Earnings Call Transcript - STNE Q3 2021

Operator, Operator

Good evening, ladies and gentlemen, thank you for standing by. Welcome to the StoneCo Third Quarter 2021 Earnings Conference Call. By now, everyone should have access to our earnings release. The Company also posted a presentation to go along with its call. All materials can be found at www.stone.co on the Investor Relations section. Throughout this conference call, the Company will be presenting non-IFRS financial information, including adjusted net income and adjusted free cash flow. These are important financial measures for the Company, but are not financial measures as defined by the IFRS. Reconciliations of the Company's non-IFRS financial information to the IFRS financial information appear in today's press release. Finally, before we begin our formal remarks, I would like to remind everybody that today's discussion might include forward-looking statements. These forward-looking statements are not guarantees of future performance, and therefore you should not put undue reliance on them. These statements are subject to numerous risks and uncertainties that could cause actual results to differ materially from the Company's expectations. Please refer to the forward-looking statements disclosure in the Company's earnings press release. In addition, many of the risks regarding the business are disclosed in the Company's Form 20-F filed with the Securities and Exchange Commission, which is available at www.sec.gov. Please note this event is being recorded. I would now like to turn the conference over to your host, Rafael Martins, VP of Finance and Investor Relations Officer at StoneCo. Please proceed.

Rafael Martins, VP of Finance and Investor Relations Officer

Thank you, operator, and good evening, everyone. Joining us here today, we have Thiago Piau, our CEO; Lia Matos, Chief Strategy Officer; and Marcelo Baldin, our CFO. Today, we'll present our third quarter 2021 operational and financial results, as well as discuss some recent trends that we are observing. Now, I will pass it over to Thiago, so he can share the main highlights of our performance. Thiago?

Thiago Piau, CEO

Thank you, Rafa, and good evening, everyone. As we start a new phase of our business with the full integration of Linx, and as we complete three years as a public Company, I want to start on Page 1 by talking about what motivates us to work hard every day, which is our purpose. Our purpose is to serve the Brazilian entrepreneur, transforming their dreams into results. In our point of view, any person who wakes up every morning to build or run a business is an entrepreneur. We want to help them think bigger, and turn their dreams into business results by serving them with excellence and helping their business to thrive. We believe that serving entrepreneurs is the best way we can positively impact Brazilian society. We want to do this by promoting fair financial relationships, enhancing business productivity, and providing more sales options. We aspire to be a positive force to transform the retail and financial industry for more balanced relationships. To achieve our goals, we decided to build the best financial operating system for Brazilian entrepreneurs. Since our early beginnings, we have always strived to build our business around merchants. This has motivated us to build the hyperlocal distribution that enable us to be closer to our clients, the proprietary technology that provides cost efficiency and the reliability that our clients want, and the best customer service in our industry. With the acquisition of Linx in our current set of solutions for multiple retail verticals, we seek to build the best workflow tools to generate efficiency for our merchants, and help them sell more through multiple channels. We're only at the beginning of our journey in combining software and financial services to bring even more tangible results to our clients and we're really excited with the opportunities ahead. On Page 2, we show that at the end of the third quarter, our consolidated TPV reached R$75 billion, representing 54% year-over-year growth and 26% quarter-over-quarter growth when excluding Corona voucher volumes. More importantly, our active client base increased twofold when compared to last year, reaching 1.4 million clients, driven by our record high net addition of clients in the quarter of 294,000. The number of active digital banking accounts grew at an even faster pace, surpassing 420,000 in the quarter. In software, with the inclusion of Linx, we had over 200,000 clients using at least one of our solutions, with annualized revenues close to R$1.3 billion, up 17 times year-over-year. Even more encouraging, the retention rate at Linx's core stayed at high levels of 99%. Now, moving to Page 3, we show that TPV growth was primarily driven by the MSMB operation, which is the combination of micro and SMB operations. The MSMB TPV grew at a two-year CAGR of 61% in the quarter, accelerating from 48% in the second quarter and 42% in the first quarter. While the more mature SMB operation was able to grow TPV over 70%, the micromerchants volume surged to R$3.4 billion in the quarter, nearly 23 times higher than the previous year. On Page 4, we show that the consolidated net-adds in MSMB also accelerated to approximately 290,000 in the quarter. And as a result, we reached over 1.3 million active payment clients, over two times higher than last year and 3.3 times higher than two years ago. We also posted a record high net-adds when excluding the micro segment, with over 80,000 of which approximately 77,000 in the MSMB segment, representing an 82% growth quarter-over-quarter. As Lia will detail further in the presentation, we balanced this accelerated growth with solid unit economics, reduced client acquisition costs, improved the average revenue per merchant both in SMBs and micro, and kept payback periods under control, ranging from 11 to 15 months. Before I pass it over to Lia, I want to recap our main strategic movements and what lies ahead. As we indicated at the beginning of the year, we will keep investing heavily in our engineering, sales, marketing, and operational teams to expand our capability and deliver on our purpose. In the third quarter, we significantly increased the level of investment in our business. We have invested approximately R$120 million more OpEx in the growth of our operation and in new business compared with the third quarter of 2020. These, combined with higher interest rates, impacted our margins. And even though we started to reprice clients, managing our payback strategy with discipline, we are doing this in a way that we keep a good level of growth, and don't jeopardize our relationship with our merchants, which is the most important thing given the opportunities we have. Looking ahead, we see several avenues of growth that reinforce each other to create more value for clients with good unit economics. We still see a big room to expand our MSMB client base. Given that, to estimate, there are over 8 million SMBs and over 20 million micro clients in Brazil. Our ability to grow the active base compounds with the potential to increase revenue per merchant over time by offering additional solutions to our clients. In credit, we envision three products to attend to different client needs. Our current credit products that we're turning around, credit card and overdraft. We continue to focus on engineering, improvement of our operation, and the strengthening of the team. We will start testing our credit product in small scale shortly. Additionally, I would like to welcome the team of Gyra +, a recent investment that we expect to close in the fourth quarter. We see the software opportunity in SMBs at the very beginning. Our footprint and distribution, combined with vertical knowledge and integration capability provide the building blocks to our vision of software and integrated financial services in the SMB space. When we look at Linx clients, they have approximately R$350 billion in annualized GMV, and we monetize only 0.3% of such value. Also, those clients have approximately R$200 billion in annual TPV, and mid-single-digit penetration with our payment solutions. We see plenty of room to grow organically in current verticals, expand vertical coverage through new investments, further help our clients with integrated financial services offers and with products to help them sell more through multiple channels. Lastly, we will always keep our eyes on the long-term opportunities, building a humble organization, eager to learn, devoted to serving our clients in the best way we can envision, and helping the team to reach its full potential for an ownership mentality. With that said, I will pass it over to Lia.

