1 Question StoneCo Has to Answer

After a sharp drop and a similarly dramatic rebound, shares of Brazilian digital payments company StoneCo (NASDAQ: STNE) have given investors a lot to worry about this year. The stock is more or less flat for 2020 through Wednesday's close, which isn't terrible considering the current state of world affairs, but it's trailing behind Latin American e-commerce giant MercadoLibre's (NASDAQ: MELI) massive return of roughly 70% over the same period. Because of shelter-in-place and related orders to try to halt the spread of COVID-19, many digital-based businesses have been doing quite well at the expense of those that rely on in-person interaction. So what gives with Stone?  

The answer lies in the industry the company is trying to uproot, which is making its operations look increasingly like a bank's -- albeit a technology-driven, customer-centric bank versus an old and stodgy one. That's a good thing for Stone's customers, Brazil's economy, and ultimately Stone. But new risks are being introduced, and the current crisis could test the war-on-cash outfit's momentum.

A woman in a store using a green StoneCo point of sale device.

Image source: StoneCo.

Massive opportunity versus economic hardship

It's undeniable that Stone has a massive runway ahead of it. In very short order, the company has come to dominate the nascent digital payments industry in Brazil (some 51% of e-commerce transactions were processed on its ecosystem during the first quarter of 2020). But with e-commerce still just a single-digit percentage of the whole retail pie in South America's largest economy, it's not like the tech upstart is running out of places to expand.

However, therein lies the potential problem. Brazil's development of modern commerce and money movement tools is getting tested by the coronavirus lockdown. Stone's executive officer of investor relations, Rafael Martins Pereira, told me in June that 200,000 merchants went out of business during Brazil's recession of 2015-16 (which corresponded to the timing of the last energy crisis in the U.S.). Even in a country with over 200 million residents and millions of small businesses, that's a significant number. And Stone itself was still a small business, just a few years old at that point. Fast-forward to today, and the company and its more than half a million customers have a great deal more to lose.  

And this economic downturn is far worse than the one five years ago. According to the Central Bank of Brazil, economic activity in May 2020 rebounded 1.3% from April as the country started to ease restrictions. Nevertheless, on a much more important year-over-year basis, economic activity in May plummeted 14%. That compares with a 3.5% and 3.3% drop in 2015 and 2016, respectively. Of course, 2020 isn't over yet, but the early numbers don't look great.

New questions as a bank, but silver lining

Of course there was some exceptionally good news contained in the first-quarter update. Digital operations are the future, and after a dip in transaction volume in late March and early April, Stone was back to double-digit growth in May. That's good news for shareholders, but even better news for the thousands of small businesses that rely on Stone in Brazil. The company is helping bring the country up to speed on the digital front, and migrating to an online operating model is the difference between viability and capitulation right now.  

But as Stone has listened to its customers to pick up on pain points they have with running a business, the company has blurred the lines between e-payment technologist and bank. This is most notable in its new credit services arm. Credit is an important function in managing a business, and Stone's tech that pieces together data from its customers and vets those in need has gained fast traction in the last few quarters. Having transaction data at its disposal can also help the company reduce its exposure to default risk, something a traditional bank may not be able to do when extending cash to a business.

However, the longer the economic downturn lasts in Brazil, the greater the likelihood that some of the merchants operating on Stone's platform and utilizing the credit feature could fold. Pereira told me that some 80% of credit in Brazil is controlled by just five banks, making it one of the most concentrated credit systems in the world. Some disruption is therefore much needed, but it also opens up Stone shareholders to new risks that weren't there before. 

The good news is that credit is still a very small part of this company's revenues overall, and cash net of debt and other financial obligations was 5.05 billion Brazilian reais ($940 million using exchange rates on July 14, 2020) at the end of March. However, with Brazil's economy still struggling and the fate of small businesses still up in the air, enough questions remain to keep this great digital commerce stock in check when compared with some of its Latin American peers. But if it can assuage some of that worry during its second-quarter update, another run higher may be in order.

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Nicholas Rossolillo and his clients own shares of Stoneco LTD. The Motley Fool owns shares of and recommends MercadoLibre. The Motley Fool owns shares of Stoneco LTD. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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