XP: A Great Equity Story (NASDAQ:XP)

XP Inc. (NASDAQ:XP) is disrupting the financial services industry in Brazil. As more Brazilian investors are looking for new investment products and digital tools to manage their savings, XP Inc. has positioned itself as the leading alternative to traditional banks in the emerging retail investment market. Its business model has proved to be working incredibly well and this has not gone unnoticed for Itaú (NYSE:ITUB) which, apart from being a competitor, has also become XP Inc.’s main shareholder.

As of 2019 year-end, XP had already 1.7 million active clients (+91% vs. 2018) and R$400 bn of assets under management (+101% vs. 2018). It has achieved a net promoter score (NPS) of 73. Besides, its financial performance has been awesome, achieving great margins and a 5y average return on equity of ~27%. The opportunity to keep growing seems huge as 90% of AUC in Brazil are held just by 5 big financial institutions that are offering a poor range of products to their clients.

Trading at 67x NTM P/E (according to TIKR consensus estimates), the stock is pricing a 30% revenue CAGR for the next 5 years, which is in line with our base case estimates. However, the risk/reward is still attractive enough to remain a buyer at current prices.

Overview and IPO

XP Inc. is a tech-driven financial services company that provides financial products and services in Brazil with a low-cost philosophy. The company aims to disintermediate the financial services industry in this country, which is currently dominated just by 5 big financial institutions, in order to offer retail investors direct access to a wide range of products and professional services so that they can make better investment decisions.

The company had a successful IPO in December 2019. They raised USD 1,100 million by issuing 42,553,192 new class A common shares. On the first trading day, the stock closed at $34.46/share (28% up from the IPO pricing at $27/share). As part of the offering, existing shareholders (founders included) also sold part of their stake. At this point, before we get into a more detailed fundamental analysis, it is important to understand how the shareholder structure changed because of the IPO. Particularly, it’s relevant to know how much of their own money the existing shareholders have left on the business.

Capital is structured as dual-class shares. Both A common shares and B common shares have identical rights, but B shares are entitled to 10 votes per share (super-voting stock), whereas holders of Class A common shares are entitled to one vote per share.

As a result of the IPO, the founders (through XP Controle) have retained control over the business given that they own Class B shares. Also, they have retained 83% of their money invested in the business (look at figure 1 and figure 2 below), despite underwriters fully executed their right to purchase additional common shares from selling shareholders.

Figure 1: XP Inc. current ownership

Source: XP investors roadshow

What is interesting is that the other existing shareholders (i.e. Itaú Bank and private equity funds) have also maintained all or a great part of their previous capital invested in the company.

Figure 2: XP Inc. ownership change after IPO

Source: IPO prospectus and own elaboration.

Overall, it doesn’t seem that existing shareholders made the IPO just as an exit strategy. While the lock-up period is still in force (180-days from the IPO), the fact that: (i) private equity funds gave up just 15% of their investment at the IPO, (ii) the main shareholder (Itaú, 46%) didn’t sell any share in the process and (iii) ~60% of shares offered (without taking into account the underwriters’ option) were issued shares, makes us confident that existing shareholders still believe that the company can continue to add value for the long term.

Itaú, which is the biggest bank in Brazil, acquired its pre-IPO participation (50%) in 2018, after getting regulatory approval. Originally, the deal (released in 2017) allowed Itaú to increase its ownership subsequently in 2020 and 2022. It also stated that Itaú will have the right to acquire 100% of XP Controle’s shares in 2033, getting full control of the company by then. Eventually, these dispositions were canceled to get regulatory approval. Instead, Itaú shall purchase in 2022 12.5% of XP’s total outstanding capital stock (pre-IPO). Two facts are relevant here: (i) Itaú, which competes directly with XP, has shown a great commitment to gain control (both in an economic and voting sense) in XP and (ii) Itaú recognized in the XP acquisition presentation that distribution of financial products through open platforms will be more relevant for the industry and more important for their clients.

Business analysis

Business model

XP Inc. offers its customers an open product platform with over 600 investment products such as equity and fixed income securities, mutual and hedge funds, structured products, life insurance, pension plans, REITs, and others. This includes both XP products as well as third party products. It also provides suited advisory services for a range of different customer profiles (retail, high- net-worth clients, international clients, and institutional clients).

XP Inc. has an omnichannel distribution network to provide the above-mentioned services and products. The company reaches clients through its three digital brands (XP Investimentos, Rico, and Clear) as well as through its distribution network of independent financial advisors (IFA Network).

The company’s business model puts the client in the center. XP Inc. not only democratizes access to financial products but also tries to offer such products at a very low price. Indeed, they have a zero-fee pricing philosophy wherever possible. Another important feature of its business model is the extensive use of proprietary media & digital content. Through its ecosystem of platforms and APPs (Infomoney, XP Educação, XP Research, Expert, Leadr…) the company aims to empower clients to make better independent investment decisions. At the same time, it allows the company to attract new clients, retain the existing ones, and monetize all of them.

