Business Breakdowns
· Matt Reustle
[00:00:00] S0: And you referenced a bit in terms of lighter capital intensity than you might see at somewhere like Amazon. But how would you think about that margin flowing down into earnings, free cash flow and just some of the capital allocation framework in terms of how they think about it? You mentioned the reinvestment into the business that can happen a few different ways, but just thinking more from the below the line and then free cash flow dynamics.
· Daniel Wu
[00:00:00] S1: So I'd say in terms of the incremental operating margins, they can be relatively high for the marketplace business depending on I suppose where the reinvestments are being made. Because obviously with the third-party merchant business they're just collecting a fee. So any growth and penetration of advertising or when they eventually start monetizing logistics, that should all fall through to the bottom line at a pretty high rate. But of course the company is also investing more into its first-party sales as well and I think that's pretty important for expanding the different categories that the marketplace is able to address, especially around the higher-value consumer electronics pieces and then the much lower-value grocery business as well. On the fintech side, I think as we discussed, the biggest driver is going to be that compression of the NIM (net interest margin). But that of course ends up being offset by faster dollar growth of the fintech operating income. Our understanding is that the company doesn't really manage the business through margins either, so they're much more focused on the long-term opportunity and they will basically sacrifice short-term profits if they can extend the long-term growth runway or just position the business to have stronger growth in the long term. Just lastly on free cash flow and capital allocation, free cash flow defined as operating cash flow less capex, is distorted by the credit and digital wallet businesses given the non-cash charges, the changes in credit receivables and customer deposits. The company started reporting an adjusted free cash flow number last year which strips out the impacts of the fintech business and that figure was $1.3 billion for 2024 and $1.4 billion for 2023. You also need to make some non-cash adjustments to net income to approximate a conversion ratio which falls between 60 and 80% for the two years we have available. As for capital allocation, the priority is very clearly organic reinvestment, which includes funding the credit business as well. Since the 2007 IPO there's been just over $1 billion in buybacks and just over $200 million spent on M&A. So the majority of the reinvestment has been back into the logistics business and also the expansion of the credit business.
· Matt Reustle
[00:00:00] S0: And I think we've laid out the risks throughout the discussion and there's some fairly obvious ones. But sitting in the investment seat, what stands out the most to you in terms of the risks to the business that you would maybe worry about the most or the market worries about the most?
· Daniel Wu
[00:00:00] S1: So I think the key risk is just around that international competition, particularly from Shopee, which we've already discussed. So I won't touch on that again, but I would just say this is probably more limited to Shopee specifically, because if you look at Amazon, I mean, Amazon's been a very early mover into LatAm and it didn't really catch on anywhere except Mexico. And then for Temu, I believe they made a splash when they launched in Brazil last year. But as a cross-border e-commerce player, I think it's very hard to really compete with the local players on any meaningful metric, whether it's delivery speed or service experience or even product quality in Temu's case. So really the only thing that Temu has going for it is just a very, very, very low price. And Shopee is also a strong player in that lower price segment. So it's hard to see Temu having a real relevant market within Brazil where it can actually attack. And I think the same could be said for Mexico as well. I mean, we saw Temu launch in Mexico and there was a spike in downloads and MAUs, and that's come back pretty quickly as soon as they stop advertising and doing their user acquisition as well. In terms of the other risks, I think there's a few other risks that are worth touching on. Firstly, there's the saturation of digital payments in Brazil. So back in November 2020, the Brazilian central bank launched Pix, which is a 24/7 instant payment system that's operated by the central bank. And that's just been an absolutely massive success. So today over 90% of personal consumption expenditure has been digitalized. And as a result of Pix, card payments have lost significant share in Brazil. But credit card volumes have still grown on an absolute basis and at a pretty healthy double-digit rate as well. So it's mainly been debit cards that have lost share, both as a percentage and in terms of dollars. The other thing I'd say is that in the long run this might even be a tailwind for credit card adoption because once the underbanked individuals are pulled into the digital banking system via Pix, it becomes much easier for them to graduate onto credit cards, where most of the value lies for the fintechs that offer them. The second risk is that there's occasional regulatory rumblings in the payments industry.
· Daniel Wu
The Brazil Central Bank has been toying with aligning the credit card settlement period to international standards. And there's also further regulation being touted for the extremely high rates of revolving credit card balances. We think these changes would fundamentally alter the business models of all the parties that are involved in the payment system. And also not necessarily for the better, because I think most of these changes will result in lower consumption expenditure from consumers. So these regulatory proposals haven't really gained that much traction. And then finally, I think it's worth mentioning that there is some antitrust litigation happening in Argentina where a consortium of banks has sued Meli for monopolizing the country's digital payments market. And then Meli has countersued, alleging that the banks have formed a cartel. So we would say that it's pretty hard to argue against Meli being a monopoly in Argentina given its 80% share of e-commerce and probably more or higher share in the fintech space. But it's not really clear to us who is being hurt by this. And then on top of that, there's President Javier Milei who disdains excessive regulation. So it's also not clear what the regulators would actually do if Meli lost. So those are the risks that I would highlight. Obviously, anyone investing in EMs, you're going to face typical EM macro risk and also FX risk as well. And particularly for LatAm, I think that FX piece you just have to be mindful of because some of these currencies can devalue pretty quickly and pretty steeply and it distorts the reported results for Meli. And you have to just, I guess, dig a level deeper to understand how the business is performing. Because for example, if GMV growth is 20% in USD, but then 80% in FX-neutral, then you'd argue that the 20% USD growth is not really reflective of the underlying business and that you should look at the 80% FX-neutral growth. But on the other hand, that 80% FX-neutral growth, how much of that is coming from the fact that say, Argentina is inflating at 50% a year or Brazil inflation is at 14%? It does mean that it is harder to track the underlying performance of the business. And that's why I've referred to a few times the growth in units sold for the marketplace because that's probably the best metric for underlying growth of the marketplace business.
· Matt Reustle
[00:00:00] S0: Yeah. Incredibly difficult to isolate the variables. I think we touched on it early. But the execution is incredible just in terms of how they've been able to evolve. And you mentioned Marcos Galperin as the leader here. What else, if anything, would you reference just in terms of the culture and leadership that went into executing on what is an academic case study of learning from some of the other businesses around the world and applying it with your own unique approach?