Author: Chong Ser Jing

Booking Holdings (NASDAQ: BKNG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Booking shares for the portfolio in May 2013 at a price of US$765 and subsequently made three more purchases (in December 2014 at US$1,141, in February 2016 at US$1,277, and March 2017 at US$1,771). I’ve not sold any of the shares I’ve bought.

The first three purchases have worked out pretty well for my family’s portfolio, with Booking’s share price being around US$1,990 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Booking shares.

Company description

Booking, formerly known as Priceline, was listed in March 1999, right in the middle of the dotcom bubble. When the bubble met its sudsy end, Booking’s share price collapsed by over 99% from peak-to-trough. But like a phoenix rising from the ashes, Booking’s share price then embarked on an incredible climb of more than 30,000% from the bottom (reached in October 2002) to where it is today.

At the beginning of its life as a public listed company, Booking was in the online travel business. Today it is still in the online travel business. The difference between now and then is that Booking was an unproven business with significant losses in the days of yore. Now, it is the world’s largest online travel company, and very profitable. Some of you may have booked hotels online with Agoda or Booking.com – that’s Booking, the company, in action!

In the first nine months of 2019, Booking pulled in US$11.7 billion in revenue. These came primarily from the following brands the company has:

• Booking.com – one of the world’s largest, if not the largest, online service for booking accommodation reservations
• KAYAK – an online service for users to search and compare prices for air tickets, accommodations, and car rentals from hundreds of travel websites
• priceline – an online travel agent in North America for reservations of hotels, rental cars, air tickets, and vacation packages
• Agoda – a website for accommodation reservations, with a focus on consumers in the Asia-Pacific region
• Rentalcars.com – an online worldwide rental car reservation service
• OpenTable – allows consumers to make restaurant reservations online, and provides restaurant reservation management and customer acquisition services to restaurant operators.

Booking.com, which is based in the Netherlands, is Booking’s largest brand – it accounted for 77% of the company’s total revenue in the first nine month of 2019. Because of the location of Booking.com’s headquarters, Booking counts the Netherlands as its largest geographical market (a 77% share of the pie). The US is Booking’s next largest country, with a 10% share of total revenue.

Each time you make a hotel reservation, Booking earns either the entire room rate as revenue, or earns a referral fee. This is because the company runs two different business models:

• There is the merchant model, where Booking earns the entire room rate when rooms are booked through its platforms. It is a more complex model as the company has to negotiate room prices and allocations with the operator of the property. Ensuring parity between the company’s room-rate and the operator’s room-rate is likely also a tricky problem.
• Then there is the agency model, which is a lot simpler. It allows hoteliers to set their own price and room allocations. Under this model, Booking is the agent that passes customer reservations to hotels and it collects a commission fee for each reservation made. Guests also pay only on checkout, compared to the merchant model where guests have to pay when the reservation is made (so now you know why certain travel websites require you to pay upfront, while some don’t!). 

In the first nine months of 2019, 68% of Booking’s total revenue of US$11.7 billion came from its agency business, while 25% was from the merchant model. Advertising and other types of services accounted for the rest. Nearly all of Booking’s agency revenue came from Booking.com.    

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Booking.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

I’m confident that online travel is a huge and growing market because of a few data points.

First, according to statistics from travel research firm PhocusWright that were cited by travel review site TripAdvisor, the global travel market was estimated to be US$1.3 trillion in 2016, with online travel spend accounting for US$492 billion (38%). The latest data from PhocusWright that was cited by TripAdvisor in the latter’s November 2019 investor presentation showed that the global travel market had expanded to around US$1.7 trillion for 2019.

Second, Allied Market Research released a report in mid-2019 that contained a forecast for the online travel market to grow by 11.1% annually from 2016 to 2022 to reach US$1.1 trillion.

Third, aircraft manufacturer Airbus expects air travel traffic to grow by 4.3% annually from 8.7 trillion RPK in 2018 to 20.3 trillion RPK in 2038, driven by a rising middle class population across the globe (from 3.95 billion individuals in 2018 to 5.94 billion in 2038). Air travel traffic has been remarkably resilient in the past, and had grown by around 5.5% annually in the 30 years from 1988 to 2018. The chart just below shows the growth of global air travel traffic, in terms of RPK (RPK stands for revenue passenger-kilometres, which is the number of fare-paying passengers multiplied by the distance travelled), since 1978.

The following chart shows the sources for the expected global air travel traffic growth of 4.3% per year from 2019 to 2038:

For context, Booking’s revenue is only US$14.9 billion over the last 12 months, suggesting a long runway for growth for the company. 

2. A strong balance sheet with minimal or a reasonable amount of debt

Booking has a strong balance sheet right now, with slightly more cash and investments than debt as of 30 September 2019 (US$8.8 billion in cash and investments against US$8.5 billion in debt).

Note: Booking’s cash and investments of US$8.8 billion excludes US$2.9 billion in strategic investments that the company has in Trip.com (a China-focused travel agent), Meituan Dianping (a China-based e-commerce platform for services), Didi Chuxing (China’s leading ride hailing platform), and other private companies, such as Grab, the Singapore-based version of Didi Chuxing.

The company also has an excellent track record in generating free cash flow. I’ll discuss this later.  

3. A management team with integrity, capability, and an innovative mindset

On integrity

Glenn Fogel, 57, is currently Booking’s CEO. He joined the company in February 2000 and was promoted to his current role in January 2017. Prior to being CEO, Fogel was already a key leader in Booking since 2009. I appreciate his long tenure with the company. Seeing Booking promote from within is also a positive sign on its culture.

Fogel’s total compensation was US$20.5 million for 2018, which is a tidy sum of money. But it is a reasonable amount when we consider that Booking’s profit and free cash flow in 2018 were US$4.0 billion and US$4.6 billion, respectively.

68% of Fogel’s total compensation for 2018 came from long-term stock awards that depend on the performance of Booking’s stock price and adjusted EBITDA (earnings before interest, taxes, depreciation, and amortisation) over a three year period. I’m not the biggest fan of EBITDA and would much prefer the use of earnings per share or free cash flow per share. I also typically frown upon compensation plans that are linked to a company’s stock price. But there are strong redeeming factors in Booking’s overall compensation structure:

• The adjusted EBITDA excludes any positive impacts from acquisitions as well as the sale of loss-making subsidiaries; so, the performance of the adjusted EBITDA will have to depend on the growth of Booking’s core businesses.
• The changes to adjusted EBITDA and the stock price are measured over three years, which is a sufficiently long time period (although I wouldn’t mind an even longer time frame!).
• Fogel’s base salary and cash bonus is designed to be below the market rate, to incentivise him to lead Booking towards strong long-term business performance in order to earn his attractive stock awards.