This customer-centric approach has proved to be working for XP Inc. The company’s client base is growing at an exponential rate while the satisfaction of the current clients is awesome for a financial services company given an impressive net promoter score (NPS) of 73. The company has a very attractive LTV/CAC (Lifetime Value/Customer Acquisition Cost) ratio as it has: (i) a very efficient marketing strategy driven by its digital business model and its reinforcing ecosystem and (ii) high structural switching cost for current clients and IFA network.

The business model is working incredibly well for XP Inc. In 2019, the company has doubled its business size by adding more than 800k of new active clients and increasing its assets under custody (AUC) by more than R$200 bn.

Figure 3: XP Inc. Assets under custody and Active Clients

Source: XP institutional presentation.

Despite we have focused on its core retail business model proposition so far, XP has four main business segments and several ways to monetize each segment.

Figure 4: XP Inc. gross total revenues by segment and % major service lines.

Source: XP Inc. 4Q earnings release, XP Inc. 2019 annual report, and own elaboration.

  1. Retail business (67% gross revenue in FY2019): revenues in this segment come from management and performance fees from funds managed by its own asset managers, rebates from third-party funds, brokerage commissions, securities placement fees on structure notes and distribution fee earned on the sale of FI and equity securities to retail clients, and net income on trading and floating balance.
  2. Institutional business (14% gross revenue in FY2019): brokerage commissions, distribution fees on securities placement, management fees, and net income from trading.
  3. Issuer services (9% gross revenue in FY2019): includes mainly placement fees (DCM and ECM businesses) from structuring, underwriting, and placement of debt and equity securities. It also includes M&A advisory services and structured finance operations.
  4. Digital content (2% gross revenue in FY2019): it’s mainly comprised of revenues from selling XP Educação educational courses, and selling advertising space through its multiple media sites and Infomoney TV insertions.

Business performance

XP Inc. is growing fast at the top line level of its P&L driven by adding new clients and therefore increasing its AUC, as we have seen before. Not only sales are performing well but also earnings, proving that this is a highly efficient business.

Figure 5: XP Inc. P&L main items (R$ mn) and margins (%)

Source: TIKR.com

Looking at its cost base and its CAPEX needs, we can see that the company operates a highly efficient asset-light business model. The two main cost components (~50% of total sales) of the business are commissions and personnel expenses. Commissions are variable costs and personnel expenses are extremely flexible as well because ~50% of employee benefits are linked to business performance in the form of profit sharing and bonuses. Overall, >60% of the cost base is variable, and there are also discretional expenditures than can be cut if necessary. On the other hand, maintenance CAPEX is minimal as the company operates the business in a digital way.

Such an asset-light digital business model is achieving consistently great returns. XP Inc.’s operating margins are above 30% and NI margins above 20%. Its adjusted cash flow from operating activities (excluding cash movements from broker-dealer activities and excess cash balances) was R$1,527 mn in FY2019, which implies a proxy cash conversion of 1.3x earnings for the year. The 5y average return on equity is ~27%. The company has delivered an impressive performance so far.

Besides, it is also important to note that the company has a high level of liquidity in its balance sheet. As of 2019 year-end, XP Inc. had R$7,750 mn net cash/financial assets (cash and financial equivalents net of financial liabilities and floating balance). XP Inc. has a very comfortable financial position, improved after the IPO, which we could see it as a competitive advantage given the current environment. Such a comfortable liquidity level has allowed the company to pursue additional strategic expansion steps. Indeed, in early March, XP signed a contract with Visa (NYSE:V) as its brand partner of debit and credit cards. The initiative marks the entrance of XP Inc. in the card segment in Brazil.

Figure 6: XP Inc. Balance sheet liquidity

Source: XP Inc. 4Q19 presentation

Opportunity

We’ve seen so far that XP Inc. has a great business model. The company has doubled its client base just in one year and these clients are very satisfied given the impressive NPS score that XP Inc. has achieved. Besides, its financial performance has been also really good and it has a solid balance sheet. Overall, it seems to me that XP Inc. stock could be a compounder if it can keep growing. So, the big questions now for the investment thesis are: (i) how big is the opportunity for XP Inc. to keep growing? and (ii) how much of that is already put in price by investors at the current market price?

Assessing the opportunity

According to Oliver Wyman, the investment market in Brazil is expected to grow at ~10% CAGR for the next 4 years, reaching a total AUC of R$13.8 trillion by 2024.

Figure 7: Brazil- Evolution of investment assets

Source: Oliver Wyman report.

Brazilian investors are looking for new products (as an alternative to traditional savings accounts, or Poupança) to diversify their investments while looking for a high yield, given the structural decline in interest rates. In this process, they are also looking for new platforms, tools, and advisors that can offer customized investment guidance.

