TIVP023: Nubank (NU): Banking on Latin America w/ Shawn O’Malley & Daniel Mahncke

26:50Not only has he built what I would say is an incredible business from nothing and improved the lives of obviously tens of millions of people probably, but he has shown that he just isn't in it for himself in the way that you might expect. And he's actually been willing to forsake some of his personal gain for the company's benefit, which we've studied a lot of CEOs. I'm not sure how many other CEOs would sacrifice their personal wealth in the way that David has for the greater good of the company. And basically what he did is he gave up this variable compensation and contingent share award for 2021, just to use the kind of legal jargon of how it's described.

27:27And by giving those funds back to NewBank, it's estimated that he saved the company over$350 million and basically 2 % shareholder dilution over the next seven years. So again, how many people would leave that kind of money on the table to support what's in shareholders' best interest at a time when there were some concerns about how profitable the business could be? And so don't get me wrong, he's a billionaire, so this isn't completely charity. But the point remains. And to invoke one of our favorites, Charlie Munger, as he once put it, we look for people who would be working even if they didn't need the money because they care about the mission of their company.

28:10And I think as the founder who also still has a 20 % stake in the company and who has led this revolution and did something very, very bold, I mean, who cares about the future of NewBank more than David Villez? He's just exactly the right person you'd want to have running the company. So I think actions tend to speak louder than words. And in this case, his actions speak very, very loudly. NewBank seems to have so many of the key characteristics that we see in all these successful US tech companies. A new and disruptive business model that works very capitalized compared to the legacy players, a flywheel where those advantages are passed on to consumers, at least to a large extent, as we've seen with Amazon as well, and a founder and CEO who thinks long term instead of just quarter to quarter and is willing to leave some money on the table if it benefits the greater good of the company.

29:09Since you know the company better than I do, perhaps let's pull the thread further on what David has built with Nubank and what advantages it actually has. You mentioned that lower costs were something of a moat for them. Can you tell us more about the lower costs and any other advantages that you think they have, which will benefit them going forward? I should really hammer in the point of their cost advantages of starting from scratch as they did. My understanding is that traditional banks in Brazil have just been very slow movers in adopting technology. and that's because they have tens of thousands and in some cases actually over a hundred thousand employees and hundreds of branches with this patchwork of it systems and software tools that have been mashed together probably over several decades and the result is you get these behemoths that just cannot move nimbly and as an example if you lose a credit card at a traditional brazilian bank at least within the last few years you would have probably been going to get a case number You would have had to fill out a bunch of forms.

30:15You would be mailing them in. And then you would have to call back in a couple of days to kickstart the process just to get a new credit card. That's not true in every case. But the point is that those kind of things have gone on pretty recently and may still even go on from what I've heard. Whereas with Nubank, it is as simple as a few clicks of a button in their app to get a new card sent to you, which is really how it should work, right? And when you aren't carrying a ton of bureaucratic inertia, it's much easier to design something that isn't just a better product, but is more efficient and thus cheaper to scale than the alternative.

30:53And while the big banks are on their back foot trying to catch up, New Bank is getting more and more customers at their expense and importantly, getting more and more data on customers that it can use and their underwriting decisions. so they aren't necessarily growing irresponsibly. They're getting data on lending and on the platform and customer habits and just creating a better and better product over time. Anyone can grow quickly by offering cheaper loans. But then at the same point, that business model falls apart when your questionable loans don't get paid back. So that is really the challenge I should emphasize for fintechs.

31:27And for NewBank, they've got the tech part down and that helps a lot with adoption and scaling. But from an investor's perspective, you want to be certain that this isn't all going to blow up either. The more companies we cover, the more you just see these patterns emerge. And data is really one that no matter what company we cover, it's so powerful to have data on customers that those legacy competitors, in this case, the banks, just don't yet have. It helps with expanding the business, but it also helps with the unit economics of the current business. and I still want to ask you about all of that more in a moment but given the old adage about never investing in fast-growing financial companies because of all their hidden risks that might be there and this is a company that has grown extremely fast in US dollar terms but actually even faster in local currency terms I think the Brazilian real depreciated by over 20 % last year against the dollar.

32:27And that has understated their still phenomenal growth figures when you look at the results in dollar terms. So we are talking about a company that has grown revenue by an average of 75 % per year over the last five years. And probably it has been even more in real terms. And a weak real is one of those risks with investing in Nubank from the perspective of an American or European. But to get back to that original question on moats, I think innovativeness and flawless design and good execution are all subtle cultural advantages for them, but not necessarily deep moats. To the extent those things help new bank recycle cost savings back into benefits or customers, maybe that's one thing and arguably is a moat.

33:16But otherwise, I don't really see any clear moats here. And there are those currency risks that we just talked about. But sometimes all you need is one good moat. And more broadly, just to take a step back, people typically say there are five types of moats. Low cost production, high switching costs, efficient scale, network effects, and intangible assets like branding. And I'd say switching costs aren't terribly high in this case because it's really not that hard to close and open other digital bank accounts or even to close and open new credit cards. It's a hassle maybe, be, but it's not terribly difficult.

33:51And additionally, there isn't really a network effect here in the traditional sense. NewBank isn't necessarily a better product for me due to the number of people who use it. I will say, however, they have reached an efficient scale, obviously, that helps with their low cost advantages and actually comes with another advantage in that they're really as big of a bank as any in Brazil now and maybe systemically important. And that does come with some probably favorable regulatory treatment. But still, ultimately, the thesis here for any advantages NewBank has ultimately comes down to just having a lower cost structure than all of their competitors.

34:30And some estimates suggest that NewBank's operating costs may be as much as 85 % less than its peers, mostly due to not having those physical branches and having a fraction of as many employees. So when I say a low cost advantage. I mean, that is what we're talking about, 85 % less in some cases. And per client, expenses can be 13 times higher at traditional banks. And the cost of acquisition, by some of the estimates I've seen, can be as much as 60 times higher for them. So traditional banks in Brazil have something like less than 1 ,000 clients for every employee, while Nubank has closer to 9 ,000 clients per employee.

