Mercado Libre: High-Quality Exposure To Emerging Markets (NASDAQ:MELI)

Sitting down to write this article, it feels tough to fit all the details in. MercadoLibre (NASDAQ:MELI) is one of those companies with so many moving parts, so many irons in the fire, that it’s tough to bring it all together into a cohesive look at the business in a concise way. That’s likely because the best analog to MELI in America has always been considered to be Amazon (AMZN). That’s mostly true. However, because of MELI’s leadership in what has been a geography behind America in terms of technological development, the company has taken a significant role across the spectrum.

As a truly one-stop shop, the company’s many different lines feed each other in ways that create what is likely one of the best examples of a network effect I’ve seen. For customers without a bank account, MELI is the place customers shop, transact, borrow and store money, list items for sale, manage assets, and more. Businesses rely on the company’s infrastructure to sell on the platform, ship items, potentially advertise, and provide credit. When taking all that information in a vacuum, you’re looking at a company that ties itself to the average user in a way no retailer likely could in America, even Amazon. 98% of the company’s merchandise volume is driven through the company’s payment system, and 91% of orders are shipped through Envios, which has reached 92% penetration in its markets. Credit is tied to a seller’s GMV, which incentivizes them to push as much traffic through the site as possible. All initiatives lead back to customers tying themselves further and further into the ecosystem.

Much of the framework for the company’s success was paved by other global leaders. Although MELI was founded in 1999 in Argentina, it is clear management has been sharp and adapted some of the winning strategies from companies that took e-commerce into the 21st century in America and made them work in the unique environment in Latin America. One of those strategies is the rollout of new product lines. Management has been very thoughtful with putting a new initiative in place, measuring, and either sinking further investment in or cutting its losses. By that same token, the company has operations in multiple countries, but over time has focused most heavily in Mexico, Brazil, and Argentina due to the importance of those three countries on driving incremental returns to the bottom line. Additionally, although MELI is profitable, the company’s long-term outlook has led to profits being sacrificed in lieu of market share growth when it suited them. This is uncommon among public companies, and in the face of quarterly earnings pressure should be applauded. There are significant differences in the markets, obviously. For one, MELI is relied upon for its logistics much more so than e-commerce companies in America. There is no company that could rival a logistics footprint like UPS in those countries, so MELI has built its own and rapidly increased penetration over time.

The company reports its next quarterly and full-year earnings on February 28th. In the most recent quarter, gross merchandise volumes grew 32%, total payment volumes through Pago were up 76%, off-marketplace payments through POS and other means grew an incredible 122% to $23.1B. This led to 61% increase in net revenues on an 11% margin.

With as many irons in the fire as MELI has, there’s no more useful place to look as far as metrics go than the company’s operating margin. However, the company does an incredible job of providing visibility to its investors. The company’s presentations and investor letters are very ‘open kimono’ with its shareholders and show more granularity than many other companies. This inspires confidence on my end and gives a really good perspective about what is driving the metrics. At 11% in the most recent quarter, the operating margin is in a great spot.

On a more granular basis, the company’s operating margin expanded on the back of cost cutting and efficiencies in marketing, while it suffered from mainly the credit portfolio, which I will discuss a little later.

The company’s fintech arm sees the highest margin in Argentina based on overall penetration, and management anticipates other markets will come in-line over time as the markets mature. Additionally, the company continues to drive marketplace take-rate expansion over time, and is in the early days of building out its advertising business, which is likely to yield significant returns over the long-term with a higher margin than the core e-commerce arm. Some color from the earnings call:

So the margin structure for the advertising business is fairly consistent across geographies. It’s a very high margin business. I think we said EBIT margins are in the high 70s, low 80s. Attach rates or adoption do vary by geography. Mexico is the country with the highest attach rate. There is, I think a combination there of 1P business, but also simply how far we’ve executed and what the overall market dynamics are. But in general, I think with 1.3% of overall penetration, it’s still insipient in any of the geographies that we look at and we expect very solid growth over a multi-year period across all of the geos.

Some more on where advertising is heading:

So, still, the vast majority of the monetization is on product ads. So the insertion of sponsored listings that are interspersed within search results are identified as a sponsored listing, but they appear in the middle of a search result.

We have growing capabilities and begin to see improved monetization in terms of display advertising and other more complex ways to work with larger merchants or even brands that want to promote the sales of their products either directly by themselves or from merchants that are already selling on the network. But that’s still a smaller part of the revenue base and where a lot of the uptick can come from.

