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Mercado Libre Adapted to Market Challenges, with Fintech Revenue gradually outpacing Ecommerce. Concluding Evaluation.

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May 16, 2024.

Mercado Libre generates two revenue streams: Commerce Revenue and Fintech Revenue.

Commerce Revenue

A. Revenue related to Services, including fees for merchandise sold, shipping, ads, classifieds, and other services.

B. Revenue from Product sales fees, from first party Mercado Libre product sales and related shipping.

Fintech Revenue

a. commissions for transactions off Mercado Libre ecommerce platform, including digital payments, installment payments, asset trading, credit and debit cards, insurance,

b. interest on loans to consumers and sellers, and on Mercado Pago credit cards

c. Fintech Product Sales revenue from sales of MPOS devices.

Prior to 2020, Revenue was reported differently. Off-Marketplace Revenue corresponded essentially to Mercado Pago Fintech revenue plus shipping, and Ad sales.  On-Marketplace Revenue corresponded essentially to Commerce Revenue. If we can for argument’s sake accept equivalence of the historical Off-Marketplace Rev and modern Fintech Rev, and historical On-Marketplace Rev and modern Commerce Rev, then….

Business revenue has grown remarkably over time.  In 2013, Marketplace Revenue was $331.3 million. By 2023 Commerce Revenue had increased by 24.7 times  to $8.201 billion, a CAGR of 37.84%.   In 2013, Off-Marketplace Rev was $141.3 million.  By 2023, Fintech Revenue had grown by 44.4 times to $6.272 billion, a CAGR of 46.13%.

Fintech Revenue has grown at a faster rate than Commerce Revenue.  In 2013,  Off-Marketplace Revenue was 42.6% of the Marketplace Revenue. By 2023, Fintech Revenue was 76.5% of $8201 Commerce Revenue.  

Fintech Revenue growth outpaces Mercado Libre marketplace commerce revenue, likely because it is derived from a wider population of users, drawing from the wider market of financial services users, not just Mercado Libre marketplace ecommerce customers.  And yet, as previously described, robust ecommerce marketplace growth powered the expansion of Mercado Pago digital payments and fintech products. 

Concluding Evaluation

While revenue has grown consistently at a high rate, diluted EPS has grown with a bumpier course.  With a decrease in 2017, and annual earnings did not exceed the previous level of 2016, until 2022.  Over the decade, annual diluted EPS grew from 1.63 in 2014, increasing 12 times to 19.46 in 2023.

Between 2014 and 2023, top line revenue has grown at an average annual rate of increase of 42.4%. GROSS margin was 71.4% in 2014, fluctuated slightly while trending down over time, ending at 49.8% in 2023.  Outstanding for an ecommerce business. 

The more uneven progression in earnings can be traced to recurrent increases in expenses which are required to build out the business. Periodically, increases in operating expenses are generated by increases in shipping costs, marketing expenses, increased cost of goods sold related to increased sales of MPOS devices, and increasing salaries. Note that total employees grew 22.4 times, from 2,599 in 2014 to 58,313 in 2023.

As earnings grow unevenly, the ROIC is correspondingly of uneven growth.  (Remember that Return on Invested Capital has earnings in the numerator, in the form of Net Operating Profit after tax).  ROIC recovers as earnings do, in years following periods of increased operating expenses. One of the issues with Mercado Libre,  small cap company, growing rapidly in an “emerging market”, is the issue of requiring large increases in operating expenses in order to build out the business, and the lumpiness of earnings this causes. 

We can consider the uneven earnings history in the context of the demonstrated history of the company’s ability to build out the business, in spite of challenges, and successfully persist in growing revenues with a fairly consistent gross margin.  It is this history that allows us to have faith in an investment in this company. Increased operating costs were necessitated by the need to address challenges in the market: the need to create fintech services including MPOS capability and credit cards, the need to establish efficient logistics and shipping network, the need to market the company in the immature ecommerce market.  And these various novel branches of Mercado Libre reinforce the competitive advantages.  There, the historically recurrent increases in operating costs are demonstrably part of the company leadership efforts to adapt to the demands of the market in such a way that enhances the competitive ability of the various capabilities of the company. Sounds like our type of investment.

The gross margin is quite satisfactory.  This is important because this means the market opportunity is supports the business. Demand for this differentiated product and services enables pricing which supports the operating expenses needed to build out the business.

Balance sheet is adequate, showing that MELI has cash flow adequate to fund the capital expenditure required to build the company.  Debt/equity a bit higher than normal for my portfolio at 1.56 but interest coverage is satisfactory at more than 6. 

Free cash flow is very consistent, and Free Cash Flow Margin currently over 30%, confirming the ability to meet demands of Capex for the growing company.

Regarding valuation, the Free Cash Flow to Enterprise Value ratio is 15.8, which incredibly enough, is lower than it has been for the past 10 years.

Enough said for this brave little company.