In all, I think that Booking’s compensation structure for Fogel aligns his interests with mine as a shareholder of the company. I want to point out too that Booking’s other key leaders, including CFO David Goulden (59 years old) and General Counsel Peter Millones Jr. (49 years old), also have similar compensation structures as Fogel’s. In addition, Booking’s compensation plan for its leaders has been substantially similar for many years – that’s another plus-point for me on the integrity of the company’s management team.

I also want to mention Jeffrey Boyd, 62. He has been the Chairman of Booking’s board of directors since January 2013, and was CEO of the company from November 2002 to December 2013. He also became interim CEO from April 2016 to December 2016 (more on this in the Risk section of this article). As Chairman of the board, Boyd’s compensation was just US$491,399 in 2018. It is an extremely low sum compared to the scale of Booking’s business, and I think it’s another testament to the integrity that Booking’s leaders have. 

On capability and innovation

Earlier, I mentioned that Booking’s key brand is Booking.com. In 2005, Booking acquired the Netherlands-based Booking.com for merely US$133 million. In just the first nine months of 2019, Booking.com produced around US$9 billion in revenue, representing 77% or so of Booking’s overall top-line. These stunning figures make the acquisition price-tag of US$133 million look like one of the greatest business deals of all time. Jeffrey Boyd, the company’s current Chairman of the Board, was Booking’s CEO at the time of the acquisition.

As a platform for online travel reservations, I believe Booking’s business exhibits a classic network effect, where having more accomodation properties on its platform leads to more visitors, which in turn leads to more accommodation properties. Booking’s management has done a fantastic job in growing its accommodations network over the years. The table below shows this, along with the growth in the number of room nights booked by travellers, demonstrating the power of Booking’s network effect.

The company’s growth in unique accommodations is noteworthy. Online travel is a massive and growing market, so I think there is room for multiple winners. But I still see AirBnB, with more than 6 million listings in early 2019, as one of the main threats to Booking’s business. (Note: The definition of listings by AirBnB is different from Booking’s property-count in the table above, but the key point is that AirBnB also has a wide network.) I’m sure most of you reading this have used, or at least heard of, AirBnB’s online platform that provides travellers with alternative accommodation options to hotels. Booking has amassed a sizable inventory of unique accommodations of its own, to management’s credit – and this part of the business is growing faster than Booking’s main hotel business.

There’s an aspect of Booking’s accommodations network that I think is underappreciated by investors: The supplier- and customer-support that is provided by the company. Booking is able to provide 24/7 support in nearly 50 languages – small, independent hotels and owners of alternative accommodations are unable to provide that for travellers. This is why Booking believes its services enable this group of accommodation-providers to reach a wider audience than they otherwise could by themselves. To be clear, Booking believes that its services are valuable to large hotel chains too. It is worth noting that independent hotels make up around 40% to 50% of the total hotel supply in Asia Pacific, Middle East, Africa, Europe, and Latin America; in the US, it is 72%. 

Bookiing’s leaders have also proven to be quick to adapt, in my view. I want to bring up two points on the matter.

First, the company had produced significant growth in agency revenue from 2007 to 2017, with merchant revenue being relatively flat (especially from 2011 to 2017). But when the agency business started facing growth headwinds in 2018 and the first nine months of 2019, the merchant business helped to pick up the slack with significant growth. These are shown in the table just below.

Second, the company had traditionally been big spenders on performance marketing, which are marketing expenses on online search engines (primarily Google) and other travel-related websites to drive traffic to Booking’s own websites. But after experiencing a decline in the return on investment in performance marketing, Booking started to place heavier emphasis on brand marketing in the past few years.

I believe that brand advertising will be a net benefit to the long-term health of Booking’s business – if the brand advertising efforts are a success, travellers will flock to Booking’s websites without the need for the company to advertise online. The changes in the growth of Booking’s performance marketing spend and brand marketing spend over the past few years is shown in the table below. The early signs are mixed. On one hand, Booking’s direct channel (where customers head to the company’s websites directly) is growing faster than its paid channel (where customers visit the company’s websites because of performance-marketing adverts). On the other hand, management had expected its brand advertising results to be better. I have confidence that Booking’s management will work things out in the end. 

Booking’s culture can be described as decentralized, empowered, and innovative. According to a 2014 interview of Booking’s former CEO, Darren Huston, the company operates in small teams that are no larger than eight people, and runs more than 1,000 concurrent experiments on its products every day. Booking’s current CEO, Glen Fogel, was interviewed in 2018 by Skift and revealed that constant testing is still very much in the company’s DNA.

Perhaps the greatest feather in the cap of Booking’s management is the fact that the company has handily outpaced its rival Expedia over the long run. In 2007, Expedia’s revenue was almost twice of Booking’s. But Booking’s revenue over the last 12 months was significantly higher than Expedia’s.

Being a travel-related technology company, it’s no surprise to learn that Booking also has an innovative streak. The company is working with machine learning and artificial intelligence to improve people’s overall travel experience. In particular, Booking’s highly interested in the connected trip, where a traveller’s entire travel experience (from flights to hotels to ground-transport to attraction-reservations, and more) can be integrated on one platform. Another nascent growth area for Booking is payments, which the company started investing in only in recent years. Here’s CFO David Goulden describing the purpose of the company’s payments platform during Booking’s 2018 third-quarter earnings conference call:

“[The payments platform] does a number of great things for us, for our customers and our partners. For our customers, it gives them many more choices to how they may want to pay for their transactions in advance or closer to the stay, it gives them more opportunities to pay with the payments product of their choice, it may not necessarily be a credit card, it could be something like an Ally pay for example.

For us, it lets us basically provide our customers with a more consistent service, because we’re in charge of exactly how that payment flow works.

And then for our partners, again, we offer them more ability to access different payment forms from different customers in different parts of the world, because we can basically pay them the partner in the form of whatever they like to take even though we may have taken the payment in on the front end, there are different payment mechanisms.”

I also think management’s investments in a number of Asia-focused tech start-ups are smart moves. As I mentioned earlier, Booking has stakes in Meituan Dianping, Didi Chuxing, and Grab. These investments aren’t just passive. Booking is actively collaborating with some of them. Here’s Booking’s CEO Glenn Fogel in the aforementioned interview with Skift describing how the company is working with Didi Chuxing to improve the experience of travellers in China:

“Now until recently by the way, DiDi only had a Chinese app. Kind of hard for most of the people who go to China to use it. Recently now, they have an English language one. But still, we have a lot of customers, English isn’t their language, right? So what we’ve done is this deal is so wonderful.

