Chit Chat Stocks - MercadoLibre (Ticker: MELI) Not So Deep Dive

Episode Date: December 6, 2022

MercadoLibre operates an eCommerce platform primarily in Latin America. The company enables businesses, merchants, and individuals to list merchandise and conduct sales and purchases online. At the end of the month, we will publish an Arch Capital episode that will cover the company: Wix. Listen closely as Brett and Ryan go through the history, financials, and future prospects of MercadoLibre. Enjoy the show! ****************************** Interested in becoming a member of 7investing? Subscribe with code “MONEY” and get $100 off your annual subscription for life: https://7investing.com/checkout/ ****************************** Subscribe to our Substack to receive free show notes and charts that go along with every episode: https://chitchatmoney.substack.com/ Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Contact us: [e-mail] Timestamps Company Background | (4:00) Industry | (13:06) Management & Ownership | (18:45) Earnings | (24:55) Balance Sheet | (29:04) Valuation | (36:02) Our Analysis | (38:12) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or a recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not So Deep Dive episode on Chit Chat Money. Today, we're going to be talking about Mercado Libre. First off, I guess we need to start introducing

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You can sign up to the newsletter for free and check out all the charts and tables along with each episode that'll get sent out Tuesday morning when this gets released. Okay. We're talking MercadoLibre today. This is a very interesting company, complex. We're not going to be able to cover everything today, but I think we can explore some things that can hopefully springboard maybe some ideas for other people to research while getting the basics of the business. But first, let's talk about our sponsor, our exclusive sponsor through the end of 2022. And that is 7investing. You guys already likely know about 7investing. We've talked about them for over two months now on every podcast on Chitchat Money. But through the end of 2022, they are doing a

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Ryan or Doc and Mercado Libre, try to say what they do because this is a very complex business in Latin America? Yeah, it took me a while to get to everything, but they are the largest internet marketplace in Latin America. I guess it's a good way to encapsulate them in a single sentence. They operate in 18 countries, but the bulk of their revenue comes from Brazil, Argentina, and Mexico. And they service, or at least this last quarter, they serviced more than 88 million unique active users across their different products. And I think you had it in there. It's more than 100 million active users each year, or at least it was last year. So it's huge and it's by far the largest marketplace in Latin America, but there's several different

elements to the business and I'll break them down into the six categories that they talk about. So the first one, this is the one that's basically the engine for the business. And this is Mercado Libre's marketplace. It's their e-commerce platform. This is where it gets parallels to Amazon. So if you ever hear people refer to Mercado Libre as the Amazon of retail, this part is very similar. It gives buyers and sellers a secure place to transact online, and it's on pace to process more than $30 billion worth of merchandise volume this year. It is functionally very similar to Amazon retail, and it gives them the capability to monetize additional services. So they have a really large logistics footprint that allows

them to deliver most orders within two days. And they also sell a number of the items themselves. So first-party sales, in addition to having third parties sell on there. And obviously, having the footprint allows them to offer logistics services to their customers. And that's another segment. I'll touch on that in a second. But the second one is Mercado Pago, which is their payments business. And this was initially started to help process payments on their own platform, but it's since grown into a more, basically one of those super apps with FinTech super apps where it's kind of a comprehensive digital wallet. And so Mercado Pago offers a white label solutions that retailers can also integrate into their

own website. So let's say you've got an online site, you're maybe selling some products on MercadoLibre's marketplace, but you also have your own website where you want to sell goods off the platform, you can integrate MercadoPago's payments processor into your website seamlessly. And then MercadoPago just takes its take rate on all the transactions. And it's one of the easiest ways to get set up for payments online. The other part of the business that's kind of grown is the peer-to-peer functionality. So if you're an app or a website user, similar to the Cash App or Venmo, you can transfer money to other users. As of last quarter, Mercado Pago had 42 million active users, and 22 million of those are wallet payers.

So for reference, the current estimate for the Cash App is just over 40 million MAUs. This is about half the size of the Cash App in terms of people using the actual Mercado Pago wallet. And then the other businesses, Marketplace and Payments comprise the majority of the revenue, but other ones include logistics, which is called Mercado Envios. Basically, this is MercadoLibre just offering its sellers access to the fulfillment and warehousing services. So sellers don't have to choose this, but if you're a seller, it allows you to offer more discounts to your customers and it can fulfill orders much faster than the typical third-party solution. The other one is ads. This is another classic example of

leveraging your scale as an e-commerce marketplace. If you're a merchant or even an external advertiser, you can promote your items on the various marketplaces that they have. So these include product searches, banner ads, suggested products. It really is just very additive both for merchants because it's prime real estate, but it's also a margin of creative if you're MercadoLibre. And then the other two businesses, one of these is maybe a low light for me, if you're looking at the business, and that is the Mercado Credito. But at the same time, you could see the opportunity here. So Mercado Libre provides loans to different stakeholders, basically two different stakeholder groups that they serve. So it provides working capital loans to its sellers, and then it provides personal loans to consumers.

Initially, this was loans to basically help consumers buy items on MercadoLibre's marketplace or through other sites that have MercadoPago as part of the checkout process. But in 2019, they began extending personal loans to recurring borrowers for off-platform purchases as well. Well, the whole credit portfolio has gone from $284 million in the third quarter of 2020 to $2.8 billion in Q3 of 2022. So it's 10x over the last two years, which is potentially – I always get a little worried when I see a loan portfolio grow that quickly because it makes me feel like there maybe isn't enough underwriting discipline. But $2.8 billion in total loan portfolio value, it's not terminal for the business. It wouldn't kill the business. But it could obviously, if some of those more loans that are expected to be uncollectible are uncollectible, then you've got a potentially large write down there on your loan portfolio. So last one I'll talk about here is storefronts. They call it Mercado

shops. This is where it's similar to like a Wix or Squarespace or Shopify. It allows sellers to easily set up basically a digital storefront where MercadoLibre acts as the host. And we should have mentioned that this is the start of our website slash e-commerce month. And so this is where it kind of has that similarity to Wix and Squarespace. It's probably why we sort of included it, but it's zero cost to set up if you're a seller using Mercado Shops. They instead just pay commissions on transactions that flow through their site. So really, they provide a lot of value to other sellers, merchants, and consumers in a number of ways. The two big ones there are Mercado Pago and Mercado Marketplace. Let's talk history briefly. Not a whole lot here.