Lia Matos, Chief Strategy Officer

Thank you, Thiago, and thank you, everyone, for joining us today. I want to start on Page 5, talking about growth and engagement with our financial operating system. Our active banking client base increased over fourfold when compared to last year, reaching approximately 423,000 clients, with the number of SMB clients who are settling transactions in the Stone account reaching 320,000. We also saw main engagement metrics improving on a quarterly and yearly basis, such as total accounts balance, which reached over R$1 billion at the end of the quarter, a threefold increase year-over-year. Net cash inflow from the legacy credit product in the third quarter was R$483 million, which reduced the credit portfolio to approximately R$1.6 billion from R$2 billion in the previous quarter. The coverage ratio remained above 100% and our legacy credit portfolio is performing as expected. This quarter, we have shifted most of the focus in the credit business to building the team, engineering capabilities, and operations, so we can resume credit offerings to our clients. We envisioned building three credit solutions based on their most important business needs. First, we're turning around our credit product by implementing improvements to our original short-term loan, so we can carefully move forward in test mode, even with the registry system not working as expected. Such improvements are the inclusion of personal guarantees from business owners and other businesses they may have; a better risk scoring through additional data; implementing minimum and maximum monthly payments to facilitate early signs of default while providing more flexibility on payment terms; improving the product so that clients can better understand impacts on their future cash flow. And lastly, enhancing our early negotiation capabilities. Also, we're working to launch two short-term lower ticket products. First, credit cards, which will provide our clients with a credit limit to use on day-to-day business expenses. Second, overdraft, giving our clients the convenience when they need to pay for unexpected or emergency expenses, and their cash flows are not enough to meet those needs. As a step towards strengthening our team, we are really happy to welcome the team of Gyra +, a data-driven SME lender, which operates under a fee-based asset-light approach. We plan to initiate assessing phase in small scale with short-term loans between the fourth quarter of '21 and the first quarter of '22, with focus driven towards getting feedback from engineering and improvements of the operation. Our insurance solution, though still in pilot mode, is showing encouraging initial results with 14,500 active contracts, in which we earn a fee without underwriting risk. Merchants, their families, and employees have multiple insurance needs and we're working to provide them superior financial protection. This is another important step towards our goal to be the best financial operating system for Brazilian merchants. On Slide 6, 7, and 8, I will provide more color on unit economics and monetization opportunities we see ahead. In Slide 6, we show that we have been able to accelerate TPV growth and net additional clients in the MSMB segments while keeping healthy levels of monetization. Average revenue per merchant in SMB is around R$365 while micro is R$117, showing improvement compared to last year. We also improved overall acquisition costs with CAC roughly stable for SMBs, and 17% lower for micro merchants, and maintained the stable operational costs of CRM, but with higher funding costs. As a net result, the payback period of new cohorts has ranged between 11 and 15 months. Due to the increase in the Brazilian base rate experienced throughout the past quarters, we have started to adjust our commercial policies to the new interest rate environment. In Slide 7, we show that in banking we have been able to not only grow our client base but also improved monetization for each client. The banking number of clients increased fourfold and average revenue per user improved by 30% year-over-year in the quarter. The insurance product, which is still in pilot mode, also improved the average revenue per user since its inception. In Slide 8, we want to show the rationale behind our investments in growth. Taking a broader look at the monetization opportunity in SMB merchants, we see that the average revenue per merchant that uses payments is R$340 and when they use our banking product with a prepaid card, they generate an additional R$30 monthly. If they decide to use the protection of life and business insurance, they generate an additional R$40 monthly. Clients that have fully paid down their loans with us generated a monthly revenue of R$327 when we look on an accrual basis. Lastly, the average monthly subscription for SMB clients currently using our POS/ERP solutions is R$160. On Page 9, we give a quick update on our Key Accounts business, which grew volumes by 10.5%, backed by two different underlying trends. First, subacquirers’ volumes continued to decrease share in overall volumes and revenues, decreased when compared to last year. Currently, our top two subacquirers represent only about 1% of our revenue net of funding costs, down from approximately 3% the previous quarter. Conversely, platform services increased volumes by 55%, and currently represent around 60% of Key Accounts' revenue. Here, we enabled third-party software providers and platforms to embed payments and financial services through API integration. In Slide 10, I want to shift to talk about our software business. In the third quarter of '21, our consolidated software revenue was R$314.8 million with 200 thousand software clients, revenue was 17 times higher than the third quarter of 2020, or 27.5% higher on a pro forma basis considering Linx. Users' recurring revenue grew 15.5% in the quarter with core POS and ERP solutions increasing 21.2%, driven by both higher average tickets and an increase in the number of stores served. The consolidated software revenue from our portfolio ex-Linx, which encompasses 10 companies, grew 182% year-over-year to R$53.1 million. On Page 11, we give an update on Linx integration and our priorities ahead. This quarter, we executed the new leadership organization, the integration of main back-office functions, especially finance, migrated half of Linx Pay sub-acquirer clients with approximately 80% having already opted in, and we plan to conclude the process by the end of the year. We're now shifting focus to capturing the growth opportunities we see ahead, and prioritize execution within different parts of the business. The first set of assets shown on the page is where we are investing in growth and quality. We will continue to drive organic and inorganic growth within each vertical and invest to expand presence in new verticals. Our OMS and impulse solutions are key assets to help our clients digitize their catalogs, better reach consumers, and sell more through multiple channels. Linx's brick-and-mortar gateway and QR gateway are important building blocks to enable software and payments integration, and we will continue to strengthen and improve such solutions.

