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A Recent Plunge in This Fintech Could Be a Huge Long-Term Opportunity - Motley Fool

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Brazilian fintech PagSeguro (NYSE:PAGS) plunged recently, falling by nearly half at its recent low. It's now down about 37% from recent highs and 31% for 2021.

The drop can be attributed to a rule change proposal on the part of Brazil's central bank to cap interchange fees on prepaid cards at 0.5%.

While that change could ding PagSeguro's Pagbank revenue, prepaid interchange fees are only a minimal part of PagSeguro's overall business, which predominantly relies on merchant processing fees and working capital loans. In that light, such a big sell-off seems wildly overdone, and could open up an opportunity for Foolish long-term investors.

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PagSeguro is a leading brand with a long growth runway

PagSeguro was founded in 2006 under the umbrella of Brazilian internet company UOL, and became an independently traded company via its 2018 IPO. The company touts its comprehensive digital finance business across merchant acquiring, digital banking, point-of-sale devices, free digital banking accounts, and other banking services. Its mission is to "disrupt and democratize financial services in Brazil, a concentrated, underpenetrated, and high-interest-rate market, by providing an end-to-end digital banking ecosystem that is safe, affordable, simple and mobile-first for both merchants and consumers."

You can think of PagSeguro kind of like the Square (NYSE:SQ) of Brazil. The company offered online payment processing services and point-of-sale systems to small and micro merchants that had long operated on a cash-only basis. PagSeguro then began offering a free digital bank account for its merchants, through which it provides other services, such an early payment on merchant receivables (Installment payment plans are common among consumers in Brazil).

PagSeguro expanded its digital bank to consumers with the launch of PagBank in 2019, where it makes money on wire transfers, interchange fees, credit cards, P2P transactions, loans, and other services – not unlike Square moving from merchant POS systems to its consumer-facing Cash App. It's the prepaid cards from PagBank that are likely to be affected by the new interchange fee limit.

How bad is the impact of the interchange rule? Perhaps not at all

While some financial analysts estimated PagSeguro's 2022 revenue might be affected by low to mid-single digits and adjusted EBITDA in the low teens by the new rule, a recent press release from management had its own more positive take. Based on several scenarios, management now expects a negligible effect on 2022 net revenue and net income, and actually expects a slight benefit from the rule in 2023 and beyond.

How could that be? It's because that while PagSeguro makes revenue from prepaid interchange fees linked to its consumer bank accounts, the merchant acquiring business actually pays interchange fees as a cost of goods sold. Therefore, the larger acquiring business will become more profitable if interchange fees go down. "The fact that PAGS has complementary payments businesses (acquiring and cards issuance) creates a natural hedge for the company," the press release said.

Meanwhile, the business has a long runway

Assuming this rule change doesn't affect PagSeguro's growth prospects, its discounted stock price could be a great opportunity. That's because Brazil's banking system is still highly concentrated among legacy institutions, there is a significant amount of unbanked people in the country, and many still use cash for transactions -- even e-commerce transactions.

In 2017, the top five banking institutions in Brazil held 83.4% of financial assets. As recently as 2017, 65% of bill payments were still made in cash in Brazil. And as recently as 2019, 57% of Brazilians had not even heard of digital banking.

As more Brazilians adopt digital banking services, move away from cash, and if PagSeguro can offer a more customer-friendly solution than legacy banks, the opportunity remains quite large. Management just pre-released preliminary Q3 results, showing consolidated total payment volume up 85% year over year, with the acquiring business unaffected by these regulations up 49%. Importantly, PagBank users grew by one million to 12.2 million active users, nearly 9% quarter-over-quarter growth.

With the stock's recent sell-off, it now trades at just 27 times next year's average earnings estimate. For a company growing that fast, that's a pretty undemanding valuation.

While the regulatory overhang and inflation fears in Brazil may put a damper on near-term sentiment, remember that PagSeguro makes most of its money as a percentage of transaction costs, so much of its revenue should grow along with any problematic inflation. Given that the recent interchange fee fears aren't as bad as first thought, PagSeguro's recent sell-off looks like a solid opportunity in this emerging-markets growth stock.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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A Recent Plunge in This Fintech Could Be a Huge Long-Term Opportunity - Motley Fool
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