It was founded in 1999 by Marcos Galperin. He was attending graduate school at Stanford. That's kind of where the idea started. He was helped by two other students, Hernan Caza and Stelio Tolda. Stelio Tolda, I believe, is the current CEO, unless I'm wrong, Brett. I can confirm that while you're talking. Okay. I was reading a report from, I think, two years ago. But one of the founders, and I guess you would call him one of the co-founders. And initially, the idea was that this was going to be a consumer-to-consumer marketplace in Argentina. At the time, This is when eBay was really big, and Galprin seemed to be living in Silicon Valley with Latin American heritage and background. He thought it would be easy, I guess, or the opportunity was large to replicate what eBay was doing in Latin America.

and apparently financial backers thought he could do this as well because he got tons of funding, including from JP Morgan, Goldman Sachs, GE Capital, plenty of others. And then within two years, eBay actually acquired a 20% stake in the business. Basically, all this funding allowed them to continue opening operations throughout different countries in Latin America. And then by 2007, they had, I want to say $50 million in revenue and they were actually GAAP profitable. And that allowed them to raise $300 million during their 2007 IPO. They were actually the first Latin American tech company to be listed on the NASDAQ, kind of a fun fact there. And since then, they've used all their excess cash to continue building out the logistics infrastructure.

And they've ventured into some of the other operations that I mentioned earlier. The history was kind of limited from what I saw. It sounds like Galperin was pretty entrepreneurial in college and seeing that he went to Stanford Graduate Business School, I think it kind of helped him receive some funding from a lot of the Silicon Valley players. Yeah, he seems very, very smart. I'll cover a little bit more of that later. And just to confirm, Stelio Tolda is the current CEO, COO, so still there. Let me hit industry and competition. The e-commerce industry in Latin America is expected to only be around $100 billion in USD in 2022, but is growing really, really rapidly. So projections are for hit about $160 billion in 2025. And given the GDP per capita of a lot of these nations,

the existing delivery infrastructure, which is pretty darn weak compared to how a lot of the United States, East Asia, or Europe are or were before these e-commerce players started investing there. And then you also have interdent penetration being behind the curve. You can see why e-commerce is behind the curve compared to United States, Western Europe, and East Asia. Now, the one question I had is, is there any reason to think Latin America won't follow the same path as the united states with e-commerce penetration but it's just maybe 10 years behind what are your thoughts ryan well this may be uh foreshadows part of my i guess highlights and lowlights uh i don't know would be my answer like i haven't been to enough the latin american

countries to understand whether or not the infrastructure like the delivery infrastructure could get there or is that going to be just not invested in for a long time and then they kind of have this like big like do they need the buy-in from the government that just isn't there um that's i would think that mobile penetration would get to similar levels to the western markets but i worry that that's like my naive western markets take which thinks like everyone can just replicate what we're doing yeah i think that's fair but i would say mercado libre is trying to do with themselves so maybe they're going to force it upon all the countries because they're building out essentially copying amazon so they might force it whether anyone helps them

or not but i would think it's it seems likely but yeah it's not a guarantee that it's going to follow the same the same path um if we look at competitors or one more thing there ryan yeah i would say like brazil's their largest market i've been to brazil for like uh two weeks one time and yeah but that was 10 years ago right it's probably entirely different now i mean ricardo libre was tiny back then yeah uh i would just like it feels a lot of the flats you have a lot of people living in really dense space and then a whole bunch of basically nobody living for a while I guess it's not that different than the cities in America. Just more so, a little more so.

Yeah. So I don't know if that helps in terms of profitability on deliveries since you're spending less time on the road. I think that would, similar to East Asia. Mexico and Argentina might be different. They're not different from Brazil. People from Latin America might be listening to this and laughing. No, their population is dense. In Brazil, at least, in those big cities.

but again there are there are nuances that we're probably missing if you're if you live there versus not yeah all right you want to talk competition yeah so there's two big competitors uh with well there's offline commerce and then i guess the structural competition with delivery infrastructure that is tough um offline commerce as a percentage of i think retail is larger in Latin America, or at least most of the areas that MercadoLibre is in versus, like I mentioned earlier, the United States or East Asia. So they're competing with that as the structural competitor, which is nice because that's easy and there should be that trend that they can follow. But within e-commerce, there's two big competitors and that is Amazon itself and then Shopee

from Sea Limited. Amazon has a decent presence in Mexico and Brazil, but only really operates and large countries in that region. The main competitor is Shopee from Sea Limited. I have a table broken out, and this is just taken at, I think, a couple of days before this recording, a breakdown of the App Store rankings of Google and Apple across all the important nations for MercadoLibre, Amazon, and Shopee competition. And if we look at it, Shopee and MercadoLibre are clearly ahead of Amazon. But if we go to Mexico, MercadoLibre is the clear winner. If we go to Argentina, MercadoLibre is the clear winner.

I don't even think Shopee was in there because I didn't find them in the rankings at all. But if we go to Brazil, it's a tighter competition with MercadoLibre as the third ranked downloaded app and then Shopee is the second and the fourth. So we'll talk about those dynamics later, but seems promising for the competition in Mexico. But Brazil might be a tougher market

where Shopee is getting a lot more traction. Let's move to management. Oh, anything else, Ryan? Do you know who the number one player was in Brazil? Brazil? I think it was Sheehan. So it's not really a competitor because it's like a fashion website.