Rafael Martins, VP of Finance and Investor Relations Officer

On Page 12, I want to highlight the strength and opportunities within the Linx business, with its deep knowledge of different verticals, attracting a powerful set of brands within Brazilian retail. Linx's Software Solutions are present in over 106,000 locations, some of which are the main franchises of Brazilian retail, where the relationship with stores is similar to that of SMB. Linx store locations jointly transact close to R$350 billion of GMV, and around R$200 billion of TPV, of which we have only mid-to-single digit payments penetration. On Page 13, we take a broader look at our Software business, considering both Linx and Stone software portfolio, and the representation from different client tiers. Key Accounts currently represents 9% of total software revenues. For this client segment, our execution is geared towards the high level of customization of large retailers’ workflows. Given the digital/omni maturity of our clients, this is an important segment regarding partnerships we are building with consumer-facing companies related to marketplace integration. Mid-to-large clients account for 80% of software revenues. In this segment, vertical expertise is key. We see an attractive monetization opportunity by creating Integrated Financial Services offerings specific to each vertical's needs. Also, we see the opportunity to help these clients sell more through multiple channels, with an efficient omnichannel integration. SMBs account for 11% of overall software revenues. We have over 120,000 SMB clients using software and 1.3 million MSMB payments clients. We are working to leverage our distribution capabilities to drive organic growth of software in this client's segment. On page 14, we wanted to share some initial experiences where we are working to improve the efficiency of our clients' processes through payments in open banking integrations with software. We highlight multiple benefits depending on their specific needs, such as enabling automatic settlement between service providers and higher professionals, such as hairstylists in hair salons. This specific feature is possible through the integration of Iris, our POS/ERP for beauty, with the Stone platform, and saves our clients time and money by avoiding double taxation. Like this example, there are several others highlighted on the page that are brought by different integrated solutions. We're only at the beginning of this journey, but we're very excited about the value we can bring to our clients in the future. Now, I will shift it over to Rafael, who will give an update on our financial performance in the quarter, and the evolution since our IPO. Rafa. Thanks Lia. Now, we're entering the last section of the presentation, the financial highlights. As shown on Slide 15, our total active client base grew over twofold, reaching nearly 1.4 million clients. While the micro-merchants active base grew by over eight times to 545,000 clients, a record net adds, excluding micro of 80,000, ending the quarter with 847,000 clients. Our total revenue in income was R$1.47 billion in the quarter, representing a 57% increase when compared to last year. Linx consolidation, which added R$262 million in revenue, and the growth of our existing business contributed positively to this growth and the lack of revenue from our credit products contributed negatively. Our business excluding Linx in our credit products grew revenue by over 55% year-over-year. The credit products, on the other hand, which contributed with R$156 million in revenue in the third quarter last year, didn't contribute to our revenue this quarter because we temporarily paused new disbursements as mentioned in our previous earnings call. Looking at our TPV, we reached R$75 billion in the quarter, or approximately R$300 billion on an annualized basis. This does not include Linx pay volumes. TPV ex Coronavoucher grew 53.6% year-over-year. In Slide 16, we show our consistent market share gains in payments. Looking at the main players in the market with publicly available data, StoneCo reached nearly 1% of market share in TPV. If we consider only our MSMB volumes, market share over total market volume is approximately 9%. More importantly, we can see that our MSMB business has been gaining share in a very consistent way with our highest ever quarterly market share gain of over 1.3 percentage points, as you can see on the chart in the bottom right of the page. Moving onto Slide 17, we show the pro forma results with Linx, both including and excluding the credit product. As Thiago mentioned, the pro forma growth of our business was 46% when excluding the credit product, and 26% when we see reported numbers with credit. There are 4 elements I would like to highlight here. First, our business kept high-growth levels after the acquisition of Linx. It's interesting to highlight that our business model is protected against inflation, both in the Payments business, which captures a take rate of nominal transactions, and in the Software business, which has inflation-adjusted contracts. Second point to highlight is that in this quarter, we had significantly higher OpEx investment in growth and new solutions, as Thiago has mentioned previously. So, you can see cost of services and selling expenses increase at a higher pace than our revenue. In cost of services, we have investments in TAG our registry platform, and other data center costs to support the growth of our operation, incremental investments in our technology, customer service, and logistics teams. In selling expenses, we have investment in the expansion of our hub operations, higher marketing expenses, and higher investments in the development of the team. The third point to highlight is that our administrative expenses increased significantly over 100% year-over-year. Here, we had over R$63 million in this quarter of one-off fees paid to advisors relative to the Linx and other transactions, besides higher amortization of fair value adjustments on intangible assets related to acquisitions, and G&A expenses related to our software operations apart from Linx. Important to note that in this quarter, we have separately disclosed the mark-to-market results from our investment in Banco Inter. We had a loss of R$1.3 billion this