Map of South America

(Source: Shutterstock)

MercadoLibre, Inc. (MELI) is quickly becoming the eCommerce king of Latin America. It is the largest player in the region with revenue of more than $2.8 billion. Starting as an eBay clone back in 1999, the company has since expanded into several eCommerce segments that have turned it into the Latin American Amazon.com (AMZN), including online storefronts, digital payment solutions, credit services, advertising, as well as shipping and logistics.

As with other eCommerce companies around the world, MercadoLibre has benefited tremendously from the pandemic, growing revenue by 123% YoY in Q2’20. This extraordinary performance comes in a region that has not only been devastated by COVID-19, but has extremely poor macroeconomic conditions.

MercadoLibre financial results for Q2 2020

(Source: MercadoLibre)

The “Missing Middles”

There are many economic challenges within Latin America, much of which boils down to the two “missing middles”: the missing middle class and the lack of mid-sized corporations. Both of these missing middles feed on each other. The lack of a middle class makes it difficult for regional companies to target customers with disposable income, thus retarding revenue growth. And the lack of mid-sized companies makes it difficult for the population to rise into the middle class. As it stands, more than 60% of workers make less than $20 per day, and the economy is dominated by large mining companies and financial institutions:

Latin American firms have yet to overcome a persistent polarization between a few very large companies and a long tail of small, unproductive firms. The missing middle tier of companies reflects the lack of dynamism: Latin America has fewer firms that have scaled up revenues above $50 million than higher-growth emerging economies do, which also translates into fewer large growth companies.”

(Source: Latin America’s Missing Middle Report, McKinsey Global Institute, May 2019)

With the social, political and macroeconomic difficulties in Latin America, it is amazing that MercadoLibre has managed to rise up to become a substantial mid-sized company with an economic moat. The environment is difficult for potential competition for economic and political reasons. But it also presents a challenge for MercadoLibre because most of the population does not have disposable income, making it difficult for the company to tap into a growing consumer base.

Pandemic Hits Hard

With regard to COVID-19, Latin America is a tragic story, primarily due to the large population of lower-class workers not able to take time off work to self-isolate or work from home.

Five of the top 10 countries in the world for infections are in the region, which accounts for 34% of global deaths despite having only around 8% of the planet’s population…

With up to 58% of workers in the informal sector, according to the International Labor Organization (ILO), many are unable to quarantine or they would starve.”

Latin America – Growth of Internet Access

Despite the extreme poverty and anemic GDP growth, Latin American countries have experience fairly significant growth in internet access in recent years. As of 2018, 68% of the population made use of the internet, “almost twice the share in 2010”. Digital technologies are one of the few bright spots for the region and provide the best hope for raising productivity and middle-class development, provided they are embraced and adopted at scale.

Even in a time of social and political tensions, Latin America has a new opportunity to revitalize inclusive growth – and new tools to achieve it: digital technologies that can raise productivity growth and develop the missing middles, if embraced and adopted at scale. Digital entrepreneurship is already on the rise, with new platforms and applications from e-commerce to digital finance springing up across the region; several digital start-ups have achieved valuations of $1 billion valuation or more.”

(Source: Latin America’s Missing Middle Report, McKinsey Global Institute, May 2019)

Digital Transformation – The Future of Latin America

GDP growth in Latin America is largely a function of labor force expansion, accounting for 72% of GDP growth between 2000 and 2016. This was primarily due to women entering the job market. But the times are changing, and the region is experience low fertility rates and little job growth due to falling commodity prices. Latin America is losing ground relative to other emerging markets where GDP growth has been driven by productivity growth more so than job growth.

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Latin America per capita GDP and future projections by country

(Source: Latin America’s Missing Middle Report, McKinsey Global Institute, May 2019)

The prime hope for Latin America’s economic future lies in the hands of digital transformation. MercadoLibre is playing an important role in the transition, by offering an online marketplace that enables companies to extend their reach in selling their goods and services, and by offering offline services that allow distance sales to customers without a debit card. The company is also tackling other regional issues such as improvements in cross-border trade, enabling merchants to process food aid cards, managing shipping disruptions through the pandemic, and partnering with global companies such as PayPal (PYPL).

