MercadoLibre: Beating Amazon In LATAM? Likely, But It’s Not A Buy (NASDAQ:MELI)

Investment Thesis

As LATAM is projected to grow significantly over the coming decades and internet access increases, the e-commerce boom is expected to continue. The strongest player by market share is MercadoLibre (NASDAQ:MELI), defended by strong competitive advantages in the form of a strong brand, network effect, and scale advantages. Although competitors like Amazon (AMZN) remain, my main concern is management taking more risks to achieve growth for the company. This signals to me that growth might slow sooner than the market is anticipating, which the company is not priced for. Therefore, I rate MELI a hold.

MercadoLibre Overview

MercadoLibre, with headquarters in Uruguay’s capital city, Montevideo, is a 100b market cap company, listed on the NYSE (ICE).

The company operates an e-commerce platform as well as a marketplace. To supplement these services, they also offer Mercado Envios and Meli Air (logistics services) and Mercado Pago (payment processing and finance). Additionally, MELI now allows companies to advertise on its platform, creating a new path of growth for the company – advertisement.

To put it simply, envision a smaller Amazon but with a fintech attached to it and only operating in Latin America.

While the company only reports in one segment, below I have visualized the revenue breakdown by geography for last quarter’s revenue:

The “Other” part is an aggregate of countries that make up too little of the total revenue to be reported on. These include almost all remaining countries in Latin America.

As seen below, Brazil and Mexico, the company’s main markets, are poised for growth over the coming decades. Germany for reference, as it is relatively similar in size:

Generally, I like the revenue mix here as it is geographically diversified enough against i.e. natural catastrophes, but with exposure to countries that are projected to be structurally growing. This is important as, over the long term, income growth ideally provides future runway and growth to MELI. As I have concerns over the fintech segment’s stability, as I will describe later on, I like to see the “Commerce” segment be overweight and growing faster.

Current and medium-term growth should be fueled by increasing internet access and growing e-commerce penetration, as well as customers ordering more products per customer.

Moat

Brand

The company has built a strong brand as the leading e-commerce platform on the continent, as I was told by friends from Chile. Similar to Amazon in the US, this has created a self-reinforcing flywheel.

Network effect

As buyers enter MELIs e-commerce and marketplace platforms for convenient access to a broad range of products, MercadoLibre gains a large crowd of consumers willing and able to pay. This is attractive to sellers, which will try to use this in essence free traffic to expand their customer base digitally. By this, the range and diversity of products further increases and, in turn, attracts more buyers, which again makes it more attractive to sellers. This is a strong network effect, making up the majority of MELI’s moat.

A graphic portraying the network effect very well:

Switching costs

As it is cheaper and faster for sellers to use MELI’s logistics offerings than to use their own warehouses or ship items themselves, they create switching costs for themselves by relying on MELI for those very sticky services. Many of which are essential for generating revenue on the platform.

Scale

While MercadoLibre dominates the Latin American E-Commerce market with a market share of over 21%, which is by no means little, this is inferior to Amazon’s 37% in the US. Still, I think this is evidence of a necessary scale advantage, which is especially beneficial for the company’s logistics and distribution network.

Advertisement

This part should in the future command a strong moat as it lets advertisers target customers very specifically, as MELI can gather data on buying behavior. Additionally, it gives advertisers access to a unique customer base, which is potentially hard to reach otherwise. Advertisements should contribute to the network effect as well as switching costs for sellers, however, is still a rather young segment with only 5% digital market share.

Fintech

I don’t believe the fintech segment to have a competitive advantage. Personally, I see it as a way to bring customers into the company’s ecosystem, similar to the brand. Fintech contributes to the overall stickiness of the company’s ecosystem, however.

In conclusion, it is safe to say that MELI has at least built a strong moat. However, I would not call it wide yet.

Besides a solid brand, I worry the other competitive advantages; scale advantages, a strong network effect, and consequently strong switching costs for sellers, are replicable with enough capital. For example, by Amazon. However, this would likely require years and an investment of ten to eleven figures.

Yet, it is something to keep in mind and closely monitor for potential as well as existing shareholders.

Financials

In the last decade, revenue grew remarkably stable and at a breakneck CAGR of 38% – with revenue growing 37.3% last year:

What I like a lot about the FCF chart here is that unlike with Amazon, stock-based compensation is rather small and does not dilute shareholders and free cash flow or any other metrics.

With the amount of cash, MELI generates, as well as existing cash reserves, I don’t think servicing their debt will be an issue any time soon. However, as a large part of the liabilities are from the fintech’s customer deposits and loans, credit quality should remain a concern for shareholders – as I will lay out in the “Risks” paragraph.

Valuation

Company	MELI	Amazon	Sea (SE)
Forward PE-ratio*	55x	36.6x	41.35x
3y CAGR EPS estimates*	40%	37.7%	83%

Click to enlarge

*based on prices at market close on 9/4/24 and Koyfin/Seeking Alpha analyst estimates

I have decided not to include the free cash flow yield here, as especially MELI and Sea are expected to invest much of it into further growth, despite growing healthily. While Amazon seems to be entering the harvesting phase. Further, these EPS growth estimates are not equally distributed, with this year being assumed to be the strongest for all of the companies. This means that this year needs to work out for the companies, as a miss will extrapolate into future estimates over proportionally and, in turn, should lower the willingness of investors to buy at current prices significantly.