One, our customers, they go onto the Booking.com or they go to the app and you’ll be able to get that ground transportation from Didi app in the language that they were doing the work with Booking or Agoda. Really good. Nice, seamless, frictionless thing. Second thing is, we’re going to work with them so we can help make sure all those Didi customers know about Booking.com and Agoda. You need a place to stay, that’s where you can go and get a great deal, a great service in Chinese.”            

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

I believe that Booking’s revenue streams are highly recurrent because of customer-behaviour. Each time you travel, you’ll need to reserve accommodations and arrange for transport options. Moreover, I think it’s highly likely that Booking does not have any customer-concentration – I showed earlier that 654 million room-nights were reserved through Booking’s platforms in the first nine months of 2019. 

5. A proven ability to grow

The table below shows Booking’s important financials from 2007 to 2018:

A few key points about Booking’s financials:

• Revenue has compounded impressively at 23.6% per year from 2007 to 2018; over the last five years from 2013 to 2018, the company’s annual topline growth was slower but still strong at 16.4%. 
• The company also managed to produce strong revenue growth of 33.8% in 2008 and 24.0% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
• Net profit has surged by 35.7% per year from 2007 to 2018. Like revenue-growth, Booking’s net profit growth from 2013 to 2018 is slower, but still healthy at 16.1%.
• Operating cash flow has not only grown in each year from 2007 to 2018. It has also increased markedly with annual growth of 37.9%, and been consistently positive. The growth rate from 2013 to 2018 was considerably slower at 18.3% per year, but that is still a good performance.
• Free cash flow, net of acquisitions, has consistently been positive too and has also stepped up from 2007 to 2018 at a rapid clip of 38.9% per year. The annual growth in free cash flow from 2013 to 2018 was 19.7% – not too shabby. Booking’s free cash flow fell dramatically in 2014 because it acquired OpenTable for US$2.4 billion during the year.  
• The net-cash position on Booking’s balance sheet was mostly positive. I include Booking’s investments in bonds and debt as part of its cash, but I exclude the company’s strategic investments. 
• Dilution has also been negligible for Booking’s shareholders from 2007 to 2018 with the diluted share count barely rising in that period. 

2019 has so far been a relatively tough year for Booking. Revenue was up by just 3.7% to US$11.7 billion in the first nine months of the year. Adverse currency movements and a decline in the average room-rate had dented Booking’s top-line growth. Profit inched up by just 0.9% year-on-year to US$3.28 billion after stripping away non-core profits. Booking has strategic investments in other companies and some of them are listed; accounting rules state that Booking has to recognise changes in the stock prices of these companies in its income statement. A 9.4% reduction in the company’s diluted share count to 43.9 million resulted in adjusted earnings per share for the first nine months of 2019 climbing by 11.4% to US$74.52 from a year ago. Operating cash flow declined by 11.0%, but was still healthy at US$3.8 billion. Free cash flow was down 6.9% to US$3.5 billion. The balance sheet, as mentioned earlier, remains robust with cash and investments (excluding the strategic investments), slightly outweighing debt.

Booking has an impressive long-term track record of growth, so I’m not concerned with the slowdown in 2019 thus far. The market opportunity is still immense, and Booking has a very strong competitive position with its huge network of accommodations spanning large hotel chains to unique places to stay.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

There are two reasons why I think Booking excels in this criterion.

Firstly, the company has done very well in producing free cash flow from its business for a long time. In the past five years from 2013 to 2018, its average free cash flow margin (free cash flow as a percentage of revenue) was strong at 26.5%. Booking’s free cash flow margin was 29.8% in the first nine months of 2019.

Secondly, there’s still tremendous room to grow for Booking. This should lead to higher revenue for the company over time. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t – that will mean even more free cash flow for Booking in the future.

Valuation

I like to keep things simple in the valuation process. In Booking’s case, I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value for two reasons: (1) The online travel company has a strong history of producing positive and growing free cash flow; and (2) the company’s net profit is muddied by the inclusion of changes in the stock prices of its strategic investments. 

Booking carries a trailing P/FCF ratio of around 20 at a share price of US$1,990. This ratio strikes me as highly reasonable when we look at the company’s excellent track record of growth, strong network of accommodation options across its websites, and opportunities for future expansion in its business. Moreover, this P/FCF ratio is low when compared to history. The chart below shows Booking’s P/FCF ratio over the past five years.

The risks involved

Every company has risks, and Booking is no exception. There are a few key ones that I see.

The first is management turmoil. I have confidence in the quality of Booking’s current leaders. But the company has seen some management shake-ups in recent years.

Earlier, I mentioned that current Chairman Jeffrey Boyd had to become interim CEO in April 2016 (till December 2016). That’s because the then-CEO of both Booking and Booking.com (Booking.com is the main brand of Booking the company), Darren Huston, stepped down from his roles in the same month after he was caught in a relationship with an employee. He was promoted to CEO of Booking only in January 2014. Gillian Tans, a long-time Booking employee, assumed the position of CEO for Booking.com right after Huston’s departure. But she was replaced by Glenn Fogel after just over three years (Fogel is now the CEO of both Booking.com and Booking the company). Booking’s current CFO, David Goulden, stepped into his current role only in January 2018 after long-time CFO Daniel Finnegan announced his retirement in 2017. The good thing is that Booking can still benefit from Boyd’s experience, and Fogel has a long tenure with the company. I will be keeping an eye on leadership transitions at Booking.

The second risk involves downturns in travel spending. Travellers could tighten their purse strings in the face of a global recession or slowdown in economic growth, for instance, since travel can be considered a discretionary activity. The good thing here is that Booking managed to post significant growth during the Great Financial Crisis. But the company’s much larger today, so it may not be able to outrun a future recession as it has in the past.

Another potential important reason for consumers to travel less will be outbreaks of contagious diseases. The world – particularly China – is currently battling COVID-19. If the situation worsens, Booking’s business could be hurt. The good thing with such cases is that the idea of “This too, shall pass” applies. Natural disasters could also dent travel spending. In 2010, the Icelandic volcano Eyjafjallajökull erupted. Many flights that involved Europe were disrupted for a period of time, and the episode was a speed bump for Booking. The clouds eventually cleared for the company, but there could be similar instances in the future.

The last important risk I see with Booking relates to competition. In 2018, Google launched Google Hotels, its search product that focuses on – you guessed it – hotels. As a result, travel websites such as Expedia and TripAdvisor started feeling the heat from Google. This is what Skift reported in a November 2019 article:

“The fact that Google is leveraging its dominance as a search engine into taking market share away from travel competitors is no longer even debatable. Expedia and TripAdvisor officials seem almost depressed about the whole thing and resigned to its impact…

… Both Okerstrom [Expedia CEO] and Kaufer [TripAdvisor CEO] complained that their organic, or free, links are ending up further down the page in Google search results as Google prioritizes its own travel businesses.”

