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Why StoneCo (STNE) Stock is a Compelling Investment Case

Spree Capital Advisers recently released its Q2 2020 Investor Letter, a copy of which you can download here. The fund posted a return of -12.41% in the first half of 2020, underperforming its benchmark, the S&P 500 which returned -3.1% in the same period. You should check out Spree Capital’s top 5 stock picks for investors to buy right now, which could be the biggest winners of the stock market crash.

In the said letter, Spree Capital highlighted a few stocks and StoneCo Ltd. (NASDAQ:STNE) is one of them. StoneCo Ltd. (NASDAQ:STNE) engages in the provision of financial technology solutions. Year-to-date, StoneCo Ltd. (NASDAQ:STNE) stock gained 16.7% and on July 29th it had a closing price of $46.90. Here is what Spree Capital said:

“Early in the second quarter, we used the market selloff to initiate a new position in StoneCo (STNE). Stone is an independent merchant acquirer in Brazil that is disrupting the financial industry. When we invest in disruptive businesses, one part of our process lies in identifying and understanding the ways in which entrepreneurs and management teams are playing multidimensional chess. The ability to think and plan several moves and several years ahead creates a business model that many investors and competitors miss. In Stone, we believe we have found such a case. After founding, scaling, and selling several financial technology businesses in Brazil, André Street and Eduardo Pontes recognized an opportunity when the Central Bank of Brazil and the Brazilian Competition Authority deregulated the merchant acquiring-card network market duopoly held by Redecard-Mastercard, and Visanet-Visa. Shortly thereafter, Stone was founded as an independent merchant acquirer on the belief that the biggest pain point in running a business in Brazil lay in the frictional nature of financial services. In initially positioning Stone as a customer service oriented independent merchant acquirer, Stone established a distribution engine to facilitate the real strategy: to become the ecosystem of acquiring, payment, customer relationship management, enterprise resource planning, banking, and credit that merchants run their entire businesses on.

Central to understanding Stone’s opportunity is understanding the many pain points businesses face from the bureaucratic and cultural roadblocks held in place by Brazil’s high cost banking system. An oligopolistic market structure has five financial institutions controlling eighty percent of the credit market through ownership of ninety percent of bank branch led distribution. Obsolete technology, inefficient distribution, and insufficient customer service has left customers underserved and overcharged. As a result, despite widespread internet access and ubiquitous smartphone penetration, Brazil still has a long runway for penetration growth in all aspects of financial technology. In closing the gap with peer countries in electronic payments, credit card usage, and e-commerce sales, Brazil has several predictable secular growth tailwinds that Stone is poised to accelerate. Stone was founded on the belief that Brazil is on the cusp of a technologically driven digital revolution. Recent legislation by the Central Bank of Brazil and the Brazilian Competition Authority is set to accelerate that.

To disrupt structural and habitual roadblocks inherent in Brazil’s high cost banking system and to capitalize on pro competition legislation, Stone created the Stone Business Model. The Stone Business Model is a repeatable go to market strategy that links Stone’s cloud-based platform and its differentiated customer service, sales and distribution system. The disruptiveness of Stone’s differentiated customer service and sales and distribution strategy is seen in Stone’s rapid growth (74% year over year client growth to 531k active clients, 52% year over year total payment volume growth), Stone’s position as the largest independent merchant acquirer in Brazil (8% total share but processes 51% of e-commerce acquirer volume), and Stone’s ranking as the highest Net Promoter Score company among peers (72). With any investment we make, we look for multiple ways to win. In Stone, we see five steps in the path to value creation.

First, Stone grows the Stone Hub distribution footprint. Stone’s repeatable plug and play process to open Hubs and efficiently hire and train sales, service, and operational support team members to onboard clients and integrate Stone’s platform into client’s enterprise workflow feeds scalable expansion across the infill opportunities inherent in Brazil’s 5,500 cities. The upfront costs of setting up a Hub are fixed, and as Stone scales their active client base from 531,300 clients across the 8.8 million small and medium sized businesses in Brazil, contribution margins quickly expand. Stone’s purpose-built operating system, in which they own the end to end platform (and thus do not rely on third parties for processing and settlement), supports this path to meaningful margin expansion.