While MELI is more expensive than SE, this is also offset by more growth – and importantly much more sustainable growth. Compared to the over 140% jump Sea Limited’s EPS is expected to make this year, before falling off to more sustainable numbers.

Additionally, MELI allows for potentially multiple decades of growth. However, that is true for both Amazon and Southeast Asia-based Sea.

Despite the company’s history of being profitable on an earnings basis being short, taking a look at the historical P/E ratios of 70s and above, the company seems fairly valued currently – assuming growth can continue at recent levels. I’m however not very confident in this, as I will lay out in my conclusion.

Notable shareholders

Marcos Galperin, by controlling the Switzerland-based Galperin Trust, holds 7.2% of MELI. Mr. Galperin is a co-founder, and the current CEO and Chairman.

Insider ownership is always a good thing as it, ideally, aligns management and employees with shareholders’ long-term interests.

Risk

Credit risk: The payments and finance part of MELI are suffering from a non-performing loans ratio of over 18% in the last quarter, down from 25% a year ago. I think this risk should not be taken lightly at all. What this ratio means is that 18% of loans have been unserviced for at least 3 months – if MELI’s main business was lending, this would cause me to rate it a strong sell on massive concerns over risk management and lending practices.

To put MELI’s abysmal NPL ratio into perspective; SoFi Technologies’ (SOFI) and Klarna’s (KLAR), both popular fintechs, NPL ratio was 0.64% and 0.46% in the last quarter. While the average US NPL ratio is at around 1.4%, Brazil, a more representative market, has not seen NPL ratios of more than 4% in the last decade. The same applies to Argentina and Mexico.

Management has noted in multiple of the last earnings calls that credit and credit cards are something they want to focus on for growth, this makes me thoughtful of their future runway as this is a rather risky approach to growth. Ideally, a strong management team can grow the business without increasing risk as it grows, which is the case here. I don’t see a reason to use this part of the business to drive more growth, despite it being comparably easy to be profitable from the very beginning, as essentially becoming a bank is not very sticky and should be commoditized.

Something to be aware of is that MELI says that the company is actively “scoring and approving loan applications using their proprietary models”, and that models have become better at forecasting. While this is evidenced by the declining NPL ratio, I remain skeptical, as the lending business might become unsustainable should LATAM enter a recession.

AI: The emerging markets are mainly projected to grow faster than the developed markets because of their superior amount of younger and cheaper labor. If AI materializes in a way that makes it pointless for companies to employ the currently existing masses of cheaper labor from emerging markets, this could mean that emerging markets grow much slower or not at all. As MELI’s customers are entirely from LATAM’s emerging markets, this potentially creates risk.

The same, emerging market growth slowing/not materializing, could occur due to other reasons as well, of course.

Political: Brazil, Mexico as well as many other countries in LATAM have experienced various levels of political instability in the past. This creates risk. Should public safety be interrupted, it would be hard to move items, assuming customers still have the means and willingness to buy. This has only happened on smaller scales in the past and hopefully gets less of a risk as development in these geographies advances, but it should be on the radar of MELI shareholders.

Competition:

Amazon: “Your margin is my opportunity”, Jeff Bezos famously said more than a decade ago. Obviously, one of the most obvious risks is that MELI’s margin becomes Amazon’s opportunity. While it would require immense effort and capital from Amazon’s side, it is not to be ruled out in my opinion, as Amazon has experience in operating at a loss to win the long game.

Visa (V), Mastercard (MA), American Express (AXP): As MELI ventures deeper into the fintech and payment processing space it will inevitably encounter the three big payment network companies. While none of them are direct competitors to MELI, they are formidable businesses with immense moats, as I recently covered in my article on AXP. While MELI has issued its own credit cards similar to AXP and operates its own payment network, I don’t think this is an imminent risk. But it could become one if MELI or any of the three runs out of growth runway down the line and decides to approach another party head-on for growth.

Valuation: Should the market have incorrectly assessed future growth, a possible spread between what the company is priced for and what materializes might occur. Possibly resulting in a sell-off, as the market re-rates the multiply it is willing to pay for the company. The same might apply to FCF or margins.

Conclusion

When I started researching the company, I asked myself if the company could fend off the North American giant Amazon is. Now I’m confident that it can.

However, risks arose I was previously unaware of, while known ones remain. My main concern is the bad credit quality of MELI’s fintech segment, or more specifically, why the company needs to focus on that avenue for growth.

Over the long term, their easily scalable business model should allow for operating leverage as well as pricing power. This, combined with their strong moat, makes me optimistic about the company’s future prospects.

Overall, I rate the company as a hold, as the current valuation requires growth to continue at recent rates. By taking more risks to grow, management does not give me confidence in this.