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  • Ryan Reeves

Q2 2023 Letter

Dear partners,

Thank you for your continued trust and support. Despite the lackluster performance start, every one of you has been supportive and you have no idea how much that means. Our investment process is improving daily, and it's only a matter of time before we start seeing things turn around. But enough about the short term, let's dive in!

Last quarter, we discussed the qualitative checklist that we go through for every investment. This quarter, I thought it would be helpful to go through the quantitative side of our process.

As a fundamental investor, the quantitative side, from my experience, is sort of under-discussed because it’s table stakes. The numbers are out in the open so there’s no edge, right? On a quarter-by-quarter basis, I’d say there’s some truth to that. The market does a pretty decent job of incorporating the new information about forward guidance or quarterly losses. But, in my experience, it can miss the forest for the trees. Truly special companies are able to sustainably grow while expanding profitability. Sure, they may have an occasional blip and miss margin targets for a few quarters, but focusing on the numbers can allow us to zoom out and focus on top tier companies. After all, a company could have all of the perfect intangibles but if revenue is in decline and they’re losing money, then something is wrong! The numbers have to match the narrative. Sure, the numbers aren’t everything but they can allow you to see right through a beautifully crafted narrative.

With that said, let’s get into the quantitative checklist. But before jumping right in, note that some of these items will actually overlap with the qualitative list. For example, looking at the goodwill on the balance sheet is quantitative but it also speaks to management’s capital allocation philosophy. If they are throwing away money on large acquisitions, that isn’t what we’re looking for. Alternatively, a company like Constellation Software has created an entire business around acquisitions but they actually have a surprisingly low level of goodwill. So once, again, the numbers provide evidence of a qualitative dynamic. Ok, enough preface, let’s jump in.

  1. Trailing 12 months revenue growth

  2. Quarterly revenue growth

  3. Gross margins

  4. EBIT margins/operating leverage

  5. FCF margins

  6. Cash/Debt

  7. Goodwill

  8. Capital intensity/returns on capital

  9. Share count/stock based comp

  10. Implied rate of return

  11. Payback period

These items are a little more self-explanatory than the qualitative checklist so let’s use a company from the portfolio to illustrate them in action.

MercadoLibre

MercadoLibre is a Latin-American e-commerce and payments company. Started right as the dot-com bubble was picking up steam, MercadoLibre was originally pitched as an eBay for Latin America. The founder, Marcos Galperin, grew up in Buenos Aires where his family ran one of the largest leather companies in the world. After studying at Wharton and working at his family’s company for a few years, Galperin went to get his MBA at Stanford. In fact, MercadoLibre was born out of a project at GSB. While Galperin was formulating his thoughts for his Latin American e-commerce company, he confided in a professor named Jack McDonald. One day, a guest speaker, a private equity partner named John Muse, came to give a lecture. What Galperin didn’t know was that McDonald had promised Muse that a student could drive him to the airport after class. That student was Marcos Galperin. As the story goes, Galperin pitched Muse his idea on the drive to the airport and boom, he had his first bit of funding. Just about a year later, eBay itself actually bought a 20% stake and in return, MercadoLibre became its exclusive Latin American partner.

MercadoLibre has adapted to the rapid changes in commerce over the years. It started out as an auction-based site just like eBay. After a while, it moved to more of a pure 3P, Alibaba model, taking a cut of each transaction. The company had 65% gross margins and 25% EBIT margins. Life was good. But Latin America is tricky. Runaway inflation, political instability, and an extremely underbanked demographic made sustainable growth difficult. That’s not to say MercadoLibre ever really struggled to grow. Rather, it had to make proactive decisions to lay the foundation for the type of leader it is today.

One such decision was to get into the payments industry. Called MercadoPago, the company created its own payment gateway around 5 years after its inception. This would allow merchants and consumers to transact online even without having a bank account. In Latin America, about 70% of consumers are unbanked or underbanked. For example, only about 115 million out of a 625 million population have a credit card. That’s just the way it is. But this difference allowed MercadoLibre to make important strides in the payments ecosystem. Today, gross payment volume exceeds gross merchandise volume by more than 3x.



You might be wondering how that’s possible if MercadoLibre is simply an online marketplace. How could payment volume be so much higher than GMV? Well, it’s because the company isn’t just a marketplace. Around 2014, the company launched a mobile point-of-sale system to give offline merchants a seamless checkout experience. Pago was also rolled out to other SMB websites, enabling them to take online payments. Think of this as a PayPal wallet rather than just a MercadoLibre dedicated gateway. Now, off-platform volume vastly exceeds on-platform volume.

