial institutions.
Beyond its foundational payment solutions, PagSeguro has cleverly ventured into the realm of digital banking, marking its evolution from a mere payment processor to a holistic financial solutions provider. The PagBank digital account stands as a testament to this expansion, offering consumers a plethora of services, from basic functionalities like bill payments and online transfers to more advanced features, including earning interest on account balances. This strategic move underscores PagSeguro’s vision of creating an integrated financial ecosystem where its myriad services interconnect seamlessly, enhancing user experience and fostering customer loyalty. Furthermore, the company’s unwavering commitment to regulatory compliance, a non-negotiable in the fintech sector, has fortified its reputation, ensuring sustained trust from its expansive user base and positioning it favorably for future growth in Brazil’s dynamic fintech landscape.
Overview of the industry and its main drivers
Legacy payment processors in Brazil were charging merchants ~5% take rates (the amount a payment processor retains as a fee for facilitating the transaction) up until PagSeguro and StoneCo (STNE) initiated a wave of disruption in the business. This is a classic example of Counter-positioning in the language of 7 Powers. The legacy players were not only reluctant to reduce the fees to compete but also needed to innovate their existing infrastructure, requiring further investment. A double whammy to margins. So, with the backdrop set, let’s examine what the main drivers in this business are: First and foremost are take rates. The higher the fee charged per transaction, the higher the revenues for PagSeguro. Second, for the most part, PagSeguro’s market comprises Brazil’s card spending on POS terminals. Online & offline. As you can imagine, this is a structural growth driver as payments are increasingly converted to digital. The third driver is the number of merchants acquired by PagSeguro.
When you think of PagSeguro, think of small merchants. That’s their strategy, going after the long tail of merchants with lower than ~$28k annually (137k BRL).
Competition and growth
PagSeguro’s counter-positioning led to market share gains. According to data in the quarterly reports, over the past 12 quarters, PagSeguro outperformed the market’s TPV growth by an average of 2500 basis points (or 25%) per quarter. Legacy players had neglected the smaller merchants for a long time, and this is PagSeguro’s main hunting ground. StoneCo, on the other hand, focuses on SMBs and larger merchants. While StoneCo mainly focuses on payment processing, PagSeguro is broadening its market to convert its payment processing business into a multipurpose financial ecosystem. According to data presented by PagSeguro, the company has 11% market share, which grew from 1% seven years ago. Meanwhile, incumbent players’ market share declined from ~80% in 2015 to 50% in 2022. The addition of PagBank into their ecosystem is helping grow their ARPU (by ~4x), increase their NPS score and significantly decrease churn.
Model (Company Financials and Refinitiv Consensus)
Revenue and Total Network Spending Volume have a 5-year compound annual growth rate of ~40% and ~80%. The slowdown in consensus revenue projections is a function of higher interest rates in Brazil, which grew from 2% in 2021 to 13.75% in 2023. This massive step-change has significantly impacted PagSeguro’s business and cost of capital.
Profitability and balance sheet
Alongside StoneCo, PagSeguro generates industry-leading margins, which reflects its innovative business model. Cielo’s margin is ~1000 basis points lower than the disruptors. Not to mention that their pace of growth is also hindering profitability at the moment.
Profitability (Seeking Alpha Data)
As PagSeguro scales the business, I expect profitability to improve even if the take rate pressure continues. Currently, the banking business is loss-making, and I expect the net impact on profitability from that business to continue being negative; however, eventually, it has the power to increase ARPU in orders of magnitude higher than what it is now. PagSeguro’s balance sheet is exceptional, with very little debt and net cash of ~2.5bn BRL (~$500mn).
The Central Bank’s SELIC Rate notably impacted PagSeguro’s financial costs. The rise in interest rates was the primary driver behind the substantial YoY surge in financial expenses, which consequently led to a contraction of the company’s net profit margin by ~300bp. Consequently, there was a noticeable reduction in PAGS’ adjusted net margins from one year to the next. This was a relatively large drag on profitability and is now being reversed.
Fundamental catalysts to the investment
The hike cycle is likely over in Brazil, and in fact, Brazil carried out its first interest rate cut in August 2023 from 13.75% to 13.25%. This will turn from a headwind to a tailwind. This is likely to be the beginning of a series of interest rate cuts, also considering the political pressure the newly elected president Lula da Silva applied.
PagSeguro’s efforts to diversify its currently vast micro merchant customer base to include more SMBs. Although this may cause some pressure on take rates, it will likely serve the business well in upselling new products within the ecosystem as well as accelerating its Total Payment Volume.
According to statistics published by the company, card penetration for private consumption was at 34% in 2018 and grew to 55% in 2021. Even as competition intensified during that period, PagSeguro managed to grow its market share. I expect this long-term growth driver to stay intact and market share gains to continue, especially as the company offers a more complete offering of financial ecosystem tools for merchants and users.
Ecosystem of products (PagSeguro)
The above catalysts should bear fruit in the year’s second half.
Valuation
I believe consensus is underappreciating the positive impact the rate cuts will have on the financials, and even with these projections in mind, PagSeguro’s valuation trades at significantly cheaper multiples in all metrics compared to peers.
Valuation Table (Seeking Alpha Data)
Valuation Chart (Seeking Alpha Data)
Not only is PagSeguro trading at cheap multiples relative to peers, it is also trading at historically lowest valuation multiples since entering the public markets. In fact, PagSeguro now trades at a ~65% discount relative to its 5-year average P/E and an 85% discount relative to its 5-year average EV/Revenue. This makes up for a compelling opportunity to invest in this well-run and growing business.
Risks
Like every investment, the upside must be weighed against the downside. A significant risk embedded in this investment thesis is a slower or less pronounced monetary easing cycle, leading to prolonged elevated funding expenses. This will have implications for my growth as well as profitability assumptions. Furthermore, even though PagSeguro has been a share gainer even in the face of competition, rivals may start to catch up with a more compelling product offering, thus causing a halt to market share gains as well as pricing pressure.
The regulatory intervention has had significant implications for Brazil’s payment landscape. PIX is a real-time payment system launched by the Brazilian Central Bank in November 2020. It allows users to make and receive payments instantly, 24/7, for free. PIX has been a major success in Brazil, with over 114 million users and over 10 billion transactions processed in its first year. It has made it easier and cheaper for people to make payments, which has led to an increase in the number of transactions. PIX has also made it more difficult for traditional payment providers like credit card companies to compete.
Below are the impacts the PIX regulation had on PagSeguro:
Increased number of transactions
PIX has made it easier and cheaper for people to make payments, which has led to an increase in the number of transactions being processed by PagSeguro. This has been a major growth driver for the company.
Decreased fees
The PIX regulation has capped the fees that payment providers can charge for PIX transactions. This has put pressure on PagSeguro’s profitability, as the company has traditionally relied on fees to generate revenue.
Increased competition
The PIX regulation has made it easier for new players to enter the Brazilian payments market. This has increased competition for PagSeguro, which will need to continue to innovate in order to maintain its market share.
Conclusion
In summary, the market currently underappreciates the financial benefits of lower interest rates, and meanwhile, the business continues to expand its product suite to offer wider and more comprehensive offerings that increase customer delight. The improved functionality of PagSeguro’s ecosystem is likely to translate into higher stickiness and lower churn. In my view, the caveats accompanying the investment are largely priced in. While Brazil’s regulatory landscape is hardly predictable, I believe the groundbreaking PIX regulation was enough to shake up the markets for five years and will not recur.
