META - MercadoLibre: Can It Double Revenues Every Three Years As It Transforms A Continent?

2024-01-14 20:41:13 ET

Summary

• I am a value investor who does not ordinarily look for hyper-growth hyper-expensive stocks, but MELI comes with advantages that make it worth the price.
• A major advantage of MercadoLibre is the huge impoverished Latin American population with space for enormous growth.
• MELI can learn from Amazon, which it resembles, but is at an earlier stage of rapid growth.

This article analyzes MercadoLibre ( MELI ) with a particular focus on questions about valuation. How much should an investor be willing to pay for hyper-growth? It depends to a large degree on how long that growth can be sustained before it begins to fade. A declining growth rate produces a double whammy of slower growth combined with a lower valuation. The current high growth rate of MELI is indisputable, but a new investor's criterion must be on the sustainability of that growth. To justify its current PE of 70 it must continue to grow revenues at something not much below its current 35% growth rate. My criterion for this article is that looking three years into the future its revenues must at least double. A company that can achieve that after almost two decades of existence is in a very elite club.

Choosing revenue as the most stable growth criterion (earnings and cash flow involve a profit margin variability which may have less consistent causes), the Q4 full-year report is the place to start. Here's what Seeking Alpha's Quant Factor for Growth has to say about that:

The key number above is the 35.29% forward growth rate which is lacking only the Q4 revenue number which will replace the Q4 2022 number. It's easy to think that the TTM number in Financials is directly comparable to the December 2022 number, meaning that the revenue growth rate as of the end of 2023 was about 25%, but that is clearly not the case. In the Q3 Form 10-Q, the 9-month rate of increase in revenues was 35.52% while the 3 month rate of growth was close to 40%. The former figure was close to the above 35.29%. With a little arithmetic, it becomes clear that the forward estimate for end of the year 2023 revenues is likely to exceed 14,500 meaning that MELI's fading from earlier growth rates near 100% is stabilizing and on track to extend its current rapid revenue growth. We will have exact numbers in the Annual Report in February.

Ultimately, of course, all hyper-growth companies begin to slow down and MELI will be no exception. The minimal expectation going forward, however, is that MELI will double revenues and increase earnings at perhaps twice that rate over the next three years. For that reason, I saw MELI as undervalued when I purchased it on November 14. It is now up 16% since I bought it and still, in my view, a Strong Buy. The Seeking Alpha Quant system sees it as a Hold despite the fact that the two most important Factors, Growth, and Profitability, ranked it A+. I know that it is hard for a 70 PE to generate anything but an F rating for Valuation. At that altitude, it's important to remember that a lot of things can go wrong, but it's equally important to remember that revenues are likely to double over the next three years which requires a compounding growth rate of around 26%. Earnings are likely to double in two years, which would bring the valuation down considerably. Past years were a bit lumpy up to 2015 when results began to stabilize. Summing it up, outstanding execution combines with a huge potential population of customers to make MercadoLibre a hyper-growth company worth its high valuation.

The Larger Context Of Opportunity

Many factors come into play, but with MELI the obvious starting point is that it does business entirely in emerging market countries. A great emerging market investment requires first choosing countries and regions where per capita GDP is relatively low but has the potential to rise swiftly. Latin America fits this description as do a few other areas. It's no coincidence that Mexico was in a virtual tie with India for the best-performing emerging market of 2023 (up 17%). Helped by near-shoring (Mexico) and friend-shoring (India) both are benefitting from US reluctance to do business with China. One major attraction of Latin America is its large population, around 665 million as of July 2023 or 1.8 times the combined 371 million US/Canadian population of North America. Here are the six leading Latin American countries by population:

• Brazil 216,423,448
• Mexico 123,485,557
• Colombia 52,085.168
• Argentina 45,773,854
• Peru 39.352,719
• Venezuela 28,838,499

Choosing a specific investment is often more difficult than choosing the country or region. With Mexico, for example, none of the Mexico ETFs had the desired mix of growing companies and industries. Wal-Mart de Mexico ( WMMVY ), though a decent candidate, didn't have the explosive growth one would seek in an emerging market. Additionally, WalMex is a single-country offshoot of its American parent and is not fully representative of the huge potential of Latin America as a whole. What I sought was a fast-growing company tightly aligned with the future improvement in the standard of living for the whole continent. Thinking of it this way MercadoLibre was the obvious choice.

Adam Smith And MercadoLibre

MercadoLibre is a company familiar to many investors but with one huge advantage which is hidden in plain sight. It really fits in two categories - emerging markets and hyper-growth retail - and both ways of looking at MELI are important. Founded in 1999 by Marcos Galperin, an Argentine just finishing his MBA at Stanford, it linked itself to the future of Latin America from the start. Its Mission Statement is most notable for its brevity and the absence of financial focus within the company. The unstated premise is that if MELI can lift the well-being of the Latin American population, financial rewards will take care of themselves. Here is the one sentence goal:

Our mission is to democratize commerce and financial services to transform the lives of millions of people in Latin America."