You are correct in saying that many of the merchants, especially the smaller merchants still have a learning curve. We see that very clearly when we look at the dollars invested per listing that we see from cross-border merchants, many of them coming from China and Asia that are much more sophisticated in terms of the use of advertising to help conversion rates.

It’s unclear how quickly the company will see traction, but I anticipate advertising being a boon for the company as it improves its rollout and monetization. The company’s advertising penetration today sits at only 1.3% of GMV, so there’s a huge runway.

One of the notably absent initiatives from the company is a Prime-type subscription program. As the company has lowered average delivery times to 1.5 days in a number of different ways, including crowdsourcing last-mile delivery and utilizing their 7,000 MELI places (corner stores used as hubs for products and banking) and driven the free shipping breakpoint down to $15 orders, it’s a natural progression the company seals the deal with a subscription to buy into the logistics benefits the company offers. Management addressed this on the call:

In terms of loyalty, we continue to work towards launching a next version of the loyalty program. I think we’ve identified that where most of the value is, is in L6. We continue to see a strong evolution of users buying L6. The overwhelming majority of Level 6 users are purchased users and not users who have earned their way towards L6.

And so, we would hope to be launching a new version of the loyalty program in the upcoming quarters that really positions it increasingly better to be a subscription model with more and more benefits that we will continue to build for that highest level where a majority of the users will probably purchase. But we will continue most likely to offer the ability to be earned into that as well.

There is some small hesitation there, and the ability to earn into it is likely born out of concern of pushing any of the company’s users away. It will be interesting to see how they roll it out in the coming years. If they’re successful, it’s just one more driver to long-term customer loyalty to the company’s ecosystem.

Like I mentioned, MELI credit offers loans to its underbanked customers, and ties the creditworthiness to a seller’s GMV, taking payback straight from sales off the platform. Management recently reeled back on credit book growth, and discussed how the credit book is not in and of itself necessary for overall company growth, and they will slow it down at any time they feel uncomfortable with risk levels. In this case, they didn’t like what they saw and flashed the yellow light. Some perspective from the call:

So, Geoffrey, what we did during the last — end of the second quarter and during the third quarter, basically we have scored users in 12 segments. And those that were lower ranking, we stopped offering them both personal loans and buy now pay later. Those that were a little bit better ranked, but still not so high up, we stopped offering them personal loans. And we – but we continue to offering them buy now pay later.

The good news that we saw is that we believe with * hindsight that we took the right decision. This was a wise decision because on the one hand, those segments where we continue offering loans were profitable. And on the other hand, we kept control groups for those groups where we were not — where we stopped offering loans and those who have not been profitable.

What you’re really looking at here is the company reinventing credit scores. The markets it operates in and the customers it serves are not well graded on their creditworthiness, and the 12 segments they are looking at is a way for them to separate their risk in a proprietary way. I don’t look at the overall growth in the credit book as indicative of the health of MELI, but more as a way the company inspires loyalty among its sellers. I’d much rather see risk aversion here than charging forward to meet some quarterly projection or goal. The company is sitting at conservative values with its provisions for overdue loans, and I like the color management provided on their calculus going forward.

Debt has increased somewhat, but not enough to cause me any concern. Free cash flow will be largely driven by the company’s investments into its infrastructure and other initiatives, which will come in waves. MELI is growing at a blistering pace currently, and its long-term track record is adequate for me to remain satisfied with cash levels so long as debt doesn’t significantly rise from here. The company is currently sitting on $1.5B in cash.

Based on the company’s fundamentals outlined above, it’s no surprise what you’re going to find here. The P/E ratio is sitting at about 120X. This company isn’t cheap. It’s a high growth enterprise offering a quality way to invest in emerging markets. There’s tons of uncertainty, but MELI is a best-in-class operator, has weathered a lot over the past 2 decades, and continues to be a strong steward of shareholder capital.

There’s not a lot I don’t like whenever I dive into this company. There’s a lot of moving parts, and the company has a ton to manage across multiple geographies that are not nearly as developed as America. However, management is very open and provides significant granularity into the business. The company went public in 2007 for a split-adjusted $18/share. That means if you took the risk just 16 short years ago, you’d be sitting on 3900% gains today.

MELI won’t be for everyone, but I’d much rather own this company than most any emerging markets ETF. MELI is a buy with an eye to the long-term possibilities for the business. Latin America has 650M people, and MELI today is a $59B business. It’s the market leader, and it’s making the right moves to stay that way.