quarter, compared to a gain of R$841 million in the previous quarter. The fourth point to highlight is financial expenses. As Lia mentioned, basic interest rates have increased significantly in Brazil over the last quarters. This combined with strong growth in our prepayment volumes, led to an increase in financial expenses pro forma for Linx of over 290%. We are adjusting our commercial policy to this new environment, balancing the pace we expand our business with healthy monetization, but we still see in the third quarter and in the fourth quarters of 2021, lower margins than usual because of that effect. As we mentioned a couple of times in the past, usually there is a lag between changes in CDI and our commercial strategy adjustment. As a result of those factors, our adjusted net income was R$133 million in the third quarter. If we exclude our credit solution, adjusted net income was R$152 million, mainly because of the financial expenses we still had in our P&L, related to our legacy credit portfolio. Now, let's advance to Page 18, where we present our reported profit and loss statement. We experienced a 57% increase in revenue, with subscription revenue soaring over 300% primarily due to the consolidation of Linx. Excluding Linx, subscription revenue rose by 64%, largely propelled by a growing active client base along with increased contributions from our software solutions. Transaction revenue saw a smaller increase of 23%, predominantly influenced by the revenue drop during the third quarter of last year due to the Coronavirus. Excluding that impact, transaction revenue grew by slightly over 47% year-over-year. Our financial income increased by 32% year-over-year, which included revenue from our credit solution, contributing R$156 million in the third quarter of 2020 but nearly 0 this quarter. Our prepayment business continues to expand rapidly, with financial income, excluding credit and Linx, growing by around 100% year-over-year. Additionally, other financial income rose by 96.7%, mainly attributed to a higher base rate in Brazil, although this was somewhat offset by a lower average cash balance. Costs and expenses increased primarily due to the Linx consolidation, as previously discussed. In our press release, we have provided detailed insights into the growth factors, minus the impact of Linx consolidation. Moving to Slide 19, we observe the growth of adjusted net income, reaching R$133 million for the quarter. Further, as mentioned in our earnings release last quarter, we have refined our managerial approach to assessing adjusted free cash flow and related metrics. This refinement aims to offer a clearer perspective on cash flow dynamics, particularly concerning prepayment and credit solutions. Additional disclosures have been provided for investors to better understand our business. In the right-hand table of the presentation, we see that our adjusted free cash flow, excluding cash flow from credit and prepayment operations, remained relatively unchanged year-over-year despite a significant rise in investments. We generated R$238 million of adjusted free cash flow this quarter, slightly exceeding last year's result. This increase was mainly due to a substantial rise in net cash income, which grew by 168%, and reduced capital expenditures, although it was partially offset by lower cash flow from working capital changes. For the quarter, our prepayment business needed R$2.5 billion in cash, primarily funded through the sale of receivables. Our credit business generated over R$480 million in cash flow as we collected repayments from our legacy portfolio without new disbursements. Furthermore, we disbursed R$4.7 billion this quarter for the acquisition of Linx, financed through our follow-on offering in the third quarter of 2020. Moving to Slide 20, three years have passed since we became a public Company. And we believe it is a good moment to come back to some of the messages we have provided by our IPO. What we have done since then, and what we're doing now. By that time, we intended to develop solutions in the banking space and to serve micromerchants. Since then, our solutions in the banking and micromerchants space have gained significant scale, despite being still in early days. Active clients in banking have surpassed 420,000, and we have surpassed the mark of 0.5 million merchants with our TON solution. Looking ahead, we aim to be the best financial operating system for Brazilian merchants, as Thiago mentioned at the beginning of our call. Also, we have mentioned back in 2018 that we would selectively pursue acquisitions, especially in the software space. Since then, we have invested in 12 companies, being today the number 1 Company in software for retail management in Brazil. And looking ahead, we aim to be the best workflow tool for Brazilian merchants and help them drive sales through multiple channels. By the IPO, we also said that we intended to continue to grow our base of Stone hubs. We have increased from 180 proprietary hubs in 2018, to over 450 hubs today, gaining density of coverage. Our client-base increased from a little over 230 thousand by the third quarter of 2018 to 1.4 million clients now, of which 1.34 million MSMBs As Thiago said, we believe there is still plenty of room to grow with nearly 30 million MSMBs in Brazil. Following to the next slide, we show how our metrics changed since our IPO. We grew our client base at over 80% 3-year CAGR, and our TPV in revenue in a 50% and 53% 3-year CAGR, respectively. Our adjusted net income has increased from R$89 million in the quarter to R$133 million now, although we continue to invest heavily in our business. We improved our ability to recruit talents, with over 130,000 applications to our recruiter program this year. We maintained very high service levels with calls rated at "Excellent" in our customer support, roughly stable at 92%, and the delivery from our logistics at 96%. Also, we have raised the bar for ourselves. Whereas in 2018, we had the goal to pick phone calls in 20 seconds, we now do it in 5 seconds. We're proud of what we achieved since we got our first client in 2014, but we are much more excited with the opportunities ahead of us. We're just at the beginning of our journey. With that said, operator, can you please open the call up to questions?