Microsoft: Extending its Competitive Advantage into the Cloud

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September 11, 2014. The public cloud offers unprecedented scale, low cost, and global distribution. Other than Microsoft Azure, there are two other hyper scale cloud competitors, Amazon Web Services (AWS) and Google (Google Cloud). Google Cloud is distinguished in that unlike the others, it primarily does not provide infrastructure as a Service (IaaS), that is, software running on Google Cloud must use the Google platforms. Azure represents a long term competitive campaign by MSFT that goes much further than simply matching competitors’ array of 3rd party service availability on their cloud. Compared to the other hyper scale providers, MSFT has several competitive advantages in the current watershed event of computing history, the move to the cloud. I will be discussing MSFT’s position chiefly relative to the two other hyper scale cloud companies.

  1. As Scott Guthrie, Executive Vice President, Microsoft Cloud and Enterprise group (Chief of Microsoft Azure) reiterated most recently at the September 3rd Citi Global Technology Conference, the MSFT public cloud preeminently enables computing at hyper scale. Today, clusters of datacenters are positioned in 17 regions globally including People’s Republic of China, where it is the first and so far only public cloud provider. Each region contains up to 600,000 servers housed in up to 16 data center buildings each the size of a football field. MSFT, AWS and Google Cloud are the providers of public cloud services at so called hyper scale. That being said, according to Mr. Guthrie, MSFT has datacenters located in twice the number of geographical regions as AWS and 5X that of Google Cloud. Is Amazon cutting prices to compete? This scale allows MSFT to cut prices “continually” in order to compete back.

2. MSFT operates in the hybrid cloud, running applications or services both in on premises datacenters and in the public cloud. For example, Windows Server runs in a private datacenter server, or on a server on Azure. In the hybrid cloud, on premises datacenters (the private cloud) connect with public cloud to optionally extend capacity or enjoy capability of specific public cloud computing advantages or business applications or services which reside on the cloud while preserving the private control of data and resources.

The hybrid model provides advantages because businesses that have been operating historically, are approaching the cloud from the on premises starting point and are not ready to move proprietary and otherwise sensitive data and applications to the cloud all at once and irrevocably. They do not want to be locked in.

Examples of hybrid cloud advantage include enabling services run on Azure to communicate with software and data that is still controlled within the on premises datacenter. Easyjet (largest airline carrier in the UK) keeps reservations data with passenger identities in on premises mainframes. However passengers book flights on the web site, which runs on Azure to accommodate global distribution. The hybrid application makes use of on premises and cloud data.

On premises datacenter workloads or data can be extended to platforms in the public cloud as an option. Azure provides disaster recovery solutions whereby the on premises data center is automatically backed up to Azure. This is available for physical or virtual servers on Windows or Linux, competitor VMware and others. Storage of specific subsections (tiers) of data can be optionally moved from on premises to the cloud, reducing storage costs roughly 50%. The data is moved on dedicated cables and is encrypted on site before moving to the cloud (Microsoft’s acquisition of storage companies StorSimple in 2012 and just recently InMage, play a role in these capabilities).

3. MSFT enjoys an advantage in its dominant market share in the on premises datacenters from which businesses are shifting to the hybrid cloud. Windows Server has 75% market share in business servers. Currently, 95% of businesses globally run on Windows Server Active Directory. Businesses want to use the same software on the cloud. When a virtualized Windows Server runs on AWS, MSFT receives revenue from Amazon (In fact, AWS advertises 750 free hours of virtual windows server instance per month when signing up for EC2. Thank you Amazon!). Perhaps this is contributing to growth in Hyper-V (virtual Windows Server machines) share, which is now at 30.6% and has helped grow datacenter additions, the Windows Server and System Center both up more than 40% for the year (2014 (Q4 earnings call). Here, MSFT wins through growth of either AWS or Azure.

4. Another advantage is MSFT’s dominant share in commonly used productivity applications. Purchasing Office and related productivity applications as a service running on Azure (Office 365) relieves businesses of the cost of maintaining datacenters, gaining the agility to increase or decrease usage with work load fluctuation, while increasing security and availability globally. Moreover, this move to software as a service is more profitable for MSFT. The reduction in revenue to datacenter IT service provider is replaced by new revenue to MSFT. Obviously, AWS does not compete in widely used business productivity apps and Google is competing from well behind.

Recently MSFT has made a concerted effort to make its productivity apps available on other mobile platforms such as Android and iOS, increasing market share of the MSFT apps. For instance, two years ago development of Office for IOS began, finally released in late March and downloaded almost 30 million times in less than two months. Once a business moves to Office 365, its users are managed via Active Directory and the devices are efficiently and securely managed using Windows Intune (for which there are over 10,000 paying corporate customers since release in late April 2014) within the Enterprise Mobility Suite. Yes, that means all those iOS and Android as well as Windows devices. This is another point of competitive advantage for MSFT, in that the device business (with relatively low gross margins) is intrinsically less attractive than the type of mission critical software with switching costs that MSFT is using to manage the devices and enable them to be productive in a secure way.