35:13So no matter how you chalk it up, and by any measure, it's just dramatically more efficient, and maybe 15 to 20 times as efficient in some cases. Wow. I mean, I figured that they would be significantly more efficient, but the numbers you are citing here are so much more than I would have ever imagined. Evidently, pays not to be bogged down by legacy systems. I've come across similar numbers when I researched for my visa episode i didn't bring them up because the business model is so different that i figured it's kind of unfair to compare that and the value of those numbers is probably low but still i'll cite them here i think for visa it was that over 150 000 cardholders come on every employee they have again these numbers are less important than if you compare new bank to traditional banks, but it shows you the pattern of how the less reliant you are on employees in the fintech and just general finance space, the better your margins and unit economics of your business will be.

36:21They just need fewer employees to provide the same fundamental services. It's as simple as that. And that's because they've been able to automate so much of the process and not in a negative way. They've built an app that is really intuitive to use and that obviously people like and that just cuts down on so much of the back and forth and the complicated processes you might normally expect at a bank which goes a long way in reducing headcount and you can actually probably argue that they have a really beloved and trusted brand too which i think plays into the fact that it's it's such an easy to use app and that probably provides some advantages as well well-known brands are just going to have an easier time onboarding and attracting new customers and they're going to have to spend a lot less on marketing due to that strong brand reputation that generates more organic growth.

37:10And that is something of a structural advantage for sure. Again, I wouldn't call that a true moat for them yet because it's all so new. It's such a young company. They've only been around for a few years. We don't really know how durable that brand reputation is. And brand reputations can be destroyed quickly, especially for new companies. but you have to say it's a growing source of moat for new bank over time and built on what is really that foundational moat the low cost of production advantage that they have i think reputation for brand is always important but if you're a bank it's even more important but at the same time once you mess up any small thing all that brand value and all that trust is immediately gone maybe on the financial risk of, we discussed it, like a fast growing financial business like New Bank.

38:04How can you make me feel better about that? We don't have to go through a bunch of historical case studies to know that when things do go bad at financial institutions, they can go really bad. And from an outside perspective, it just can happen so suddenly. Right now, the numbers look fantastic. But if we dig down into all the loans they give, Who knows what might happen in a year or two or even just five years ahead? I totally agree. I'm not here to say there are no hidden financial risks at NewBank. I don't work there and I'm not a bank auditor or even someone who otherwise invests in banks very often.

38:40So I'm not going to be the one who can completely assuage those concerns. And if the seats were flipped, I would be asking the exact same question. That said, if we look at what the experts think, Moody gives NewBank an investment grade credit rating in line with Brazil's other major banks. So clearly the credit rating agencies don't necessarily see any major red flags. And one of the things that really matters with banks, since we can't see their loan books and the risks that they're truly taking, we have to try to assess the bank culture. Are people being incentivized to do fraudulent things like Wells Fargo a few years back where employees were pressured to create these unauthorized accounts for people?

39:25Or is there just a culture of excessive risk-taking or not tricking customers and employees fairly? And with Nubank, they really seem to be in a league of their own again. Their widespread adoption tells you about how beloved its services are. And we've already mentioned what a great leader David Velez has been. But even just when you look at Glassdoor reviews from employees, the company gets 4.4 stars with 90 % of reviewers saying they'd recommend working there to a friend and 96 % of folks there saying they approve of the CEO. So that might strike people as a strange tangent to go on when talking about financial risk, but how employees are treated and incentivized matters a ton with banks.

40:05And in this case, it does seem like NewBank has as good of a corporate culture as you could hope, especially given its broader mission to level the playing field for underbanked people. I used to think it was a bit weird when people brought up stuff like open jobs on LinkedIn or ratings on Glassdoor. Kind of like the numbers don't bag your story, so then you have to come up with something else. But since a couple of years, I see myself doing that quite often. As a supplementary thing, of course, but it can be very helpful. Since you hook me on Reddit, I even see myself going through some subreddits every now and then, especially when it's about goods or services that I'm personally not aware of or that I personally don't use.

40:52In this case, you could go to the subreddit about Brazil and see what locals are thinking about Nubank. And perhaps you get to speak to some employees. I think as you mentioned, if you want to figure out the culture, it just pays to be at the root, like talking to the employees, talking to customers. Since you and me sitting in the US and Europe, we have no clue what the experience actually is. Yeah. My hope is just to try to get as many touch points as I can as possible to understand the business, which is something I always do. But again, it's especially important in this case, given that, as you said, we can't interact with NewBank.

41:30But to talk more about whether NewBank does have these financial risks brewing beneath the surface, I should say that I mentioned earlier that big banks in Brazil charge interest rates on credit cards with APRs that can sometimes be north of 400%, or at least historically they did. And I can't even imagine the anxiety I'd feel missing a payment with those rates. And it's not that Nubank is offering considerably lower rates. In some cases they do, but really what they've done is cut out many of the other fees that banks charge. And as such, they've been much more transparent about how that interest accrues and they've made their products more accessible to a wider range of people.

42:10So you can make a lot of risky loans and have a lot of people not pay you back, but if you're charging 200 or 300 or 400 % APRs, you probably are going to make more than enough in interest from those who do pay to make up for the bad loans. And the question is really, are those traditional banks in Brazil and to some extent now a new bank just extorting customers with high rates, raking in profits simply because they can for the time being? Or are those the necessary rates that they have to underwrite the financial risk of lending to these types of customers? And again, I should say that Brazil's baseline interest rates, so they're equivalent to the Fed funds rate, is about three times higher than in the US because inflation is also much higher.

42:55So when you have a much higher baseline interest rate that does ripple across the system, meaning if those rates are shocking to you and they are very high it's not entirely an apples to apples comparison across currencies and economies that said though there are countries with higher inflation rates in brazil that do not have 400 interest rates on credit cards and the consumer lending culture in brazil and interest rates there are just notoriously the least consumer friendly in the world i would say even with new banks up in emergence onto the seen yeah i think it's similar in germany and the us where most cards i see have aprs between 18 and 27 now i think about what those high rates mean for people in brazil and sure for everyone who defaults if there's just one or two people paying 400 they can probably make up for it but generally i just don't see it as a good business model i mean if someone falls behind on a small balance, it can balloon into something unpayable within just months.

