Value Investors Club / MERCADOLIBRE INC (MELI)

Description

Mercadolibre is a higher quality, earlier stage, faster growing eBay+PayPal, with

significant management alignment and two potential strategic bidders. Local

currency sales are growing 55-90% year-on-year, which should dominate current

macroeconomic challenges, and justify what appears an expensive valuation on

historic earnings.

Introduction

For a bunch of supposedly cheap value investors, VIC members over the years have

done a pretty amazing job of picking some of the long-term winners from

technological change. I am thinking of torico780 (AAPL), miser861 and olivia08

(GOOG), and charlie479 (AMZN: who in 2011 at about ¼ the current stock price was

patient enough with us mere mortals to explain why

“I think Amazon is one of the most admirable companies in the world”)

http://www.valueinvestorsclub.com/idea/AMAZON.COM_INC/60325/messages/579

Each of these long-term winning companies shared great business economics; management that

was smart, driven and appropriately financially motivated by large equity stakes; and

product familiarity to VIC members through personal use. Valuations varied, but

were rarely obviously value territory.

Mercadolibre looks similar to me*. One reason that it has not yet appeared on VIC I

suspect is that few members are users, due to geography. The other reason could be

that it has never looked cheap. But if growth continues to follow what seems a

relatively predictable playbook, the current above-average valuation could

over time prove in fact to be lower risk and cheaper than a broadly rich market.

(*though it pains me to recognize that I do not look similar, even in writing, to any of

the VIC rock stars cited.)

Business quality

Network effect businesses, such as marketplaces and online payments, have been proven

elsewhere to be good businesses. The obvious comparison is to eBay, on which

Mercadolibre was originally based in 1999, and to PayPal for MercadoPago since

2004.

Evidence for historic business quality has been decent returns on capital: double-digit

returns on total assets since 2007 IPO, and 20%+ return on equity. Because working

capital is negative, and fixed asset requirements are light, returns on narrowly-defined

capital are almost meaninglessly huge.

When these attractive economics are overlaid on less-efficient, more fragmented retail

markets like in Latin America, profitability can be sustainably higher: MELI’s

consolidated operating margins have consistently outperformed EBAY (prior to spin)

by 10% annually since 2007, and should still exceed EBAY’s this year despite very

significant Latin American macro challenges.

Nor must this high profitability necessarily compress as competition enters. Latin

American e-Commerce is meaningfully behind the US, at just 2.7% of total retail vs

9.0-10% for US. Therefore the #1 player in each of its geographic markets should be

able to sustainably grow for many years, even with robust competition.

Valuation

This is not a conventional value investment. For me to argue that it is cheap on

current or historic earnings multiples would first require of me plastic surgery,

elocution lessons, plus a follicle and personality transplant. The closest I can get,

slipping on a pair of fabulous 1990’s purple Gucci loafers acquired from its US competitor, is

that Price to trailing FCF (CFO – D&A – working capital changes) is…29x. Would it

help if I tell you that with no net debt the balance sheet is at least safe?

So the valuation is all about future growth. Though macro effects might in future

have material effects on the business, recent rapid FX depreciation have caused

translation effects to obscure underlying growth. This answers why I think it has

become cheap now. Unit measurement metrics can be used to isolate the underlying

growth rates of the business. For example, number of items sold is running at 28%

(consistently 20’s or 30’s growth during the past decade) and total payment

transactions last quarter was 76% (never below 30% since Pago was introduced).

These impressive pre-inflation, unit metrics suggest a robustly growing business.

Sure enough, when measured in local currency, the half of total sales coming from

Brazil is still growing at 58% despite a clearly depressed consumer environment, and

the quarter of total sales represented by Argentina is currently growing at 90% year-

on-year. Bad neighborhoods can have some bars and restaurants that make the trip

worthwhile….

Both Brazil and Argentina would come close to bottom in terms of macro-economic

sentiment right now, for many good reasons best stated by people more eloquent than

me on the subject. Brazil’s decline in investor perceptions has been particularly rapid,

sinking from close to “most valuable player” status only a few years ago, to a market

that many investors currently appear to consider uninvestible. The feedback loops

from macro into this company’s earnings are real and many: significant currency

depreciation and inflation, higher cost of capital, depressed consumer sentiment. All

this translates into reported USD operating income actually declining, as some second

order metrics such as USD GMV should decline for the second consecutive year in

2015. It is hard to pay top dollar for a business that is likely to report horrible USD

numbers for several quarters to come. Yet at some point the FX should stabilize, and

meantime current local currency hyper-growth rates should continue during a

challenging economy. CFO Pedro Arnt has recently argued why:

1. Online marketplaces carry a deeper SKU count, allowing consumers to trade

down more easily.

2. Users approach the marketplace as sellers, trying to raise cash.

3. Consumers who would otherwise not come to the website approach the

marketplace due to excess time, or budget constraints.

Management

Co-founder Marcos Galperin continues to hold 9.6% of shares outstanding valued at over

$400 million. He has realized $160 million in cash proceeds over the years from

stock sales (last in August 2013 at $124), and restructured his remaining holding

exclusively into a family trust. He continues to be very involved in the business.

Senior management is local, long-standing, and long-term in approach. This is

important for playing both defense and offense. Wealth preservation, let alone wealth

creation, during macro-economic crises requires foxlike ingenuity. For example,

Venezuela’s meltdown in recent years, while not without pain, has been intelligently

and conservatively managed. Many multi-national companies simply withdraw in

order to curtail losses, but MELI has remained active while isolating it from the rest

of the group, hoping that reduced competition outweighs the macro-policy costs. On

offensive tactics, rolling out a PayPal-like product has required a nuanced local

understanding of the integral role of credit with consumer purchase behavior. Since

changing the Brazilian Pago product to match zero-interest credit terms (with

financing offset by other embedded fees), 92% of all GMV is now being paid through

Pago. Such local risks and opportunities have historically been hard for US

executives to manage remotely.

Risks

1. Competitive entry. Amazon entered Brazil with Kindle Store in 2012, but has

since not rolled out any further product in the country, despite frequent

rumours. When asked, Amazon typically cites a disciplined capital allocation

framework. Local risk free rates in Brazil are 14.25% and rising, but I

suppose the breadth of Amazon’s ambition and the size of the regional

population makes full entry inevitable at some point. Alibaba continues to

grow Latin American sales, though Brazilian unique visitors are still just 37%

of MELI.

2. Policy risks, which are hard to dimension or predict during economic and

political crises. E.g. Brazilian Central Bank Authorization of MercadoPago is

pending; therefore a key growth driver could conceivably be turned off

overnight.

3.Macroeconomic risks, most obviously measured by exchange rates.

Additional materials

The Evolution and Growth of MercadoLibre

- Founder presentation, 2011 Stanford Graduate School of Business

https://www.youtube.com/watch?v=oBymG-PVSXE

Header financials are TTM 2015 and consensus.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Speculative: acquisition by Ebay (already largest shareholder at 18% of outstanding) or Alibaba.

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			2015	2016
Price:	98.50	EPS	2.00	2.23
Shares Out. (in M):	44	P/E	49	0
Market Cap (in $M):	4,349	P/FCF	29	0
Net Debt (in $M):	-50	EBIT	153	0
TEV (in $M):	4,367	TEV/EBIT	28	0