So it's not for a full-blown. Technically, that's a competitor, but we would kind of agree that's more for the I'm going for the broad websites. All right. Management and ownership. Again, like Ryan mentioned, MercadoLibre is run by the founder, Marcos Galperin. He's about 50 years old. Also the chairman of the board, graduated with Stanford with that MBA. Dare I say that the comparisons to Jeff Bezos are pretty apt here.

And we've got a founder who's been around for a while, still fairly young. um when i look at the age of a ceo i think you have to be a bit ageist to younger people and older people where that middle ground of 50s is probably ideal but the 40s also can be good as well where it's it's uh how i look at it is okay is that person in the prime of say their working life? Are they going to put in a lot of time to this? Do they have a long runway of left that's probably a decade long? And do I have to worry about them either being immature or close to retirement? I think really no concerns there from Galperin. 50 might be the exact ideal age for CEO, especially with two decades of experience at this point. Stock ownership, fairly standard

for MercadoLibre. They have no two-class share structure, which is nice. Growth funds, as you might expect, like Bailey Gifford, Capital Research, and then Morgan Stanley own shares. If we look at the table here, Bailey Gifford actually owns 11.5% of the stock, which is quite a big amount. So I think that's important to note. The Galperin family, which is, I'm assuming, mainly Marcus Galperin. Is it Marcos or Marcos Galperin owns majority of that, but it's really through his family trust, and they own about 7.75% of the company. And then if we look at board of director compensation, not a concern. They pay everyone pretty fairly. It's about $1.24 million in 2021. One yellow flag, which I don't think is a huge concern, but something to watch

because board compensation can be important in evaluating culture. Galprin's brother is on the board. They still have a lot of independent directors that seem to check out and were truly independent, but you don't like to see too many family members on board of directors. Although you could have said the same thing about Berkshire Hathaway. That's one of the best performing stocks ever. Also, the CEO of Brex, who is only 26 years old, which when someone's around our age, we get concerned because that's a lot of responsibility for a young person. That person is on the board, the CEO of Brex. I don't really like to see that because it seems like, well, why?

That person's supposed to be focused on their startup, right? It doesn't matter that they're working at Brex, but again, that doesn't seem like the best board of director to me. But that's a bit nitpicky. If we look at executive compensation, I hope I forgot to do the calculation here. It was only $35 million in 2021, which is not that high of a percentage of gross profit.

I actually forgot to calculate it, but let me tell everyone. I mean, the company did almost $10 billion in revenue over the trailing 12 months and $700 billion in operating income. So they're not overpaying, I don't think, versus how large this business is. Although we'll get into maybe Galperin still pays himself, which again, it's not. It's more than $5 billion in gross profit, right? I would think so, but again, I forgot to calculate it. But again, $700 million in operating income over the trailing 12 months versus $35 million in executive compensation, not crazy, definitely not the worst we've ever seen. If we look at Galper and himself, he pays himself a handsome salary. I don't necessarily like this for someone who owns a big chunk of stock, but it's not a big concern and they are based on some solid metrics.

which speaking of, MercadoLibre has what I would call refreshingly aligned executive compensation. It is complicated, but I'll go through, say, maybe the basics for any investor and what they should understand and why we like this. So one, they have a small base salary each year. Two, they have annual cash bonuses based on net revenue, operating income, total payment volume, which is total payment volume through MercadoPago, shipping time, and net promoter score hurdles. They are unique hurdles, but all of them check out, I believe, as good incentives for those annual cash bonuses. Now, the one that's more unique is the long-term retention plan, which they call the LTRP. It is paid out over six years, subject to executives staying employed.

It is divided equally over the years, and half of the bonus can get larger or smaller based on where shares are trading at that time. It's very unique, and I like it. And again, these are, or I should mention that they are not paid in stock options. They are paid in cash, which I like as well, where you're not having the complications with that. You give someone cash, whether if the stock price is double where it was, they probably get a little bit more cash than what they actually would have. You don't what?

You don't adjust it out. That's right. They don't talk about adjusted EBITDA. They don't measure all this on adjusted EBITDA. They measure basically over a six-year period if the executive is still there. so that incentivizes you to stay at the company. They will pay you a nice cash bonus, which isn't too large either.

It's in the few millions of dollars, which is great. But again, everyone's kind of aligned. And you might worry a bit about being too incentivized to drive up the stock price, but I don't think it's that bad in this situation. Yeah, and then my only issue I had was really Galpern. He pays himself a lot of these bonuses as a percentage of executive compensation

while also owning a ton of stock. It's not huge compared to some of the other things we've seen, like maybe an Elon Musk at Tesla or some of the other ones, but a little nitpicky with that, but I didn't love it. He doesn't need the money, let's just say, right? He has, if things go right,

what's his stake worth? A few billion dollars? What is the $20 million each year going to do with that? Okay, let's get to how the company's been doing. Ryan, let's go through the earnings. Yeah. Last 12 months, just to give sort of a more rounded encapsulation here, it did $9.7 billion in revenue. They're encroaching here on the $10 billion revenue mark, 53% gross margins, and then basically 17% free cashflow margins over the last 12 months. That

was a little elevated than prior years. Generally, I've found that it's right around 10%, 10%, if I'm not mistaken, Brett, you kind of had a chart that talked about it. Yeah, their free cashflow is definitely elevated right now. I would 100% be tracking operating income as well as free cashflow and operating margin as well as free cashflow margin because typically, yeah, so one, I think it was their operating cashflow. I don't have it in the table exactly of what the line items were, but there were some things on working capital

that made operating cash flow just elevated this year or over the trailing 12 months, right? Right. And then I guess the most recent quarter, it was probably slightly elevated as well, but not quite as bad. So I guess the big metrics to track here

