MercadoLibre: A Must-Own For Growth Investors (NASDAQ:MELI)

Thesis Summary

MercadoLibre, Inc. (MELI) has become a very followed company in the last couple of years. Thanks in part to the coronavirus shutdowns, the business has managed to increase its growth and valuation at a very fast rate. In this article, we explore the growth opportunities for both eCommerce and Fintech and value MELI under the assumption that it could achieve similar profitability levels to Alibaba Group Holding (BABA), given the similarities in their businesses.

Source: labsnews.com

Company Overview

MercadoLibre was founded in 1999 and operates as an online marketplace and payment provider in South America. Within these two areas, MercadoLibre has four identifiable segments; “Logistics” and “Marketplace,” which together form “Commerce,” and “Payments” and “Credit,” which the company categorizes under “Fintech.”

MercadoLibre has garnered the interest of investors in the last couple of years. Due to the nature of its operations, MELI has been labeled the Alibaba of South America. There are certainly many similarities between the two, and given the current trends in eCommerce and payments, investors believe that MELI’s revenues could continue to grow at very high rates, sending its stock price and valuation sky-high.

To get some sense of the magnitude and distribution of income here is a revenue breakdown from the latest quarterly statement:

Source: 10-Q

What we see here is a breakdown by country and segment for the latest three and six-month periods. One key insight here is that about ⅔ of revenues come from Brazil and Argentina. The other takeaway is the proportion of income that comes from each of the segments. This is important because each segment has very different profit margins, which will in turn affect our profitability assumptions and valuation. Right now, Fintech contributes around ⅓ of the revenues.

A superficial glance at the valuation metrics shows that MELI is incredibly overvalued. But like always, this could be justified given sufficient growth and future profitability, so these are the key areas we must identify to accurately value the company.

How much can it grow?

MercadoLibre operates mostly in Latin America, meaning there is a potential TAM of 638 million people. Furthermore, e-commerce penetration was just 4% of total retail sales in 2019, something that is quickly changing. In the last year, MercadoLibre managed to grow its revenue by 55.79%. Certainly not a bad number, but this alone wouldn’t seem to warrant today’s valuation. However, this is somewhat of an anomaly, no doubt aided by the coronavirus pandemic. In the last 10 years, revenue CAGR has been much closer to 30%. One thing seems to be clear; investors are betting on high future growth. Let’s look at the growth outlook for each of the segments.

Starting with commerce, both Statista and eMarketer offer very similar outlooks of the trajectory:

Source: eMarketer

ECommerce sales are expected to grow at a CAGR of around 12% over the next 3 years. However, this is not a direct indication of how much MercadoLibre can grow its revenues. In the latest quarter of 2020, consolidated GMV grew by 102%. At the same time, revenues grew 149% YoY.

The key takeaway here is that COVID has accelerated the rate of growth or transition into eCommerce. In other words, what has increased is the penetration into these markets. Indeed, LATAM is one of the places where online commerce still has a way to go. At the moment, roughly 68% of people have mobile subscriptions, meaning there is still a largely untapped market of potential clients, both for eCommerce and payment services.

For the time being, MELI remains a clear market leader in this segment, as is evidenced by the growth in sales and unique visits that its site generates:

Source: MercadoLibre investor relations

In LATAM, MELI receives around 54% of unique eCommerce traffic. The next largest competitor in the space is B2W (OTCPK:BTOOY), followed by OLX Group. MELI’s dominance is especially prevalent in Argentina and Brazil, which are also the largest in terms of population and spending.

“Fintech” is the more interesting part of the equation here, in terms of both growth and profitability. First off, it is clear that payment services carry much higher margins, which could be comparable to those had by PayPal (PYPL) and Visa Inc (V). This is where MercadoLibre has an opportunity to surprise investors. For now, 70% of people in Latin America remained unbanked, and only 25.59% of people own a debit card, depending on the specific region. That’s around 446 million unbanked people who MELI can potentially target.

Mercado Pay offers a great middle of the road approach to facilitate transactions without the need for traditional banks. Again, the expectation is that MercadoLibre can penetrate the market and essentially be the leading force in bringing cashlessness to the region.

Source: Global Payments Report

According to the above forecast, non-cash payments in LATAM could surpass 50% by 2023. MELI has a great opportunity here, especially since it can leverage its commerce platform to gain traction.

Once again, MELI is one of the dominant players in this space, though the competition is tougher here:

Source: eMarketer

MELI is the market leader in Argentina but is behind Samsung Pay in Brazil. However, this information does not reflect the most recent development in this area. In the second quarter of 2020, Mercado Pago grew 64% year on year. Most encouraging is the fact that off-platform payments increased by 175%. This shows consumers view MELI as a superior payment service, even when it comes to transactions outside their platform. And of course, MELI can still leverage its own e-commerce platform, which is something its competitors can’t do.

