Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Businesses, as a rule, are in business to earn profits -- and you don't earn profits by giving stuff away for free.
This, in a nutshell, is the new concern that Goldman Sachs laid out this morning as it downgraded shares of "Argentinean eBay (NASDAQ:EBAY)" MercadoLibre (NASDAQ:MELI) from buy to neutral, and slashed its price target on the stock by $19 (to $290).
Here are three things you need to know about that.
1. What MercadoLibre did
Last month, MercadoLibre announced it is expanding its free shipping pilot project, already in operation in Mexico for a year, to its largest market, Brazil. Sellers operating official stores on MercadoLibre's website will begin offering free shipping on marketplace orders of about $40 or more.
2. What Goldman Sachs thinks about what MercadoLibre did
This new initiative has Goldman Sachs feeling nervous. In a write-up covered on StreetInsider.com (link requires subscription) this morning, Goldman worried aloud about the potential for the added cost of providing free shipping upsetting the "cycle of constant positive EBITDA beats" that MercadoLibre has been producing.
Goldman admits that the introduction of free shipping is likely to "boost" MercadoLibre's gross merchandise volume (the amount of goods being bought and sold on its website) and also help to grow MercadoLibre's market share in the key Brazilian market. Nonetheless, in this analyst's view, the costs will outweigh the benefits. In particular, Goldman sees free shipping costing MercadoLibre as much as $3.65 per share over the course of the next three years.
Goldman's predictions for MercadoLibre's earnings fall from $5.26 per share to $4.35 this year, from $6.84 to $5.39 next year, and from $8.57 to $7.28 per share in 2019.
3. What other analysts think
Not everyone is so pessimistic. After all, here in the U.S., eBay offers free shipping on many of its orders as well, and free shipping hasn't exactly killed its business (eBay's profits were up 115% last quarter). Amazon.com famously offers free shipping options as well, both through buyers of its Prime subscription service and to non-Prime shoppers purchasing more than $35 worth of goods in a single transaction. So if free shipping works for eBay and Amazon, why wouldn't it work for MercadoLibre as well?
Well, some analysts think it will.
As TheFly.com pointed out last week, for example, Barclays Capital just cited MercadoLibre's free shipping program as reason for raising its target price on MercadoLibre stock $25 to $300 a share. Goldman Sachs may worry that free shipping bringing will "limit the room for near-term outperformance" at MercadoLibre, you see, but Barclays thinks it gives the shares "plenty more room to run."
Similarly, Susquehanna Financial crunched some numbers last month and concluded that "if Brazil free shipping follows the free shipping results [MercadoLibre] enjoyed in Mexico last year," then "free shipping could add $95 [million]-$190 million" in payments via MercadoLibre's Pago Payments system, and add a similar amount to the company's gross merchandise value sold in a year. Over time, company management told Susquehanna, "20% of the items sold" via MercadoLibre could be shipped free eventually, and account for "50% of the marketplace's GMV" in Brazil.
As for the expense, Susquehanna predicts that free shipping will add about "$80 million" to MercadoLibre's cost of goods sold. But Susquehanna thinks MercadoLibre will recoup all of these costs through "increased merchant take rates." Susquehanna thinks the increased attractiveness of buying on MercadoLibre could drive sales growth up as high as 79% (based on what happened when free shipping was introduced in Mexico), and add as much as twice as much revenue to MercadoLibre's business as it adds cost.
The upshot for investors
Now admittedly, investors still have to ask themselves whether MercadoLibre's prospects -- with free shipping or without -- justify the stock's very high valuation of 77.3 times earnings. With most analyst projections still calling for long-term earnings growth rates of 33% annually, I have to admit that I'm a bit doubtful on that point.
Still, the situation isn't nearly as dire for MercadoLibre as Goldman Sachs' downgrade makes it seem. And if free shipping is the thing that helps to goose MercadoLibre's growth rate high enough to justify its high price tag, this development might actually be a good thing.