Operator, Operator

At this time, we're going to open it up for questions and answers. Please proceed.

Tito Labarta, Analyst

Good evening. Thank you for the call and presentation, and for taking my questions. I have a couple of inquiries. First, I would like to understand more about Linx and the opportunities you see there. You mentioned the payment volumes from Linx, around R$200 billion. Do you have any insights on capturing those volumes over time? Additionally, regarding your omni-channel strategy, as you provide software to your merchants, can you share any potential synergies that might emerge? My second question pertains to your margins. I understand your financial expenses have increased as you invest heavily in the business, and you mentioned that margins could decline again in the fourth quarter. Currently, your margin is at 9%, which is significantly below historical levels. Do you anticipate continued pressure on margins due to elevated financial costs and ongoing investments? Is there a pathway to return to the historical margins you had previously? Any insights on that would be appreciated. Thank you.

Lia Matos, Chief Strategy Officer

Hi, Tito. This is Lia. Thank you for your question. I'll start and then hand it over to Thiago. Regarding Linx, the key takeaway is that we are observing a larger total payment volume than we expected before operating the Company. We see numerous opportunities to enhance value for our clients. Our focus is on understanding each vertical better. We are beginning to showcase some initial tests and pilots, and our approach will not solely concentrate on basic payments, but rather on how we can genuinely enhance our clients' experience and simplify their workflows through payment and open banking integration. We want to ensure our investors recognize these opportunities as we do, but we are not prepared to provide any synergy guidance at this moment. As for omnichannel, our main emphasis is on the pyramid depicting Linx clients by tier. For our key accounts within Linx, these clients tend to be more digitally advanced, with many already engaged in omnichannel operations. Our initial aim will be to assist these clients in connecting to various consumer ecosystems, with Inter being a prime example. In the next phase, for mid-large clients, we foresee a significant opportunity to support them in becoming omnichannel, digitizing, and selling through multiple channels. Regarding the SMB opportunity, we consider it a slightly longer-term prospect. Thiago, would you like to discuss margins?

Thiago Piau, CEO

Thank you for the question. I’ll provide some insights about Linx. We are currently in the initial phase of migrating clients from Linx Pay to our platform. We are carefully planning the integration and sales processes to implement this strategy within Linx's client base. So far, 80% of the clients have agreed to migrate, and we are focused on making this transition as smooth as possible. Our goal is to complete this by the end of the fourth quarter or the beginning of the first quarter, and we are putting in place all necessary processes to engage our clients effectively. We are pleased to find that Linx has a stronger focus on medium and small clients than we initially thought, presenting us with significant opportunities. Regarding omnichannel efforts, we are looking to enable clients, especially those in brick-and-mortar sales, to sell through various channels like e-commerce and social media, which could significantly boost their sales and enhance their relationships with merchants. On the topic of margins, we acknowledge the current unusual levels. In the short term, we anticipate our margins may dip below the usual levels, but we view this as a temporary issue rather than a structural one. There are a few points to consider about margins. Firstly, we are positioning our company for greater scale and making significant investments with discipline in unit economics. As we grow, we expect to benefit from operational leverage, reflecting positive returns from our investments. Secondly, we are investing in new initiatives to better serve our merchants, as demonstrated by our additional product offerings. We aim to build strong relationships with our merchants, which we believe will lead to margin expansion over time. Lastly, our business is affected by the macroeconomic environment, both positively and negatively. We benefit from inflation as it raises total payment volume (TPV) and adjusts our software contracts accordingly. However, we face headwinds from rising interest rates since access to funding is crucial for our growth. To counteract this negative effect, we are focused on our product offerings and pricing strategies. Recently, we increased our outstanding client balance to over R$1 billion, which is creating a natural hedge for us. Although there is a delay between interest rate hikes and our repricing strategy—because we are mindful of maintaining good client relationships and growth—the strategy will progress effectively. In conclusion, we anticipate our margins will improve based on the factors I've mentioned.

