BABA - MercadoLibre: The Amazon And Argentina Problem

2023-08-15 11:29:41 ET

Summary

• MercadoLibre, Inc.'s stock has reached 52-week highs, but the growth rates may be inflated by high inflation rates in Argentina.
• The company's financials have been strong, but competition from other e-commerce operators and the current valuation raise concerns.
• Consensus estimates for future growth may be too optimistic, and the potential for margin expansion is limited.
• While the stock can offer market-beating returns under certain scenarios, I argue that the risk-reward proposition is poor given cheaper alternatives.

By all financial metrics, MercadoLibre, Inc. ( MELI ) looks like it is firing on all cylinders. The stock has benefitted from such momentum as well, now trading near 52-week highs. But I wonder if investors really know what they are buying, as much of the growth rates appear to be boosted by extreme rates of inflation in Argentina and the associated high yields on debt instruments.

MELI stock looks buyable based on consensus estimates, but “buyable” is not offering much margin of safety when considering the limited potential for upside surprise. If anything, consensus estimates may prove too optimistic and may be more representative of a best case scenario. Given that MELI is facing intense competition in its core markets from some of the strongest e-commerce operators in the world, I question whether the current valuation makes sense, even for growth-minded investors.

MELI Stock Price

After crashing along with the broader tech sectors, MELI has come roaring back. Its financials were quite strong throughout the stock price weakness, but it is incredible how much of a difference sentiment can make.

I last covered MELI in June, where I explained why I remained neutral on the stock in spite of strong fundamental results. Not all growth stocks can be bought at any price - too much optimism is being priced in here.

MELI Stock Key Metrics

In this past quarter, MELI delivered explosive growth with gross merchandise volume growth accelerating to 47% YOY (on a constant currency basis), up from 26% YOY growth in the year prior.

Net revenues grew by an astounding 57% YOY (again on a constant currency basis). As can be seen below, the bulk of the growth came from triple digit growth in Argentina.

I should note that, as usual, Argentina growth rates are inflated due to triple-digit inflation and the associated devaluation in local currencies. On a constant currency basis, overall revenues grew by 31% with Argentina revenues growing by 30%.

MELI saw its credit portfolio show surprising strength in the quarter, with 90 day past due loans declining to 25.1% and provision coverage rising to 137%.

The decline in bad debt led MELI to show a remarkable 36.8% net interest margin after losses in spite of a growing credit portfolio. MELI credited some of the strong performance as being due to an intentional positioning away from Brazil and towards Mexico, which it views to be of stronger credit quality.

Continuing the trend from the first quarter, MELI delivered strong operating margin expansion, led by improvements from the credit portfolio.

MELI ended the quarter with a solid balance sheet position. Net debt stood at $2.16 billion, which excludes the $3.25 billion credit portfolio.

Looking ahead, management guided to “use some of the headroom created by this operating leverage” to invest in growth. On the conference call , management curiously did not specify where they would be investing these growth dollars in, stating the following:

And really there are multiple vectors of growth and that's what we're trying to continue to be very consistent on, which is taking a long-term view and trying to capture as many opportunities as we can and continuing to maximize market share while delivering operational leverage over longer periods of time.

I was surprised to see the market’s reaction to the print, as one could have easily explained any stock price weakness as being due to the implicit guide for margin compression moving forward. But with growth sectors returning to full bull market mode, it is possible that many investors overlooked this detail, or have decided to take a more optimistic perspective regarding the investment. Management appeared to be more willing to grow their credit portfolio, even in Brazil where they have been showing caution as of late.

Is MELI Stock A Buy, Sell, or Hold?

As of recent prices, MELI had fully recovered its valuation profile (if we ignore the valuations when the stock traded at all-time highs), with its stock not looking cheap until several years of operating leverage take hold.

Consensus estimates call for near 20% growth over the next 5 years.

If we apply a 1.5x price to earnings growth ratio ("PEG ratio"), then MELI might trade at around 30x earnings by 2029, implying a stock price of around $3,369 per share. That implies around 16% compounded annual return upside over the next 6.5 years (I have not included the earnings yield in this calculation due to the heavy reinvestment required for growth). That return potential would likely be sufficient to outperform the market, but I see some issues here. For starters, consensus estimates look awfully optimistic as they are implying a conservative pace of deceleration, even as many e-commerce operators in the U.S. have seen drastic cuts to growth following the pandemic. We can see below that MELI wasn’t exactly growing at meteoric levels prior to the pandemic, and like other e-commerce operators showed incredible growth in the 2020 and 2021 years.

I see little reason to expect the company to materially outperform consensus estimates, if at all.

But what about the potential for margin expansion? After all, MELI is often regarded as “The Amazon of Latin America,” and that stock is frequently thought of as a margin expansion story. MELI is already charging a take rate not too dissimilar with that seen in the U.S., suggesting little room for take rate expansion.

On the cost end, MELI is already highly profitable on its e-commerce operations. Property & equipment totaled $993 million at the end of 2022, just around 9.4% of total revenues. In contrast, Amazon ( AMZN ) had $160.3 billion in property & equipment at the end of 2022, good for 41% of total revenues. Whereas I expect AMZN to derive significant margin expansion over the long term, the path to the same for MELI isn’t as clear. I note that consensus estimates have net margins doubling to 14% in 2029.

What about risks to the downside? I am skeptical of the company’s high growth rates in Argentina - I previously noted the triple-digit rates of inflation in the country.

On the conference call, management touted their 80% deposit rate as powering their ferocious growth in fintech customers. But something just doesn’t add up to me, especially as I read articles talking about the toll that inflation is taking on the lower and middle classes, like this one from AP News . One is hard pressed to find any investor who thinks that the situation in Argentina is sustainable over the long term, and it remains to be seen what happens to MELI’s growth rates when things eventually resolve themselves there, whatever that means. Management reiterated conviction in the country, stating that they are “not considering anything like scaling down” their operations there, even stating that they “can lean into it a little bit more in the back half of the year.”

I have previously stated that MELI is often called The Amazon of Latin America. We mustn’t ignore the fact that AMZN themselves are competing with MELI in many LATAM countries including Brazil, as well as Chinese e-commerce juggernaut Alibaba ( BABA ) among others. Unlike in the USA, where AMZN has developed a large and expensive logistics advantage, MELI does not have the same presence in LATAM and it is possible that competition eventually leads to pressure on margins.

With all these potential risks and headwinds, I return to the question of valuation, with MELI trading at 66x this year’s earnings estimates. BABA in contrast is trading at just 11x earnings, and that is before accounting for the net cash and equity investments making up over 50% of the market cap. Yes, BABA is subject to unique Chinese regulatory risk, but my point here is to illustrate that MELI is not pricing in its own set of risks to the same extent.

Amidst a furious rally in the growth sectors over the past 3 quarters, it is admittedly difficult to find names delivering this combination of above-market revenue growth with GAAP profitability, all while trading at potentially market-beating valuations. But I caution investors that MELI is looking overvalued here when considering the numerous risks that might be more plausible than is reflected in the stock price. I reiterate my neutral rating on MercadoLibre, Inc. stock, as the potential of upside does not outweigh the risk of downside here.

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