44:03And if that happens, people can pay, so they default. But instead of adjusting, banks use those high default rates to justify keeping the sky-high interest rate. So that sounds to me like a vicious cycle. If rates were lower, wouldn't more people might be actually able to pay their debts, benefiting the bank and the entire system. I mean, I get how some people can make up for 10 or 20 people who default, but it still strikes me as an unhealthy way to grow and make business. I agree with you. And my question is the median credit card user in Brazil, that much worse of a credit quality than their equivalent in the US or Germany.

44:49And I think to some extent that there is an answer that yes, they are because of the cycle you mentioned here. if people simply don't have as much experience with banking and borrowing in general too of course that doesn't help the point being though and we haven't seen it yet but lending rates will almost certainly eventually come down pretty dramatically as brazilians build up credit history and earn higher incomes and as there's new competition to come in and offer lower rates and that could all hurt new bank and offset some of their growth and earnings power by reducing the rates that they can charge.

45:24And as you put it, though, that actually may not entirely be a bad thing if it means lower default rates. So to summarize, I actually do think it's a big risk for Nubank that as more fintech competition enters and the credit ratings of Brazilians generally start to improve, interest rates could drop much faster nationwide than default rates and hurt Nubank's net interest income. Or, and this would have the same effect, regulators might simply come in and try to cap the interest rates banks can charge on consumer loans, which is something they've actually already done in some ways. There was a new regulatory rule mandated last year that effectively capped credit card APRs at 100%.

46:05And yet, even with this new rule, NewBank had no issue growing interest income 50 % year over year. So this is all clearly very nuanced, and there are kind of mixed and offsetting effects in different directions that can be hard to separate. If banks are forced to charge lower rates, that in theory reduces interest income. But again, if it actually results in more people being able to pay off their balances, then there might not be that much of a negative drag at all, as you sort of alluded to, Daniel. And again, I'm not an expert on modeling credit risk, especially not on millions of credit cards.

46:39But I think you could probably take two very simplified views of new bank. Either you think they're underpricing financial risk relative to their peers or taking on too many risky loans as a percentage of their portfolio, and that's going to cost them eventually, if not cause their business to potentially blow up in some kind of worst case scenario, because they're taking on loans with just such high default risk that more established lenders aren't willing to do at this scale, who after all, these traditional banks, at least in theory, probably understand the risk profile of Brazilian consumers better than anyone because they've been lending to them the longest.

47:17Or the other view, again, that's very simplified, is that there was and honestly still is an oligopoly in Brazilian banking. And large banks haven't needed to lend to low-income families to generate excess profits. So they haven't, and they really don't know as much as you think about underwriting lending to them. And New Bank is still charging high enough interest rates to probably safely cover those risks. And while NewBank has grown quickly, that is maybe primarily because their app is so superior and they have just been structurally willing to lend to people with less credit history using alternative metrics to assess that risk that they're taking.

47:53And as such, they're not necessarily taking as much outsized financial risk as you might think, or at least as the bears might argue. And they actually have a reputation for now offering very modest lines of credit to people with limited or no credit history. So small credit lines is sort of another way that they've been able to hedge some of that credit risk. And I should say that the answer between those two very simple frameworks of understanding NewBank is, of course, somewhere in between. These are really famous last words to sit here and imply that just because nothing has gone wrong, that nothing will go wrong.

48:32And if I were to get really bullish on them, I would basically be going off of a lot of the work that others have done to try and assess the risks that they're taking in lending. And what we do know for sure is that Nubank has powered its ascent by doing something that Brazil's historically conservative banking tight ends never really had a stomach to do, and that is lend to low-income families. And at a high level, it's up for debate how well Nubank is handling that opportunities and also the risks that come with it. One other subtle risk I should mention is that when you primarily cater to retail clients and low-income clients, as opposed to commercial clients managing deposits for businesses, you can have a very sensitive base of depositors who, maybe in some sort of financial crisis, could panic and withdraw funds all at once.

49:21And that's a fancy way of saying that another one of the risks that NewBank may be more exposed to is a greater chance of being hit by a bank run by individuals and households who might be more likely to panic. Do you have any data you can share on the risks they may be taking in lending? I do have some notes for you just to make things more tangible. And for the sake of journalistic integrity, I should mention that there have been some alarmed reports over New Bank's lending practices, though there are certainly people who think this is all too good to be true. There was a Bloomberg report a few months ago, for example, that cited New Bank's percentage of 90-day non-performing loans, that is loans where someone hasn't made a payment in over three months, and that had reached a new high at 7 % of their total loans outstanding, which is considerably higher than the average of 5.5 % for the wider banking sector, at least according to Brazil's central bank.

50:21And at the same time, the company's provisions for loan losses, which is the money they set aside to cover future losses, declined. So immediately, sort of a yellow flag. I don't really have a good explanation for that other than to say that this is the weak point in a bull thesis on Nubank and really does require careful attention. It can be really easy for banks to use loan loss provisions to manipulate earnings because if you set less money aside, your earnings today are actually going to look higher at the expense of your future results if you don't have enough money aside to basically cushion losses.

50:56and I'll just read a quote from that Bloomberg article. Fernando Fontura, a portfolio manager at Persevera Asset Management said, the discussion on credit quality made us decide to follow this from a little further away. That is something to take note of and I go back and forth here because I wouldn't say it's a consensus view on Wall Street to think NewBank is taking dangerous risks but whenever things seem too good to be true and especially for a financial firm that's growing so fast, alarm bells should go off. And yet also, on the other hand, I would argue that with any financial firm, you could probably find numbers to quote unquote freak out over.

51:37When you're growing loans at 28 % year over year, it would seem like though that just leaves a lot of room for error. And when you layer over the fact that their chief credit officer left last year, there really is plenty of ammunition for bears to dwell on and worry about. And this has always been the downside of digital banking. It's just tempting to grow too quickly and take on risks you might not have even realized you were taking. And on the bright side, you can look at NewBank and also say, okay, they're trying to push toward lending to less risky demographics and doing more collateralized lending, where I should lend against an asset or a security deposit.