But the revenue tells a different story because of the different take-rates. The company keeps about 3% for itself on payment transactions but the marketplace rate is between 3-4x higher because of a bundled fee structure. In 2013, MercadoEnvios launched, helping merchants with fulfillment and warehousing. Over the past few years, the company has taken deliberate steps to create its own delivery infrastructure. It’s certainly not as robust as Amazon but the company is making strong progress. These days about 87% of items sold go through Envios. What’s interesting is that Envios is only available in 6 out of the company’s 18 locations (Argentina, Brazil, Mexico, Uruguay, Colombia, and Chile). It goes to show you how concentrated MercadoLibre is in its top markets. In fact, just Brazil, Argentina, and Mexico account for 95% of revenue.


Surprisingly that’s not all MercadoLibre does. We haven’t even talked about its credit arm, MercadoCredito, its asset management business, MercadoFundo, its online store solution, Mercado Shops, or its online listing service, MercadoLibre Classifieds. While these businesses don’t make up a ton of overall sales yet, each one acts as a lever to increase customer retention in the company’s ecosystem.

Imagine you’re a small merchant that started on the marketplace years ago. You don’t have to worry about taking payments, shipping, demand generation (as you can buy ads on the marketplace) and now you start taking loans from MercadoLibre. You’re making a good living! But where to put that extra cash? How about transferring it right into a set of index funds, all through a digital wallet. If you’re doing all of that through MercadoLibre, your lifetime value is immense.

MercadoLibre has done a great job of using its e-commerce business as a wedge to popularize its payments wallet. The functionality has developed nicely and the flywheel increases stickiness. Further, the company has a loyalty program that is taken quite seriously, with the goal of becoming a Level 6 customer. Users can buy their way into the program, much like an Amazon Prime membership, where they get free deliveries and other bundled perks like Disney+.

That’s the narrative, do the numbers support it?

1. Trailing 12 months revenue growth

In 2022, MercadoLibre grew 50% in US dollars. And in the previous five years, the company grew at a CAGR of 54%, though that is somewhat skewed from COVID. I prefer companies that are growing faster than 30% and MercadoLibre passes this test.

2. Quarterly revenue growth

I also like looking at the quarterly cadence of growth, though you can sometimes miss the bigger picture by getting hung up on each quarter. The last five quarters of growth for the company have been (oldest to most recent): 63% -> 53% -> 45% -> 43% -> 35%

Growth has been slowing slightly but if you study the history of the company’s numbers, they jump around a bit, one reason being the currency changes in Latin America. For reference, the last five quarters of YoY growth in constant currency were 67% -> 57% -> 61% -> 56% -> 58%.

Definitely not falling off a cliff.

3. Gross margins

Last year, gross margins were 49%, down from 64% in 2016. So what happened? Well, before 2017, the company was a true, asset-light marketplace with a fledgling payments business. In 2016, total payment volume was just $7.7 billion and last year it reached $123.7 billion. Payments, of course, carry lower gross margins but they have very high returns on capital, especially since MercadoLibre already had a strong customer and merchant base. Further, as the company experimented with holding some of its own inventory, that was a slight drag on margins. It’s interesting that companies like MercadoLibre and Alibaba started as asset-light companies and have made large investments in logistics while Amazon started as more of a wholesaler and has shifted to a third-party marketplace. I think what these companies are finding is that there is a happy medium – too asset light and competitors can steal share because there is less of a focus on logistics but too asset heavy and the returns on capital aren’t great.

4. EBIT margins/operating leverage

Similar to the degradation in gross margins, EBIT margins have also dropped 11 percentage points since 2016. Notice that gross margins drop 15 percentage points since 2016 but EBIT margins dropped only 11 points. That shows that there isn’t an operational efficiency problem so much as the business model has evolved. Payments making up a larger part of the business is the main culprit here. With that said, MercadoLibre did make some very important investments in free shipping over the past five years. In 2016, sales and marketing made up 19% of revenue but by 2019, that was up to 36%. The company heavily invested in Envios, their shipping solution. Now, more than 80% of shipments are delivered in 2 days and more than 60% of packages are received on the same-day now. The free shipping initiative really started in the first half of 2017 when the company started offering it to customers in Mexico, Colombia and Chile that spent more than ~$20. This was rolled out in Brazil but at a higher dollar amount – $40, because logistics are a little more complicated in that region.