Tito Labarta, Analyst

Thanks, Thiago. That's helpful. Just to clarify, does that mean increases in margins will happen next quarter or next year? Is this a longer timeframe for those margins to rise? You mentioned that margins remain below historical levels. Should we expect a downside from the 9% margin we experienced this quarter, or are you indicating that we will remain below the near 25% to 30% margins? I'm trying to understand the changes better, as there's a significant difference between where you were and where you are now.

Thiago Piau, CEO

Yes Tito, so we are already executing the repricing strategy, both in the sales and in the current client base we have. We're taking a cautious approach, as we said, not to jeopardize relationships, but we're doing well. So, we are executing this with discipline throughout November and December and I think that we are moving well. When we think long-term about margins, we expect to have a high-margin Company, mainly because we believe in our ability to drive much more engagement of our clients with the solutions we are building, keeping the cost to serve under control. So, I think that, in the very short term, you will see levels of margins higher than what we had one year ago. But mid-term, we expect a very high margin Company because of the expectations in terms of products.

David Togut, Analyst

Thank you. Good evening. Could you expand upon your expected timeline to restart credit origination? How the integration with the registry of receivables is going, and when we might see some operating leverage in the credit business?

Lia Matos, Chief Strategy Officer

Hi David. Lia here. Thank you for the question. So, as I mentioned, we expect to start retesting our original port product, which is short-term loans, between the fourth quarter of '21 and the first quarter '22. We're implementing in this product several improvements, so that we can start to test, and test the impacts of those improvements without needing to rely on the registry systems fully functioning. Those improvements are, for example, the inclusion of personal guarantees from the business owners and potentially other businesses they may have, improve risk scoring through additional data. Part of that has to do with a very important fact that I didn't detail much, which is incorporating our hub operation into the credit and much better than we did before. So, part of that data has to do with the thousands of interactions that our sales agents, our green angels, and our customer service teams have with our clients every day. Implementing some product adjustments as well. So, we will have a mix of minimum and maximum monthly payments that will facilitate and make it more flexible for our clients to pay. It enables us to actually identify earlier signs of default and improve the user experience overall. This also has to do with incorporating hubs better into the process. So, we really will pass all of these improvements as we start testing in the fourth quarter and the first quarter of 2022. We will not wait for the registry to be fully functional. And we want to do this without having to rely on that. But that said, we do expect that long-term the registry system will work and that we will get into regime eventually.

David Togut, Analyst

Thanks for that. Just as a follow-up. When do you think you'll start to originate credit and volume? In other words, you talked about starting to retest in the fourth quarter of this year and the first quarter of next year. But when do you think your lending product will be back at volume levels that we saw prior to halting the origination of credit?

Thiago Piau, CEO

Hi David, Thiago here. I think that we're not ready to provide a specific guidance in terms of scaling the credit. We're really focused towards engineering and getting the feedbacks of clients and all the clients experience that we have learned throughout this one year executing the credit. We expect to start disbursing this quarter, and we think that this mindset towards engineering, towards client experience, making sure that all the negotiation and renegotiation processes work in the best way possible for clients; is the mindset that we need to have today. I think that by maybe the end of the first quarter or beginning of the second quarter, it would be easier to provide you some guidance. In terms of scale, we want to keep our minds focused on engineering and getting the product in the way we want.

Mario Pierry, Analyst

Hi, everyone. Good evening. Thank you for taking my questions. I have two questions that might seem a bit repetitive, but I want to be clear. Regarding Linx, when you first announced the acquisition, you anticipated it would be accretive to basis points in the first year. Is that still true? Linx's revenues are nearing R$1 billion; should we expect any significant revenue acceleration for Linx in the next 12 months? Also, considering the costs associated with Linx, as you mentioned you've been investing heavily to migrate clients to your platform, could you clarify this further? Is this transaction expected to be accretive to EPS in the first year? My second question is about your ability to pass on higher prices due to increased financial expenses. I realize that other companies in similar situations are facing similar challenges with wholesale funding. However, I am concerned that some incumbents might view this as an opportunity to regain market share, leading them to hesitate on pricing adjustments. Can you discuss the market dynamics and your ability to implement higher prices moving forward? Thank you.

Rafael Martins, VP of Finance and Investor Relations Officer

Hi, Mario. Rafael here. Thank you for the question. So, regarding your first question of EPS accretion. So Linx is a very healthy business in terms of margin. So, I did the margins very healthy. When we look at interest rates right now, Linx's bottom line today is contributing negatively to our result. So, we are reassessing in our re-budgeting for next year, and the opportunities that we see. The EPS accretion, we do believe that this is a very accretive business. Regarding the timing of when this should be accretive, we'll come back to you on more details with the synergies. But I think that the interest rate scenario makes the bottom line in terms of net income and EPS slightly lower than we expected. But when we look at other opportunities, for example, as Linx's core growth is performing better than we expected when we did the deal. So, I think it will be a trade-off that the opportunity here is not maximizing Linx's bottom-line, but rather building into the future that Lia mentioned. So, we are testing already integrations in different segments of clients. And one important thing I think to mention is when we talk about penetrating financial services and Linx clients, we are much more focused on rather than going to the big clients and selling payments and penetrating payments with small fees, we're trying to have a deep knowledge on what product fits best for each vertical and client profile. And from the conversations we have been with the team, there is a lot more to explore than we thought; and this will be a bit very accretive. This is the update on Linx.