are total payment and total merchandise volume. So payment volume is referring to everything going through Mercado Pago and then merchandise volume is the actual merchandise or goods that are being exchanged in the marketplace. Total payment volume this quarter was up 76% on a constant currency basis. However, they kind of have a... Well, I guess the constant currency is the one to look at, but reported currency, I believe they struggled with because they're converting it back to US

dollars and there was significant inflation within a lot of the markets that they operate. And then the other metric that I think is important to pay attention to is take rate, but take rate can kind of be loosely defined. I basically look at it as revenue, as a percentage of logistics, marketplace, and payment volume, which has been right below 20%, percent, which has grown over time as the value of their services that they provide to buyers and sellers has grown over time as well. But revenue is growing 45% on a reported currency basis, 61% in constant currency in the last quarter, $2.7 billion. So on pace for that $10 billion in annual revenue. FinTech is the fastest growing segment and Argentina is the quickest

growing geography. Other things worth reporting, 88 million unique active customers, that's growing. So they're active customer base, despite being the largest player in a lot of these markets is still growing. And this quarter is 11% growth year over year. And then total payment transactions are growing 66% year over year. So if you're wondering why the payment volume or all the volume flowing through the platform is so much faster than the actual customer growth, It's because they're making more common use out of MercadoLibre's services. Last thing I'll mention, 11% operating margins this quarter. I guess just to summarize the business, it's slightly low margin when we look at it compared

to like we just had a whole month worth of engineering software stocks. If you look at it relative to those, it's slightly lower margin just because of the nature of the e-commerce business. However, fairly profitable for an e-commerce business. And I think a lot of that is driven by the growth, the payments business that they've been able to tack on. And then they're doing about, well, I'm going to talk about the debt here in a second, but they are not in any sort of financial crunch and they've consistently shown an ability to generate cash and generate profits. So let's talk balance sheet real quick. This is probably one of the more complicated balance sheets I've ever looked at because, and I'm not sure what the rationale or the reasoning is for this, but they have borrowings in pretty much all their companies of operation.

So they've got like Chilean debt, Argentinian debt, Argentine debt. I'm guessing that's currency. So they don't have some sort of currency mismatch that screws them over. Yeah, I guess that makes sense. I guess they could, couldn't they also default in one business without defaulting? That's probably another reason. Yeah. Yeah. But that's, that's not, it doesn't matter for this podcast. Yeah. It doesn't matter, but I'll try to go through the parts real quick and let's talk assets first. So a billion and a half in pure cash and cash equivalents, and then $1.9 billion

in short-term investments. So basically $3.5 billion in really liquid assets. They also have another $400 million in long-term investments. I don't usually include that because typically that's things like equity securities where they buy stock in another company, but I looked at it. It's just long-dated government debt. So I kind of threw that in there as well. I'm not sure why they didn't just make that short term, but I guess it doesn't really matter. So $3.8 billion in cash-like assets is what I'll call it. And then basically they classify their borrowings as loans payable. So $4.7 billion in total loans payable, 42% of it is current. So you've pretty much got less than a billion dollars in net debt is the way to look at it.

And then I'll go through each line item. But like I said, it's tons of different types of loans payable. So I'll kind of summarize it afterward and talk about the important ones. They have loans from banks, bank overdrafts, secured lines of credit, financial bills, deposit certificates, commercial notes, finance lease obligations, collateralized debt, 2028 notes, 2026 sustainability notes, 2031 notes, and other lines of credit. The three things to pay attention to here are the loans from banks, the convertible notes, and the collateralized debt. So they have a billion and a half in convertible notes, really low rate debt on all of these. 2026 is 2.4%, 2028 is 2%. 2031 ones are 3.1%, so really low.

Are they all convertible? Not a huge deal, but just because the interest rate was different, I was just wondering. I don't know if the sustainability ones were, which are the 2026 notes. Not too relevant though, because they're similar interest rates, low single digits. No, the 2028 notes are the only ones that are convertible. And those are at 2% interest. That's the lowest rate that they have. They raised those at a really good time during 2020. And I think everyone that raised in 2020, we look back and say, oh, they raised at a really good rate. But they now have the cash to finance a lot of their operations. They're already cashflow positive. So I thought it was taking advantage of their kind of strong position already. So a billion and a half is the notes. The other 1.2 billion is collateralized debt. And frankly, I had a difficult time understanding what these exactly are. I read through the description in the 10K, and it was a bit of a word salad and kind of vague, but they said, the company securitizes financial assets associated with its credit cards and loans

receivable portfolio. With that credit portfolio that I talked about where they extend loans, that adds some risk to the business. I don't understand exactly why these are loans payable and how they're securitizing them. Right, because they already have the, since they are lending that out to say the credit card stuff and the other loans that they're giving to merchants

and individuals that's in the receivables that I have a good chart of has really grown over the last couple of years. But it's strange that it would be in the payables. Maybe we're both missing something obvious here, but it just creates uncertainty for the business because again, as someone that, It's a Latin American company with some collateralized debt that there's a word salad.

And what are we missing there? Why is it there? It's not that big, but it's definitely something to track if you're looking at this business. What does that line item look like on the balance sheet each quarter? Yeah. And it doesn't matter because they have so much cash and they have enough cash flow to cover their debt like five times over. Well, that's why I would say track it because if it grows and it becomes a way bigger portion of the business as a percentage compared to their cash or all the available liquidity they have, then it becomes something more and more important to make sure that they're going to be able to pay it back and no concerns there. Yeah. And the other big thing that's not necessarily explicitly stated on the balance sheet, but is worth looking at is the loan portfolio. They break this out pretty concisely on their earnings reports.