… digital can and is already creating new, more productive jobs in Latin America – and the potential productivity boost it could give to the region’s economies as a whole could offset the drag from its changing demographics.”

SUmmary of Latin American online/offline metrics by country.

(Source: MercadoLibre)

Economic Recovery

MercadoLibre operates primarily within three Latin American countries: Brazil, Argentina, and Mexico. More than half of revenue is generated in Brazil, as shown in the chart below.

MercadoLibre

(Source: author)

Brazil is expected to recover to a pre-pandemic GDP level in 2022, whereas Argentina, and Mexico will take somewhat longer to get back to normal.

Latin America projected GDP levels by country

(Source: Economic Research: Latin America’s Pre-COVID-19 Growth Challenges Won’t Go Away Post-Pandemic, S&P Global, September 24, 2020)

Stock Chart

MercadoLibre stock has been quite bullish this year, consistent with the company’s financial performance during the pandemic. As can be seen from the chart below, the stock is currently breaking out to new all-time highs.

MELI stock chart

(Source: Yahoo Finance/MS Paint)

Stock Valuation

There are numerous techniques for valuing stocks. Some analysts use fundamental ratios such as P/E, P/S, EV/P, or EV/S. I believe that one should not employ a simple ratio, and the reason is simple. Higher-growth stocks are valued more than lower-growth stocks, and rightly so. Growth is a significant parameter in discounted cash flow valuation.

Therefore, I employ a technique that uses a scatter plot to determine relative valuation for the stock of interest versus the remaining 170+ stocks in my digital transformation stock universe. The Y-axis represents the enterprise value/forward gross profits estimate, while the X-axis is the estimated forward Y-o-Y sales growth.

The plot below illustrates how MercadoLibre stacks up against the other stocks on a relative basis based on forward sales multiple.

Scatter plot of fundamentals for 170+ digital transformation stocks. EV/Sales versus revenue growth

(Source: Portfolio123/private software)

A best-fit line is drawn in red and represents an average valuation based on next year’s sales growth. The higher the anticipated revenue growth, the higher the accepted valuation.

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In this instance, MercadoLibre is positioned well below the best-fit line, suggesting that the company is undervalued relative to its peers. I have also accented eCommerce giants Amazon.com and Alibaba (BABA) for comparison purposes. All three companies are undervalued on a relative basis, but MercadoLibre has the highest future growth expectations based on analysts’ estimates.

The Rule Of 40

One industry metric that is often used for software companies is the Rule of 40. The rule provides a single metric for evaluating both high-growth companies that aren’t profitable and mature companies that have lower growth but are profitable. Revenue growth and profitability (expressed as a margin) must add up to at least 40% in order to fulfill the rule. Analysts use various figures for profitability.

Given the pandemic-related massive revenue growth I am going to forego my normal Rule of 40 calculation and instead present a similar forward-looking calculation that I refer to as the Efficiency Score Estimate (“ESE”).

The ESE is based on analysts’ estimates mean value of next year’s (“NY”) sales growth plus NY earnings margin. The formula for earnings margin is:

100% * (NY EPS estimate * shares outstanding) / NY sales estimate

Scatter plot of forward-looking Rule of 40 metric for 170+ digital transformation stocks

(Source: Portfolio123/private software)

As can be seen from the above chart, the ESE for MercadoLibre is approximately 40% and puts the company within the top 25 of the 170+ digital transformation stocks that I track. 40% is not bad considering that analysts’ estimates are usually quite conservative for this type of stock.

The ESE score implies that MercadoLibre fulfills the Rule of 40 metric, suggesting that this company has a healthy balance between growth and profitability. Amazon.com and Alibaba are highlighted for comparison. Alibaba scores higher than MercadoLibre, while Amazon.com scores much lower.

