Viva la revolución

Latin America is finally being liberated to the age of eCommerce and the company best placed to capitalise on this is MercadoLibre.

noragrets
#noragrets

It is never healthy to dwell on what could have been, especially in the game of investing, but many people regret not riding the decade long run up in Apple, Google, and [insert tech name here]. Similarly many are amazed at the wealth created for Amazon shareholders as it recently blew through a 500bn market cap, yet I always saw it as trading far beyond reasonable value for a company that couldn’t even turn a profit. What my value-orientated perspective missed was that Amazon & Jeff Bezos had a singular focus – a moat. Bereft of profits it had cash flow, to continue to plough into new ventures and innovations as investors gave them credit to continue to execute with the vision that one day they should be the last one standing in a winner-takes-all landscape.

Second bite at the apple

Hit rewind a couple of years on the Amazon corporate timeline and we have a similar opportunity today, MercadoLibre (“ML”). ML is often dubbed the Amazon or eBay of Latin America (“latam”). When looking at the ecosystem of ML however it instead reminds me more of an Alibaba. At the core lies Marketplace, a place for third party buyers and sellers to transact either through an auction or fixed price format similar to eBay where a fee is skimmed on each dollar of Gross Merchandise Value (“GMV”) sold through the platform. Once a transaction is completed, payment is encouraged to be made via MercadoPago a payments solution in the mould of a Paypal where fees are taken as a % of Total Payment Value (“TPV”). Financing is also bundled into MercadoPago whereby users may elect to pay via instalments, and then ML can offload credit risk to underwriters and take a revshare. MercadoEnvios is their third party logistics (“3PL”) solution that merchants can utilize to take care of the logistics of transactions (just like Cianiao for Alibaba). MercadoShops offers an end-to-end solution for offline retailers to create their eCommerce store for a fixed fee, similar to Shopify. They also have a sizeable classifieds business that works off a fixed fee business model rather than a take rate on transaction value. Finally, there is also MercadoClics which offers advertisers real estate on ML websites and charges on a cost-per-click basis similar to other eCommerce websites such as Amazon and Alibaba. ML is the dominant eCommerce player in Latin America today, and as you can see it could easily be viewed as the Amazon (B2C), eBay (C2C), Craigslist (C2C), Shopify and PayPal of latam. Despite the attractiveness of such a description it is also worth noting that global behemoths such as Amazon and Alibaba have already built similar ecosystems in their home markets and there is nothing stopping them from stepping on MLs toes.

Multi-decade story

The Total Addressable Market (“TAM”) is huge. Latin America has over 600m people, that’s nearly as much as the US and EU, combined. Yet due to the lagging telco infrastructure in the region, lower disposable income and lack of adoption, internet penetration in the region severely lags other markets.

Yugetrump
The TAM is yuuuuuuuuuuuge

Emerging markets across latam offer secular GDP/capita growth as the middle class grows in the region and the macro growth will bring a host of benefits for ML. Growth in internet penetration to catch up with the developed world will see the world of e-commerce open up to more of the 600m consumers in end markets.

Internet penetration (% of population)

2010 2017 Penetration increase
Latin America / Caribbean 36% 62% 26%
Asia 23% 47% 24%
Europe 58% 80% 22%
North America 79% 88% 9%

It is still very early in the innings for eCommerce and widespread adoption of smartphones will further support the strong positive momentum for penetration increases region wide. There’s not much value in trying to perfectly predict growth but the basic message for regional internet and smartphone penetration is this – it’s going up. The trajectory of adoption will of course depend on infrastructure spending and discretionary income and therefore overall economic health is likely to be the underpinning factor.

eCommerce as a % of total retail sales

2015 2016 2016 YoY growth in eComm sales
Latam 2.2% 2.6% 22%
Brazil 3.1% 3.6% 14%
Mexico 1.4% 1.7% 27%

eCommerce catching up – Consumers in the region haven’t appeared to widely and completely embrace eCommerce as a medium yet, as shown by ecommerce penetration as % of retail above. This is a key lever for growth as latam consumers get more accustomed to using the internet to transact. The blue print is clear as developed markets have high single digit eComm penetration and China the truly digital society at c. 15%!

ecomm penetration
ML markets (yellow) significantly lag developed nations / China

However, it is worth noting there are challenges specific to the region including mistrust of online payments, and logistical challenges (unionized state postal service) meaning delivery times are often relatively slow. Smartphone adoption (mCommerce share of eCommerce is growing rapidly) and familiarity with the internet will eventually help latam eCommerce growth inflect.

Macro double-edged sword – Key risk but reasons for optimism

The macro story is a double edged sword as the long history of political instability suggests. The headline risk is political turmoil that may trigger GDP slowdowns, spiraling inflation and FX deterioration which would severely hamper ML fundamentals. It is US-listed hence reports in USD$ and latam currency depreciation as experienced in the past few years substantially reduces reported revenues/earnings.

Maduro
Dic(k)tator Maduro loves a hi-five

Brazil (54% of 2016 revenue) – The BOVESPA has rallied significantly in recent times from its lows as investors begin to see the light at the end of the tunnel as the country slowly emerges from one of its worst ever recessions. While the outcome of the next election is unclear at this point it is difficult to see a far left (Lula) or far right (Bolsonaro) candidate winning. Recent data supports the uptick in sentiment as real growth in wages and economic activity appears to be returning.

Argentina (31% of 2016 revenue) looks set to pick up over the next few years as the political environment remains stable as recent polling showing President Macri’s coalition Cambienos being favored which would suggest economic reforms will continue. Political certainty and healthy demand for government bonds should lend support to the currency. There is also very low leverage in the private sector (20% of GDP) which allows for a multi-year credit cycle to fuel growth. The central bank also have acknowledged they are committed to fighting inflation which has been a drag in recent periods.