This is where Booking’s huge spending on performance marketing and pivot toward brand marketing comes into play. Booking has been spending billions of dollars on performance marketing, most of it likely on Google Search – this stands in contrast to Expedia and TripAdvisor, which have relied more heavily on free search results from Google. So I believe that Google and Booking currently have a frenemy type of relationship – both rely on each other for business but are also somewhat competitors. But if Booking is successful in building its brand and mindshare among travellers through its brand marketing initiatives, there will be a lot less reliance on Google, thereby lessening the threat of the online search giant.

AirBnB, with its focus on alternatives to hotels, could also be a formidable threat for Booking. Moreover, AirBnB has been making inroads into the hotel-reservations business, such as its acquisition of HotelTonight in March 2019. But like I mentioned earlier, Booking has its own huge and growing supply of hotel-alternatives for travellers to choose from. Ultimately though, I believe that online travel is such a huge pie that multiple winners can exist – and Booking is likely to be one of those.

Meanwhile, in Booking’s latest quarterly earnings report, it also listed other internet giants besides Google – the list includes Apple, AliBaba, Tencent, Amazon, and Facebook – as potential competitors with significant resources to mount a serious assault on the company’s business. So far, Booking has held its own. But it is always possible that another company might build a better mousetrap in the future.

A smaller risk that I perceive relates to Booking’s multi-billion stakes in the Chinese companies, Meituan Dianping, Trip.com, and Didi Chuxing. Booking’s investments in them are based on a variable interest entity (VIE) structure, which is considered to be common with Chinese internet companies. But there’s a risk that China’s government may someday view the VIE structure as a violation of China’s laws.                  

The Good Investors’ conclusion

I think the online travel market holds immense opportunities for companies, especially for an organisation with a wide network of hotels and alternative accommodations, such as Booking, for instance.

Furthermore, Booking has a robust balance sheet, a proven ability to generate strong free cash flow, high levels of recurring revenues, and an excellent management team whose interests are aligned with shareholders. Booking’s P/FCF ratio is also low in relation to its own history.

Every company has risks, and I’m aware of the important ones with Booking. They include recent management turmoil, competition from Google and other tech players, and a few factors that could dampen travel spending. But after weighing the risks and rewards, I’m more than happy for my family’s investment portfolio to continue flying high with Booking.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

PayPal Holdings (NASDAQ: PYPL) is one of the 50-plus companies that’s in my family’s portfolio. I first bought PayPal shares for the portfolio in June 2016 at a price of US$38, again in November 2018 at US$83, and yet again in June 2019 at US$117. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with PayPal’s share price being around US$116 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold PayPal shares. 

Company description

PayPal was first listed in the US stock market in February 2002, but it was acquired by e-commerce site eBay just a few months later. The acquisition made sense for PayPal, as the company could tap on eBay’s larger network of users and gross merchandise volume.

Interestingly, PayPal outgrew eBay over time. Eventually, PayPal was spun off by eBay in mid-2015 through a new IPO. On the day of PayPal’s second listing, its market capitalisation of around US$47 billion was larger than eBay – and has since nearly tripled.

It’s likely that even for us living in Singapore, we have come across PayPal’s online payment services. But there is more to the company. PayPal’s payments platform includes a number of brands – PayPal, PayPal Credit, Braintree, Venmo, Xoom, and iZettle – that facilitate transactions between merchants and consumers (and also between consumers) across the globe. The platform works across different channels, markets, and networks.

PayPal recently added discount-discovery services for consumers to its portfolio. It announced a US$4 billion acquisition of Honey in November 2019 that closed earlier this month. According to PayPal, Honey “helps consumers find savings as they shop online.” Honey has around 17 million monthly active users, partners with 30,000 online retailers across various retail categories, and has helped its user base find more than US$1 billion in savings in the last 12 months.

PayPal’s revenue comes primarily from taking a small cut of its platform’s payment volume. This transaction revenue accounted for 90.3% of PayPayl’s revenue of US$12.8 billion in the first nine months of 2019. Other business activities including partnerships, subscription fees, gateway fees, service-related fees, and more (collectively known as other value added services) comprise the remaining 9.7% of PayPal’s net revenue. 

The US was PayPal’s largest country by revenue in the first nine months of 2019 with a 53.2% share. In a distant second is the UK, with a weight of 10.5%. No other single country made up more than 10% of the company’s net revenue.

Investment thesis

I had previously laid out my investment framework in The Good Investors. I will use the framework, which consists of six criteria, to describe my investment thesis for PayPal.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

PayPal’s business is in digital and mobile payments. According to a 2018 PayPal investor presentation, this market is worth a staggering US$110 trillion, as shown in the chart below. For context, PayPal raked in just US$17.0 billion in revenue in the 12 months ended 30 September 2019 based on US$676.2 billion (or just US$0.676 trillion) in payment volume that flowed through its platform.

Around 80% of transactions in the world today are still settled with cash, which means digital and mobile payments still have low penetration. This spells opportunity for PayPal. 

2. A strong balance sheet with minimal or a reasonable amount of debt

PayPal’s balance sheet looks rock-solid at the moment, with US$5.0 billion in debt against US$6.9 billion in cash, as of 30 September 2019. The picture is likely to change with the aforementioned US$4 billion acquisition of Honey, but we will only know when PayPal announces its 2020 first-quarter results (which should take place sometime in April this year).

I’m not worried though, because PayPal has a storied history of producing strong free cash flow which I’m going to discuss later.

3. A management team with integrity, capability, and an innovative mindset

On integrity

PayPal’s key leader is CEO Dan Schulman, who’s 61 this year. In 2018, the lion’s share of the compensation for PayPal’s key leaders (including Schulman and a handful of other senior executives) came from the following:

• Stock awards that vest over a three-year period
• Restricted stock awards that depend on the growth in PayPal’s revenue and free cash flow over a three-year period
• (Specifically for Schulman) Stock awards that depend on the performance of PayPal’s share price over a five-year period

PayPal’s compensation structure for its key leaders has emphases on free cash flow, multi-year-vesting for stock awards, and a dependence on the company’s long-term share price movement. I think this structure aligns my interests as a shareholder with the company’s leaders.

Moreover, PayPal requires its CEO and other senior executives to hold shares that are worth at least three to six times their respective base salaries. This results in skin in the game for PayPal’s leaders. As of 29 March 2019, Schulman himself controlled 719,297 PayPal shares that are collectively worth around US$80 million at the current share price; other members of the company’s senior management team each controlled around US$11 million to US$14 million worth of shares.

On capability and innovation

Some members of PayPal’s senior management team have relatively short tenures with the company, as illustrated in the table below. But together, they have accomplished plenty since PayPal’s separation from eBay.