Which eCommerce Company Makes The Best Investment?

When it comes to eCommerce, Amazon.com, Alibaba, and MercadoLibre are all terrific investments. I should also throw in Sea Limited (SE) as another possibility, a company that operates in South East Asia. Unfortunately, I don’t track Sea Ltd. because not all of the necessary financials that I employ are available in my database.

Amazon.com: The US government has anti-monopoly issues with Amazon.com, making it a less attractive investment for some. It is possible that the company may be split up, making it difficult to exploit advantages between the various markets that the company serves. On the flip side, a breakup of the company may possibly unlock value, which may make this an attractive investment.

Alibaba: Alibaba is the Chinese eCommerce giant and may be subject to USA-China trade wars. The company could, in the future, be targeted for security concerns similar to what is happening to TikTok (BDNCE) and Huawei.

Sea Ltd.: This is an excellent company operating not only in eCommerce but also online games, so it is not entirely an eCommerce pure play. I should mention that Sea Ltd. does have some presence in Latin America.

MercadoLibre: doesn’t have to deal with government-related anti-monopoly actions, or trade wars with the USA, and is therefore more attractive from that perspective. The company also has an economic moat, making it an attractive investment that should grow as Latin America embraces digital transformation and the economy recovers. However, investors must also consider the future prospects for Latin America, which are less promising than those of other emerging economies.

All in all, I believe that MercadoLibre is one of the better eCommerce investments, and I believe that it will prosper as Latin America progresses on its digital transformation, something that will help to grow the region’s middle class.

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Investment Risks

There are several risks that investors should consider before investing in MercadoLibre. First of all, I view the current stock market action to be reminiscent of the dot.com era, immediately prior to the crash starting in 2000. Technology stocks were performing well beyond what many analysts considered acceptable valuations. It wasn’t long before the market turned into a disaster, and the same could happen here, although I believe that there is much more substance behind the internet companies than existed 20 years ago.

MercadoLibre’s performance is very much tied to the Latin American economy, which has been severely depressed and could take longer to recover than other emerging economies. No one really knows how long the recession will persist or how deep it will get.

This investment also depends on Latin America’s digital transformation, the population’s internet usage, and ability to create companies in the digital economy.

Summary and Conclusions

MercadoLibre is an eCommerce leader in Latin America, primarily within three countries: Brazil, Argentina, and Mexico. 56% of revenue is generated in Brazil, the country expected to recover the fastest from the pandemic. Latin America has a high level of low-class workers and has been hit harder than any other region in the world, with 8% of the world’s population but 34% of the COVID-19 deaths.

MercadoLibre’s financial performance for Q2’20 was phenomenal, with revenue up 123% YoY. Its forward-looking Rule of 40 metric, or ESE, is approximately 40%, putting this company within the top 25 of the 170+ digital transformation stocks that I follow.

There are several broad-based eCommerce investments, including Amazon.com, Alibaba, and Sea Ltd., all of which are excellent investments. But Amazon.com does anti-monopoly issues that may be a detraction for investors, and Alibaba could be an issue for USA-China trade wars or Western security (although not an issue at present). Sea Ltd. may also be an attractive eCommerce investment, although I don’t track it due to missing fundamentals in my database. MercadoLibre is an attractive investment due to its economic moat and Latin America’s ongoing digital transformation, but against the backdrop of anemic GDP growth.

I find that MercadoLibre stock price is undervalued on a relative basis considering its future revenue growth expectations and forward sales multiple. Therefore, I am assigning a Buy rating to the company.

Businesses need to convert to the new digital era or risk being left behind. And the pandemic has dramatically accelerated this paradigm shift. You can take advantage of this opportunity by subscribing to Digital Transformation, my private investment community. The service provides four high-growth portfolios, each with explicit end-of-week buy/sell signals. Performance statistics are are provided in the weekly reports.

Don’t miss out on the digital revolution. We are still in the early innings and there are plenty of high-growth investment opportunities out there waiting for you!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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