By Dan Su, CFA
With strong brand recognition and well-established operations across all major economies in Latin America MercadoLibre (NASDAQ:MELI) remains one of our favorite investment ideas to capitalize on the region's e-commerce boom, which has been driven by higher Internet adoption and disposable income. We forecast average annual growth of about 24% for the next decade and modest operating margin expansion following a period of investment in IT infrastructure, marketing, and payroll during the next several years.
Nevertheless, we think the stock--trading 37% above our $65 fair value estimate--overstates these lofty growth expectations, and we would suggest that investors wait for a wider margin of safety. Signs of a global economic slowdown and softening commodities demand are likely to weigh on export-driven Latin American economies and their currencies in the near term, prompting investors to scale back from emerging-market exposure; this could send the stock down in the coming months. Additionally, Amazon (NASDAQ:AMZN) and eBay (NASDAQ:EBAY) lurk as potential rivals in Latin America.
Upside Potential Abounds for Market Leader
MercadoLibre commands a leading share in Latin America, where e-commerce is at an early stage of the growth trajectory. More than 12 years of strong execution has turned MercadoLibre into an e-commerce powerhouse in every major Latin American economy, which collectively has more than 500 million people and a combined 2010 GDP of close to $5 trillion, according to the World Bank. Research firm IDC ranks MercadoLibre as the top player in the region, with monthly unique visitors (33 million) nearly 3 times that of its closest competition. A strong brand, well-established operations across the region, and a multiprong growth strategy should position MercadoLibre to ride the e-commerce boom in the years to come.
E-commerce accounts for only about 2% of total retail sales in Latin America. We believe a preference for cash transactions and high shipping costs as a result of less-developed transportation infrastructure were key bottlenecks, although the situation has improved steadily. Convenience and access to merchandise hard to find in physical stores are driving shoppers online. Third-party research showed that online retail revenue was $15.4 billion in 2010 and is likely to grow 21% annually to $27.5 billion by 2013. Meanwhile, the number of online shoppers is expected to grow 20% annually to 63.7 million by 2013.
Given MercadoLibre's position as a hub of e-commerce traffic in the region and the attractive growth outlook for online retail, we are comfortable with our forecasts that the firm can deliver top-line and free cash flow growth in the 20s during the next 10 years.
Upside potential abounds in the online marketplace, payment services, and advertising. We expect growth in the online marketplace to come from expanding buyer and seller communities and higher traffic conversion as users embrace online shopping. In 2010, MercadoLibre reported 52.9 million confirmed registered users, or 24.9% of total Internet users in Latin America, and items sold per registered user was only 0.74. During the next 10 years, we expect Internet penetration to rise from less than 40% to slightly more than 70% as the cost of Internet access falls. Meanwhile, MercadoLibre should be able to raise its share of Internet users to 36% by 2015 and 48.5% by 2020. We also expect the firm to convert more browsing traffic into transactions. In 2010, only 26% of registered users did transactions on the MercadoLibre platform. MercadoLibre's efforts to expand into popular categories such as apparel should help broaden its appeal to shoppers. As such, we model gross merchandise volume to grow 22% annually during the next 10 years.
Management has left room for increases in the take rate from transactions, although it says the current focus is on reducing the hurdles for novice users to try MercadoLibre's service, indicating there is no rush to raise commissions. The current commission rates of about 4% that MercadoLibre charges on transactions are significantly lower than eBay's 7%, but fairly comparable with the 3%-5% that Chinese e-commerce giant Alibaba charges.
We also see substantial upside from MercadoPago payment services, which processed only 20.5% of marketplace transactions in 2010 and 27% in the first half of 2011. In comparison, PayPal processed 60% of eBay transactions globally. The low penetration was attributable to the slow rollout of the service in key markets since the service debuted in 2004. Moreover, the traditional preference for face-to-face cash settlement and payment through bank transfers in the region took time to change.
The firm has taken several steps to encourage users to adopt its payment services. It is lowering costs for customers and coming up with more favorable financing options, including interest-free installment payments. These measures, coupled with a more streamlined user interface and stepped-up efforts to fight fraud, should help MercadoLibre to convince more customers to use its payment services. Off the MercadoLibre network, e-commerce ventures that look for convenient payment services are another promising growth opportunity for MercadoPago services, although at the current stage, their contribution is probably negligible.
Brand and paid search advertising has attractive growth opportunities as well, given a loyal user base and increasing site traffic on MercadoLibre properties. Unique visitors to MercadoLibre sites are estimated at 33 million on a monthly basis. Thanks to the firm's position as a gateway to e-commerce traffic, regional and global brand names are flocking to its sites to do display advertising. As MercadoLibre has built separate sites for each country, the advertising can be fairly targeted and effective. Paid search advertising, which has outpaced display ads in recent quarters, has benefited from growing adoption among sellers that use search to generate business leads.
But Competition Looms, and Stock Is Overpriced
We see potential threats from Amazon and eBay, both drawing meaningful traffic from Latin America despite the lack of websites dedicated to customers in the region. Although Amazon and eBay accounted for 4.2% and 2.8% of total e-commerce traffic in Latin America according to comScore, both players offer premium branding and access to merchandise sourced globally, which can be particularly appealing to affluent consumers in the region.
However, we expect MercadoLibre will give its rivals a run for their money should they decide to enter the region directly. After 12 years of strong execution, MercadoLibre has dug a narrow economic moat with the largest registered user base in the region and benefits from a network effect. Deep understanding of local preferences in e-commerce and a payment network that is plugged into the regional banking system are also competitive advantages that are hard for rivals to emulate. If history is any indication, it won't be easy for Amazon and eBay to make inroads in Latin America. Attempts by both firms to build up local operations internally in another emerging market, China, were thwarted by shrewd local competitors in the early 2000s. Both had to acquire local players to gain access to the market, and neither is particularly successful there. With an 18% stake in MercadoLibre, eBay will more likely partner with the firm to tap Latin America or eventually make a takeover bid, in our view.
We think the market has overlooked the regional economic risks inherent in MercadoLibre's stock, which is trading at a 37% premium to our $65 fair value estimate. Our valuation model already reflects an optimistic view of the firm's near-term growth. We forecast revenue growth of 36% and 31% in 2011 and 2012, with operating profits increasing at a similar rate.
Economic headwinds and lower investor appetite for emerging-market exposure are downside risks in the near term that may send the stock down in the coming months. MercadoLibre's major markets, such as Brazil, Argentina, Mexico, and Venezuela, look particularly vulnerable to cooling global demand for commodities like iron ore and oil, as well as to shrinking consumer appetites in advanced economies for imported goods.
Currency fluctuation is something else that MercadoLibre has to wrestle with. During the past several years, a steady 30% appreciation in the Brazilian real against the U.S. dollar, the reporting currency, was a clear tailwind, but the sell-off in Brazilian and other Latin American currencies this summer indicated investor unease about the outlook in the region.
We suggest that investors wait for a pullback in the stock price to allow a sufficient margin of safety, especially given the firm's very high uncertainty rating.