It's grown, like I mentioned before, but at the same time, the days past due, the amount of debt that hasn't been collected that should have been collected is continuing to grow really, really quick, which is cause for concern. And they're slowing, or I believe they said they've stopped lending in that segment. So if a whole bunch of that is uncollectible, they're going to have a pretty big write down or impairment on their loan portfolio. So just another thing to keep an eye on. Last thing I'll mention, in total interest expense this quarter was 92 million. So if you annualize that, it's about a 7.8% interest rate. Some of that is variable though, so it could rise. And that might also be lumpy with the quarterly because they have so much of the debt that's current and a lot of the convertible notes are elongated. So they're probably going to have

lower rates going forward because they were able to capitalize on the situation in 2020. So I don't know. This is just a really long-winded way of saying it's a complicated debt structure, but it doesn't really matter because they have a ton of cash and cashflow. Yes. And that's why cashflow is very important. Let's talk valuation though. Let me you get the terms up here. We got about a market cap of $44 billion as of recording. It's been pretty volatile out there the last couple of days. So who knows, could be up or higher or lower. Enterprise value, just because of that net debt of 1.3 billion is $45.6 billion. And the three metrics I'm looking at here are EV to sales, which is not that important, but I think it's

important if you want to model out what their margin structure could be in the future. Their EV to sales is 4.7%. Now, if we look at EV to trailing operating income, it's 64.4%. But remember, and again, this is not to say that the stock is cheap or anything, but what I'm looking at is the Q3 2022 trailing 12-month operating income and margins there were 7.3%. But remember, Ryan mentioned that last quarter, it bumped up to 11%. So those operating earnings could grow rather quickly, and especially when they've grown revenue per share at a CAGR of 50% since 2017, which is highly, highly impressive. But let's look at the other two numbers. Yeah, we have EV to operating income of 64.4, and then EV to free cash flow is 28.5. However, remember that

free cash flow is not... I don't believe that's sustainable. They do have a working capital advantage with the e-commerce business, similar to how Amazon is run. However, they mitigate all that and kind of use that advantage not to generate cash, but to start loaning out money to customers. I made a nice little chart with both funds payable to customers, which is that working capital advantage lined up with credit card receivables and loan receivables, which is kind of reversing it as they're loaning money to customers. And hopefully they get money back from that and they make money off of it, but it is going to hurt cashflow. They've grown almost in tandem. And actually in 2021, credit card receivables grew faster and hurt cashflow.

But in 2022, some of that working capital stuff reversed. Suffice to say, I would not look at free cashflow in a vacuum here. Definitely look at operating income. Definitely look at margins, on operating margins when doing valuation and kind of judge on that EV to sales multiple. Okay. Let's get to the more fun stuff. Anecdotal evidence, Ryan. Well, we don't live in any of country, so it's tough, but any thoughts here? Yeah, it's actually kind of a bummer that I have no anecdotal evidence or experience interfacing with any of the products or living in any of the markets because it's a bit of a low light for me. I'm worried that there's, especially with the Latin American companies, I look at what they say and I often think, wow, that's a wonderful

business. And then I've seen people get hurt, especially Stoneco is a good example where it seemed like it checked a lot of boxes and then Berkshire had an investment in it and everyone's clung to that like, well, he's probably done enough due diligence, that kind of thing. And then there's kind of like a ticking time bomb somewhere in the portfolio that I don't know, or there's something about the markets that I don't have a great understanding for. And by markets. I mean, geographies that they're operating in. So it's a bummer for me that I don't because I really like the business in theory. And I like everything that they're saying. It honestly does feel like Amazon 10, 15 years ago. Yeah. And maybe I can give some anecdotal

evidence. I lived in Mexico for two months and I didn't use MercadoLibre, but I wish I tried it because I guess I didn't think about it when I was living there. I tried to use Amazon. It was a pain. The shipping and delivery infrastructure in Mexico is a total pain. And I think Mercado Libre, if they're going to succeed here in building and replicating what they've done and say other markets are getting strong margins, they're going to have to invest a lot in CapEx. However, that gives, I think anecdotally, that would give them a huge advantage over either amazon if amazon doesn't invest in the capex or anyone else that has to ride because there's no ups that's good there's no fedex that's good uh it's really really expensive

to ship stuff uh on its own amazon was not good i just didn't use it so i didn't use really e-commerce at all when i was there but i wonder because of what mercado libre has been talking about in their investor reports with shipping times coming down and all that good stuff for the customers in Mexico, Brazil, and Argentina. I wonder if I would have had a much better experience with MercadoLibre. And it wasn't like I was in a city. So it wasn't like I was back in some little resort on the beach. It was where the people they're targeting, the citizens that live there over the long term would be using as well. But it's interesting. I also think Given that position in a lot of their markets where the delivery stuff is not up to speed or up to where it is in a lot of the Western markets, that gives them a ton of room to invest in the business, especially the logistics, while getting solid returns on invested capital, which seems great.

And that kind of leads up into the future growth opportunities. Ryan, you have logistics here, right? Yeah, I know it's boring, but it feels like this is how they solidify the most out of any other segment of the business, which is simply investing in that fulfillment center. I feel like that's a very basic thing to say for an e-commerce business, but that's going to be the biggest differentiator between them and their competitors. And from my understanding, it's at such a stage that if they're able to do it, it's such an advantage relative to their peers. Exactly. I'm going to share my screen for a quick second to show the chart here. Let me get this on the full screen. One second. Okay. Ryan, are you seeing this on capital expenditures? I mean, in 2017, so say five years ago, they did $55 million in CapEx. And in 2021, they were at close to $600 million at about $573 million. The amount of CapEx they put in

has been astounding. And each year they've done this, they've been free cashflow positive. So their ability to reinvest here, I wonder how this chart will change or grow over the next years. Are they going to be investing a billion dollars in CapEx a year? And how much of an advantage can that give them over the next decade? Very, very interesting to look at. And that CapEx has just exploded, especially as they've tried to invest in Mexico. Anything else there, Ryan, before I move on to Mai? The other one for me, and this is maybe the pessimist in me, is slowing down the lending business.