First, the company has grown its network of users impressively since the spin-off. The table below shows how PayPal’s transactions, payments volume, and active accounts have changed from 2014 to the first nine months of 2019.

Second, PayPal has made a number of impressive acquisitions in recent years under Schulman. They are:

• Digital international money-transfer platform Xoom (acquired in November 2015 for US$1.1 billion). The platform’s money-transfer network covers more than 160 countries.
• iZettle, a provider of solutions to small businesses for the acceptance of card payments and sales management and analytics (acquired in September 2018 for US$2.2 billion).  PayPal acquired iZettle to strengthen its payment capabilities in physical stores and provide better payment solutions for omnichannel merchants. I believe that a retailer’s ability to provide a seamless omnichannel shopping experience is crucial in today’s environment. When iZettle was acquired, it operated in 12 countries across Europe and Latin America, and was expected to deliver US$165 million in revenue and process US$6 billion in payments in 2018.

Third, PayPal has been striking up strategic partnerships in many areas since becoming an independent company. The slides below from PayPal’s 2018 Investor Day event says it all: PayPal had no strategic partners when it was still under eBay!

4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour

I mentioned earlier that PayPal’s primary revenue source is payments that take place on its platform. And when I discussed PayPal’s management, I also pointed out that the company had processed 8.9 billion transactions in the first nine months of 2019 from 295 million active accounts (at the end of 2018, PayPal had 267 million active accounts, of which 21 million are merchants).

I think that these high numbers highlight the recurring nature of PayPal’s business. It’s also worth noting that there’s no customer-concentration: No single customer accounted for more than 10% of PayPal’s revenues in 2016, 2017, and 2018.

5. A proven ability to grow

PayPal returned to the stock market only in 2015, so I don’t have a long track record to study. But I’m impressed by what the company has.

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” PayPal fits the bill. A few key things to note:

• Revenue has increased in each year from 2012 to 2018, and has compounded at a healthy clip of 18.2% per year.
• Net profit was always positive, and has increased by 17.6% per year.
• PayPal has not diluted shareholders too. Its 68% growth in net profit from 2015 to 2018 is similar to the 71% jump in diluted earnings per share (EPS) over the same timeframe. 
• Operating cash flow and free cash flow were always positive in each year, and the two important financial metrics have compounded at impressive annual rates of 23.2% and 28.1%, respectively. 
• PayPal’s operating cash flow and free cash flow in 2018 had enjoyed a one-time boost from the sale of the company’s US consumer credit receivables portfolio in July that year. But even after making the relevant adjustments, PayPal’s operating cash flow and free cash flow for the year would still be strong at US$4.1 billion and US$3.3 billion, respectively. 
• PayPal’s balance sheet was stellar throughout, given the high net cash position. 

PayPal continued to grow in the first nine months of 2019. Revenue was up 14.1% to US$12.8 billion, driving a 32.5% jump in net income to US$1.95 billion (diluted EPS grew 34.4% to US$1.64). Operating cash flow and adjusted free cash flow came in at US$3.3 billion and US$2.8 billion, respectively; adjusted free cash flow was up 25% from US$2.2 billion a year ago.

I see two notable traits in PayPal’s network: 

• PayPal has a global reach. It is able to handle transactions in over 200 markets, and allow its customers to receive money in 100 currencies, withdraw funds in 56 currencies, and hold PayPal account balances in 25 currencies.
• I believe PayPal’s business exhibits a classic network effect. Its competitive position strengthens when its network increases in size. When I discussed PayPal’s management earlier, I showed that the volume of payments and number of transactions increased faster than the number of accounts. This means that PayPal’s users are using the platform more over time – to me, this indicates that PayPal’s platform is becoming more valuable to existing users as more users come onboard.

I also want to point out two payment services providers that are in PayPal’s portfolio; I think that they are crucial for the company’s future growth:

• The first is mobile payments services provider Braintree, which was acquired in 2013 for US$713 million. Braintree provides the technological backbone for the payment tools of many technology companies, including ride-hailing app Uber, cloud storage outfit DropBox, and accommodations platform AirBnB. Braintree helps PayPal better serve retailers and companies that conduct business primarily through mobile apps.
• The second is digital wallet Venmo (acquired by Braintree in 2012), which allows peer-to-peer transactions. Venmo is highly popular among millennials in the US, and PayPal reported that there were more than 40 million active accounts for the digital wallet in 2019’s first quarter. During 2019’s third quarter, Venmo’s total payment volume surged by 64% from a year ago to US$27 billion (and up more than five times from just three years ago in the third quarter of 2016). The annual run rate of Venmo’s total payment volume has also now exceeded US$100 billion. Meanwhile, monetisation of Venmo has progressed at a rapid clip. The digital wallet’s annual revenue run rate in 2019’s third quarter was nearly US$400 million, double the US$200 million seen in 2018’s fourth quarter.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

PayPal has excelled in producing free cash flow from its business for a long time, and has huge growth opportunities ahead. There’s no reason to believe these will change any time soon. 

Valuation

I like to keep things simple in the valuation process. In PayPal’s case, I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value. That’s because the payment services outfit has a strong history of producing positive and growing free cash flow.

PayPal carries a trailing P/FCF ratio of around 38 at a share price of US$116, after adjusting for the one-time boost to the company’s free cash flow in 2018. This ratio looks a little high relative to history. For perspective, PayPal’s P/FCF ratio was only around 28 in the early days of its 2015 listing.

But I’m happy to pay up, since PayPal excels under my investment framework. 

The risks involved

There are six key risks I see in PayPal.

First, the payments space is highly competitive. PayPal’s muscling against other global payments giants such as Mastercard and Visa that have larger payment networks. Then there are technology companies with fintech arms that focus on payments, such as China’s Tencent and Alibaba. In November 2019, Bloomberg reported that Tencent and Alibaba plans to open up their payment services (WeChat Pay and Alipay, respectively) to foreigners who visit China. Let’s not forget that there’s blockchain technology (the backbone of cryptocurrencies) jostling for room too. There’s no guarantee that PayPal will continue being victorious. But the payments market is so huge that I think there will be multiple winners – and my bet is that PayPal will be among them.

Second, there’s eBay’s relationship with PayPal. When the two companies separated, they signed a five-year deal – expiring in July 2020 – for PayPal to help eBay process payments. eBay announced in 2018 that it would not renew the deal when it expires (although PayPal will still be a payment-button on eBay’s site through July 2023). eBay accounted for 8% of PayPal’s total payment volume (TPV) in 2019’s third quarter. But PayPal’s management expects the percentage to fall to “well under 5%” by the end of 2020. eBay’s also a waning presence in e-commerce, so I don’t think it holds any importance to PayPal’s future growth. During 2019’s third quarter, PayPal’s total TPV (excluding currency movements) grew by 27% despite the 3% decline in eBay’s TPV (similarly excluding currency movements) on PayPal’s platform.

