dLocal: An asymmetric opportunity with significant upside potential

This article details my high conviction investment thesis in dLocal. I believe that dLocal is a highly misunderstood business with great potential not reflected in today's share price.

If an investor could dream of the perfect business in which to invest, what qualities would they search for? This question has been answered, rather definitively, by many great investors including Warren Buffet, Chuck Akre, and Joel Greenblatt.

• High ROIC

• Ability to continually re-invest at high returns

• High quality management team

• Low price

An exceptional investment, for long term investors, embodies these qualities and the investor is able to maintain a silent partnership while asymptotically earning the underlying high returns on capital of the business.

In this article, I will argue that it would be difficult to find a business that embodies these qualities better than dLocal does today. dLocal has extremely high returns on capital, the ability to re-invest at high returns for at least a decade of growth, and high-quality management with a significant ownership stake in the business. The recent market reaction to macroeconomic challenges and a temporary investment cycle have resulted in a highly irrational price for what is an exceptional business.

For these reasons, dLocal is by far my highest conviction investment and is currently a large portion of my portfolio. I believe that by 2030, dLocal could be able to grow into a global payments business with a market cap exceeding $20 billion.

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Contents:

1. Macroeconomic Analysis and Secular Trends

2. Business Model Overview

3. Competitive Advantage(s)

4. Evaluation of Management Quality

5. Valuation Model

6. Risks

7. Concluding Thoughts

Macroeconomic Analysis and Secular Trends

Before diving into business details, I will first provide the macroeconomic backdrop to put the dLocal investment into a contextually accurate lens. The global south is growing much faster than developed economies dominated by North America and Europe — within this context, digitization is happening rapidly as there is more relative scarcity in the emerging markets of the global south.

For example, without large-scale in person retail distribution, e-commerce provides a far more valued service in developing markets as goods and services are often not available via legacy brick and mortar stores. As internet penetration continues to increase in emerging markets, demand for digital goods and services will continue to grow and outpace already accelerated GDP growth (compared to developed western economies).

dLocal operates exclusively within the global south and therefore the growth of the business is directly correlated to these aforementioned trends. The underlying TAM dLocal can serve today is estimated at $2 trillion (digital payments in global south) and is growing at a high teens CAGR through 2030 in most of markets in LATAM and APAC (1).

Continuing, dLocal operates in unstable markets with frequent regulatory changes, limited financial infrastructure, and exotic currency pairs. This is an intentional direction taken by the dLocal management team, and allows for higher margins than scaled western markets due to limited competition, difficulty of execution, and higher FX spread for cross-border transactions. dLocal has several cost-advantages in the markets they operate which will allow for dLocal to sustainability deliver the highest quality service in the markets they operate at the lowest cost. I will continue to expand on this topic later in the article when discussing competitive advantages.

Although the markets in which dLocal operates in have some inherent volatility, over the long term dLocal’s approach will prove highly prescient as the aforementioned secular trends start to dominate results. As long as dLocal is able to continue to take market share, the performance of the business is likely to be exceptional.

Business Model Overview

dLocal is the leading payment gateway in emerging markets. dLocal operates a digital technology stack that enables businesses to accept electronic payments by connecting merchants with banks and payment processors. dLocal specializises in solving the complexity of payments in emerging markets where financial infrastructure is often fragmented and regulations are complex.

Revenue Streams:

1. Transaction Fees - dLocal’s net take rate has been steady at 1.2% for the majority of FY 2024 and is the majority of revenue. Transaction fees vary significantly by payment method and country. In smaller markets, dLocal’s take rates are significantly higher due to limited competition and higher complexity.

2. Foreign Exchange (FX) Spread - Revenue from currency conversion when processing cross-border payments. FX spread is significantly higher in smaller markets with more exotic currency pairs.

Key Costs:

1. Payment Processing Costs - Fees paid to local banks and financial institutions. Card network fees (Visa, Mastercard, etc.) or payment method processing fees.

2. Operating Expenses - Technology infrastructure and development, compliance and regulatory costs, customer support, and sales and marketing.

