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StoneCo: Why Warren Buffett Made a Mistake

InvestorPlace - Stock Market News, Stock Advice & Trading Tips StoneCo has had an awful 2021, losing nearly 80% since Jan. 1. But there is a logical justification for this...

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This story originally appeared on InvestorPlace

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

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StoneCo Ltd. (NASDAQ:STNE) is a Cayman Islands-based financial technology solutions company operating in Brazil. STNE stock began trading in 2018 with an initial public offering price of $24, raising then $1.22 billion in total proceeds.

a credit card reader with a credit card in it
Source: Shutterstock

This has been a dramatic year for STNE stock, having lost nearly 80% in value since Jan. 1. What is interesting about StoneCo is that Warren Buffett is a major investor in STNE stock.

Is STNE stock a flop? I argue that Buffett has got it wrong about this fintech, but that’s fine. It’s impossible to be correct on all your stock recommendations.

How did this famous and great investor make a mistake with this stock?

First of all, the Q3 2021 earnings showed some negative trends. Revenue growth, total active payment clients and total payment volume increased. On the negative side, there was a net loss of 1.26 billion Brazilian reals ($223 million) as a result of a significant write-down related to an investment in Banco Inter, and the take rate decreased.

Class Action Lawsuits

When I read about a lawsuit against a company, I am very skeptical for two reasons. First, I believe that a law firm would not file a lawsuit if it did not have evidence to support its case. Second, bad publicity for a company may not be supportive for its stock price to recover.

Unless, of course, its fundamentals are great which makes it easier for a sustainable rebound.

Take for instance the following class-action lawsuit that was recently filed: “StoneCo and certain of its executives are charged with failing to disclose material information during the Class Period, violating federal securities laws.”

The main argument is that StoneCo paused its credit product and when it stated that it would retest it in the form of short-term loans, it did not provide specific guidance about credit volumes. As a result, STNE stock plummeted about 34% on Nov. 17, and investors suffered heavy losses.

The Macro-Economic Environment Is Unstable

A company and its stock to thrive need a strong economy, and a strong sector and industry. Brazil has important problems like inflation, and unemployment and a local currency that has been depreciated against the U.S. dollar.

The resurgence of the coronavirus crisis in Brazil is another problem for its economy.

Buffett’s Investment of STNE Stock

Berkshire Hathaway’s (NYSE:BRK.A, NYSE:BRK.B) Buffett focuses on Benjamin Graham’s value investing philosophy, searching for stocks with prices well below their intrinsic value. By examining a company as a whole, Buffett invests not for the short-term but for a considerable amount of time until the desired convergence of the stock price and its intrinsic value starts to take place.

Some crucial factors to monitor the company’s debt, profit margins, free cash flow, earnings per share and valuation metrics.

My first argument is that StoneCo turned unprofitable in 2021 with negative EPS. This is the first red flag as the company was profitable in 2018, 2019 and 2020. My second point is that the net operating cash flow trend has been both weak and mostly negative from 2016 to 2019, according to data on MarketWatch. On a quarterly basis in 2021, there has been a rebound with positive net operating cash flow reported in Q2 and Q3. Still, the long-term trend is a negative one.

Operating cash flow is a measure of the amount of cash generated by normal business operations.

Turning to MorningStar examining a five-year trend for gross margin, we can see that StoneCo witnessed a peak value in 2019 of 82.1%, and declining values in 2020 and the trailing 12 months of 75.8% and 65.9%, respectively. The same trend is valid for net margin, with a peak figure of 33.61% in 2019 and then of 26.86% and -6.67% for 2020 and the trailing 12 months, respectively.

Free cash flow per share trend has been very weak. The free cash flow for 2016-2020 was negative. This means the company burned cash and from a valuation perspective, it’s not good news. Free cash flow is used to estimate the intrinsic value of stocks. The higher the number, the better it is. Here we have the opposite case.

Is STNE stock cheap now after its dramatic sell-off? There are mixed signals. On a relative basis in some key metrics STNE stock seems to be undervalued and in other significantly overvalued.

The Bottom Line for STNE Stock

With a 52-week range of $14.02 to $95.12 and a current price of less than $18, STNE stock had a wild year. If Buffett sold its shares near its peak price, then he would have made a nice profit.

A deterioration of financial performance and net losses on a trailing 12 months basis, an unstable economy and a weak local currency are major negative factors for STNE stock. It has been a flop. I do not like the stock even after this sell-off.

Beware of trying to catch a falling knife in stock investing. It may hurt a lot.

On the date of publication, Stavros Georgiadis, CFA  did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

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