The ability of services run on Azure to accommodate various cross platform devices at incredible scale was exampled in the largest content streaming event in history, the Sochi Winter Olympics. Content was streamed via over 6 million app installations cross platform on mobile devices, and over 500 million web pages were viewed with more than 25 billion requests to Windows Azure virtual machines.

MSFT dominance in historical productivity services and apps means hybrid cloud represents an extension of MSFT’s durable competitive advantage into the future. Here MSFT is leveraging its franchise in office to extend its competitive advantage to the cloud, in a way that competitors cannot. By enabling customers to keep managing their data flexibly and continuing to use established management software, MSFT is keeping the high margin productivity software business as customers gradually transition to the cloud with software as a service (Saas) such as Office 365. Meanwhile, MSFT is competing with AWS and Google Cloud by lowering prices in infrastructure as a service (Iaas). AWS and Google have fewer high margin businesses to move to the cloud.

5. For the past 2 years, because businesses demand services from providers other than Microsoft in the public cloud, Windows Azure has increasingly accommodated services on 3rd party platforms running on Linux or from other providers such as Salesforce, SAP, Oracle and many, many others. These disparate services and platforms can be accessed on Azure via a single sign on credential using Active Directory, allowing businesses to efficiently and securely manage access to services by staff worldwide. In fact, 3rd party platforms or services are easily managed within a graphical user interface. As Azure accommodates the platforms and services that are demanded in global business, this has produced a hockey stick upshift in Azure revenue growth.

6. Emerging classes of applications on the cloud include business intelligence (BI) and machine learning. (ML). In BI, cloud applications can process large amounts of data from MSFT and non-MSFT platforms running in Azure and present it in useful ways to the customers. This was demonstrated using Salesforce in the recent WPC 2014. In machine learning, amounts of data that are too large or physically separated to process on the business’s own datacenter are analyzed in the cloud to make predictions. For instance, a retailer might upload data from customer purchase behavior to be analyzed in Azure ML, to guide targeted email marketing to target offers based on predicted next purchases. Machine Learning is the basis for the newly announced Delve, which provides up front display of the most relevant information for the user within Office 365, thereby keeping track of relevant events and new information from the entire enterprise for the user. BI and ML are being introduced to the widely used applications within Office to integrate the power of cloud computing to enable more complex questions to be answered simply, in everyday business.

Recent revenue growth in Azure and related software is a result of the ability of Azure to enable innovative agility, scale and distribution to Microsoft software applications that have switching costs with captive customers. Even though Microsoft has not been the first to the public cloud, it is succeeding because of previously existing competitive advantages. Moreover, openness to 3rd party platforms and applications enables access to novel markets.

Over 57% of Fortune 500 companies are now deployed on Azure. Synergy Research Group reported that in the second quarter of 2014, Azure revenue grew three times faster than the other hyper scale cloud providers: MSFT at 164% yoy, AWS 49%, Google 47%. In the 2014 Q4 Earnings Release \ it was announced that Commercial Cloud revenue (Azure) had grown 147% since the year previous Quarter, at a run rate of over $4.4B. The attractions of the cloud (low cost, scale, agility, global reach) are helping MSFT applications. Over 25% of global businesses have now licensed Office 365.

Summary:
The emerging generation of cloud driven apps brings the power of hyper scale computing to everyday business applications. But the path to that new era runs from on premises datacenters through the hybrid cloud. MSFT is using its dominant market position in productivity apps to forge a strong share in IaaS hosting 3rd party platforms and becoming a one stop shop for enterprise software. Over a period of likely more than a decade, MSFT can bring businesses to MSFT platforms in the cloud as a PaaS provider, to cement its control of business “plumbing”, the standards for business processes. Then, it will control its economic future in the public cloud. An investment in MSFT represents a part ownership in this massive future market. In 20 years when we say, “business today runs on the cloud”, to what extent will this imply, “runs on MSFT software”? Notwithstanding, surely there will always be partners as well as competitors at all levels.

Finally, where does this leave us regarding a purchase decision? I will not add an exhaustive valuation analysis of MSFT here. In fact, for years the investing community has had low enthusiasm for Microsoft and therefore valuation of MSFT is relatively safe.

MSFT had Free Cash Flow (FCF) of over $26B in 2014, with FCF/sales of over 30%. The lowest such ratio in the past 10 years was 27%, in the teeth of the recession in 2009. PE is 17, midway between the high PE of 25 and low of 9 in the past 10 years. One of my favorite valuation measures is also extremely simple: Cash Return. This is the cash a company generates, as a percentage of its capital, both equity and debt. Cash Return equals FCF plus interest expense divided by enterprise value. Enterprise value (EV) is market cap, plus debt, minus cash. EV is in fact the price an investor would need to pay to purchase the entire company. According to Morningstar, MSFT Cash Return is 8.5%. Excellent, considering this is a company with clear competitive advantages that should continue to generate an above average return on its investments well into the foreseeable future as it has in the past, without important changes to its capital investment requirement.