The third risk I’m watching is regulations. The payments market is heavily regulated. What PayPal can take per payment-transaction could be lowered in the future by regulators for various reasons.

The fourth risk concerns recessions. I don’t know when a recession (in the US or around the world) will occur. But when it does, payment activity on PayPal’s platform could be lowered. PayPal’s business was remarkably resilient during the last major global economic downturn in 2008 and 2009. Back then, eBay had no revenue-growth from its main e-commerce platform. But the segment that consisted primarily of PayPal produced strong double-digit revenue growth in both years. PayPal’s a much larger company today, so it may not be able to grow through a future recession that easily – but its historical track record is impressive.

The US$4 billion acquisition of Honey represents the fifth risk. I want to be clear: I like the deal and I think it will work out great. But it’s still a risk. Let me explain. Honey’s revenue in 2018 was over US$100 million, with growth of more than 100% –  and the company was already profitable. In a recent article, Ben Thompson from Stratechery shared how the acquisition can lead to upside for PayPal’s business:

“The most important effect, according to Schulman, was on PayPal’s relationship with consumers. Now, instead of being a payment option consumers choose once they have already committed to a purchase, PayPal can engage with consumers much higher in the purchase funnel. This might be one step higher, as would be the case with coupon search, but it could also be around discovery and calls-to-action, as might be the case with the app or notifications and price-tracking…

…Honey is also an intriguing way for PayPal to actually make money on Venmo in particular. Honey’s audience skews heavily female and millennial, which means there is a lot of overlap with Venmo, and there is a good chance PayPal can really accelerate Honey’s adoption by placing it within its core apps (which it plans to do within the next 6 to 12 months)…

…If PayPal, via Honey, knows exactly what you are interested in buying, and can make it possible for merchants to offer customized offers based on that knowledge, well, that may be a very effective way to not only capture affiliate revenue but also payment processing revenue as well. Demand generation remains one of the most significant challenges for merchants… And here the fact that PayPal has 24 million merchant partners versus Honey’s 30,000 is a very big deal.”

But Honey is PayPal’s largest acquisition ever, and the deal comes with a steep price tag of US$4 billion. Assuming Honey can grow its revenue by 100% in 2019, PayPal is effectively paying 20 times revenue for the discount discovery company. I will have to face a situation of PayPal writing down the value of Honey if the integration of the two fails to live up to expectations.

Lastly, I’m mindful of succession risk. PayPal’s CEO, Dan Schulman, is already 61 this year. Fortunately, PayPal’s key leaders are mostly in their mid-fifties or younger.

The Good Investors’ conclusion 

I think the transition from cash to cashless payments holds immense opportunities for companies. I also think a payment company with a wide network of consumers and merchants (PayPal, for instance) stands a good chance of being one of the eventual winners. 

Furthermore, PayPal has a robust balance sheet, a proven ability to generate strong free cash flow, high levels of recurring revenues, and an excellent management team whose interests are aligned with shareholders. PayPal’s P/FCF ratio is on the high end, but I’m happy to pay up for a top-quality business.

Every company has risks, and I’m aware of the important ones with PayPal. They include competition, regulation, and more. But after weighing the risks and rewards, I’m still happy to allow PayPal to be pally with my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

MercadoLibre (NASDAQ: MELI) is one of the 50-plus companies that’s in my family’s portfolio. I first bought MercadoLibre shares for the portfolio in February 2015 at a price of US$131 and subsequently made two more purchases (in May 2016 at US$129 and in May 2017 at US$287). I’ve not sold any of the shares I’ve bought.

The purchases have worked out very well for my family’s portfolio, with MercadoLibre’s share price being around US$660 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold MercadoLibre shares.

Company description

MercadoLibre – “free market” in Spanish – was founded in 1999 and has rode the growth of the internet and online retail to become the largest e-commerce company in Latin America today, based on unique visitors and page views. The company is present in 18 countries including Brazil, Argentina, Mexico, and Chile.

There are six integrated e-commerce services that MercadoLibre provides:

• MercadoLibre Marketplace: An online platform that connects buyers and sellers; it earns revenue by taking a small cut of each transaction.
• Mercado Pago: A fintech platform that primarily facilities online payments, and online-to-offline (O2O) payments. It can be used both within and outside MercadoLibre’s marketplaces.  
• Mercado Envios: A logistics solution that includes fulfilment and warehousing services. 
• MercadoLibre Classifieds: An online classifieds service for motor vehicles, real estate, and services; it also helps direct users to Mercadolibre’s marketplaces.
• MercadoLibre advertising: A service that allows advertisers to display ads on MercadoLibre’s websites.
• Mercado Shops: A solution that helps sellers establish, run, and promote their own online stores.

MercadoLibre has two business segments. The first is Enhanced Marketplace, which consists of MercadoLibre Marketplace and MercadoEnvios. In the first nine months of 2019, Enhanced Marketplace accounted for 52% of the company’s total net revenue of US$1.6 billion. The second segment is Non-Marketplace, which houses the other four of MercadoLibre’s services. It accounted for the remaining 48% of MercadoLibre’s total net revenue in the first nine months of 2019. Most of the net revenue from Non-Marketplace is from MercadoPago – in 2018, more than 80% of Non-Marketplace’s net revenue came from payment fees.

From a geographical perspective, Brazil is MercadoLibre’s most important country. It accounted for 64% of the company’s total net revenue in the first nine months of 2019. Argentina and Mexico are in second and third place, respectively, with shares of 20% and 12%. The remaining 4% are from the other Latin American countries that MercadoLibre is active in.       

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for MercadoLibre.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

According to Satista, e-commerce sales in the Latin America region was US$53.2 billion in 2018, and represented just 2.7% of total retail sales in the region. For perspective, e-commerce was 11.2% of total retail sales in the US in the third quarter of 2019.

Forrester also expects the e-commerce market in Latin America’s six largest economies – that would be Argentina, Brazil, Chile, Colombia, Mexico, and Peru, which are all countries that MercadoLibre is active in –  to grow by more than 22% annually from 2018 to 2023. The projection of high growth for Latin America’s e-commerce space is reasonable in my eyes for two reasons.

First, there’s the aforementioned low penetration rate of online retail in Latin America’s overall retail scene. It’s worth noting too that despite Brazil, Argentina,and Mexico (MercadoLibre’s three largest markets) having similar internet-user and smartphone penetration rates as China, online retail is a much higher percentage of total retail in the Asian giant.