Figure 8: Brazil- Selic rate evolution & investment assets product mix evolution

Source: Banco Central Do Brasil, Oliver Wyman report.

The opportunity to gain market share seems huge for XP Inc. as just 5 big banks hold 90% of the total AUC in Brazil. Traditional banks are offering a much narrower (generally only proprietary products) range of products at a higher price. Besides, they have complex legacy systems, processes, and organizations that are expensive to maintain. Challenger institutions, on the other hand, are light and can provide greater tailoring to a broader base of clients. According to Oliver Wyman’s survey with investors, over 70 percent of respondents were satisfied with the product range offered by independent platforms, whereas only 35 percent were satisfied with banks’ product range.

Figure 9: Brazil- Evolution of investment distribution channels

Source: Oliver Wyman report.

XP Inc. is positioned as the leading alternative to traditional banks as it has the first-mover advantage (~50% market share among independent platforms). Oliver Wyman estimates than independent platforms, which currently hold 10% of total AUC, could reach a 25% market share in 2024. That means that XP’s AUC could grow up to ~R$1800 bn in 2024 (>30% CAGR).

Valuation and risks

Using the Oliver Wyman’s industry analysis report and the XP Inc. annual reports as inputs for my own model, I’ve performed a top-down valuation analysis to get a sense of how much growth is already put in price by investors at the current price of $25/share (~67x NTM P/E). First, I started with a very conservative set of hypotheses to reach a pessimistic case valuation, and then I adjusted such assumptions upwards to calculate the base case and the blue sky scenarios incremental value, as you can see in the following chart (Figure 10).

  • The conservative scenario assumes a total Brazil AUC growth of 4% (CAGR) up to 2024 (vs. the estimated 10% CAGR by Oliver Wyman). XP Inc. would increase its AUC market share to 10% and that would be consistent with a revenue growth rate of 20% (CAGR) until 2024. I assume that XP Inc. can maintain its NI margin at 21-22% in each scenario. Applying a terminal value P/E multiple of ~25x in 2024 and requiring a quite conservative 18% equity return, I reach an equity value of ~$14/share. I add back the excess cash to reach a conservative case target price of $ 16.2/share.
  • For the base case, I’ve considered a total Brazil AUC growth of 6% (CAGR) up to 2024. Additionally, XP Inc. would achieve a 15% market share by 2024 under this scenario. That would be consistent with top-line growth of 30% (CAGR) until 2024. Under this growth hypothesis, I reach a $27.5/share target price applying a TV P/E multiple of 30x and requiring a 15% equity return for the investment.
  • For the blue sky scenario, I’ve further adjusted upwards the growth assumption. Total AUC in Brazil would grow at a 10% rate (CAGR) until 2024 and XP revenues would grow at 40% (CAGR) after increasing its market share by up to 20% in 2024. The fair price in this scenario will increase to reach $48/share, after applying a 35x TV P/E multiple and a 12% cost of equity.

The current market price ($25/share) is consistent with our base case moderate growth rate (30% gross revenue CAGR vs. the company’s guidance of 35% gross revenue CAGR). However, the implicit cost of equity would have to be quite high at 18% to reach the current market price. Despite there are important risks that we should take into account when considering investing in Brazil (i.e. country risk premium), requiring an 18% cost of equity seems to be excessive for a company that has already proved its business model.

Despite the recent re-rating, I think that the risk is quite skewed to the upside, making the stock’s risk/reward attractive at current prices. The downside potential in the conservative case is -35%, while the upside potential in the blue-sky scenario is +92%.

Figure 10: XP Inc. valuation*

Source: Own estimates.

* Every scenario assumes identical assumptions regarding (i) the retail revenue yield at ~1.2%, (ii) growth rates for the other segments, and (iii) overall NI margin at ~21-22%. Valuation is performed at the current spot FX rate.

Conclusion

I believe that XP Inc. is a great equity story. The growth opportunity still seems huge when you look at the current XP Inc.’s total AUC market share. Its business is proving very effective as XP Inc. is increasing the number of new clients exponentially and, at the same time, is delivering a great financial performance. The current price is roughly pricing my revenue growth assumption of 30% CAGR for the next 5 years (vs. the company’s +35% 3-5 years CAGR guidance) but the risk/reward is still very attractive, especially in the long term. Any price weakness should be taken advantage of to increase the position in the stock. Going forward, we should monitor the quarterly KPIs (i.e. AUC and clients) to check if the company is growing according to our estimates. Despite I have taken into account the country risk within the cost of equity assumption, it is also important to monitor the macroeconomic situation of Brazil as BRL potential depreciation represents an important risk for the investment.

Disclosure: I am/we are long XP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Opinions, estimates, and projections constitute exclusively the current judgment of the author as of the date of this report.

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