52:20And that secured lending portfolio grew 6x last quarter to $1.4 billion. And now that represents about a quarter of their total lending portfolio. So this has not been a subtle transition. They're very clearly trying to change the composition of the risks that they're taking now that they've hit a certain scale. And at the same time, they've also expanded into payroll finance, which again, is this relatively safer form of lending because you're just lending in advance against payroll payments from companies that you know are almost certainly going to come through. Companies are going to have a big issue if They're not paying their employees.

52:54So in different ways, as concerns have started to mount about their past lending track record and their exposure to just how levered they might be to any kind of downturn in the Brazilian economy, which has historically had some frequent and big downturns, they've also made a very public push toward what you might call safer forms of lending. What would be really interesting for me to see is as NewBank has become more established and traditional banks have had to accept this shift and the status quo, how have they responded to that? I mean, have they, for example, lowered interest rates on credit cards or have they cut out banking fees to be more competitive with Nubank?

53:41And if not, maybe they can because they have a higher cost structure such that they have to charge certain fees to maintain profitable. I'm guessing they have tried to offer digital services too, but clearly those haven't had the same adoption as Nubank. So tell me, what exactly did they do and did it work out? I think this has all happened so fast that you could probably argue that they don't have a fully hashed out response, even still, based on the way they're bleeding market share. As we talked about already, interest rates on credit cards and personal loans haven't come down that much and are still very high by global standards.

54:20So the response from legacy banks has mostly been to offer no free credit cards like New Bank, and by trying to improve customer service with chatbots and by revamping the digital experience for users. New mobile apps, 24-7 support, real-time spending tracking, more transparent explanations of their interest rates, even some financial education initiatives, one-click freezing of cards, and just digitalizing many of their processes, like opening accounts or card applications, that kind of stuff. And these processes have become so much less bureaucratic than they used to be. So it is a risk that eventually these legacy banks continue to close the technology gap and can pull customers back by offering higher touch services that a digital first bank can't really do.

55:10Recognizing that they can't directly compete with Nubank's tech stack, some of these big legacy banks have instead opted to just acquire fintech companies and try to build on what they've done rather than building something completely from scratch themselves. Nubank, I would think, has been a big wake-up call on the quality of their service since customer expectations have shifted dramatically in just a few years because of what Nubank has been able to do. And really the winner of all this competition ultimately are Brazilian consumers. It actually became very common for members of other banks to threaten to switch to Nubank as a way to get fee waivers.

55:49So I do worry that the end game here is a commoditization of financial services in Brazil such that no bank is a winner in the way they are now and used to be. And kind of surprisingly, so given the degree of market penetration that NewBank has in Brazil, they have a relatively small share of Brazil's total banking assets, partly because they filled a void in the market by targeting Brazil's sizable population of underbanked households who don't have a lot of money, while traditional banks there have really continued to serve those high net worth cohorts and serve them well. That is starting to change, I should say, was NewBank has this new ultraviolet program that offers cash back and a travel portal that does cater to what you probably call wealthier customers and also charges monthly fees, which does sort of go against what originally made NewBank popular.

56:43So in summary, NewBank is starting to target those higher income demographics and is sort of fundamentally changing its strategy to do so. And it'll be really interesting to see how that shapes the next frontier of competition with these legacy banks. Certainly. I guess many high net worth individuals just value the personal connection to the banks, but the upper middle class might be one that they can target and they likely will target them through programs like Ultraviolet. What can you tell us about the marginal costs of each new customer relative to the value they create, especially now that they might target the upper middle class.

57:25I would think for a digital bank, those unit economics should look pretty attractive, especially compared to those legacy banks. They already have some pretty compelling operating margins of nearly 25%. But if the unit economics are as good as I think they are, that margin could actually continue to go higher as the business scales. It's a really good point. And due to having the cost advantages we've mentioned a few times today, The unit economics of NewBank's business do end up being compelling and can probably only become more compelling if they hit those higher income cohorts that you mentioned.

58:00And the way to think of it is that NewBank's average lifetime customer value relative to their customer acquisition costs is something like 20 to 30 times higher. For every dollar of revenue a new client generates, NewBank might only spend a few cents to acquire them. that's primarily because they have such a massive referral program and get so much of their business that way as opposed to having to do paid marketing or all the things that traditional banks try to do to entice new customers and on that front in the u.s at least just think about capital one and their cafes that they run they literally run coffee shops as a way to ultimately bring in customers and when i compare that with how new bank has grown it's just a considerably costlier way to attract business.

58:46And Capital One is, for the record, playing a different game in a different country. But I just say that to make the point that there are different ways for banks to acquire customers. And NewBank has shown that it can do so very cheaply at a massive discount to what the average customer is worth to them. And it's not entirely a function of cheap acquisition, though. Those really attractive unit economics also come from significantly increasing their average revenues per customer over time, such that the lifetime value of the median customer is higher than it used to be. And from effectively cross-selling new products and just generally increasing transaction volumes as customers become more and more reliant on new banks offerings over time, the company's average revenue per active customer, aka RPAC, has risen steadily in the last few years.

59:36This is a really impressive stat, but for people who've used a new bank product for more than 12 months, 60 % have converted to opening a bank account with them. And related to all this is that Nubank customers don't leave. The churn rate is almost unbelievably low. We're talking about a few tenths of a percent a month. And that has resulted in a very loyal customer base with higher lifetime values because people stick around for longer and they tend to use more products over time. So from the company's earnings presentations, we know that active customers tend to increasingly rely on Nubank as their primary banking platform.

1:00:12Use more services over time, as I mentioned, and as such, of course, their RPAC is going to increase over time too, which makes the business only more and more compelling. So you'll have to take my word for it, Daniel, but there is a real argument here for Nubank actually being one of, if not the most efficient banks in the world. And when you combine that with the explosive growth they've seen, just you get incredible results for shareholders, assuming that, and this is the big caveat, that the financial risks they're taking are at least in check or as conservative as you'd hope, which is a big assumption when it's difficult to truly verify that for ourselves.