Taking those dollars and putting it into logistics instead. yeah i agree with you yeah but that's what they're doing they they said on the last call that they're going to stop it was either stop lending or like really tighten the the conditions on what they determine as credit worthy um that for me i just i get so worried when i see that the loan volume grew 10x in two years like yeah it feels like it was being exploited or something got away from them. Yeah. Luckily, it didn't grow too big, but yeah, I agree. And I could have used that to- And it was actually... Oh, sorry. Go ahead. I was going to say, you could have used that to invest in even more CapEx

and further try to widen your moat at a quicker pace. Yeah. And you mentioned the 570 million there and the purchases of property and equipment, and they actually label in the 10K, they say they spent 630 million in CapEx in 2021. I think they also include investments in intangibles yeah i was i didn't include intangibles yeah they do have a little bit of that so yeah i would more warehouses more more vehicle fleets i know they've they've bought up a lot of airplanes as well um yeah and latin america's got yeah it's a tough geography just like the united states this is not we've looked at coupang before this is not Seoul, South Korea. This is going for Mexico City, Guadalajara, Cabo, Cancun. Yeah, it's tough. And

that's just Mexico. They got all these other countries as well. But speaking of which, my future growth opportunity is Mexico, which I would say, at least from a volume perspective, has been their best executed country over the last few years. If you look at the App Store ranking, shoppers are flocking to MercadoLibre in the nation. And I could see a gaining market share for many, many years once they build up again. We talk about the infrastructure again, once they build out a better offering for consumers, especially in the large cities. I mean, you got a huge population, you got strong demographics, and you got an e-commerce industry really ripe for the taking that is behind a lot of other countries just on, say, the take up of

e-commerce in Mexico. I would not be surprised if MercadoLibre is doing $10 billion in revenue alone in Mexico five to seven years from now. Now, for reference, through the first nine months of 2017, the Mexico segment did $58.3 million in sales through the first nine months of 2022. It did $1.26 billion in sales. Right now, the country has extremely low margins for Mercado Libre, and that's bringing down their consolidated margins. But that should change, I think, over the next three to five years as expenses start to scale up. Let me share the screen once more and show some of these charts. I mean, can I go through them? Because I think it's very important for anyone to look at. Okay. So if you look at the difference between contribution margin

between two of their different countries, you have Brazil, which has been increased, say, just under 20%, something like that. But if we look at Mexico, their contribution profit was actually negative. And if we look at the margin here, it has only just gone positive in that country. And there's no reason that leads me to believe that over time, Brazil and Mexico will have that different margin structures because you're selling the same exact product.

So I think that's... Tracking Mexico's contribution margin, I think is very, very important for investors. Would you agree with that, Ryan? Yeah, and it's one of the... It's the second fastest growing geography for them aside from Argentina. And over five years,

has been the fastest let me look at they they've grown that since 27 through from 2017 through 2021 mexico grew revenue at 118 year over year argentina was 34 brazil was 54 and mexico has been highly impressive and they're the number one in the app store there so if i'm not mistaken and the demand seems to be there it's more about i think just being able to service that demand yep they're winning versus Shopee and Amazon. So yeah. All right. Highlights and lowlights. Ryan, what do you like, dislike about this business? I think the opportunity is massive. Internet penetration rates from Latin America have gone from 35% to 72% over the last decade. And Latin American e-commerce volumes represent only 13% of overall sales. It's much higher

in the more developed markets like the US. Well, yeah, it's getting closer to 20%, which is a huge difference. Yeah. And then the second one, and this is kind of obvious, I guess, but scale and being early. So for an e-commerce marketplace, obviously scale is huge. It provides a lot of optionality. And once you have enough users, there's a lot of ways to increase your margins, like selling the ads, providing logistic services to third parties. And once you're kind of ahead of the game and you've got the scale,

you're able to invest in your logistics infrastructure at a faster rate than your peers, which is going to further deepen your competitive advantage, which seems to be what's going on right now with MercadoLibre. I find it weird that Amazon hasn't been able to win because I would think they would have that advantage. Yeah, I don't.

what's interesting is I think they maybe could, and it's weird because it's close to the United States. So maybe there would be some overlap, but I've read some things about how Amazon has just dropped the ball in Mexico. And I think it's because it's not their top priority. The top priorities are what? United States, Europe, India, and then a few East Asian markets like Japan. And I don't think Mexico has been their priority, and especially because they do many other things besides e-commerce. And maybe MercadoLibre with their focus has had a much better time. If we look at the app store rankings again, Amazon was ranked three and five in Mexico. So not bad. But MercadoLibre was one in both app stores.

All right. Anything else, Ryan? I guess MercadoPago just looks like a really solid business. I think it benefits from the strength of the marketplace and it also helps marketplace at the same time. And there's a great network effect anytime you're able to reach scale with a peer-to-peer payments provider. And it seems like Pago has been able to do that. The other one, raised convertibles at a great time. So honestly, there's tons of highlights for this business. I know it's like an overused term, but optionality galore here. Low lights for me, though, Mercado Creditos, the loan portfolio. Now, having watched what happened with StoneCo, and I don't have a complete understanding of the situation, but they basically got burnt on their loan portfolio, partly because of the government in Brazil.

And I think it collapsed the business or the stock like 50%. on. I am very tentative whenever I see a giant loan portfolio. Loans past due, according to MercadoLibre, grew by 150% over the last nine months. It's a lot. It's a lot. And then I think it was in their press release, they said, we took a deliberate decision to slow originations this quarter as we recognize the risks associated with a weaker lending environment, particularly in Brazil. That might help them on future loans, but I think there's a chance that they have to write down a big chunk of their loan portfolio, which is going to definitely hurt.