Profitability Outlook

As mentioned above, we believe that MELI could achieve similar profitability levels as BABA. Let’s look at how each of these performs in this area as measured by operating margin:

Source: Macrotrends

Source: Macrotrends

The first chart is of MELI, while the second is of BABA, and both start in 2014 and end in the second quarter of 2020. As we can see, MELI is currently not profitable. The company is focusing on growth and rightly so. This is something that BABA also did. In 2014, the company had almost a 50% operating margin, but this has slowly fallen to around 18.5%. However, the company has enjoyed great growth in this period too.

We believe that MELI could at least raise its profitability to where BABA’s is now, just below 20% operating income margin, and this is reflected in our valuation. There are two key reasons we believe this to be the case:

Firstly, as mentioned above, both companies are incredibly similar operationally. We already looked at MELI’s revenue breakdown, so let’s go into BABA’s here:

Source: Statista

BABA’s operations cover a lot more areas than MELI’s at the moment. Alibaba has business in cloud computing and digital media, amongst other things. However, in 2020 around 65% of revenues came from eCommerce, while the remaining belongs to what could be generalized as “others.” Notice also that the latest years don’t add up to 100% of revenues. This is because Alibaba receives significant revenues from joint ventures, which include Alipay, where it has a 33% stake.

In any case, the other segments in Alibaba have been growing more than eCommerce, which has indeed led to a higher profit, especially as measured in terms of Net Income. BABA’s Net Income bottomed at just under 20% in 2018 and is now around 30%. It is reasonable that MELI’s bottom line will behave similarly as MELI’s payments system outgrows eCommerce, and the company invests in other initiatives, such as cloud.

So one reason that justifies higher profitability is that margins will be higher. The other is that costs will be lower relative to revenues. This happens often when companies are growing very fast. It was the case with BABA, and we expect it to happen with MELI.

In 2016, operating expenses for BABA were 36.81% of revenues, but have steadily fallen to around 25% at the time of writing this. In the case of MELI, operating expenses have increased in the last 5 years, mostly due to increased spending in SGA. MELI has invested heavily in attaining market leadership, and for the most part, it has succeeded. For this reason, we believe the company could sustain high organic growth while keeping a cap on Marketing and Administrative expenses.

In conclusion, the comparison of BABA to MELI seems apt on many accounts. Both are the leaders in their respective regions when it comes to eCommerce and payments. In terms of growth, they also have a similar profile. This comparison will serve us well when analyzing the potential value for MELI in the next section.

Valuation

Given the acceleration in the shift towards a cashless economy, and the growing popularity of online retail, we believe MELI could sustain the growth rates of the last year shortly. Furthermore, we believe it is reasonable to assume that the company could achieve a similar profitability level to that of BABA. With that in mind, we have projected a 5-year DCF for MELI.

Source: Author’s work

The table above shows select data over the last 10 years, highlighted in orange, and our projection for the next five years, in blue. Our valuation projects future results through a method that focuses on the evolution of key financial ratios in recent history for the company itself combined with potential drawn from analyzing comparable companies. We summarize the balance sheet separating what we believe to be financial and operational items, so note that there may be a discrepancy with other sources in terms of what we consider debt or levered items.

The idea of the forecast is to evaluate the company’s potential to generate cash flow in 5 years. That is why we freeze investment and R&D expenses in the fifth year and calculate a terminal value based on potential cash flow rather than what we think will be actual cash flow. Terminal value is calculated based on the fifth year cash flow, assuming it will grow beyond that at a rate that will fall gradually from current revenue growth levels to 2% in the long run.

We use discounted unlevered cash flow and subtract current net debt to estimate the value of common equity. In this case, we found the discount rate that fits the current price to obtain an approximate return of 12.82%.

Source: Author’s work

Risks

Of course, this valuation works off a core assumption, which is that MercadoLibre will be able to retain its market leadership. This is certainly possible, but the company will have to fight off seasoned veterans in both eCommerce (Amazon.com (NASDAQ:AMZN)) and payments (local banks).

Amazon is already the second-largest company in the eCommerce space and with a market cap of $1.4 trillion and money to burn, MercadoLibre will certainly struggle to compete. On top of that, banks are also going to be entering the fintech space, and many of them have better infrastructure and experience in the business.

Lastly, for American investors, there is also significant currency risk in the region, and with the world’s debt at its highest ever, we could even see some form of defaults and political instability.

Takeaway

While at first glance the valuation seems rich, we believe the current price is justifiable given the above assumptions. In reality, it is likely that, rather than maximize cash flow after 5 years, MELI will want to keep expanding its business and invest in growth. But the above is still a valid hypothesis as to the cash-generating potential the company has. Compared to BABA, the company offers a higher risk/reward profile. If MELI maintains its market leadership, there is no doubt that it will grow into its valuation.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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