1:00:50And management has said they actually think gross margins can rise another 15 percentage points over the next few years. And so, of course, that is going to definitely boost operating margins too. And I mean, I could imagine that operating margins might be north of 30%, at which point they really do look like a big tech company. I know that when you started researching new bank, you kind of pitched me on the numbers and I've looked into them myself and the numbers are just insane across the board if you compare them to any legacy banks not only in brazil they are so much better that i understand your feeling that there has to have something to that it can't be that good without any hiccup on the story but you just mentioned the margins and to unlock even further margin growth they are going to have to keep growing growing and growing as they basically are doing right now and that way they could also get more of these scale benefits, which are part of the reason why the numbers are looking so good.

1:01:49So maybe on that point, it seems like a good time to discuss the different ways that new bank could still grow its business. We know that the banking industry is a pretty regional market. Even the biggest banks in the world, many of the large US banks, have most of their customers, at least on the consumer side in the home country. And that's because of regional regulation, its differences in credit risk, and even the entanglement of banks and national politics. And we've seen that in Brazil when the legacy banks try to keep New Bank out using their connections to Brazilian politicians. New Bank never had that political edge or advantage.

1:02:33And as a digital bank, they might have it easier to comply with regulations as well in other countries. And even if the differences in credit risk might be less of a problem for them with all the extra data, there is still an argument to make that expanding into other countries could at least be difficult. In my mind, all of this could benefit them when they try to do this, but maybe you could talk a bit more about how you see them growing in the future and what part expanding into other countries can play. Yeah, yeah. So We've talked a lot about Brazil, and there is probably an opportunity to move up the income ladder there.

1:03:12But that would also require a change in their strategy more fundamentally. So more interesting to me is that Nubank could really just run the same playbook in Mexico and Colombia, which are these similarly large countries. And in Mexico's case, it actually has a higher GDP per capita, but only 24 % of the population use credit cards compared to 40 % in Brazil. and again if you combine Mexico and Colombia's population it's about the size of Brazil's so theoretically they could double their customer base by just recreating the same success there which is aggressive but not crazy given that these countries now have unbanked populations that are larger than Brazil as of 2021 for example over 50 percent of Mexico's adult population was unbanked.

1:04:01These markets just seem to be begging for fintechs like Nubank to come in. And of course, that has drawn in a lot of competition from new competitors. But Nubank certainly has some large scale data and financial advantages working in its favor. There are probably thousands of fintech startups across Colombia and Mexico that are vying for control over very promising financial markets. So I don't want to make it sound like it's easy for Nubank to come in and just penetrate those markets, but they're certainly doing so from a position of strength. They already have 9 million customers in Mexico, for example, and I'll just take a moment to read something from David Vlez here, as he has put it, over the next 10 years, we will continue to go after that hypothesis of testing this model really in more countries beyond Latin America.

1:04:47But this is not an easy model to internationalize, especially the way we do it to become the primary bank account of our customers. And according to the gentleman overseeing Nubank's expansion into Mexico, 20 % of Mexico's adult population with a smartphone has already applied for at least one financial product through Nubank. So that is just so very promising and telling of what direction things are moving for Nubank outside of its home market. And for half of these clients too in Mexico, their new bank credit card is the first credit card they've ever had. So the opportunity here goes without saying.

1:05:31And to maybe just invoke David Velez again on his dream scenario, he said in a call that, quote, nobody in history, as far as we can tell globally, no other global consumer retail bank has been able to build a multi-country platform that is extremely efficient and that has one code base that ultimately could give them a significant an advantage in expanding. And that's what we've been building for about 18 months already and probably have another 18 to 24 months and is something that will continue maybe forever is having a proprietary core banking platform that allows us to be in multiple countries and allows us to launch in new countries with relatively low investment.

1:06:10And if you want to be really bullish on new bank, you could argue that they have a potential to take over all of Latin America at scale with low cost. And if anyone is going to do that, it's probably going to be them. Having this single software platform powering that business is just a huge leg up over their competition that probably lack the technical prowess and have tangled legacy infrastructure or just don't have the resources and scale and data that NewBank has. This would totally change the regional aspect of banking that we've just discussed before and that we also talked about in the Visa episode, which is an advantage that Visa has that they don't really care where the bank is.

1:06:51And now NewBank could potentially do the same just in South America. Having said that, I know too little about the fragmentation of the South American market and the differences between each country, especially in banking. But based on NewBank's success in Mexico and Colombia, I would buy into that story. Just in Mexico, I've pulled the numbers quickly before we started the call. they account for 23 % of Mexico's bank population. And growth in Colombia, while at an earlier stage, is similarly impressive. And if you just look at those growth numbers, that's one thing. But what we are seeing are all the other key metrics that currently look fantastic, but you could maybe tell us a bit more about how they matter for NewBank.

1:07:38What are the key metrics we should look at to understand a digital banking business like NewBank? we always talk about returns on capital as being one of the core determinants of returns but when looking at banks that is actually not typically the best performance metric i think you know that daniel but i say that just for the audience since banks almost by definition use a lot of capital in the sense that you have a lot of financial assets via loans and liabilities in the shape of deposits roic can be less telling of reality and as a result we want to see is using their capital structure, what returns can a bank like NewBank generate for shareholders?

1:08:17As in, what is the return on equity? And for NewBank, it is, well, very, very good. NewBank's ROE last year was 28%, while for some of NewBank's biggest competitors, that return on equity is closer to the mid-teens, like Banco de Brazil at 15%. And if you look at a premier bank in the US, like Bank of America, their ROE is just 10%. JP Morgan's is around 15%. So clearly, NewBank stands above local and global competition in terms of its returns on equity. And of course, the more leveraged a bank is, the more it can amplify ROE. But you also are increasing the risk of a blow up too. And on that front, NewBank isn't as highly leveraged in the sense of going out and making every possible loan as you might think.