At least it's going to impair their assets. So that'll hurt profitability. Second one for me is the regulatory or legal risk. I don't necessarily trust the operating environments of Brazil and Argentina, and I don't know them very well. So that's the other one, which it's, and I know this is like the most boring cop-out answer, but what don't I know about those markets? That's, that's a big concern for me. Yeah. All right. My highlights, the execution over the last decade has been outstanding. They copied a lot of what made Amazon successful. But I think that is a very good thing. And on top of copying Amazon, they're building a really legitimate financial technology company through Mercado Pago, which if it was its own separate business, that might have been, again, that would have been a bubble valuation. but in 2021 would have gotten an absurd valuation. I'm not saying it deserves that, but again, I think Mercado Pago with the execution there, if we look at FinTech revenues,

they have grown by 64% since 2017, and in 2021 were $2.4 billion. So there's a ton of value there. And I think that makes it, it's definitely not as big as PayPal, but it's as big as someone one like Square. It's probably as big as Shopify's payment business. There's a lot of execution they've done there. And again, the moat should be strong with Mercado Pago with that peer-to-peer stuff, plus the switching costs with the Shopify type websites, payment processing on Mercado Libre or on the marketplace. They've executed much, much better than Amazon has in that regard. Second highlight is the growth of Mercado ads. Ads, as we know, high margin can mitigate a lot of the margin risk that you have in areas where, say, infrastructure is poor, or they'll need a

lot of capital investment, or there's foreign currency headwinds, stuff like that. Ads revenue was 1.3% of GMB in Q3 2022. That's up from 0.9% a year ago. So it's growing faster than GMB. And I think generally, it could reach probably 3% to 4% over the long term. So there's plenty of room to increase advertisement over the next decade, and it can be extremely high margins. Third one, Ryan already talked about this, and we've talked about it before, is building out the fulfillment and warehouse infrastructure with, again, how little there is of fast delivery right now in a lot of the major Latin American markets. I think it could be even better for them to invest in e-commerce infrastructure instead of that credit lending

stuff or just prioritize that. Maybe they are now, but I think that's where the moat comes from and how MercadoLibre can separate itself from competitors like Shopee and Amazon who might not be as focused in these core markets. Lowlights though, I think the number one concern for a US investor is foreign exchange risk and political risk. Over the last decade, Argentina has really kind of moved close to hyperinflation. The inflation rate is currently at 88%. Brazil and other Latin American countries also have recent political track records that make me nervous for business owners, to say the least. I like Mexico a lot, but the other ones, not so much. And they experienced this with Venezuela, I believe. And again, I was just glancing at this

because it wasn't too important for doing the show today. But they were in Venezuela. They basically had to write down a lot of that country. We would know what has gone on there, the hyperinflation and all that. Argentina is a huge part of this business, highest margins for them right now. That's just a big concern for me. What happens if Argentina goes into hyperinflation? They almost are right now. And it seems like they're doing fine, but that's got to be a head wind eventually. Second low light is the lending stuff that we already discussed. I'll give another stat here. Installment payments are now 25% plus of purchases through Mercado Pago. So if someone is making a purchase, I believe for an item, whatever, could be a Mercado Libre, could be off

of it. They're using installment payments, which is basically buy now, pay later. They hold billions of dollars in receivables. We talked about how that could be bad. They also have been hyping up their AI pricing models. I'm not sure. That just makes me, a lot of the words, a lot of stuff that's going on there makes me nervous. And the other low light that also gives me a little bit of concern, but it's not a huge deal. It didn't affect the business that much was the embracing of cryptocurrency near the top of the bubble. Don't think it was a good look. It wasn't a large bet, but I don't think it was good for the brand long-term. It couldn't have been by trying to get all these people within Latin America

to embrace crypto right at the bubble peak. I think they were partnering with Paxos, and that is a really sketchy company. Everyone has missteps, but that was definitely one, and it's a low light for me. I would hope within Mercado Pago they do not

embrace cryptocurrency further. Okay, bull case, let's wrap things up here. Ryan, what do you think needs to happen for this to be an investment? Well, they have to continue growing their volume, GMV and TPV, so merchandise volume and payment volume. So basically Pago and Marketplace have to continue to grow and they have to sustain their take rate. Simon Erickson has actually talked with us about this before. And he says something interesting, which is that take

rates are the most telling sign of whether MercadoLibre's big infrastructure investments and digital payments are being valued by the buyers and sellers on its platform, which makes a lot of sense. And I think it validates the spend in those areas. And then I guess this is a bull case. So not only do those businesses have to grow, but I think at the current price, the GMV and GPV have to grow by 20% annually over the next five years, and they have to sustain their take rate for this to be a market-beating investment, that's probably going to lead to the mental math here is like, I'm guessing that's $2.5 to $3 billion in operating income at a 10% margin, I'm guessing. So given it's a $44 billion

EV, I think those returns would be fine. Those returns would be good if you're getting 20% plus growth. Obviously, that's optimistic outlook, but they've been able to do it for the last five years. And there is a ton of different ways they could grow. And this is a business that will probably trade at a premium for a long time, just given their place in the markets that they serve and the opportunity in those markets. Yeah. I think through that logic, and especially with their track record of growth, if they're still growing at a high rate, they'll definitely get a premium however i think maybe the latin america stuff should counteract that and maybe right do you agree or disagree with that where since it's in latin america i

maybe would want a little bit of a discount or maybe expect that i get the the uncertain regulatory environment discount but the opportunity is so huge that i think it bodes well for future growth that I don't know if it really makes sense to give it a discount. If they put up that track record of growth, even in USD terms. Yeah. My bull case is similar. They've grown revenue, even in USD terms at a rapid rate this decade. It was such a large market opportunity in the early days of e-commerce in Latin America, the bull cases that it continues and they start generating $30 billion, $40 billion in sales annually. I think a margin expand, which again, last quarter, they hit 11%. I know there is some seasonality. So

I would bet Q3 has larger margins than Q4 just because of the holiday season. So if they're at 10%, if margins are at 10%, business could be doing $4 billion, maybe even $5 billion in operating income if they really scale up that advertising business. And the fintech stuff probably will have higher margins as well, which I think would equate to solid returns from this share price. You could probably say maybe if that happens, you'd have a double within five years. I know shares outstanding have grown a bit. So take that into consideration. Just for reference, they've grown at about 2.8% a year. So that could be a headwind. Again, I think it would probably still stay a headwind.

