Pagseguro and Stone, cheap for a reason?
Economics and prospects of the two large Brazilian POS networks.
Pagseguro ($PAGS) and Stone ($STNE) are two Brazilian payment processors. Each holds about 12/15% of the Brazilian card acquisition market. Both companies are heavily discussed in the market today because of their low multiples, even compared to other Brazilian financials.
I had already covered the companies briefly on my Brazilian Capital Markets Primer, but this article goes a step ahead, in order to really explain their business model, where they make money (and where they don't), competition, etc.
My general read after this research is that both are cheap for a reason: their main market is currently saturated and at risk of commoditization or replacement by PIX parcelado. Neither PAGS nor STNE has or can enter other businesses to replace that market.
Given saturation, the ‘best scenario’ for the companies is growth at a rate of GDP plus inflation, whereas downside scenarios can easily see the business evaporate or shrink quickly. The multiples are undemanding, but for a reason.
Disclaimer: The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product.
I own shares of Pagseguro.
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The real business: receivables discounting
PAGS and STNE core business is owning and developing a network of merchants that use their POS machines to process payments with credit cards, debit cards, and PIX. The companies charge a percentage (take rate) on each payment received by the merchants.
This take rate represents two different services provided by PAGS and STNE to the merchant: payment processing and receivables discounting.
Payment processing consists of informing and confirming with all players in the payment chain that the payment is valid. These players include the card network (Visa, Mastercard, etc.), the issuing and receiving banks, and the Central Bank.
The take rate on the processing business goes from 0.75% to 2%, depending on whether it is a PIX, debit card, or credit card payment. In turn, PAGS/STNE have to pay a (big) portion of that take rate to the card networks and the banks involved. These costs are called the Interchange and transaction fees.
Most people think STNE and PAGS make money because of the above service, but in reality, they do not, or only barely. The processing part of the business has been mostly commoditized away, so that almost all of what the companies charge gets paid to the banks and networks. Below is the Payment Processing Revenue (called Transaction Revenue in the companies’ financials), net of interchange fees, as a percentage of Total Payment Volumes (TPV).
The real business of these two companies is receivables discounting. This type of business is only generated when credit card payments are used.
It works like this. When a customer pays with a credit card, neither the merchant nor PAGS/STNE receives the money automatically, but only after 20/30 days. During that period, it registered both as a payable (to the merchant) and a receivable (from the bank) in the balance sheet of PAGS/STNE. These receivables make up the bulk of the assets of the companies.
However, most merchants are willing to pay an extra take rate, usually 2 percentage points, to receive the money on the payment day, without waiting 30 days. In this case, PAGS/STNE pay the merchant in advance with their own cash (therefore offsetting a liability, merchant payables, with an asset, cash), and keep the receivable from the issuer bank.
The extra take rate paid by the merchant is actually a discount rate of about 2% for 30 days, or about 25/30% annualized, which is pretty high, even for Brazilian standards.
Further, this type of financing has basically no risk for PAGS/STNE, because it is guaranteed by the issuing bank, and if not, by the card network (Visa, Mastercard).
Because they have low credit risk and a short maturity, receivable assets can be leveraged with interbank funds, paying the interbank rate (CDI in Brazil, currently around 15%), without losing profitability.
The discounting business, recorded in the financial statements as Financial Income, is by far the most important revenue generator, as seen below.
The discounting service is so profitable that most payment processors (except PAGS) do not offer the opportunity to wait for credit card funds. The funds are directly deposited into the merchant’s account after applying the higher discount.
The discounting service is also why both PAGS and STNE concentrate on the Micro Small and Medium Business (MSMB) segment. These merchants don’t have access to other forms of credit, and their working capital management is not very sophisticated, so they need the funds ASAP and don’t mind paying the extra rate. Corporations and large companies can negotiate lower discount rates or wait for the original payment terms in order to save on financing.
The problem: the market is saturated
This is a great business, with low capital requirements (payables can be financed because they have low risk), and good profitability.
The problem, however, is that the market is already saturated. PAGS and STNE grow at the same speed and have reverted to the growth rate of the cards market, as seen below.
Further, the card payments market is basically growing at the same speed as the economy (2/4% real GDP plus 4/6% inflation), because the digitalization of the economy is mostly completed.
Risk 1: Price competition
Payment processing has already been commoditized away. As seen above, both PAGS and STNE make less than 0.5%/TPV after paying the networks. Technically, the same could happen to the financing side. Because this is a very safe credit (guaranteed by the banks or the card networks), the spreads should compress much closer to CDI.
The pricing power of the companies in the financing side can be seen by dividing their gross financial income by their net receivables (the receivables that are not covered by payables). We can see that financing is still very profitable, but has been coming down.
However, I do not think that margins will continue to shrink. Brazil is a country of oligopolies, and companies know better than simply running prices to the ground. There are many three-to-five company markets where all players have good profitability, and market shares are stable.
Risk 2: PIX Parcelado, a game changer
Currently, PIX is only available as a direct debit option. It does not have the advantage of deferring payments till the end of the month or installment payments, like credit cards.
However, from September 2025 onwards, banks will be allowed to integrate installment options into PIX payments. The only requirement is that they need to pay the merchant instantly. Banks can then implement the installments as a loan or credit card balance.