1:09:05they have a loan to deposit ratio of about 40%, meaning that for every$1 of deposits they have, 40 cents is loaned out. And that is actually very low by global banking standards. A more typical number would probably be 70 to 80%. And so this does suggest they're not just blindly making as many loans as possible. If anything, you might actually say they're sitting on too much deposit or cash and could be making more loans to optimize their earnings power. and I think in part the explanation for that is well for one they're growing so fast in Mexico and Colombia they're collecting a ton of deposits from people who are opening new accounts and they haven't yet started lending at scale in those new markets then also there's sort of this regulatory kink in Brazil where merchants in Brazil typically receive card transaction proceeds after 30 days unlike in the US and Europe where there's sort of this near instant settlement that occurs and this This means that card issuers like NewBank fund customer purchases up front, but don't need to send payment to the merchant acquirer immediately.

1:10:08And that gives them an extra 30 days of float that boosts their deposits and allows them to finance their growth more cheaply than other banks around the world. And we talked about this earlier, and this was the loophole that the big Brazilian banks wanted to change to crush NewBank. And obviously that did not come about. And now it creates a time afloat for Nubank that sort of distorts the loan-to-deposit ratio. But yeah, that's a summary of the loan-to-deposit ratio for you. That's one of the idiosyncrasies of researching a bank, right? They have so many ratios that you don't usually look at for other companies.

1:10:44On the balance sheet, that can be the loan-to-deposit ratio that you mentioned, which is surprisingly low for Nubank. I think many of the European banks are deep into the 80%. And then you usually also look at the proportion of short-term borrowings just to show the fragility with respect to changes in funding conditions or the liquid asset ratio to show a bank's ability to absorb funding shocks. And the same is true for the income statement as well and the ratios that you look at. For example, when we talk about new banks operating margins, even this is calculated differently than how you would assess operating margins and profitability for a non-bank stock.

1:11:25Exactly, exactly. Bank stocks, as you said, are a niche of their own, for sure. And with any bank, we also want to look at the net interest margin, which is a measure of how profitable the bank's core business is. And that is, to what extent are they lending at higher rates than they pay depositors. Net interest margin is calculated by dividing a bank's total net interest income. So the interest they earn on loans minus interest they pay depositors by the average amount of interest earning assets they have. And this matters because banks largely finance themselves with deposits. So that's borrowed money that they owe and deposit rates are the costs of financing, which they use to make those loans with.

1:12:13So a bank that's lending at relatively high rates and paying relatively low deposit rates is going to have an above average net interest margin. And again, NewBank's numbers here are just extraordinary. Their net interest margin was around 17 % last year. And I can't emphasize how massive that is. The global standard is something like 3 % to 5%. And the Brazilian banking industry is probably on the higher end of that average. but still new bank's net interest margin is an anomaly which i feel like is starting to be a pattern in this episode as we talk about just how excellent they are at seemingly everything they do and that leads into a whole conversation about trying to adjust the net interest margin for the lending risk taken we probably don't have time to get all the way down that rabbit hole other than to say that in theory they are of course taking greater risk to earn that higher interest spread because they're making so many consumer loans.

1:13:06And then the last thing we want to look at are their loss provision ratios, which can we touched on a little bit earlier. And that does relate to the conversation on risk adjusting new banks lending margins. Because they're dependent on much higher risk lending than the average bank, they set aside about 13 % of their total loan portfolio in reserves to cover losses, which is going to be typically higher than traditional banks. and that makes them sound more financially conservative. But of course, they have to set aside more funds to cover losses because again, they're making more risky type of loans to less credit worthy borrowers.

1:13:43And there are a bunch of similar metrics to these that show the nuances of the risks that banks take. But I'd say to go back to your original question, the net interest margin, the loan deposit ratio and loan loss provision ratio, those are sort of the key metrics that we need to understand for any bank. and we've touched on them a little bit here with NewBank. With all these numbers and the ratios, I think if any one of our listeners has never researched a bank stock and this is the first one they come about, it's incredibly hard to understand how astonishing all of these numbers are. They are best in class in pretty much everything what they do.

1:14:22And with all that said, how about you tell us how you approached valuing NewBank? There are so many risks you have to factor in and I can assume it's just getting difficult. I mean, fast-growing young companies are always tricky to model. Then when you add in the financial risks of a bank, layered over with the currency and political risks of a company based in an emerging market country, I don't really envy the work you probably had to do to estimate new banks' intrinsic value. Thank you for saying that, Daniel. It wasn't easy, but it's not heroic work either. I do enjoy doing it. And so yeah, I tried to model out new banks earnings and also get a feel for new banks operating margins, which I adjusted to include net interest income, net of the interest they pay on deposits.

1:15:12And I mentioned that because normally, as we touched on a minute ago, when we say operating a profits, that usually excludes interest costs. But with banks, interest on deposits is their costs of doing business. So we can't ignore it. And interest on loans is their primary revenue driver, so we really can't ignore that either. And when projecting out new banks' net profit margins and earnings per share, I used a 12 % discount rate to bring those future profits into present values. And keen listeners will notice that this 12 % discount rate is a few percentage points higher than the rate we normally use of 8 % to value large cap companies like Nike or Visa or Alphabet or Airbnb.

1:15:55They're all based in the U.S. And I would say this is for a few reasons. The discount rate is like our hurdle rate. Think of it as the rate of return we need to earn to accept the risk we're taking. And so when investments come with higher risks, you should demand a much higher discount rate. And because a new bank primarily earns its revenues in Brazil, which is an emerging market country, as we've said a few times, that comes with a number of risks. For starters, as we already know, the Brazilian real can fluctuate dramatically in value due to changes in Brazil's inflation rate and growth in its very cyclical economy.

1:16:31So you're dealing with an inherently more volatile currency. And when you convert those earnings in real to USD or euros, the same earnings from Nubank may not always be worth as much. Since 2015, the real has lost almost half of its exchange value against the dollar. So that's a huge headwind to fight against, assuming that trend continues. And if your USC earnings get cut in half every decade, well, you don't need me to tell you that you're going to need some really incredible earnings growth in local currencies to offset that. And the USC earnings are, at least for an American investor, ultimately, what matter?