Others: Mexico (6% of revenue) has shown relative strength in the region and with stable political leadership looks poised for steady growth (c. 2%) in the near term. Venezuela used to be a core market contributing 10% of 2014 revenues before President (Dictator) Maduro plunged the country deep into turmoil and essentially turned it into a failed state (Venezuela contributed 4% of 2016 revenues).

Payments Platform

As with many emerging markets, latam has a significant unbanked population and payments offers a huge runway for growth to accompany internet adoption. Cash is still the prevalent form of payment however MercadoPago TPV growth has outpaced GMV growth as the TPV/GMV ratio tracks a very similar path to that of Paypal TPV growth vis-à-vis eBay GMV growth as it grows to be a platform beyond ML. The option value embedded in MercadoPago is extremely high as a standalone fintech enterprise that will be able to resolve a key friction point of eCommerce via payments but also offer a multitude of services beyond that of an online payment gateway (e.g. Consumer lending, Vendor financing, Off-platform payments processing etc.).

GDPbubble
MercadoPago has a pathway to become the dominant payments platform in the region

Competitor risk

Is first mover advantage enough? Network effects built into a marketplace model give MercadoLibre a big edge. Longer term a capable management team with local knowledge improves understanding of end markets and users better than international players. Ultimately it becomes a question of business model. Alibaba operates a similar capital-light model to MELI and moved first in China, when eBay subsequently tried to enter China they failed and now Alibaba has a dominant position. JD continues to be a threat due to the advantages to the consumer of a capital heavy vertically integrated model which allows for a better customer experience in certain instances (similar to AMZN logistics network).

Bezos
The squeeze is about to come…

Initially when reports of Amazon entering Brazil were published two months ago ML stock plunged 10% as clearly the market acknowledged the threat of the Bezos behemoth. ML mgmt. have faced this threat head on by playing an aggressive share game to reduce the risk posed by the AMZN model – their solution was to subsidise free shipping across their Brazil website. This is an expensive move as the previously healthy margins take a huge hit to support growth and protect share. I do not view this as temporary. eCommerce customers expect free shipping and I don’t see a future whereby ML will be able to revert back to having healthy margins and not having to subsidise shipping costs. This is a fantastic move by ML as it means management are taking a long term view to being the dominant platform in latam, just as they have done since 1999. This singular focus is similar to the approach taken by Amazon in North America. The resultant impact is likely going to be no or very low profitability for the foreseeable future (c. 5 years) as ML seeks to ride the wave up, but LT EBITDA margins should ultimately fall in-line with targeted margins for similar players at c. 10 – 15%. The short term depression of earnings means share price is likely to be volatile over the next few years, creating stress for holders but opportunities for those in it for the long haul.

Management

Management are critical as minor strategic missteps in an industry that moves as fast as eCommerce can be fatal. Marcos Galperin the founder and CEO has almost all his net worth ($1bn) tied up in stock. However it isn’t his financially aligned interest in ML stock that gives me comfort – it’s his story. Long story short he was the heir to SADESA (his family business which is one of the largest leather companies in the world) yet instead founded ML in his mid-20’s while doing his MBA with a vision to build the eBay of Argentina. His vision has grown along the years and it is clear today that his aspirations were always greater than financial reward as he seeks to build a truly fantastic company. CEO’s with this tunnel vision eventually create tremendous value for shareholders in the long term. Still incredibly young at 45 years old he has a long road ahead to build ML into something completely different to today. The rest of the senior management team are also tied to long term retention plans with cash vesting over rolling 8 year windows.

Valuation

It is difficult to value the ecosystem today however each piece (payments / financing / logistics / advertising) helps compound the value of each $ of GMV.

Without wasting time attempting to build a DCF, lets just focus on the five drivers that matter: (i) TAM; (ii) GMV; (iii) Take rate; (iv) EBITDA margin; and (v) Multiple.

By far the most important variable for value is the GMV, hence the long term regional macro story is the key driver for TAM while the ability of management to fend off AMZN (and others) will determine market share to arrive at GMV. We are also relying on management to continue to effectively monetize the platform to increase take rates hence a high degree of confidence in their capability is required. EBITDA margins are likely to trend towards steady state for vertically integrated eComm players which based on targeted margins for similar players may fall within the 10 – 15% range. The multiple is difficult to predict in steady state as it will likely be years if not decades before these types of companies trade based on traditional metrics (feel like we will be waiting a while for the day a P/E ratio will matter for Amazon). Regardless of when that day will arrive, the market will ascribe significant value to a dominant, profitable and cash flow generative eCommerce franchise.

From a comparative perspective MLs EV/GMV of 0.74x appears in-line with peers approximately: Alibaba 0.57x; eBay 0.48x; Amazon ex-AWS c. 0.7x

Arguably the growth runway ahead for ML is more attractive and for the purposes of an analog comparison to consider the addressable opportunity let’s compare China to Latam. China’s GDP is approximately 3x Latin America GDP. However Alibaba and JD.com combined market cap is $550bn while MercadoLibre’s market cap is $12bn (46x larger). On a relative basis looking far out into the future of MercadoLibre potentially as the leader of latam eComm the opportunity to invest today is attractive.

At $266/share, for the reasons discussed above MercadoLibre represents a compelling investment opportunity today. Don’t be mistaken though, to buy this for the reasons above is to make a long term commitment. Not a long term commitment like Kim Kardashian getting married for 72 days, a real commitment to a story that may take a decade to play out. Expect volatility in the next few years however the payoff will be immense if MercadoLibre ends up being a key player in Latin America’s eCommerce landscape.

Disclosure: I am long MercadoLibre (NASDAQ: MELI)