A typical payment transaction involves the following entities:

• Merchant Acquirer

• Issuing Banks

• Payment Networks

• Payment Gateway

The following diagram depicts a payment transaction in sequence:

Economics of payments are shared between all of the aforementioned entities for a typical credit card transaction charging around 2-3% total fees in developed western markets as follows (2)(3):

• Interchange Fee (goes to issuing bank): ~1.5-2.5%

• Network Fee (goes to Visa/Mastercard): ~0.05-0.15%

• Merchant Acquirer Fee (goes to payment gateway): ~0.2-0.5%

Within online payments landscape in developed western markets, the payment gateway receives the merchant acquirer fee. This is either retained by the payment gateway in the case where the gateway is the acquirer or the majority of the fee is sent to the merchant bank.

In emerging markets, economics of payments are shared between the same entities but are slightly different in the following ways:

1. Higher take rates due to increased risk and complexity

2. Increased fragmentation of payment networks

This ultimately allows for more economic value to flow to the payment gateway entity in emerging markets as the payment gateway is responsible for increased complexity which includes:

• Integration with a highly fragmented local banking system to ensure local acquiring for high performance

• Integration with highly fragmented local payment networks

As a result of operating in emerging markets, dLocal is able to charge significantly higher take rates of approximately 1.2% as of Q3 2024 (4). This is in comparison to the typical 0.2-0.5% take rate within developed western economies. Generally, as emerging markets develop the expectation is that take rates should normalize toward that of developed economies. However, my expectation is that dLocal’s take rates will remain structurally higher the next decade due to the increased complexity of running a payment gateway in emerging markets. As dLocal is able to scale their business in smaller markets, I believe that take rates could even slightly increase due to the high complexity we previously discussed.

Continuing, dLocal’s business model is one in which there are essentially zero variable costs (a miniscule amount of increased server capacity to serve more traffic). This means after operations have been started which does require up-front investment, dLocal is able to continually grow revenue with little incremental investment. dLocal has been able to grow TPV at exceptionally high rates over the last 3 years (well exceeding 40% annually) while simultaneously using free cash flow to repurchase shares.

There are very few business models with the ability to grow significantly with such little capital — the only business models of this caliber I can identify are Meta and Google Search. This results in exceptionally high ROIC, consistently in the mid-30% range (7). I will note the typical SaaS business is not advantaged in this way, as SaaS businesses are plagued by high marketing costs and cash flow is often invested into marketing dollars to drive growth. Stopping the marketing investing effectively slows growth, so excess cash flow is reinvested to drive growth instead of repurchasing shares.

Competitive Advantage(s)

At first glance, an investor may conclude that dLocal has little competitive advantage and will likely be usurped by Visa, Mastercard, Adyen, and Stripe. However, I do not believe this is the case as the digital payments landscape in emerging markets is significantly different than western economies.

1. Visa / Mastercard do not have the same dominance in emerging markets as in western economies; emerging markets are moving toward digital payment methods often issued by central banks. Example of this are UPI in India and Pix in Brazil. This creates an innovator’s dilemma situation for Visa / Mastercard as success in emerging markets payment gateway means ceasing to be the sole monopoly payment network. Mastercard has been pursuing emerging markets as a payment gateway over the last decade but has not been exceptionally successful.

2. Adyen and Stripe both act as the acquirer in western economies which involves setting up banking operations and does not lead to the same strategic advantages in emerging markets. This is due to the low performance of local banking systems in emerging markets and the high fixed costs relative to the potential revenue pool. The playbook to win in emerging markets is to use many local acquirers and route payments among many local acquirers. This results in higher uptime as certain issuer / merchant bank pairs offer higher authorization rates which translates directly into increased sales.

3. My belief is that the company which solves this problem will come from emerging markets — anecdotally, western people will not understand the problems with financial infrastructure in emerging markets with the same level of depth. dLocal has an operating advantage compared to western players as they already know what the problems are and have a defined playbook for solving them with great success as evidenced by the exceptional TPV growth over the last 8 years.

With the established view that the playbook to win as a payments gateway in emerging markets is to route payments between many local acquirers, scaled economies shared models start to come into play. dLocal is able to aggregate demand across many different merchants who need payment processing and then negotiate contracts on behalf of the aggregate volume of all merchants. This leads to lower cost of acquiring which allows dLocal to continually reduce prices or increase margins.