Second, internet penetration rates in Latin America are still relatively low: 86.0% of the US population currently has access to the internet, which is much higher than in Brazil, Argentina, and Mexico. For another perspective, Latin America has a population of around 640 million people, but has internet users and online shoppers of merely 362 million and 200 million, respectively.

Given all the numbers described above – and MercadoLibre’s current revenue of US$2.0 billion over the 12 months ended 30 September 2019 – it’s clear to me that the company has barely scratched the surface of the growth potential of Latin America’s e-commerce market.

I also want to point out that I see MercadoLibre possessing the potential to expand into new markets over time – I will discuss this in detail later.  

2. A strong balance sheet with minimal or a reasonable amount of debt

At the end of 2019’s third quarter, MercadoLibre held US$2.8 billion in cash, short-term investments, and long-term investments, against just US$732 million in debt. That’s a strong balance sheet.

3. A management team with integrity, capability, and an innovative mindset

On integrity

MercadoLibre’s co-founder is Marcos Galperin. He’s still young at just 48, but he has been leading the company as CEO, chairman, and president since its founding in 1999. Galperin is not the only young member of MercadoLibre’s senior management team with long tenure.

In fact, MercadoLibre’s Chief Financial Officer, Chief Operating Officer, Chief Technology Officer, and head of its payments operations are all between 41 and 51 years old, but have each been with the company for more than 10 years. They also joined MercadoLibre in less senior positions – it’s a positive sign for me on MercadoLibre’s culture to see it promote from within.

In 2018, Galperin’s total compensation was US$11.4 million, which is a tidy sum. But more than 90% of the compensation of MercadoLibre’s key leaders (Galperin included) for the year depended on the company’s annual business performance (including revenue and profit growth) and multi-year changes in the company’s stock price. To me, that’s a sensible compensation plan. Moreover, MercadoLibre paid its key leaders less in 2018 (Galperin’s compensation was 6% lower than in 2017) despite growing net revenue by 18%. That’s because MercadoLibre had flopped in terms of its profit-performance. I’m not worried about the profit situation – more on this later.

It’s also likely that Galperin’s interests are squarely aligned with myself and other shareholders of MercadoLibre. As of 15 April 2019, Galperin controlled 4 million MercadoLibre shares (8.1% of the total number of shares) through a family trust. These shares are worth around US$2.7 billion at the current share price.

On capability and innovation

As an e-commerce platform, there are a number of important business metrics for MercadoLibre, such as registered users, gross merchandise volume, items sold, and unique sellers. All four have grown tremendously over the years – even from 2007 to 2009, the period when the world was rocked by the Great Financial Crisis – as the table below illustrates. This is a strong positive sign on management’s capability.

A short walk through MercadoLibre’s history can also reveal the strength of the company’s management team and their innovativeness.

MercadoLibre started life in the late 1990s operating online marketplaces in Latin America. In 2004, the company established MercadoPago to facilitate online payments on its own platform. Over time, MercadoPago has seen explosive growth (in terms of payment volume and number of transactions); opened itself up to be used outside of MercadoLibre’s marketplaces; and added new capabilities that facilitate O2O payments, such as a mobile wallet, and processing payments through QR codes and mobile point of sales solutions. Impressively, during 2019’s third quarter, MercadoPago’s off-platform payment volume exceeded on-platform payment volume in a full quarter in Brazil (MercadoLibre’s largest market), for the first time ever. Then in 2013, MercadoLibre launched MercadoEnvíos, its logistics solution. MercadoEnvios has also produced incredible growth in the number of items it has shipped.

MercadoLibre’s service-innovations are intended to drive growth in the company’s online marketplaces. Right now, there are a number of relatively new but growing services at MercadoLibre:

• MercadoFondo: A mobile wallet service launched in the second half of 2018 that attracts users with an asset-management function.
• MercadoCredito: MercadoCredito, which was introduced in the fourth quarter of 2016, provides loans to merchants. Providing loans can be a risky business, but MercadoLibre is able to lower the risk since it knows its merchants well (they conduct business on the company’s online marketplaces). Furthermore, MercadoLibre can automatically collect capital and interest through MercadoPago, since its merchants’ business flows through the payment-service. MercadoCredito also provides loans to consumers.

Amazon.com is North America’s e-commerce kingpin. But it’s so much more than just online retail. Over time, Amazon has successfully branched into completely new areas with aplomb, such as cloud computing and digital advertising.

I would not be surprised to see MercadoLibre’s future development follow a similar arc as Amazon’s, in terms of having powerful growth engines outside of the core e-commerce business. Today, there are new growth areas that have already been developed outside – such as in the case of MercadoPago. MercadoLibre has an expansive and noble mission – to democratise commerce and access to money for the people of Latin America. I think MercadoFondo and, in particular, MercadoCredito, have the potential to grow significantly beyond MercadoLibre’s online marketplaces. Access to credit and investment/banking services is low in Latin America for both businesses and individuals (see chart below). It will be up to MercadoLibre to grasp the opportunity with both hands. I am confident the company will do so.

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

I think it’s highly likely that MercadoLibre enjoys high levels of recurring business because of customer behaviour. Two things to lend weight to my view:

• No single customer accounted for more than 5% of MercadoLibre’s net revenues in the first nine months of 2019, and in each of 2018, 2017, and 2016. 
• The company’s gross merchandise volume, number of items sold, number of registered users, payment volume, and number of payment transactions range from the hundreds of millions to billions. 

5. A proven ability to grow

The table below shows MercadoLibre’s important financials from 2006 to 2018:

A few things to note:

• Revenue growth has been excellent at Mercadolibre, with compound annual growth rates of 32% from 2006 to 2018, and 25% from 2013 to 2018. 
• Net profit was growing strongly up to 2016, before the situation appeared to have deteriorated dramatically on the surface. Thing is, the company had ramped up investments into its business in the form of higher marketing expenses, subsidies for shipping services for buyers on its marketplaces, and selling mobile point of sales solutions at low margins to entice off-platform usage of MercadoPago. These actions hurt MercadoLibre’s bottom-line in the short run, but I see them as positive for the long run. They draw in customers to MercadoLibre’s ecosystem, in turn creating a network effect. The more users there are on the online marketplaces, the more sellers there are, which lead to more users – and off the flywheel goes. It’s the same with MercadoPago, especially with off-platform transactions. The more merchants there are that accept MercadoPago, the more users there will be, leading to even higher merchant-acceptance – and off the flywheel goes, again. (Another reason for the drastic decline in profit in 2017 was an US$85.8 million loss related to the deconsolidation of MercadoLibre’s Venezuelan business in December of the year – more on this later.)
• Operating cash flow and free cash flow have both been consistently positive since 2006, and have also grown significantly. But in more recent years, both are pressured by the aforementioned investments into the business. It’s all the more impressive that MercadoLibre has produced positive operating cash flow and free cash flow while making the investments.
• The balance sheet has been strong throughout, with cash (including short-term investments and long-term investments) consistently been higher than the amount of debt.
• At first glance, MercadoLibre’s diluted share count appeared to increase sharply in 2008 (I start counting only in 2007, since the company was listed in August 2007). But the number I’m using is the weighted average diluted share count. Right after MercadoLibre got listed, it had a share count of around 44 million. This means that the company has actually not been diluting shareholders at all.