This brief Mission Statement goes all the way back to Adam Smith, the intellectual father of capitalism who in fact never used the word capitalism . The true focus of Adam Smith's work was not on the profits of businesses but on the well-being and improved standard of living of the population. That's the title and theme of his foundational book The Wealth of Nations (1776). It is not capitalism per se but its "invisible hand," which explains the way in which the pursuit of profits by the rich produces desired goods efficiently and provides them to the population at a reasonable price. The miracle is that this happens without any central direction. Profit-making businesses end up doing what a planned economy might aspire to do, but they do it better. Smith wrote about the democracy of the "invisible hand" in these words.

They (wealthy businessmen) ....make nearly the same distribution of the necessaries of life which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species...the beggar, who suns himself by the side of the highway, possesses that security which kings are fighting for."

In this SA article "How Adam Smith Might Have Valued Amazon, Netflix, Tesla, and Small Biotechs" (August 10, 2020) I made the argument that the value a business provides to its customers is conjoined with the value of a business to its self-interested owners. Smith understood implicitly that for a business to flourish, the important thing was providing value to its customer base. It's this reciprocity of customers and owners which makes the scale of potential customers a useful tool in estimating the long-term sustainability of rapid growth. This is especially useful in analyzing companies that cannot be fully evaluated by the standard market metrics of sales, margins, earnings, PE, and discounted cash flow. It is also the reason revenues are the most useful statistic to consider.

Adam Smith's thinking is thus central to the universe of young and innovative companies like MercadoLibre. The potential market is all of Latin America where it has all the advantages of a first mover. The very extent of the obstacles to doing business in Latin America along with its past failure to catch up with other Western economies amount to both a challenge and a vast opportunity. To get a full understanding of both the challenge and the opportunity it's helpful to take a look at where Latin America is now and how it got there.

Huge Challenges Come With Enormous Opportunity

The long-term economic history of Latin America is dismal. The last time Latin America had a higher GDP per capita than North America was 1492 and the two decades until the Aztec and Inca empires both collapsed. There is a vast scholarly literature attempting to account for this poor performance but until the piece of research cited below, there had never been a single authoritative view. All countries in Latin America now have populations that are predominantly European in origin with little difference in ethnic makeup, culture, and education. Why, then, has South America consistently performed so miserably compared to North America?

This 2005 NBER Working Paper (#1008) entitled "Latin America In The Rearview Mirror" written by distinguished scholars Cole, Ohanian, Riascos, and Schmitz lays out the important historical facts. NBER (National Bureau for Economic Research) Circulating Papers are generally the most authoritative sources on important subjects which are passed around among interested scholars and policymakers. This one, though written 25 years ago, is still the gold standard for providing a full explanation as to why since 1950 Latin America as a whole has made zero progress in catching up with the US. It provides the definitive answer as to why the US, Europe, and Asia have pulled further and further ahead with only a few brief local successes such as Venezuela at the beginning of the oil boom and Chile, which gained a little in a period of economic reforms. East Asian countries which had a different population and no background in Western economics were slightly poorer than Latin America in 1950 but have left Latin America behind and largely caught up with the US since then. This situation has continued to the present as has the influence of this paper which has three recent follow-ups published in 2010, 2020, and 2021.

A few data points from the Cole et al NBER paper lay out the depth of the problem. (I suggest that ambitious readers Google the paper, sign up for the free NBER membership, and familiarize themselves with the detailed argument.) In 2000, the level of LatAm employment was 70% of that of the US while per capita income was only 22% versus 69% for all other Western countries. This is the clear result of a huge deficit in Total Factor Productivity - productivity which arises not from human failure but from competitive barriers. From 1950 to 1998 Total Factor Productivity in Latin America actually fell from 33% to 32% while Europe as a whole rose from 39% to 79% of that of the US and East Asia from 15% to 54%. If interested, this links to the Federal Reserve Bank of Minneapolis published version of the paper which contains at the bottom a number of tables in which the above numbers and quite a few others are included.