Marcelo Baldin, CFO

Just a quick comment on Linx. On Slide 11, we've categorized our observations on Linx into three main areas. First, we are very impressed with the strength of Linx's core business. The growth in core areas such as POS and ERP solutions, OMS, and the TEF solution, which serves as the gateway for brick-and-mortar stores, was surprising to us. We aim to invest in both growth and quality, leveraging the distribution channels that Linx has developed through its own franchises and the network that Stone has established with its hubs and franchises. This combined effort should enhance our software strategy. We appreciate the execution regarding these assets and recognize that the growth potential in software is greater than our initial expectations. Regarding the e-commerce platform, we see the need for increased investment in scalability and features. We're committed to assisting the team in improving the platform. With a two-year CAGR of 39%, we see positive momentum, although the pandemic in 2020 contributed significantly to that growth. To achieve our goals for the e-commerce platform, we must invest in technology. A negative surprise came from the payments platform, which we chose to discontinue swiftly due to quality and risk concerns that were worse than we had anticipated. We focused our efforts on migrating clients quickly, which has slightly delayed our penetration but has not altered our plans or the opportunities we see. We've already adjusted pricing for new sales and initiated a gradual repricing strategy for existing clients. We're approaching this with care, balancing payback periods and contribution margins for each client. While repricing matters are sensitive in terms of competition, we handle them on a case-by-case basis, considering each client's segment, size, and product usage. We aim to make proposals that best suit them without rushing, as we want to maintain strong relationships with our client base. The initial results indicate that we can execute our repricing strategy without compromising our partnerships, and we are proceeding thoughtfully.

Mario Pierry, Analyst

Okay, guys. Now that's very clear. Thank you very much.

Operator, Operator

Our next question will come from Jamie Friedman with Susquehanna. Please go ahead.

Jamie Friedman, Analyst

Here guys. I'll just ask my two upfront. About Slide 11, Thiago and Lia with your comments, when you say 50% of the clients migrated to Stone 81% opted in. My understanding was that you were targeting 20% in Year 1 run rate. Am I just mixing things up here? What is sub acquiring as a percentage of the TPV, I guess is my question.

Thiago Piau, CEO

What's the first question?

Jamie Friedman, Analyst

Thiago, I thought you said earlier, and I may have misheard, for which I apologize, that you expected the margins to be higher in the short term. Could you clarify that, as it seems different from what I anticipated? Thank you.

Lia Matos, Chief Strategy Officer

Hi, Jamie. I'll take the first part of the question and then pass it to Thiago. So yes, let me clarify your question regarding migration versus the synergy in terms of penetrating Linx's base. The number that we give here relates to Linx Pay. So, Linx had a subacquirer within its Linx space set of assets. And that's where we put the first focus of the team, because we saw some risk there related to regulatory compliance, things like that. So, we really prioritized very quickly to migrate that volume, but that volume wasn't that large, it's about R$2 billion in the quarter. That's pretty much a process that we're completing by the end of the year, where we really see the opportunity is when we talk about the R$200 billion TPV that we mentioned. And that's where we're really looking into, vertical by vertical, and the teams are coming in and really understanding from clients where the opportunities are and where we can create value through payments and Open Banking Peaks. So, several different types of integrations between our financial services platforms and Linx's software. So that's really where our focus is. And then that's where we look ahead to penetrate that opportunity in terms of TPV. Was that clear, Jamie?

Jamie Friedman, Analyst

Yes, that clarified everything. Thank you, Lia. I understand now. Thank you.

Thiago Piau, CEO

Hi, Jamie. Thiago here. So regarding margins. Back again, I think that I didn't say in the right way actually. So, what we see is in the short term, our margins are lower than the margins we had historically, right. And interest rates were going up much faster than what we thought in the beginning, and we decided to accept a little bit lower margins during a short period of time not to jeopardize the client base. And we are repricing the new sale in a way that we don't decrease level of growth too fast. We took the time to learn the dynamics of the market, the dynamic of the client base, and we accepted lower margins in the very short term because of that. I don't want to make promises now about the margins next quarter, but what I can say is, the quarters ahead, the very short terms of quarters ahead, we will have margins lower than what we have historically. But our ability to drive margins in our business model in the medium-term, it hasn't changed. So, I think that we are balancing investments in terms of growth, looking to payback contribution margins from our clients, understanding what is our ability to drive more value in the more unit economics for each segment and size give the strategy in terms of products road map we have, and now we are executing this with a lot of discipline. So we believe that's worth it in the very short term to have margins that are lower than the historical margins that we had in order to gain much more scale and have a much stronger business model in the future. And we're doing this with discipline. But over the medium to long term, we expect to have a high-margin business with strong cash flow generation.

Neha Agarwala, Analyst

Could you provide more information about the competition, specifically in the core SMB market? You mentioned having a 9% market share; how do you expect that to change over the next 2 to 3 years? Additionally, can you share your progress in the long-tail segment? Is the situation encouraging, particularly regarding the payback period you mentioned? Have you reached a break-even point in that segment, and what are your expectations for profitability moving forward? Thank you.