Historically, dLocal’s management team has wisely opted to continually reduce take rates which results in increased demand. Increased demand begets lower cost of acquiring begets lower prices begets increased demand. Sound familiar?

Increased Processing Volume → Lower Cost of Acquiring → Lower Prices

Evaluation of Management Quality

In my view, the main responsibility of management is to establish a company’s culture and allocate capital. My process for evaluating management quality is to evaluate the company’s culture, capital allocation decisions of the management team, and the insider ownership to ensure that incentives are aligned with shareholders.

Insider ownership is very high at over 20% of shares outstanding (6).

Company Culture

dLocal has a culture of innovating on behalf of merchants to solve merchant needs. This is evidenced by the exceptional TPV growth since the company was founded 8 years ago. In addition, the company continues to innovate on behalf of merchants and continues to announce important features to solve merchant needs:

• Payment Orchestration Product - allows for contract flexibility with financial services merchants

• Platforms Product - designed for large digital marketplaces

I expect that the company will continue to gather data from merchants and prioritize product roadmap to innovate on behalf of their customers.

Capital Allocation

With the poor share price performance over the last two years, management has allocated over $300 million in authorized share repurchases. The company continues to have best in class margins with best in class growth rates and has a culture of frugality. I expect that share repurchases will continue in a similar model to Visa/Mastercard.

Commentary

My personal judgement is that the current CEO, Pedro Arnt, is an exceptional person having been CFO of MercadoLibre (MELI) and helping to build the most successful business out of LATAM ever. I think that Pedro Arnt is very talented and my confidence in the management team was bolstered by his joining the company — frankly, without Pedro Arnt I would not have invested in this company. I was previously studying MELI and learned of dLocal through Pedro’s departure from MELI, and found Pedro’s comments on dLocal when he joined highly compelling.

“Having worked in Latin American tech over the last 25 years, I have obviously been aware of dLocal since its inception, merely 7 years ago. However, upon being approached by the Board and undertaking my diligence, what I found was a set of business success drivers even more remarkable than I had initially anticipated. I’d like to spell some of those out for you today: 1) A vast untapped Total Addressable Market (TAM) of 1.4 trillion dollars within the rapidly expanding markets that we currently serve. 2) An exceptional opportunity for growth alongside these markets, as well as the potential to extend our reach to numerous additional markets, and this allows us to increase our TAM by over 2.5 times over the next five years. 3) The product and technology stack is fantastic as it serves many of the world’s leading, and most demanding Mega Cap tech companies. 4) This is an entirely customer centric organization that is obsessively dedicated to our customers' success, and continues to pile up client win over client win, growing clients by 41% CAGR and TPV by a phenomenal 126% CAGR over the past 3 years. And last, but certainly equally important, an extremely attractive financial model characterized by a Revenue CAGR of 101%, Adjusted EBITDA over gross profit surpassing 70%, and an annual conversion of free cash flow to Net Income exceeding 90%.“

The only skepticism with the management team is the Muddy Waters short report which accused dLocal of fraud in 2022. My view is this report is not of great substance and was directed at dLocal due to the exceptional business results, region in which dLocal operates, and precious affiliation with AstroPay/Directa24. The details of the report are refuted with great detail in the VIC writeup in the appendix (5).

Valuation Model

To estimate the valuation of dLocal in the future, we must consider both the long-term margin potential of the business and the long-term growth prospects of the business. Currently, dLocal is in a disciplined investment cycle impacting near-term profitability. For reference, in 2023, Adjusted EBITDA / Gross Profit ratio was consistently in the 75% range and has recently plummeted to the 65% range. This is due to an investment in engineering talent which is offsetting natural operating leverage — as the business grows, operating leverage inherent to the business model will allow for the long term margins to exceed the previously stated 75% range.

For the purpose of our model, we will use the 75% ratio although I believe over the long term this can be exceeded.

