Business Breakdowns
· 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.
· Matt Reustle
[00:00:00] S0: Fascinating. I could go on probably for hours, just in terms of the dynamics going on here. But rather than derail us, I'll try to push us forward a little bit just in terms of managing that risk on the books, like you mentioned, and going the wholesale route. It does feel like it would introduce risk. And then from a cash flow perspective, it has implications. It's interesting to me that they would go that route. Do you think there's anything that drives that? Because it increasingly makes this a credit business which operating requires different muscles than e-commerce and marketplace. So just how do you think about that and that exposure?
· Daniel Wu
[00:00:00] S1: You're right, Matt, in the sense that as that credit business grows, it just continues to introduce a different set of risks versus what the original business around the marketplace has been. We get comfort around the credit piece of the business just based on the historical performance of that credit book and how management goes around managing the risks there. In particular, the number one priority for that business is to essentially control the risk rather than try to grow the credit portfolio as fast as possible. I believe management has said in the past that none of the leaders of the credit team have a KPI where you've got to grow the credit book by a certain amount every period. Meli's also developed its own credit scoring and underwriting models because as you can imagine in Latin America, where a lot of the population is underbanked, things like FICO or VantageScore aren't going to be applicable. And that means that essentially you do need to have a lot of proprietary data to feed into your underwriting models. And having that marketplace business where you can see the transaction history and the payment history for the buyers and also for the merchants as well, and being able to even sweep the merchant cash if you give them any credit, that reduces the risk a lot for the credit business compared to if you were just a stand-alone credit card issuer in say Brazil.
· Matt Reustle
[00:00:00] S0: Fascinating. Again, if we were to take everything together, look at the financial drivers, particularly on the top line. If you want to break it down by segment, that's great. Can you just outline, when you think about Meli on a consolidated basis, how you think about those drivers going forward?