I went to Buenos Aires a few weeks ago and had a lovely time eating delicious food and walking down its beautiful streets. But there was an awkward experience you can only live in very few countries: tourists do not use their credit cards because the official exchange rate is about double the non-official one, also known as "dólar blue". Most Argentinians try to save in USD as the Argentinian Peso is experiencing a 70% inflation rate, and they even publish real estate prices in USD. But, their central bank is short on the green note, and the local Government makes it hard for nationals to buy USD. Hence the abusive official exchange rate and a limit on how much USD you can buy, even when Argentinians use their credit cards overseas. Now imagine you are Uber, and you need to send payments to Argentinian drivers abroad; How do you navigate these Kafkian legal and tax systems? You call Dlocal to make it for you...
Surfing the digitalization of emerging economies - Dlocal Mission
Dlocal mission is to enable global merchants like Uber, Netflix, TikTok and so on to connect seamlessly with more than 2 billion internet users in emerging markets, both to "cash in" from and "cash out" to these markets. Argentina is just one of the 35 markets from Asia, Africa and Latin America Dlocal gives access through one API and contract. Besides promising a high acceptance rate from cash-in, they offer value-added services such as fraud prevention and tax compliance, which gives them higher product stickiness and average revenue per customer. If they can help with compliance matters in Argentina, I guess they have a heads up to replicate this know-how in about every corner of the world.
Dlocal value drivers
Dlocal Network effect: medium. Serving more customers, or helping one customer enter other emerging markets, decreases the marginal cost of servicing this emerging market. I guess Dlocal is not making a profit on the 35 needs it serves, but it eventually will. However, competitors such as Adyen have a broader customer base and services in developed economies such as Europe and North America, with more significant economies of scale already.
Dlocal Switching costs: medium. The operating impact of changing pay-ins and pay-outs channels for a business can be huge. If you add tax compliance and fraud detection to the mix, Dlocal gets stickier, and its customers are less likely to churn. According to Dlocal earning's call from Q3 2021, it translates into a churn rate below 1%. I just don't give this item a "high" rating because there is growing competition in the space, which can pressure its pricing power as customers may look for margin improvement.
Dlocal Revenue quality: High. It is recurring by design with long-term contracts and grows in sync with its customers' revenue from emerging markets.
Dlocal Profitability: Medium. This is a highly profitable business with operating margins sitting at 35%. Still, it is not expanding, their filling even talks about a possible decrease.
Dlocal Barriers to entry: high. Navigating regulatory, licensing, tax, integrations and operative specificities of 35 markets as diverse as Egypt, Turkey, Indonesia, Argentina, Brazil etc. must be a nightmare, which makes it a competitive advantage.
Dlocal Intangibles: medium. Even though its products are not patentable, it manages to delight its customers if their churn rate is so marginal. Their Argentinan DNA to creatively navigate all kinds of operative & legal barriers also give them an intangible advantage.
Dlocal Future growth and optionality: high. They have multiple growth avenues like onboarding more customers (their current base is relatively small at 400 vs. 3500 for Adyen), helping their existing customers enter more markets, and upselling them more value-added services. They have proven they are quick to add new markets, new payment methods (a quick look at Adyen Payment methods in markets such as Nigeria, Philipinnes and Mexico shows that Dlocal has a broader set of payment methods integrated into each of those) and build new value-added services. Their latest innovation is a direct issuing product, which gives their customers a white label platform to issue debit cards to their clients.
Dlocal Client concentration: One client represents more than 10% of their revenue, but this concentration has decreased over time.
Dlocal Financials: There are no risks here, as they have almost no debt and are not far from being Free Cash Flow positive.
Geo-political and ecosystem risk: the most significant risk I see is their dependence on Card network's (Visa & Mastercard) policies. There is already friction in Chile, where Visa and Mastercard tried to change their commission scheme with Dlocal to be later blocked by the local free trade court. This intent could spread to other jurisdictions and significantly impact fees paid by Dlocal to Card Networks. Then there are geo-political risks because of the very nature of emerging markets with unstable institutions, hence regulations, which could negatively impact the Dlocal business model. This is why I punished DLO margins by 10 percentage points in my bear case.
Dlocal Tax risk: Dlocal is based in the Cayman Islands are tax exempted company. It is unlikely this kind of loophole be accepted forever, and their current low effective tax rate of 9% should be impacted. I accounted for it in my valuation model.
Dlocal Valuation stories
Forecasting the next 10 years of growth of Dlocal
The current pace of new customer onboarding is 10 per month, with RFP processes that can take months to years. It means a 29% customer base growth considering churn. I modeled a lowering acquisition pace of 10% on average over the next 10 years in my bear case (to reach 1000 clients), and 20% in my bull case (to reach 2500 clients).
The average annual revenue per customer grew 64% in 2021 to reach USD 610.300 per customer. This growth will also depend on their clients' total processed payment volume in the emerging world. As per management comments: "the growth of our merchants that are some of the leading e-commerce typically growing from 20% to 30% annually in emerging markets". With a growing list of services and markets offered, I modeled an aggressive 25% average ARPU growth over 10 years in my bull case, and a more modest 7% growth in my bear case.
|2032 projections||BEAR Case||BULL case||Base Case (median)|
|Implied subscribers growth||10%||18%|
|number of merchants||1,037||2,094||1,566|
|avg new merchants per month||5.3||14.1|
|ARPU implied growth||7%||25%|
|TOTAL annual ARPU per merchant||$1,200,552||$5,683,862||$3,442,207|
Forecasting Dlocal Margins
To account for the above risks and commoditization of payments, I don't expect Dlocal to expand its margins. So the best-case scenario is that they manage to keep operating margins at current levels and drop to 25% operating margins by year 6 in my worst-case scenario.
Forecasting Dlocal Returns
This one is harder for me to forecast. The current sales-to-capital ratio (aka working capital turnover) sits at 1.0, which isn't great as every penny Dlocal makes needs to be reinvested to fund its growth. It is very early for Dlocal as they have been adding features at a crazy pace in the past few years, so I expect their sales to capital ratio to improve over the next 10 years. How much? is the trickier part of the equation. I input a ratio of 1.2 from year 6 onward, and the return on capital by year 10 would be 25%, not far from Adyen and Visa.
The boring stuff, aka cost of capital
To calculate the model's discount rate, or cost of capital, I used a risk-free rate of 3.75%, higher than today's 3.2%, because I expect it to keep rising in sync with the FED rate. The final cost of capital I used, including equity risk premium, is 11.5%
How good is Dlocal Management
Dlocal is a founder-led business. Insiders own approx. 45% of the equity, so a lot of skin in the game. However, its Glassdoor ratings have been dropping below 4 recently and should be carefully watched.
Is Dlocal a good investment right now in 2022?
Dlocal is an excellent but risky $8 Billion business. It fares just below the 10 points on the Rookie Investor scorecard, which is out of my comfort zone. In terms of valuation, I calculate a fair value of $32 per share in my base case. It is close to its market price and does not leave much safety margin as I write this. It is a hold for me, and I would consider adding to my position if it gets below $22, or selling if it gets higher than $42 within the next 12 months.
What to watch in the subsequent earnings? The pace of new customer acquisition, the rate of ARPU growth and the operating margins levels. I look forward to evaluating other promising FinTechs such as Nu, Adyen and Marqeta to get a clearer picture of my favorite pick in this sector.
Fe de errata: in my latest Shopify valuation, I made a mistake on the number of options outstanding, which significantly impacted the final fair value I calculated. I corrected the model and changed my conclusion from Hold to Buy! Sorry for that.