1:17:12It's the ever same problem for US or European investors. And one of the things we also wondered when we listened to Buffett this year at the Berkshire meeting because he seemed a lot more concerned about currency risks than basically ever before. Mostly about the US though, but I highly doubt he wouldn't feel more uncomfortable with owning a bank like Nubank operating in regions with highly volatile and depreciating currencies. It's a huge headwind that many investors, at least in my opinion, ignore when they see a good company. but that headwind is so strong it can easily turn a great investment into a mediocre one and a mediocre investment into a terrible one.

1:17:54So yeah, you've got more significant currency risk and sort of baked into that is higher political risk where you're investing in a country that by most measures does not have a strong rule of law as US or Western Europe. And then we're investing in a young company in a sector that can carry serious hidden balance sheet risks. And all of that combines together for me to say, okay, we need to use a higher discount rate to value the equity of this company. Aswalt de Motoren does a really great job estimating in detail the equity risk premiums and country risk premiums for stocks and markets all around the world.

1:18:32And after viewing his estimates on Brazil's risk premiums, I landed on a 12 % discount rate for Nubank. And people try to make this an exact science and it's not. And you may feel like a different discount rate is necessary, but this is just what I thought was appropriate after digging into the risk premiums typically calculated for Brazil and their equity markets generally, and then also for the banking sector there. And so when you're using a higher discount rate, that is going to reduce the future value of earnings more, but also raises your expected return from a given price target. and then on top of that higher discount rate i also added in a 25 of margin of safety from my estimated fair value of new bank stock so between the high discount rate and the baked in margin of safety that's how i get to a target buy price where assuming we felt comfortable with the story and risks for new banks qualitatively then i would recommend buying the stock when it's at least near or below that price range that I get.

1:19:36And what is that price range that you get? Do you have a detailed price target or is it a broader range? What did you come up with? That's a big question, isn't it? Well, I should say that at every quarter, I did try to be as conservative as possible to acknowledge everything I don't know about the risks that I'm taking here as someone who doesn't otherwise have a ton of experience with Brazil, NewBank, or even financial stocks. And my model, for example, has NewBank growing quickly, but still below the range of estimates I've seen from analysts projecting their 2029 sales figures. And I accounted for some improvement in their operating margins due to the attractive unit economics and scale we've talked about.

1:20:13But I also only accounted for really only one or two percentage points of operating margin improvement, whereas some of the bulls out there are arguing for margins to rise by as much as five or ten percentage points. And whenever you model out a company that's growing earnings by nearly 18 % a year as I did, it's hard to say that you're being truly conservative. But relative to the company's recent track record of growth, the very large runway ahead of it in Mexico and Colombia, and then analyst projections, I would say my assumptions are fairly tame. And on top of all those caveats, I also added an implied exit multiple of about 22 times earnings, which would be a pretty significant compression from the company's current valuation, where it's trading at about 30 times last year's earnings and was trading at as high as 50 times last year's earnings just a few months ago.

1:21:09So again, being somewhat conservative or at least not overly aggressive in my assumptions, I get a really wide target buy range, which is sort of a cop-out because this is such a hard company to value. But I would say between$10 and$12.50 cents, I think that's really attractive to maybe build a position. And at the top of that range, I would really only want to nibble on the shares, probably 1 % to 2 % portfolio position. But then at the bottom of that range, once you hit$11 or lower, that's when I would say, okay, I'm starting to see that the risk reward here starts to look very attractive, such that I would be inclined to make NewBank a larger portfolio position, or at least make a more aggressive bet, depending on how comfortable you feel with it, Daniel.

1:21:56That said, I should say, when I talk about making a bigger bet on them, I don't think we want it to be the size of like an alphabet in our portfolio. Because even with the higher discount rate and the margin of safety, this is still a company where things could just go very badly. Things could blow up in a different way than they could for some of our other portfolio companies. So there's just a substantial risk to the downside. as for example if their lending habits prove to be a lot riskier than we think or there's just some sort of really massive economic downturn in brazil which wouldn't be unprecedented then that could really be bad for their business and that's why i said we need to hedge our position size accordingly so in the middle of that range at around 11 per share just for context i get an estimated rate of return that's implied at about 16 % a year, which obviously we're not guaranteed to get that estimate.

1:22:55Reality rarely matches estimates, but I think that's probably the highest expected annual return over five years that we've found for any company yet. And current prices are a good bit above that. But still, I think that does tell you about just how much potential there is with this business. I feel though like you're wavering back and forth here bit like on the one hand the valuation is attractive or at least the growth prospects are outrageously good and there's a very promising story to be told about the company's history and future and yet you've kind of seem reluctant to really commit toward recommending it why are you not sure about your pitch here or am i wrong about my feeling here i think personally i have a a lot of conviction in it.

1:23:42You said, you know, five years, is a new bank going to be worth dramatically more? My gut instinct would be, yeah. But, as we're talking about it here, and I think I've maybe just read too many financial history accounts about bank blowups, that just generally I'm nervous about owning any bank. And, the fact that this is such a fast-growing digital bank in a distant country gives me more pause to just be humble about what I don't know. So, that's why I'm not banging my fists on owning something that I do think is, I mean, it's a great company from what I can tell. So the range of possible outcomes here is probably wider than any company we've looked at.

1:24:23And that even includes Reddit, which is probably the most speculative bet we have in the portfolio at the moment. I mean, it's not hard to estimate NewBank's value to actually be dramatically higher than I did. As just an example for that, for anyone who doesn't believe that I'm being conservative. I have NewBank's monthly RPAC at around$15 in 2029. Yet NewBank's more mature clients today are already worth$25 in RPAC. And wealthier clients at traditional banks have historically had RPACs north of$40. And I'm saying RPAC a lot. It stands for average revenue per active customer. And then those are monthly numbers.

1:25:03So as people come to rely on new bank more for services and as new bank attracts even wealthier clients it's not that crazy to say that their average rpac could ascend toward twenty dollars twenty five or even thirty dollars matching some of their more mature client cohorts that they already have and some of the wealthier customers at brazilian banks for example at a twenty dollar rpac which is a number that a lot of analysts are kind of marking as a reasonable target for new bank to get to then my estimate of new bank's intrinsic value probably jumps by about 40 and at current prices you'd be talking about as much as a 20 25 implied annual return from those levels and i would say to anyone wanting to value new bank don't just focus on the number of active customers they have but again you really have to think about the RPAC and how much revenue they're going to be earning per active customer monthly.