The above are stunning comparisons that go a long way toward explaining the extreme poverty of the majority of Latin American citizens accompanied by the deprivation of many goods and services and such simple basics as available banking. The Cole et al paper explains these problems almost entirely in terms of Total Factor Productivity, low and static productivity deriving from the absence of helpful institutions (such as banks), and the determination of small wealthy elites to maintain their advantages by tariffs and other means of constricting competition. The below are tariff rates on consumer goods for a few major countries included in a table at the bottom of the NBER paper:

• Argentina 176%
• Brazil 260%
• Chile 328%
• Columbia 247%
• Mexico 114%

The above numbers date from the period when founder Marcos Galperin was rounding up financial support for MELI. The egregious tariff rates show the barriers he would have to get past. Its major competitors were and remain government entities that are satisfied with a status quo that makes goods expensive and inefficiently delivered and for which the poor and dependent must pay in cash because they are without access to banks. Recently MELI scored a victory with new August 1 import tax rates exempting the first $50 of cross-border imports (critical to MELI) while enacting a general rate of 17% as discussed briefly in this SA News link. Brazil nevertheless remains the most protectionist country in Latin America, and investors need to keep a close eye on all developments involving imports. On the other hand, MELI's profits, as stated in the Q3 earnings call, were 60% from Mexico and 40% from Brazil. Getting the cross-border import duties on a reasonable basis is well worth some trouble.

The devastating poverty and backwardness of Latin America present a huge opportunity that is available to the company that is able to deliver quality goods and services cheaply along with fintech to enable the less privileged to buy efficiently. The size of the gap between Latin America and more developed Western countries is thus the long-term scale of the opportunity.

MercadoLibre And Amazon By The Numbers: Does Valuation Even Matter?

MercadoLibre and Amazon ( AMZN ) are very similar companies, so much so that most of MELI's business units are the equivalent of similar units of Amazon. It's always a bit of a surprise when reminded that Amazon is in fact less than five years older. Much of what Amazon does serves to provide an instruction manual for MELI as in Amazon Prime which served as a model for MELI Royalty. MELI's Royalty program turns out to be a more comprehensive, slightly more expensive, and profitable version. This applies equally well when it comes to considering appropriate valuation. As with Amazon, the major questions are how fast this company can grow and for how long. The corollary question: how high can the PE ratio be and how long can it remain high before revenue and profit growth begin to slow and cause PE to decline?

MercadoLibre is an amazingly efficient and rapidly growing company and would certainly merit a higher PE than ordinary healthy and growing companies. The question is how much higher? It's interesting that the CRSP (Center for Research In Security Prices, U. of Chicago Booth School) methodology used to select growth stocks for the major growth indexes has no factors that include valuation. What this says in effect is that a company blessed with crazy growth numbers and good prospects for the future does not need to be evaluated by normal value criteria such as PE, PB, and PS - the P in each case being Price.

Price, per CRSP, isn't really a factor worth considering in the early stages of a hyper-growth company, so you should just forget about Valuation. Being a lifelong value investor this hasn't been easy for me to accept, but it stems from the best-minds research at Chicago's Booth School and is now used in the largest growth indexes. All you need are short and estimated long-term growth, (produced by Wisdom of Crowds methodology via 18,000 analysts), three-year historical earnings growth, three-year historical growth in revenues, a good investment-to-assets ratio, and a good return on assets. All of the above are gangbusters for MELI except the investment-to-assets ratio which is erratic from year to year and relatively low in general because MELI's business is so capital-light.

At some point in a company's life, of course, Valuation begins to matter. Focusing on valuation implies that the heroic growth days are over and the CRSP methodology begins to allocate part of its market cap to Value funds as it did with Meta ( META ) over the past few years. The critical question for investors is working out how far in the future slowing growth will trigger that slide toward becoming a Value stock. A comparison of MELI and Amazon suggests that Amazon, though still growing rapidly, is much closer to the transition where Valuation begins to matter.

With MercadoLibre, where results are inherently a bit lumpy, revenues have recently grown at an annual rate of a bit more than 35%. That 35% annually is a little under seven times the median revenue growth rate for the sector (numbers being taken from SA Growth Factor above). Amazon revenues by comparison grow at a pace of 10-11% annually, meaning it requires around seven years to double and grows around twice the median growth rate of its sector. The bottom line earnings numbers are 27% for Amazon versus 58% for MELI (both from SA Quant Growth Factor, 3-5 year CAGR). Combining these numbers with the chart below, Amazon is beginning to look like a growth company for which Valuation is beginning to matter. MELI continues growing at a rate for revenues, earnings, and stock price which continues to say, Never Mind Valuation.

The ten-year chart below comparing the two stocks shows a broad correlation of highs and lows suggesting for two persistent growers that price reflects market views on valuation rather than operating results. Over the entire ten years MELI stock price has grown twice as much while going up much faster to the 2021 twin peaks and falling much faster to the 2022 bottom. Note that MELI recovered earlier and faster from the bottom.

The overall implication from both operating numbers and the chart is not so much that Amazon is a lesser company but that it is much further along in its life cycle from incredible growth to a more ordinary growth rate. As growth rates fall from the stratosphere, valuation begins to matter, thus the divergence begins to be visible in 2019-2020. The chart pattern shows similarly timed spikes and drops which parallel patterns in all high-growth stocks but the predominant trend steepens in favor of MELI.