Continuing to growth, I expect that dLocal should be able to grow gross profit at a 35% CAGR over the coming 5 years. My confidence in this level of growth comes from macroeconomic tailwinds (as previously discussed, TAM is growing ~15%) and recent comments from dLocal’s management team in Q3 2024 earnings call:

“Secular trends also favour us. We have a huge and growing TAM underpinned by shifts towards payment digitalization, the growing importance of emerging and frontier markets, and surging demand for cross-border and instant payment methods. Industry forecasts predict the cross-border payments market will reach $65 trillion by 2030, and we are well-positioned to be capturing a reasonable portion of the growth in this immense addressable market. Our ability to innovate and capitalise on these trends, coupled with our financial model characterised by operational leverage and high cash conversion, will fuel long-term value creation for our shareholders and merchants. We are just beginning to realise the compounding nature of this strategy, and we remain steadfast in our mission to deliver on this promise, in all the relevant geographies that our merchants present needs.”

I will use the 35% growth rate as my bull case and temper expectations significantly from there to ensure downside risk is protected.

Bear: 15% Growth Rate, 13x Adj. EBITDA - $5.2 billion

Base: 25% Growth Rate, 17x Adj. EBITDA - $10.3 billion

Bull: 35% Growth Rate, 20x Adj. EBITDA - $18 billion

Under conservative assumptions we can see the distribution of returns from the $3 billion dollar market cap as of writing is highly attractive. I will calculate a CAGR to give investors a clearer idea of the distribution of returns. All calculations are from a market cap of $3 billion.

Bear: 15% Growth Rate, 13x Adj. EBITDA - ~12% CAGR

Base: 25% Growth Rate, 17x Adj. EBITDA - ~28% CAGR

Bull: 35% Growth Rate, 20x Adj. EBITDA - ~45% CAGR

I am optimistic that the bull case could even be exceeded — perhaps significantly — take this with a grain of salt as I am certainly biased. Most importantly, the distribution of returns protects downside risk so as investors we have the luxury of being able to purchase and find out.

Risks

dLocal operates exclusively within emerging markets in LATAM/Asia/Africa and there is a risk that US economic policy could lead to increased relative strength in the US dollar which could impact dLocal in the short term. I won’t pretend to know what will happen to the US dollar or global currencies however I will note that this is a risk that investors need to consider with this thesis.

dLocal operates in highly volatile markets and therefore unfavorable macroeconomic conditions in LATAM, or Asia/Africa could impact dLocal’s results materially.

However, my view is macroeconomic risk is already priced into dLocal today. Recent macroeconomic circumstances in Nigeria and Argentina have been highly unfavorable and my view is that this has moved toward a near-term tailwind. Argentina’s economy is predicted to rebound with aggressive strength in the near term. If an investor is to take a long-term view, the aggregate GDP of the economies in which dLocal operates is likely to grow at rates exceeding western economies. Although bumps in the road are likely along the way, secular trends are favorable for the long-term investor.

The other significant risk is competition (we have previously addressed in the “Competitive Advantage(s)” section of this article). It is my view that the market is large enough for multiple winners and dLocal is a highly motivated company moving fast and executing toward winning in this market. My view is digital payment gateways in emerging markets are likely to mirror western markets in which the market is dominated by two large players — Adyen and Stripe have approximately 40% market share — and is highly fragmented otherwise. dLocal is currently the front-runner to be one of the large players in digital payment gateways in the global south and my view is this is position is likely to be maintained.

Concluding Thoughts

I believe that dLocal is an underappreciated gem and significant upside is to come for investors. dLocal is an exceptional business that generates very high returns on capital, has potential for significant growth, and has an exceptional management team.

Despite my optimism, the low share price as of writing allows for downside protection if dLocal is only able to grow alongside the TAM and fails to continue taking market share — a significant change in trend.

I own a significant position in dLocal and intend on holding it as long as the business remains excellent and the stock price remains at least somewhat rational. It is wise for us to let our winners run as investors, and I intend to do just that with this position.

Appendix

1. https://investor.dlocal.com/wp-content/uploads/2023/06/Investor-Day-presentation.pdf

2. https://www.adyen.com/pricing

3. https://stripe.com/pricing

4. https://investor.dlocal.com/financials/quarterly-reports-annual-reports/

5. https://valueinvestorsclub.com/idea/DLOCAL_LTD/4720760162

6. https://investor.dlocal.com/wp-content/uploads/2024/03/DLO_2023-Annual-Report.pdf

7. https://finbox.com/NASDAQGS:DLO/explorer/roic/

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