1:26:04And just by betting on their RPAC converging with their most loyal customer cohorts or some of these other banks, you're already talking about a business that in a base case has significant room for growth without even talking about continued expansion of the customer base. And if we wanted to take maybe a small bet on them, Daniel, maybe 2 % of our portfolio at current prices that are kind of between 12 and 13 dollars per share where at least according to my model we're still getting an expected return of 12 to 13 percent per year and then keep a close eye on the position and revisit it frequently i would be inclined to do it and maybe we'll end up getting an even better price than that but if you're not on board with it i'm more than happy to set this thing aside and kind of watch it from the sidelines too and it's something that i'm not sure I could totally sleep well at night with.

1:26:53I feel like there's a lot of work left to do on this name. Like we're not anywhere close to be done with the process. And maybe the reason to take a small position in it would be to really just ensure that it keeps our interest so that we keep pushing ourselves to dig deeper and deeper into it. And if we continue to learn more and like what we find and we like the prices that we're able to get the stock at, it could build up to a bigger position over time. But I've rambled enough here, Daniel. I'm tired of hearing my own voice. So why don't you just tell me how you're feeling about Nubank? I think the advantage that we have in establishing smaller positions is keeping them on the radar.

1:27:34We've talked off script about Nintendo, which is a company we covered quite a while ago, and it went up 30-40 % since we covered it. And we just didn't buy into it at that price, although it was very close to our intrinsic value target. And sometimes you just miss the opportunity if you don't take it when it's there. And NewBank is a company that has been extremely volatile. It will keep being extremely volatile. So there's a good opportunity that you can buy it at cheaper prices down the road. But if we're talking about a 2 % position, I would feel more than comfortable adding it to the portfolio, which makes it a bit hard is that all their numbers look outstanding.

1:28:19If you just look at their numbers, if you model them out, as you said, you've been quite conservative, at least as conservative as you can be with such a company. And the numbers look fantastic. The only problem is that the downside you have with a company like this is asymmetric in terms of lots of upside, but this could blow up at some point. And then you're just left with zero. And that's fine if you have a small position in it and you believe that the upside can balance out that risk. But it just feels like there's a natural limit to the position size you can give to a company like Newbank.

1:28:55We've talked about other portfolio companies and you've mentioned Reddit where even that company, although the business model is not yet as proven as Newbank's business model is, feels like there's less downside just if you compare it to other peers like Snapchat. the company isn't making any money, but it's almost as valuable as Reddit. And with Nubank, while the company is making money, while the expansion plans look like they could succeed, and there's huge room for growth left, there's always the opportunity that some of the loans are not as good as you think, they cannot cover them, the company could blow up, and it's something that you and me from the outside could never see coming.

1:29:36And that risk is something we have to assess and we cannot model it out. Even though you try raising the discount rate, you put on 25 % margin of safety. It doesn't really show us the probability of it going to zero. So I'm completely fine because I love the company. I love the business model. And it has a proven track record to start a position, let's say 2 % for now, see if we can average down over time, how the company is doing, I'm totally on board. I think the other thing I should say too with NewBank is this is a company, you know, we usually look at a five-year time horizon and this is a company where I truly, we need to look on a five-year time horizon because once you start thinking about 10, 20 years out, I do think that there is this trend of commoditization of banks generally, right?

1:30:26Like ultimately a credit card is a credit card. How differentiated can a credit card be? And a savings account is a savings account. And so we kind of know that in the really long term, NewBank is probably going to converge to being a more average business. And yet it can be such a wide runway across the rest of Latin America that it's a business I think we could do well owning for the next five, maybe 10 years. But we should add that caveat that sometimes when we try to buy companies, this is something we want to hold for the rest of our lives. And maybe my feeling will evolve with NewBank and they'll just continue to be excellent and excellent and excellent for years to come.

1:31:08And then, you know, yeah, of course, this is a business we want to hold indefinitely. But at this moment, I kind of had that caution with NewBank where I think, okay, on a five-year time horizon, truly, this is a business that has so much room to improve and grow that it makes sense to own. But it's not something I want to hold and give to my kids in 30 years. We kind of know that it's going to eventually trend toward much more average results. And it's not always going to be the stellar business that it is today. So with that caveat, Daniel, I agree. Right now at the time of recording, the stock is trading around$1 ,250.

1:31:43So it's kind of at the top of the range that we had talked about buying it in the model. But at the same time, the numbers and the models are just rough guides that kind of help us ground our thinking into reality. And so if NewBank is as good of a business as we think it is, and we've been as conservative in the model as I like to think I have been, I'm not losing any sleep if we buy it at 1260 and that's 10 cents over the top of our rancher. That's not really exactly how we want to invest. We don't want to be strictly bound by these targets and not own a really great business because of a few cents in the model.

1:32:21So we're being the first to say we're buying this, we're nibbling on it at the top of our range where we find it really attractive. And we can build it up, as you said, as it goes down. So with that said about NewBank, why don't we wrap up with a preview of what you'll be pitching for your company next week as an addition to our intrinsic value portfolio? Sounds great. I mean, for my hints, I thought about some and I think they are good in terms of some people can guess it, while others might not get it if they don't know the company yet. So my first hint would be that without my next company, all the big tech giants that we discuss often couldn't do their business.

1:33:03They just couldn't do what they're doing if they don't get what my company produces. and then both you and me as well as pretty much all of our listeners I can say that with a high degree of certainty have their products although most of us are probably not aware of it and then last but not least it's a company from a country that we haven't yet covered Newbank was such a company as well and the next one will be an international company again okay I don't know what it is so I'm curious to hear maybe offline what the pick is, Daniel. And I'm certainly looking forward to it. So I'll leave everybody with a quote from Leeloo, who tells us, being a value investor means you look at the downside before looking at the upside.

1:33:53And with NewBank, we really need to think about the downside before we get swept away by all the growth prospects that we could get really excited about. So that's a good reminder for us. We will see you all again back here next week. Thank you.