Why does Amazon appear to be many years older than its near-contemporary MercadoLibre? The best explanation is that Amazon operates mainly in mature markets with meaningful competition and where it has already begun to push limits of sales and market share.

The key advantage for MercadoLibre is that it operates in a much larger market. So far it has had little competition from peers. For countries that have a fraction of the GDP per capita of the US, the enormous mass of the population amounts to a happy hunting ground. The first big jump in standard of living is relatively easy to achieve while there is a likelihood that advanced fintech and methods of selling and delivery will leap over traditional banking and slow-motion delivery of goods. Barring something unexpected, MELI should have years before it reaches the place where Amazon is now. The real question is why MELI's current price-earnings ratio of 70 is only 30% higher than AMZN's 54.

Checking In With SA Quant Ratings

Quant ratings are particularly helpful with evaluating MELI and its older peer AMZN although it is necessary to look with a magnifying glass at a few numbers beneath the surface. The headline is that both MELI and AMZN have overall ratings of Hold despite the fact that every category of measurement aside from Valuation is from A+ to A-. This is somewhat unusual in the SA Quant system which sometimes accepts a lesser valuation number on rapid growth stocks that are stellar in Growth and Profitability. My somewhat convoluted interpretation is that it amounts to a warning that if growth stocks should falter MELI in particular could fall quite a bit in a hurry even if operating results were fine.

It should also be noted that the SA Quant System does not go quite as far as CRSP when it comes to ignoring Valuation. The SA Quant system sometimes bends a bit if the Growth and Profitability Factors are perfect, but in this case, valuation just seems to be too much of an issue. Oddly, Amazon is a little weaker than MercadoLibre on Profitability, an A- versus MELI's A+, but is nevertheless ranked a few points higher and two positions higher in the Broadline Retail Industry. In both cases, the major exception in the many Valuation categories is in PEG ratio, price to earnings growth, in which MELI does slightly better. This blip makes sense as both companies do well enough in Growth to push the PEG ratio out of the F rating.

The simplest way to look at valuation in hyper-growth stocks is to estimate future PEs based on expected growth rates a few years out. Here MercadoLibre has a strong case because earnings growth seems likely to outgrow revenue growth by a large enough margin that a constant price would minimally cut PE in half to 34 within a couple of years. Something like that happened with Meta which kept growing rapidly until price tagged the single digits, won a Strong Buy Rating in the SA Quant System, and has since rallied strongly. A PE ratio drop like this may not be ideal, however, as it might imply that the market sees problems on the horizon. The ideal would be a PE holding its ground or declining slightly and steadily as operating results continue to pull the stock price up.

Operational Risks

MercadoLibre has the same risk as most companies that a competitor will come along to challenge it. It also has a moat which consists of being the first mover on a large scale, knowing its customers, and knowing the two local languages, Spanish and Brazilian Portuguese.

Government actions also pose a risk. Unfriendly legislation and import taxes can't be ignored. Any addition of trade barriers would be harmful.

Inflation is rampant in Latin America and accounts for some of the lumpiness of MELI's financial data. While the countries of Latin America speak just two languages, they do not have a single currency like the Euro. Major differences in inflation, among other things, make a single currency unlikely any time soon, and as tourists already know currency fluctuations are a headache which can be a nightmare when it comes to business transactions. MELI has lived in the middle of that briar patch, however, and should be able to deal with it better than most competitors.

Conclusion

For me, the most difficult part of buying MELI was the psychological barrier requiring a lifelong Value investor to ignore Valuation. SA's Quant system doesn't quite buy the "Ignore Valuation" argument of the CRSP system, and it's also not easy for me to do so. However, the CRSP argument is a strong one, with the structuring of Growth Indexes standing behind it, and even if hyper-growth stocks are potentially pricey it was a moment for my portfolio to add a carefully chosen high-growth position.

After considering the above arguments I bought a pilot position in MercadoLibre on November 14 at a price of $1431 per share. When I have conviction that my premise is right, I sometimes average down although I also sometimes take a tax loss hoping to buy back and add in 31 days. I would do this with MELI. I would also be happy to average up as a rising stock price is always a good Bayesian indicator that my premise is working. Seen by the PE number alone MELI looks just as expensive to me as it does to everyone else but the greater risk seemed to me doing nothing only to see the stock price continue to rise making it harder and harder to initiate a position.

From my perspective, an investor in MELI is likely to have long-term success even if the initial price is a bit high. I aspire to be a long-term holder of everything in my portfolio. This principle has worked well over the years (I currently hold no losing positions) and I would expect it to work particularly well with a hyper-growth company like MELI. To me, it is a Strong Buy.

My suggestion to readers who haven't thought about some of the above arguments is to read the important passages a few times and consider taking a modest pilot position. As always keep your losses small and let your winners ride.

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