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The company had a decent earnings report today, but the valuation is just crazy. Here's the case I wrote up for Fool.com that proves that: http://mot.ly/cfFRJV

Tim
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(This is a cross-post from the Rule Breakers MELI board, where Tim bravely posted his bearish analysis and, um, didn't get much support.)

One of the more remarkable aspects of TMF's growth has been to watch the divergence in cultures between its various offspring. Rule Breakers still represents the initial growth philosophy the Bros. Gardner espoused when TMF was young. Global Gains and Hidden Gems have come to represent much more the value sensibility that Bill Mann brought to both and handed down to his successors. Hence Tim, who is the pied piper at GG, gets no support for his views here [on the Rule Breakers board], other than Rick's thanks for playing devil's advocate.

My own investing sensibility has developed alongside TMF's thanks to the education I've derived from it. I seem to have ended up about halfway between Bill and the Gardner Bros. I didn't sell MELI when Tim did at GG because I thought his concerns were too short-term for a long-haul investor (currency issues) and because I thought his strict value analysis was a poor fit on a company with such explosive growth prospects. You're just picking numbers out of the air when you try to predict growth rates five years into the future in such cases. Tasteless as it may be, I have to admit Emilio Gomizelj had a great line here:

Finally, please remember that DCF valuation is like masturbation: the more you have been doing it, the more you think [it] is the real thing.

Frankly, I think this applies to the various predictions about MELI's growth prospects too, whether they are Tim's bearish ones or this board's bullish ones. There are so many variables, so many things that could happen both to the upside and the downside, that believing these looks into the future are much more than guesswork is, I think, also subject to Gomizelj's analogy.

But the company's growth prospects going forward are just one question. As important to me as a MELI investor are the prospects for the shares, separate and apart from the prospects for the company. I trust even the most exuberant bulls would acknowledge that at some price point, the shares would be too expensive to offer good future returns, no matter how sublime the company. So the question becomes what is that point?

For me, as someone who has run up and fallen all the way back through a number of market and economic cycles as a buy-and-hold investor, the psychological turning point has become a price/earnings ratio of 60. I can't rationalize it with data, so any criticism of it as arbitrary is accepted in advance. But in my experience, stocks whose P/Es exceed that level -- except in special circumstances, of course, just turning profitable from a loss, cyclical companies, etc. -- have generally been subsumed by the cyclical logic of the greater-fool theory. This works very well until it doesn't. It depends upon irrational exuberance, which can go on for quite a while, but not forever. There is seldom a rational justification for such a multiple once a company reaches a certain size, and so, no matter how good a company, the multiple tends to come down from there over time.

This is where I believe MELI is, and why I finally sold this morning. At the price I got, $66.80 per share, it was trading at a P/E of 70. That's twice the rosy 35 percent earnings growth analysts expect next year. As many have said, that doesn't mean it can't keep going up. Market psychology is a strange beast. But it also means there is nothing to keep it from coming down.

Over on the Google and Intuitive Surgical boards, people have been puzzled and disappointed lately over the failure of those great growth companies to keep rewarding them with capital appreciation in the shares proportional to recent earnings performance. Google has had a few hiccups, particularly in China, but remains a great company by anyone's reckoning. Intuitive Surgical has a monopoly on one of the great businesses in the world. But lately, good earnings have been greeted with range-bound stock prices. GOOG shares are roughly where they were four years ago, although earnings have more than doubled since then. ISRG is about where it was three years ago and its earnings have nearly tripled. So what happened?

Multiple contraction happened. These companies are now quite large. GOOG is a $150 billion market cap; ISRG nearly $13 billion. The market is no longer willing to give multiples that suggest stratospheric growth rates because of the law of large numbers. GOOG's P/E has come down to the low 20s, befitting a large cap, and ISRG is down to the low 40s, befitting a smaller but still pretty large, fast grower. So Google and Intuitive Surgical, great companies that they are, have been ordinary investments over these spans because, had you bought them at those highs in late 2006 and 2007 respectively, you would have been buying at P/E ratios that were about to shrink. Over the past several years, all the macro volatility aside, these great companies have been growing into their early, exuberant market valuations.