This completely changes the game for the payment processors, because now the merchant can receive the payment instantly, without integrating PAGS or STNE into the receivables circuit.
The merchant would still use PAGS or STNE machines to process that transaction, but only paying the PIX transaction fee (which is low and commoditized). The receivable, which is the profitable part of the business, would remain at the bank directly.
Whether PIX Parcelado replaces credit card payments depends on the costs for the customer and the merchant, which in turn depend on bank and merchant economics.
For the bank, the risks of a credit card and a PIX Parcelado transaction are similar, the bank does not enjoy the card network guarantee. However, the cash flows are not the same because the card is settled after 30 days, and the PIX is settled instantly for the merchant. Therefore, the PIX Parcelado has a higher financing cost (say CDI). On the other hand, with PIX Parcelado, the bank avoids paying card network fees as well. I would think that the interchange is approximately similar to CDI during high interest rate periods (~15% annualized). The end result for the bank is probably slightly positive for credit cards, especially during high-rate periods.
From the perspective of the merchant, if the cost of a credit card due date transaction is 4% (and up to 25% on installments), then the merchant can offer a discount on PIX Parcelado.
Finally, PIX Parcelado makes a lot of sense for Brazil as a country, so it will probably get promoted. Why would a very large country like Brazil pay a fixed percentage of all payments to foreign companies like Visa or Mastercard in order to go cashless? By implementing the equivalent of a credit card network inside the country (or a substitution of it), it saves a lot on interchange payments that are mostly a royalty to a US oligopoly.
Therefore, although the advantage is not evidently clear for PIX Parcelado over credit card payments, the risk of replacement is high over time.
Regular credit is not an exit
Some people comment that STNE and PAGS can grow by offering other credit products, like working capital solutions, personal loans, or even credit cards. That is, STNE and PAGS can increment their regular banking activities, outside of payments.
I don’t agree with this view for two reasons.
First, the company’s current credit business is very small compared to the receivables business. To replace payment financing, other credit should grow a lot very fast, which has significant risks. The credit business is not guaranteed, and therefore has a lot of delinquency risk. STNE already had to pull back its whole credit operations in 2021/22 because its NPLs went out of control, and you can take a look at their current NPLs to notice that they are not the best in the risk credit business.
Second, PAGS and STNE are a drop in the ocean of Brazilian credit, and the companies have no inherent competitive advantage in this business, compared with banks from digital like Nu or Inter to megabanks like Banco do Brasil and Itaú. They don’t have the scale of the banks, nor the technology.
Finally, even if they did grow other credit profitably, the business profile would be that of a bank, and there are already many cheap banks to choose from in Brazil (see my Primer on Brazilian Banks).
Best Scenario: Growth from GDP plus Inflation, and Leverage
Summing up, I think the best scenario for STNE and PAGS is that they don’t engage in financing rate price wars and can maintain an approximate return on TPV.
There is some indication of this in terms of Total Revenues over TPV (above) or EBIT over TPV (below). In this scenario, the companies can grow with credit card payments, which grow at GDP + inflation.
They can also grow ‘once’ by leveraging their balance sheets, something they are increasingly doing by returning excess cash to shareholders via buybacks. By adding leverage, the companies can increase their balance sheets at a good cost, and therefore grow EPS. If banks, which carry much higher risk, can leverage to 10x equity, then technically PAGS and STNE could go to 20x, just like XP, or other short-term collateralized operators. This could double or triple the asset base, technically, at a net return of 10/12% on assets. The plans are not to get to those levels, however, but rather much, much lower, close to maybe 7/8x equity.
The main challenge is simply that these companies cannot create more receivables, and therefore cannot grow their balance sheets even if they wanted to. Receivables have been consistently close to 30/35% of quarterly TPV, that is, a 1-month turnover.
Conclusions and valuation
So, the companies have a profitable business with low capital requirements that can be levered even more than they have so far, and where competition so far has been somewhat well-behaved.
However, this business is at risk of either its own competitive forces or replacement from PIX Parcelado. It is not clear if the market will be commoditized or move to PIX, as Brazil has many oligopolistic markets that have remained so for decades.
Still, we can be certain that, in the best scenario, these companies will grow with the economy, plus some small addition from incremental leverage. All other scenarios (price competition, or product replacement from PIX parcelado) lead to lower profits. There is no other market to grow to.
The question is, is the price low enough to justify this outlook?
Both companies have very low capital needs, so that most earnings can be used in buybacks or dividends, also increasing returns on equity by leveraging. Therefore, assuming multiples remain fixed, PAGS can generate a 14% return from buybacks (7x P/E), and STNE about 11% (9x P/E). Each can grow at GDP + inflation in a good environment, in BRL. We are talking of maybe 5/7% from that kind of growth.
The result is 18–21%, at fixed multiples (no expansion). Is that enough to pay for the risk of the business shrinking, plus BRL devaluation? Maybe, or maybe not, that’s for you to decide.
Finally someone shedding some light on this topic. I kept wondering why the low valuation for a strong business, IMO, such as PAGS. Thanks!!
This is a fantastic write up. You have a very clear gift of transforming numbers and reports into narratives and analysis.
I'm patiently waiting on Creditas to go public, potentially a different play on Brazilian fintech growth.