Why This E-Commerce Site Could Be Overvalued

With more than $1.7 billion in gross merchandise volume handled last quarter, MercadoLibre (NASDAQ: MELI  ) is the king of e-commerce in Latin America, with a strong presence in 13 countries, including Brazil, Peru, and Mexico.

Although e-commerce is a fiercely competitive space, with eBay (NASDAQ: EBAY  ) and Amazon (NASDAQ: AMZN  ) leading the way, MercadoLibre has been able to defend its position as market leader in Latin America for several years. Since this market has one of the world's fastest-growing Internet and smartphone penetration rates, investors are very optimistic about the firm's long-term plans. However, with roughly $400 million in revenue per year, the company's current six billion market valuation may be too high to be sustainable. How does MercadoLibre plan to justify its high valuation? Can MercadoLibre live up to investor's expectations?

The bear case for MercadoLibre
According to Ron Reuven from Reuven Capital Investments, MercadoLibre's overvaluation is due to the fact that most investors, by calling it "the eBay of Latin America," get an incorrect perception about the company's real value.

Comparing eBay with MercadoLibre is similar to comparing David and Goliath. eBay has a long growth history. It is expected to grow its revenue 20% next year. That's roughly $19 billion in revenue, with four billion in operating income at current margins. Even better, eBay owns online money platform leader, Paypal. On the other hand, MercadoLibre, founded in 1999 (four years after eBay) only experienced real growth in the last five years, when it quadrupled its revenue to $374 million in 2012.

MELI Revenue (TTM) Chart

Source: YCharts

However, the real difference between MercadoLibre and eBay isn't the scale of operations. Reuven notes that, unlike eBay or Amazon, MercadoLibre's user base has a strong focus on trading "grey market" goods. These are goods that are illegally imported, i.e., smartphones that people may buy in America and bring home in personal luggage. Obviously, such a model isn't scalable. In this sense, the company could be facing a strong growth constraint in the near future. 

The company is also exposed to the macroeconomic situation of Venezuela and Argentina. Unlike Amazon, which is present in countries with strong institutions, MercadoLibre could face high volatility, political risk and undesired currency fluctuations due to sudden changes in macroeconomic policy or political regime in both countries.

As a matter of fact, the company's exposure to Venezuela could become a strong negative catalyst. Consider that, to report its financials, MercadoLibre uses the government's official rate of 6.3 bolivars per dollar, when according to rate-tracking website dolartoday.com, one dollar actually buys almost 45 bolivars on the black market. Considering that MercadoLibre gets more than half of its earnings from Argentina and Venezuela, investors should watch inflation carefully in both countries, where it is currently over 25%.

With more than $11 billion in cash and a well-diversified cash flow thanks to PayPal's contribution to revenue, eBay shows considerably less risk. eBay uses its 18% stake in MercadoLibre to control exposure to Latin American economies. It also uses a partnership-model to compete in China, where it cooperates with luxury online seller xiu.com, and it is directly entering Russian and Brazilian markets. Unlike MercadoLibre, eBay changes its strategy according to the country. As a result, its operating cash flow trend, which increased from $874 million in 2003 to $3.8 billion in 2012, shows little downside deviation.

Amazon also takes geographical diversification very seriously. Of the $48.86 billion that Amazon has made in net sales for this year so far, North American net sales only represented $29.18 billion. The remaining $19.67 billion is well-diversified, with Asia, Australia, Canada, Europe, India, Latin America, and Middle East as the main contributors.

Finally, despite its huge market share in Latin America, MercadoLibre is not free from competition. There may be few direct competitors at the moment, but U.S. sites of Amazon and eBay may be indirectly capturing MercadoLibre's market share. According to Morningstar, 4.2% of Amazon's U.S. site's total unique visitors come from Latin America. Furthermore, Amazon quietly launched its Brazilian site in December last year, and considering Jeff Bezos' huge appetite for growth, it won't be long before we see more Amazon presence in Latin America.

The Foolish takeaway
MercadoLibre managed to quadruple its revenue in five years. However, in order to keep top-line growth as sustainable as possible, the company could improve its economic moat by eliminating potential grey goods from its catalogue, going beyond Latin America, increasing cross-selling situations, and reducing its exposure to Venezuela and Argentina. These changes may sound controversial because their short-term effects may produce negative momentum. However, without a long-term focus and improvement in the company's competitiveness, a $6.2 billion market valuation, and a 60 price-to-earnings multiple may be difficult to justify.

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