But yeah. All right, Ryan, what's your bear case? I don't know if I'd call it the bear case, but I'm looking at basically two risks. The first is the loan book risk. It's not terminal. It's not big enough. Even if they had to write off half of their loans as uncollectible, that's what, $1.4 billion? That would suck, but that's not going to completely kill the business. But it could be, obviously, a headwind to earnings, and there's no way that if that happened, the stock would just forgive it. That would be reflected in stock performance. Second one is multiple compression. I know that's also boring, but anything less than 20% growth in reported currency, I have just a hard time imagining that's going to lead to market beating returns. There's going to be multiple compression. The growth needs to outpace multiple compression here. I think everyone's aware of that. Look, they've grown revenue at 50% for the last five years. That is highly impressive. It's not going to be 50% for the next five. Well, if that happens, I mean, this is going to be one of the biggest businesses in the world, but you need to expect that growth rate to still stay in the healthy double-digit range. Yeah, yeah, I agree.

What do you think about, is competition a part of the bear case here? I like MercadoLibre's competitive position, but I don't think it's as strong as maybe some other markets people looked at. For example, Coupang in South Korea seems to have a much stronger competitive position versus anyone else, where I think MercadoLibre is winning and should win over the long term across Latin America versus Shopee, where Shopee might win in a few markets. but generally I think MercadoLibre will win and it's probably a large enough market where there can be multiple winners but the competition is definitely yeah I think it's definitely

could be a bear case I don't think Amazon is one though what would be interesting is to see if Amazon pulls away from Latin America if they did I bet Mercado Libre would the multiple would expand yes

and they might sell some of that whatever infrastructure that Amazon has to them but yeah because Amazon wants to get profitable now so I just kind of thought about that like Amazon wants to get profitable over the next five years do they exit this market that's not there

in their top five the other thing I'm thinking about here is you look at CapEx that's, so CapEx has jumped. And if you compare it to like Amazon, they're doing $600 million a year, let's say in property and equipment purchases. The real estate and the competitive, like I would imagine the fulfillment center real estate is not nearly as competitive in the markets that MercadoLibre serves or nearly as high of, it's not going to be as high of a price tag as what Amazon's doing. So I kind of have to keep that in perspective. And then on top

of it, I imagine real estate prices have come down a bit over the last year or so in Latin America, just given what interest rates have done. I don't know for sure whether that's true. I know Mexico, the average selling prices on homes have come down slightly, but that means they could be buying more real estate with the same amount of capex. Yeah. It could be a better environment if they're still growing while interest rates are rising. Although if they're financing that with finance, with lease liabilities, it might not be... From an affordability perspective, it might be the same. Wouldn't you think a recession is almost a good thing for them? I think so. Competitive positioning wise, if you're looking out 10 years, wouldn't you want

every other you would want higher cost of capital higher barriers to entry because everyone's struggling and they're the one that's still afloat and they're the one that can reinvest yeah i agree i think that i agree with that i think to a point though we don't want argentina get a little nervous about that inflation rate so you don't want the countries to totally collapse. Yeah. Yeah, that's true. My bear case is going to be,

it's simple. I mean, the stock trades in earnings multiple north of 50. That's it, right? That's the bear case is that they don't grow into that. I think there's some risk that margins could be permanently low.

And I also think foreign exchange could be a nuisance here as they stop growing at such a quick rate. And then the financial services is somewhat of a black hole for me. I can understand the e-commerce part fairly well. It's the same sort of business that goes around the world, right?

But the Mercado Pago business, it's just harder to understand. So, yeah. All right. More or less interested. Let's wrap things up. Final thoughts here, Ryan. More interested. Yeah, more interested.

I think this is a really quality business and it feels very similar. I know it gets this parallel all the time, but it does feel similar to Amazon's retail business. And specifically, Amazon retail like 15 years ago. Yeah. I don't know if I would have bought Amazon 15 years ago, but I don't know. There's definitely a lot to like about the business. The only thing really holding me back is, well, valuation and then just the markets they operate in. Yeah, I like this business as well, but I do think it deserves a discount compared to other companies just because of the countries it operates in.

So yeah, I'm more interested, but I would not be more interested in actually buying the stock unless the, well, I guess at today's prices, unless the stock went down 50%, it's pretty expensive versus the risk they have. It's a double-edged, like the markets they operate in are a double-edged sword because there's a whole bunch of uncertainty and you don't know what inflation is going to look like. And the operating environment is just very different from the US. but it's a like significantly larger opportunity for them for them to serve yeah i agree so that's why i'm more interested but just no way at these prices um all right let's wrap things up the stock for next week uh i have to confirm go daddy go daddy go daddy okay well their website software a little bit on the opposite end of the spectrum because there's not as much e-commerce as definitely not as much as MercadoLibre.

Don't know that business solutions. They might have some nice business solutions for their customers. Maybe. We will investigate next week. All right. That's going to do it for this episode. Remember, we are not financial advisors.

Anything we say on the show is not formal advice or recommendation. We are general partners at Arch Capital and clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next week. Thank you.