Lia Matos, Chief Strategy Officer

Sorry Thiago, you want to take it?

Thiago Piau, CEO

Yeah, Lia, go on. Hi, Neha, Thiago here, speaking. Regarding competition, no updates in terms of everything that we have said in the previous two quarters. But I would like to take a moment to talk briefly about the medium-term. I think that when we see our industry and our business and what we are building into Stone, I think that this is really a lifetime opportunity. It's incredible to see the changes in terms of the merchant needs, in terms of how the industry is evolving. So, we took the challenge. We're moving from the payments relationship that brought us here to building the entire financial platform that our clients need in order for us to be the only relationship when they think about financial services. I'm seeing that the team is really moving fast. We're now focused on the engineering side to take the credit because we think that credit is a very important product to help our clients to sell more, and I still see some of the players in the market trying to do the same, evolving to the whole financial platform. But I think that in the end of the day, we have the best service level, we have the best team, we have the best execution. I really believe in what our team is doing. And there's one challenge that we took, and I think that nobody took the challenge yet, which is to win on the software side of the industry, to really drive efficiency in the operation of our merchants, and taking the challenge to bring additional sales for our merchants in the scale that we're doing. We believe that in the medium-term, the importance of the software, and our ability to connect the brick-and-mortar operation of our clients with multi-storefront operations with the digital channel is something that we really transform our business in the next 3 to 5 years. I'm confident with our ability to win in the MSMB space. I'm confident with the ability of the team to build the whole financial platform, to change the way we have a relationship with our clients, and to win on the software side to bring more sales to our clients. We want to create a Company which is humble to learn. And we made mistakes in the past, we learned from them, and we are much stronger now. But the opportunities in the industry are very, very big. In the micro segment, what I'm happy to see, and we have disclosed this here on Page 6, is that the average revenue per merchant is actually better than we thought in the beginning, and we had the ability to decrease the cost of acquisition of clients. And those are two very important factors for us. So, we're confident in our ability to execute in the micro segment. I think that the team is really performing well. And the capital allocation we did, I think that is on track in terms of our plans. So, we will continue to drive growth, and we will continue to invest in the Micromerchants segment because we believe in our ability to offer better products and better service to micro-merchants in Brazil and to help them to dream bigger. I think that this team is capable of doing it and winning in this market.

Lia Matos, Chief Strategy Officer

I would like to add an important point regarding your question about market share. What Thiago mentioned is significant in terms of the numbers we present related to acquiring market share. However, I believe a better way to discuss this is in the context of what Thiago introduced at the start of the call. We truly see a flywheel effect, beginning with our capacity to expand our client base. Acquiring is just the initial entry point for that relationship. When we discuss market share, we must acknowledge that there are additional addressable markets and opportunities ahead. As we continue to introduce more products and solutions for our clients, the focus should be on how we can grow our client base by delivering the best service to those merchants. We've developed a model that includes distribution and customer service capabilities, allowing us to effectively serve those merchants. While acquiring serves as the starting point, we will provide more solutions over time. Looking 2-3 years into the future, particularly concerning our distribution capabilities, I believe we will witness a significant transformation compared to what we have today. With the Linx acquisition, we have strengthened our software distribution, and within Stone, we not only employ a hub strategy but also have strong distribution in the micromerchant segment. We are increasingly considering how to merge our efforts to deliver the right products to the right clients through appropriate channels. There is a lot of work ahead, as Thiago noted, and while we are at the beginning of this journey, I am confident that in 2-3 years, we will have a greatly enhanced set of distribution assets and offerings for our clients. I felt it was essential to highlight this aspect.

Neha Agarwala, Analyst

Thank you so much, Lia and Thiago. If I can have 1 additional question. How easy do you think it will be to reprice and pass on these higher funding costs to your customers? Because if I understand correctly, for the hub business, it also depends on what your competitors are doing. So, how much of the higher funding costs do you think you can pass onto your customers? Thank you so much.

Thiago Piau, CEO

Hi, Neha. With our client base and current growth rate, making pricing changes is never easy. However, it's not just about ease; it's about delivering the best value to each client. Our pricing strategy is based on the products our clients use and their level of engagement with those products. We're taking the time to leverage our strong relationships and analyze engagement data to determine the right price points that align with our capital allocation and expected contribution margins. It's important to follow our plan carefully without rushing, especially since interest rates have risen quickly. While there may be pressure to adjust pricing immediately, our priority is to maintain our client relationships and execute a well-balanced plan. I trust our team's ability to carry out this strategy, and we will share more details in the fourth quarter, particularly regarding our repricing efforts in November and December. October was focused on planning, while November and December will be about execution, making it easier to discuss outcomes at the end of the fourth quarter. I’m confident in the plan we have.

Neha Agarwala, Analyst

Great. Thank you so much. Very helpful.

Thiago Piau, CEO

Thank you very much, Neha.

Lia Matos, Chief Strategy Officer

Thank you, Neha.

Operator, Operator

There are no questions at this time. This concludes the question-and-answer session. I will now turn it over to your host for final considerations.

Thiago Piau, CEO

Thank you, everyone for having the time to be here with us, and see you next quarter. Bye-bye.

Operator, Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.