2022 is shaping up to be a year investors will wish they could forget. Propelled by the combination of unusually high inflation and the rapid series of interest rate hikes that the Federal Reserve initiated in response to it, stocks got hit hard. Formerly richly valued growth companies -- especially those that haven't yet put much priority on reaching profitability -- have been absolutely clobbered.
However, some of these companies are still good investments. Every business has its issues, but those with solid foundations should be able to roll with the punches and emerge in better shape in the wake of the economic disruption they've endured this year. Three Fool.com contributors think MercadoLibre (MELI -1.79%), Embracer Group (THQQ.F 6.55%), and RH (RH 1.32%) would be smart buys before 2022 comes to an end. Here's why.
Latin America's leading e-commerce and fintech, still going strong
Nicholas Rossolillo (MercadoLibre): If you think folks in the U.S. have had a rough go of things because of high inflation this year, have a chat with a consumer in Latin America. Some of the countries in that region -- among them, major economy Brazil -- are experiencing far higher inflationary forces, as well as sky-high unemployment, and they've been flirting with recession as a result.
But through it all, MercadoLibre has been a resilient growth story. Its total revenue was up 55% year over year through the first nine months of 2022 to $6.77 billion – including a 49% increase in Q3 (which would have been a 61% increase without the negative effects of shifting currency exchange rates). These gains are being driven in part by new buyers joining MercadoLibre's online marketplace, but its financial services technology is especially moving the needle. Total payments volume rose by 76% in Q3 (excluding currency exchange impacts).
By some measures, MercadoLibre still isn't particularly profitable. Its net income in the first three quarters of 2022 was just $317 million. But it is highly profitable on a free-cash-flow basis. Free cash flow was $1.06 billion in the first nine months of 2022. This can be a noisy profit metric from one year to the next, but MercadoLibre is at least demonstrating its ability to ratchet up cash generation from its massive user base in Brazil, Argentina, Mexico, and the other developing countries of Latin America.
The company also has a solid balance sheet with $3.4 billion in cash and short-term investments, offset by debt of $2.7 billion. Shares trade for 173 times trailing 12-month earnings, or 29 times trailing 12-month free cash flow -- and that's after they've fallen by more than 50% from their all-time high.
Despite the difficult macro conditions, Latin America's economy overall has been proving far more resilient than many economists expected. Growth is expected to continue trudging along in 2023 at a slow pace. But MercadoLibre shook off this sluggishness as it helps households take part in the digital economy. The stock rallied strongly from the lows it touched this past summer, but I'm comfortable adding to my small position in this e-commerce leader before 2022 comes to a close.
Here's the most promising $6 billion company you've never heard of
Anders Bylund (Embracer): You may recognize the name of Embracer Group if you follow the video game industry closely. The Swedish company made some headline-worthy waves in August when it bought the rights to develop video games, board games, merchandise, movies, theme parks, and stage productions based on J.R.R. Tolkien's Lord of the Rings. And if you read the fine print on your game disc packages (or the terms of use for your digital game downloads), you may have seen the Embracer name on titles such as Saints Row, Catan, Exploding Kittens, Goat Simulator, and Duke Nukem 3D.
The company didn't exactly build those familiar names from the ground up. Instead, Embracer is a serial acquirer of game development studios. These groups are then allowed to operate independently, supported by the financial assets and marketing tools of the parent company. Embracer was decentralized before the cryptocurrency industry made it cool. CEO Lars Wingefors and his management group reserve the right to green-light or cancel projects, with an explicit long-term focus.
"The right decision is always to put the product quality first, even in cases where short-term gains seem tempting," according to Embracer's business strategy statement. "Therefore, decisions to postpone, or even cancel releases are not seen as failures but as evidence of an active quality control."
I can get behind that attitude. And in that same long-term-thinking vein, I don't mind picking up Embracer shares on the cheap while traders are distracted by temporary challenges. Its share price has fallen by more than 50% in 2022 even as its sales and earnings continued to skyrocket.
Image source: Embracer Group.
And the growth story has only just begun. The Lord of the Rings purchase should generate plenty of cash in the long run. Oh, and you may have noticed that media-streaming giant Netflix is leaning into the video game space with gusto. Did you know that Embracer's Dark Horse Media subsidiary already publishes the graphic novel versions of Netflix's Stranger Things, The Witcher, and Umbrella Academy? I can't say for sure that Embracer will develop games for Netflix, but a press release revealing such plans wouldn't surprise me, either.
So Embracer's stock is trading at fire-sale prices, its business is booming, and the company enjoys tremendous growth prospects in the video game industry. Based on these qualities, Embracer looks like a no-brainer buy right now.
An opportunity to buy a premium brand at a value price
Billy Duberstein (RH): After a blockbuster 2021, luxury furniture maker RH was on the cusp of a major business expansion this year. However, supply chain constraints and a weak home furnishings market in 2022 have delayed its plans.
While RH managed to grow its revenue slightly in its fiscal second quarter (which ended July 30) thanks to some fulfillment of its considerable backlog, management forecast that revenue would fall by 15% to 18% in its fiscal third quarter. RH is lapping the pandemic boom in home furnishing sales, and higher interest rates are also taking a big bite out of consumer demand. No wonder the stock is down 63% from its all-time high.
Still, RH's margins should remain healthy even in a down market, as CEO Gary Friedman decided to maintain pricing discipline to retain RH's premium brand, rather than follow competitors into widespread discounting. Adjusted (non-GAAP) operating margins were a healthy 24.7% last quarter. While management projects that metric will decline to the 18.5% to 19% range in Q3, that would still be a fairly healthy margin in a down market, and it includes several growth investments. RH also has a pretty solid balance sheet, with $2.1 billion in cash against a little over $2.5 billion in debt. The company has even been repurchasing shares. It bought back about a million shares at an average price of $255 in fiscal Q2 -- not too far below where shares trade now.
Moreover, RH has a lot of exciting developments underway. September saw the opening of RH Guesthouse, a luxury boutique hotel with a champagne and caviar bar in New York City. That marks its first venture into the hospitality space. It will also be launching two private planes and a chartered yacht under the RH brand by the end of this year.
Unfortunately, RH's debut in Europe -- the opening of RH England at a 17th-century country estate in Aynhoe Park -- was delayed from this past summer to spring 2023. The opening of RH Palo Alto was also postponed until next year.
Still, this just means RH is on the brink of a major expansion of its brand in 2023. While furniture will likely always be its biggest business, its expansion into restaurants, hospitality, and travel is a compelling turning point. If Friedman's audacious plan bears fruit, RH could become a multibagger from here -- especially since it trades at a price-to-earnings multiple of only 10 today.