Impressively, MercadoLibre’s top-line growth has accelerated in 2019. In the first nine months of the year, revenue was up 60.3% to US$1.6 billion. The loss widened, from US$34.2 million a year ago to US$118.0 million, as the company continued to invest in the business in a similar manner as mentioned earlier. However, operating cash flow nearly doubled from US$196.1 million in the first nine months of 2018 to US$372.8 million. Slower, but still substantial, growth in capital expenditures resulted in free cash flow surging from US$124.0 million to US$272.0 million. The balance sheet, as mentioned earlier, remains robust with cash and investments significantly outweighing debt. Lastly, the diluted share count only crept up slightly from 44.3 million in the first nine months of 2018 to 48.4 million. 

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

Gale-level tailwinds are behind MercadoLibre’s back. The company also has a strong history of growth and innovation. These traits suggest that MercadoLibre could grow its business significantly in the years ahead.

Meanwhile, the Latin America e-commerce giant has a good track record in generating free cash flow despite heavy reinvestments into its business. I don’t expect MercadoLibre’s reinvestments to be heavy indefinitely, so there’s potential for the company’s free cash flow margin to improve significantly in the years ahead. The strong possibility of having a higher free cash flow margin in the future as well as a much larger revenue stream, means that MercadoLibre ticks the box in this criterion.

Valuation

You should hold your nose… because MercadoLibre’s traditional valuation numbers stink. Are you ready? At the current share price, the company has a negative price-to-earnings (P/E) ratio since it is sitting on a loss of US$2.65 per share over the last 12 months, while its trailing price-to-free cash flow (P/FCF) ratio is 115.

I will argue though, that MercadoLibre’s valuation numbers look so horrendous right now because it is reinvesting heavily into its business to grab the massive opportunity that it sees in Latin America’s e-commerce and digital payment markets. Management is willing to endure ugly short-term results for a good shot at producing excellent long-term business performance – I appreciate management’s focus on the long run.

The current sky-high P/FCF ratio and negative P/E ratio do mean that MercadoLibre’s share price is likely going to be volatile. But that’s something I’m very comfortable with.

The risks involved

For me, I see the instability in the political and economic landscape of the Latin America region as a huge risk for MercadoLibre.

If you look at the table on the company’s historical financials that I shared earlier, you’ll see this big drop in profit in 2014. The reason was because of impairments MercadoLibre made to its Venezuela business during the year. As recent as 2017, Venezuela was still the fourth-largest market for MercadoLibre. In fact, Venezuela accounted for 10.4% of the company’s revenue in 2014. But the country’s contribution to MercadoLibre’s business have since essentially evaporated after the company deconsolidated its Venezuelan operations in late 2017, as mentioned earlier. Venezuela has been plagued by hyperinflation, and political and social unrest in the past few years, making it exceedingly difficult for MercadoLibre to conduct business there.

On 12 August 2019, MercadoLibre’s share price fell by 10%. I seldom think it makes sense to attach reasons to a company’s short-term share price movement. But in this particular case, I think there’s a clear culprit: Argentina’s then-president, Mauricio Marci, who was deemed as pro-business, lost in the country’s primary election to Alberto Fernandez, a supporter of the Peronist movement; Fernandez ended up winning the actual presidential election a few months later. Meanwhile, Brazil’s president, Jair Bolsonaro, and his family are currently embroiled in serious corruption scandals.

MercadoLibre reports its financials in the US dollar, but conducts business mostly in the prevailing currencies of the countries it’s in. This means the company is exposed to inflation in the countries it operates in, and adverse currency movements. Unfortunately, both are rampant in Latin America (relatively speaking, compared to quaint Singapore). The table below shows the growth of MercadoLibre’s revenues in Brazil and Argentina in both US-dollar terms and local-currency terms going back to 2011’s fourth quarter. Notice the local-currency growth rates frequently coming in much higher than the US-dollar growth rates.

The silver lining here is that MercadoLibre has still produced excellent revenue growth in US dollars since 2006, despite the difficulties associated with operating in Latin America. In fact, I think MercadoLibre is a great example of how a company can still thrive even in adverse macroeconomic conditions if it is in the right business (one powered by powerful secular growth trends) and has excellent management.

Another big risk I’m keeping an eye on is related to competition. Other e-commerce giants in other parts of the world could want a piece of MercadoLibre’s turf. For instance, Amazon has been expanding its presence in Latin America; in December 2019, Amazon announced the launch of its second distribution centre in Brazil. But I also want to point out that the US-based online marketplace provider eBay decided to invest in MercadoLibre in 2001 after finding Latin America’s e-commerce market a tough nut to crack (eBay sold its MercadoLibre stake in 2016).

I’m confident that MercadoLibre has already established a strong competitive position for itself, but I’ll still be watching for the moves of its competitors.

The last risk I’m concerned with about MercadoLibre is key-man risk. Marcos Galperin has led the company since its founding, and has done a fabulous job. The good news here is that Galperin is still young. But should he depart from the CEO role for whatever reason, I will be watching the leadership transition.

The Good Investors’ conclusion

Latin America may scare many investors away because of the frequent unrest happening in the region. But MercadoLibre has grown its business exceptionally well for more than a decade despite the troubles there. The company also aces the other criteria in my investment framework:

• Latin America still appears to be in the early days of e-commerce adoption, so the region’s e-commerce market is poised for rapid growth in the years ahead.
• MercadoLibre’s balance sheet is robust with billions in cash and investments, and much lower debt.
• Through a study of the compensation structure of MercadoLibre and the history of how its business has evolved, it’s clear to me that the management team of the company possesses integrity, capability, and the ability to innovate.
• There are high levels of recurring revenue streams in MercadoLibre’s business because of customer behaviour
• MercadoLibre has been adept at generating free cash flow even when it is reinvesting heavily into its business.

There are of course risks to note. Besides the inherent political and economic instability in Latin America, I see two other key risks for MercadoLibre: Competition, and key-man risk. The company’s valuation is also really high at the moment because of what I see as depressed earnings and free cash flow due to heavy reinvestments back into the business – but the high valuation is something I’m comfortable with.

After considering both sides of the picture, I’m happy to continue allowing MercadoLibre’s business to continue flourishing in my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.