That's where I think MELI is today. Great company, but with a market cap now of nearly $3 billion, not long for the multiples of microcaps. I think it's an investment likely to be battling the headwind of multiple contraction somewhere in the not-too-distant future and therefore not as promising from here as good, lesser-known companies trading at discounts to their intrinsic value. MELI, in short, is deeply in fashion with the market right now, and that, in my experience, tends to be a good time to sell.

I'm not pretending to call the top. I finally sold BIDU at a P/E of 65 last fall. Google promptly got into its tiff with the Chinese government and BIDU soared to a P/E of 100. It's now at 90. Still glad I got out because that multiple simply makes no sense to me. If the stock price stagnates for the next five years as the multiple contracts, that would make perfect sense to me. And if I was holding the stock while that happened, I would be asking myself, "Why are you holding this stock when this was so predictable?"

A valid counter to this argument is that I'm dramatically understating the effect of macro economic forces over the past several years and that MELI too is just back to its speculative highs of late 2007 and early 2008. You could argue it has plenty of time to run on stratospheric multiples before it gets to be ISRG's size and even then, if it follows ISRG's pattern, multiple contraction will have been quite reasonable, from 70 to 40 while the company was quadrupling its market cap. And that could be, although counting on any company to replicate ISRG's growth is, as they say, pricing it for perfection.

But again I would say this bull case rests on the greater fool theory, that people will continue to pay irrational multiples in the future so you are justified in paying an irrational multiple now. It might happen. But it might not. And if it doesn't, it will be very hard in retrospect to argue that it made sense to invest based on that possibility.

JMO, of course. Maybe I've been brainwashed by the value hounds. But over time, even with great companies, I've found that price does matter. It's not all that matters, but it does matter. And in my experience it's hard to earn market-beating returns buying stocks with P/Es over 60. Not impossible, just hard. Like running against the wind.
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It's been an interesting discussion both over there and on the article's comments thread where a former MELI employee posted his critique of my analysis. All told, my experience with emerging markets is that they're extraordinarily volatile -- both the stocks and the underlying markets themselves. Yet when things are going well, people convince themselves that they will keep going well and when they're going badly, people convince themselves they will never get better.

In the case of Brazil, it has a lot going for it, but it remains one one of the world's worst places to do business, with a horrible crime problem, and an upcoming election that will change the political status quo. That's a lot of variables in a market -- particularly when it doesn't take much to undermine a valuation as rich as MELI's. A more onerous corporate tax rate, for example, could do serious damage to MELI's profits -- and we know Latin American politicians don't mind soaking profitable companies.

Tim
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I don't mean to sound mean-spirited, but that article contains not a single verifiable fact that supports any of its conclusions. Take this, for example:

He pegs user annualized growth at 29% over the next 10 years, yet marketplace revenue is targeted to climb at a mere 22% pace. In other words, Hanson believes that folks will be spending less -- and a lot less once you begin to bake in 10 years of consumer price inflation. I don't buy it.

The 2009 ASP on the MercadoLibre platform was a little more than $90/item ($2.7b GMV/29.5m items sold). EBay's 2009 ASP in the was about $50/item ($25.7b GMV/@500mm items sold) based on my estimates for the division. This is a function of the fact that people in lower income brackets have more access to the Internet in the US v. LatAm and because Ebay is more of a mature broad market and auction platform while MELI does a lot of big ticket sales (cars) and fixed-price sales.

But if you're going to assume massive traffic expansion downmarket in LatAm (remember the rich are already online), you have to assume ASPs decline. I mean, to do otherwise just makes no sense. Now, if you can make a case that ASPs should go up as the market expands, I'll listen, bu "I don't buyt it" is not by an measure a "case."

Tim
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Well, to counter Tim's counter, that particular comment of mine is based on both average selling price AND frequency per user.

I see where he's coming from with his downmarket argument. I won't refute it. Average selling price on MELI was $98 in 2008 and $93 in 2009, BUT that's only part of the equation of spending per user.

Kenneth, what's the frequency?

In fact, even though registered users grew just 26% in 2009, the number of items sold popped 40%. In other words, there are more transactions per user (even if these are simply confirmed registrations and not necessarily active users). In the end, GMV/user ROSE in 2009 despite lower price tags per transaction and THAT was my point.

Rick
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