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3/23/08

Mercado Libre (MELI). Hype is no help

Is it possible to talk a bit of sense about Mercado Libre (MELI)? Here are the rules of the game:

UNO: Stop listening to the inane chatter.
DOS: Stop reading the pumps.

TRES: Find the facts.

So, rule 1). Forget the shills and pump merchants (yeah, you know who they are) who scream “buy BUY BUY! just cos it’s internet, it’s growth, it has eBay (EBAY) as a minority shareholder and it kinda-but-doesn’t-quite remind you of Baidu (BIDU). The day that you stop believing the TV-sponsored constant hype is the same day you’ll turn into a better investor who isn’t chasing the crowd, chasing the market or wondering why they aren’t making the money they were told they’d make.

But wait up, rule 1) also means you shouldn’t give any time to the automatic knee-jerkers who oppose a stock and then find a few after-the-fact reasons. In MELI’s case, the bashers just go “yeah well, it’s Latin America, isn’t it dude?” and trot out some BS about Hugo Chávez or inflation or cyclical growth or how ‘they don’t even have color TV down there’ yet without knowing what the hell they’re talking about.

As for rule 2), here’s just one example another type of pumping going on round this stock. I read a piece on MELI in Forbes magazine last week, which typifies the second kind of trap to avoid. Now, cos it’s in Forbes you’d expect it to be well written, and of course all the facts and figures are correct, but I couldn’t help noticing how the figures have been cherry-picked to suit the occasion. Then I noticed the author Sramana Mitra saying “One that has really caught my eye is MercadoLibre as if it was something new, then a little further on disclosing she was invited by MELI to do some consulting and advisory work for them last year (presumably remunerated). So two minutes worth of Googling later, it turns out that Ms Mitra has written four different articles on MELI since late November. Well, I suppose it ‘caught her eye’ four times……….

Anyway, let’s leave the people with pre-set agendas to one side, find some facts about MELI and see for ourselves if it’s any good. The place to go is the SEC filings of course, and then you can whack a few charts together if you feel that way inclined. Then once you see how the company has been stacking up you can forecast how things will go in the future. First thing to note is that MELI is a growth play and net revenues are the beginning and the end of the story; if sales don’t keep growing at a good clip, this stock is toast. So here’s a chart mapping out what a decent sales growth should look like from here.

It shows how revenues grew as a percentage of the previous quarter in 2007, and then projects into the future what I think MELI has to do to keep up the good work. So from that we can do this chart, and break down the three main components of net revenues, costs and the resulting gross profit per quarter. Again, the projections are the important thing here, cos if you don’t have a good idea of how MELI is going to perform in the future you are investing on a hunch. So note a couple of things here:

a) I’m assuming net revenues grow pretty well in the quarters to come.

b) BUT watch out, cos costs are also forecast to grow. This is because of how things are in the real world. Once other companies recognize that MELI is the centre of a growth sector, it won’t take long for the competition to hot up and the market leader (MELI) will have to spend more (advertising, offers, higher salaries for key personnel etc) to stay top dog. And despite what the hype merchants have told you, there is already plenty of competition trying to eat into MELI’s sector lead in LatAm. If you don’t believe, plug www.deremate.com into alexa and see how many hits that site is getting.

c) This costs growth is inevitable, and even if I haven’t hit the exact numbers on the head here it’s foolish to think it won’t happen. This will therefore eat into gross profits. From there we can put together this next chart…

…which looks at how the quarterly net profit line develops. This is a statistic that the shills and pump-artists will often headline without mentioning EPS. But real analysis cares much more about the EPS than the absolute profit in dollars, because from there we can do a chart like this to see how the Price/Earnings ratio pans out: And that looks pretty darn promising to me. If we presume MELI stays at U$38 per share until late 2009 (it’s U$36.35 right now), the PE ratio drops to a little over 20X. But the whole point of owning a growth stock like MELI is the growth in revenues driving the stock price higher (witness any of the hot tech stocks and how they have higher PE ratios than established industries). So as the earnings grow, we can presume the stock will go up. This final chart shows the previous static-price PE ratio in red, and then another PE curve in blue that assumes the stock will grow steadily to a price of U$75 by 4q09 (represented by the dotted black line). So what this suggests is that if revenues grow as forecast and the stock more or less doubles in the next two years, you’ll be looking at a trailing PE of around 45X at the end of the period.

For a growth stock like MELI, a projected 45X PE sounds about right to me. There’s a balance to be found between the continued growth at the company (which looks promising), the company maturing its PE from today’s very high levels (trailing PE is 173X right now), plus the greater risk of operating in Latin America rather than the USA or Europe. A company like EBAY can demand a higher PE than MELI because of the lower risk and more mature market in which it operates, but the MELI investor has to be taking a greater chance that the growth won’t suddenly dry up due to bigger issues like a sudden regional growth halt, a big jump in regional inflation, some kind of politically destabilizing event, etc.

To bottom line all this, if you’re long MELI you have to watch that net revenues number develop and continue its growth. If the company manages to grow quarterly revenues by around 17% quarter-on-quarter and costs grow but don’t suddenly rocket, then hold and look for a double in two years. But the moment revenues growth weakens you should get the hell outta Dodge and not look back.

My personal recommendation on MELI right now is neutral. I’d say there are worse places for the speculative part of your portfolio, but there are better too (but hey!..that’s just me). If you buy MELI, you’re betting that the whole region keeps growing the way it did in 2007, and you’re betting that MELI keeps up its good 2007 too. Neither of these things is the slam dunk that both the subtle and not-so-subtle pump artists would have you believe. So make your own choice, but block out the hype. It won’t do you any good in the long run.