Second, Stone expands the range of financial services offered. Key to Stone’s opportunity to expand financial services lies in the accelerating structural change in the economy. The Central Bank of Brazil and the Brazilian Competition Authority are enacting increasing changesthat have the effect of breaking down the boundaries between payments, banking, and credit. The enactment of open banking rules in the second half of 2020 are one part of this. Under open banking rules, banks will be required to disclose the costs and terms of products and services offered, including client data, transactional data, and payment data. This is significant because these structural roadblocks have historically made it prohibitively difficult for merchants to change their banking relationships. With this change, Stone will now have access to merchant credit relationships that they can then bring into the Stone ecosystem. Upon bringing businesses into Stone’s ecosystem, Stone will underwrite working capital loans based on proprietary data feeds from an expanding operating system. This service will be disruptive in part because of the existing dynamics of the corporate credit market for small and medium sized businesses. High spreads and short-term financing due to information asymmetry and rate volatility make it difficult for businesses to finance their working capital needs. Stone’s platform and the real time information it generates means that Stone is able to facilitate lower cost working capital loans. Importantly, Stone earns a fee for facilitating these loans, and because the loans are backed by third party investors, Stone does not take credit risk. Stone currently has less than a 1% market share in the $80B market for financing small and medium sized business working capital loans. We expect Stone’s solution to remove frictions to grow this market significantly, and for Stone to gain meaningful market share.

Third, Stone expands into the micro merchant market. Through a recently launched joint venture with Grupo Globo under the TON brand, Stone will combine Grupo Globo’s marketing and consumer intelligence capabilities with Stone’s customer service and distribution expertise to scale the TON brand on top of the fixed cost of the Stone operating system and Stone Hubs. Brazil has 5.5 million micro merchants and twenty one million autonomous workers who are largely unbanked and without access to card-based transactions. Digital distribution from Grupo Globo’s contributed media spend and marketing expertise will lead to low customer acquisition costs, and scale economics from Stone’s platform and Hub network enable TON to offer the best product at the lowest cost, resulting in accelerated market share gains.

Fourth, Stone adds services organically that automate customer’s enterprise workflow. Stone’s position in owning both distribution and the end customer relationship puts them in an advantageous position to integrate services onto core payment offerings. This integrated platform of payments-software-bankingcredit replaces a disjointed system with different systems for front office operations, payment acceptance, and back office functions. The customer feedback loop provided by the high level of integration between Stone Hubs and clients and the software integrated in client’s enterprise workflow supports a model driven business that makes the operating system better for all users. A better product experience brings in more users, which further enables Stone to design new products for changing customer needs that they can rapidly push to scale using their purpose-built distribution system.

Fifth, Stone adds vertical applications from a position of strength given their chosen acquirer status. Stone’s end to end distribution, service, and merchant operating system positions Stone at the central nexus of a long-term opportunity to grow software businesses in Brazil. We believe there are two key facets of this advantage. First, Stone has a closed customer feedback loop that provides real time information on client needs. This helps Stone identify attractive niches early on to vet potential M&A opportunities. Second, Stone management’s expertise in supporting entrepreneurs in strategically growing their businesses and the distribution advantages to potential parties afforded by Stone’s ability to push products to a growing base of 531,000 clients awards Stone chosen acquirer status. Chosen acquirer status means that Stone will increasingly get not only the first look at emerging software companies but will get that look at advantageous terms. To date, Stone has taken stakes in a variety of ERP, POS, CRM, social commerce, and health oriented businesses that all offer significant optionality for long term profitable growth.

In StoneCo, we are investing at a valuation attractive for an independent merchant acquirer. What we are getting in return is a disruptive business that is taking share in merchant acquiring and is riding several longterm secular tailwinds to expand their adjacent businesses that will compound earnings over the long term.”

In Q1 2020, the number of bullish hedge fund positions on StoneCo Ltd. (NASDAQ:STNE)  stock increased by about 17% from the previous quarter (see the chart here), so a number of other hedge fund managers believe in StoneCo’s growth potential. Our calculations showed that StoneCo Ltd. (NASDAQ:STNE)  isn’t ranked among the 30 most popular stocks among hedge funds.

The top 10 stocks among hedge funds returned 185% since the end of 2014 and outperformed the S&P 500 Index ETFs by more than 109 percentage points. We know it sounds unbelievable. You have been dismissing our articles about top hedge fund stocks mostly because you were fed biased information by other media outlets about hedge funds’ poor performance. You could have doubled the size of your nest egg by investing in the top hedge fund stocks instead of dumb S&P 500 ETFs. Below you can watch our video about the top 5 hedge fund stocks right now. All of these stocks had positive returns in 2020.

Video: Top 5 Stocks Among Hedge Funds

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Disclosure: None. This article is originally published at Insider Monkey.