Business Breakdowns
· Matt Reustle
[00:00:00] S0: 30 to 40%?
· Daniel Wu
[00:00:00] S1: Yeah, it actually annualizes to 450% a year. Wow. Which is absolutely insane. There's a lower rate for credit card installments with interest and that's around 180%. So then the question is, how can that be a low margin product? Well, if we take a step back and look at the credit card data. So nearly 80% of credit card receivables in Brazil are interest-free installments. And this means the 20% of credit card receivables that do pay interest need to earn enough interest income to cover the credit losses for the entire card pool plus the funding costs for the entire card pool plus the operational overhead plus earn an acceptable margin for the card issuer. If you look at the US I think 2/3 of credit card balances are interest earning and then even in Mexico that number is over 60%. So once you blend that rate out and just adjust for the fact that there's effectively a 45-day interest-free period on any card balances, the gross yield ends up being something like 40%. And compare that to the gross yield on personal loans that have been north of 80% over the past few years, especially in Argentina, and we can see why the credit card business is a lower margin product. As a matter of fact, Meli's entire Brazilian 2023 credit card cohort only became NIM positive this year and only 51% of the Brazilian credit card portfolio is currently NIM positive. The Mexico portfolio is still NIM negative and Argentina is also expected to be NIM negative for the first few years after the product launches. And then just the other reason as to why this is a structurally declining NIM is the fact that the credit business continues to push up market into higher credit quality cohorts. And that's obviously going to come with lower interest income. But we do think it is necessary for the healthy long-term growth of the credit portfolio. And you mentioned credit risk as well. Given the rapid growth of the credit business and the relatively high credit risk profile of the borrower base, I think it is fair to be concerned about blow-up risk, especially in an emerging market where economic conditions tend to be more unstable. If we look at the reported credit metrics, non-performing loans have been broadly stable since the launch of the credit card business except for a few quarters in 2022. And the portfolio has been adequately provisioned in all periods.
· Daniel Wu, Matt Reustle
For us beyond the reported metrics, we think management has been very prudent when it comes to managing the growth of the credit portfolio. So even though originations have grown an extremely fast clip, the priority is on building a sustainable credit business over the long term. So for example, when credit conditions started deteriorating in Brazil and Argentina in mid-2022, the company immediately scaled back origination volume and significantly tightened its underwriting standards. So while there was some temporary degradation of the credit metrics, it wasn't anything concerning to us and the provisions were more than adequate. [00:00:00] S0: What does the NPL percentage typically revolve around? You mentioned it was pretty stable. [00:00:00] S1: Yeah, I believe the NPL percentage is quite high relative to what we might think of in a developed market, but I think it bounced around mid-30s to low-20s and for the past several quarters now it's been around 28%. So if you think about it, a quarter of the credit book is essentially past due at any given point in time. And that again also contributes to why the net income margin after losses can be relatively low for the credit business.
· Daniel Wu, Matt Reustle
[00:00:00] S1: Yeah, I believe the NPL percentage is quite high relative to what we might think of in a developed market, but I think it bounced around mid-30s to low-20s and for the past several quarters now it's been around 28%. So if you think about it, a quarter of the credit book is essentially past due at any given point in time. And that again also contributes to why the net income margin after losses can be relatively low for the credit business. [00:00:00] S0: It can also explain those yields that are associated with those. Some of those numbers were eye-popping. This provides a nice basis for why that might be the case. You also made reference to non-interest installment payments as being a big piece of credit. I'm picturing this as the buy-now-pay-later program. One, is that the right way to frame it? And then two, why would you use that approach given the credit dynamics and challenges potentially with managing credit risk?
· Daniel Wu
[00:00:00] S1: Yeah, that is absolutely the right analogy. I would say that parcelados are basically the original buy-now-pay-later. So this is something that is unique to Latin America and more specifically Brazil. The Brazilian credit market is, as we've already discussed, unlike any other market in the world. So in Brazil, credit card settlement period is D + 30 days. And that compares to the international standard of D + 1 or D + 2. So this means that when a customer pays for a purchase using a credit card, the merchant only receives cash payment after 30 days. So you can imagine the working capital challenges that this creates for any merchant that accepts credit cards. And then culturally, Brazilians also love installment payments, or what's called parcelados. This feature is only available on credit cards and allows consumers to split their purchases into a number of interest-free monthly payments. And that typically ranges from 3 to 12. So instead of charging the entire purchase to their credit card upfront and then having all of it for due a month later, the card issuer will bill the cardholder in equal monthly installments, which each of the installments fall due as per your standard credit card agreements. Now from the merchant's perspective, this just further exacerbates that working capital challenge. So instead of receiving full payment 30 days after the sale, if it's a three-month installment, the merchant will receive a third of the sale amount every 30 days. And if it's four installments, then a quarter. And for a 12-month installment, the merchant isn't receiving the final payment until 360 days after the sale, which is pretty crazy if you think about it. So to get around this cash flow timing problem, merchant acquirers created a solution known as the anticipation of receivables. For a fee that reflects the time value of money plus a margin to the merchant acquirer, the merchant can elect to receive all of those installment payments upfront, which is why this business is also called prepayments. This ends up being a win-win for all the parties involved: the merchant gets a discounted upfront cash inflow, the consumer gets to split large purchases into multiple interest-free installments, and then the merchant acquirer receives a fat risk-free fee.
· Daniel Wu
And this is because ultimately it's the card issuer that's the one that guarantees the receivables in the event of cardholder default. Now, once the acquirer has bought the stream of credit card receivables from the merchant, it now has two options. It can either put the receivables onto its balance sheet and collect each installment as they settle, or it can sell that receivable onto a bank. So either option comes with its own funding costs, which then turns the anticipation of receivables into more of a spread business. We estimate that Meli earns circa 3% net spread on its prepayment business, which is higher than the merchant discount rate that it earns on the payment processing business. So if you dig into Meli's filings, there's actually disclosure around the percentage of TPV that comes from installment payments, and they also provide net prepayment revenue as well. So you can use that to calculate the net spread. And I think, interestingly, we've observed that the net spread has actually widened to over 4% over the past three years, which on the face of it looks pretty attractive. But we think that this is actually because Meli has been increasingly turning to wholesale and deposit funding rather than discounting the receivables back to a bank. So by our estimates, the percentage of credit card receivables that Meli holds on its balance sheet has risen to over 40% of gross credit card receivables, up from around 11% in 2019. And net prepayment revenue only includes the cost of discounting receivables to a bank, and it doesn't include the interest cost of wholesale funding. So that ends up overstating the net spread. So essentially we think net spread is probably still around that 3% range.