At the trough, EBIT margins went from 24% in 2015 to -7% in 2019. About 3/4th’s of this was from free shipping investments and the rest was the overall lower gross margins from payments. The important thing is that these were proactive investments in customer experience rather than a lack of ability to make money.

EBIT margins in the last four quarters have all been above 10% and I wouldn’t be surprised to see even more operating leverage over the next year.

5. FCF margins

The company actually holds a surprisingly small amount of inventory which certainly helps free cash flow. As of the end of 2022, inventory was $152 million, just 1.5% of revenue. Compare this to Amazon which carried $34 billion, or 7% of revenue. That is also probably a little skewed since AWS does $80 billion in revenue, so the truer value is closer to 8%. That means Amazon carries 5x more inventory per dollar of revenue than MercadoLibre does.

Further, the company only spends about 4% of revenue on capital expenditures. Compare this once again to Amazon’s 14% of revenue after including leases. It’s not a perfect example because we don’t know exactly how much of Amazon’s capex is for AWS but it’s likely a good chunk. Based on my estimates, it’s probably not more than half so maybe in the range of 5-7%. The point is that Amazon still spends quite a bit more on capital expenditures than MercadoLibre. As we briefly touched on, there are positives and negatives to this. For one, MercadoLibre has much higher returns on capital. However, you could argue that Amazon has a much stronger moat from all of its infrastructure investments. All of those investments pay off in customer satisfaction and higher utilization of the existing assets.

At the same time, MercadoLibre’s logistics providers already have decent infrastructure so the company doesn’t want to step on any toes whereas Amazon doubled the size of their fulfillment capabilities during COVID, which they are now optimizing. There are certainly trade-offs and I think there is a nice tension of continuing to invest in the customer experience while also ensuring those investments are hitting NPV hurdles.

It’s also important to note the company’s other working capital dynamics. As MercadoLibre’s credit business grows, it uses its own balance sheet so as credit receivables increase, free cash flow takes a hit. Alternatively, as the company flexes down its credit book, free cash flow gushes, like we’ve seen over the past 12 months; during this period, the company’s free cash flow margin was 32%. One of the main differences between net income and free cash flow is the provision for loan losses. Over the past year, the provision was about $1 billion that the company's auditors thought was reasonable to estimate. If losses are far less than this, then the company's GAAP profitability is currently being masked.

6. Cash/Debt

The company’s balance sheet has gotten a little bit more complicated over the years as MercadoPago has become a larger chunk of the business.

At the end of the fiscal year, the company had $4.5 billion in cash and total investments and $4.7 billion in net debt, which is understated by about $700 million after adding operating lease liabilities. So the company has $800 million in net debt and plenty of cash considering it doesn’t do big acquisitions and is solidly profitable.

7. Goodwill

The company does very few acquisitions and when they do make one, it’s usually so small that it’s for an undisclosed sum. The two most recent acquisitions were in 2021 when the company bought Kangu, a Brazilian logistics provider, and Redelcom, a Chilean point-of-sale system to strengthen MercadoPago in that region. Currently, MercadoLibre has $153 million in goodwill compared to $14 billion in assets and a $60 billion enterprise value. The company passes this quick test with flying colors.

8. Capital intensity/returns on capital

There are different ways to calculate returns on capital but I like to keep it simple. We can start off with 2022 EBIT and subtract taxes. That would be approximately $1 billion. Then PPE is about $1 billion. Net working capital has the most nuance here but at the end of fiscal 2022, current assets were nearly $11 billion and unrestricted cash and marketable securities were about $4.2 billion. I prefer taking out excess cash as a company shouldn’t be penalized because they’ve built up a lot of cash from being profitable. It’s another story if the company has just continually diluted itself to raise that money. As with everything, there is nuance. That’s why it can be helpful to calculate ROIC with the operating approach (fixed assets + net working capital) and the financing approach (debt + equity). That way, if a company has a large negative equity position, the company will be penalized. We can do the same thing on the operating side by subtracting the amount of money they’ve raised (additional paid-in capital) from the excess cash balances. So that means we have $9.1 billion in net current assets.

The company also has $8.6 billion in current liabilities though we have to take out the $2.1 billion loan because that will be paid back in less than a year. The goal of calculating ROIC is trying to find out the long-term capital that is going into the business and seeing how much profit returns back to shareholders. So subtracting $2.1 billion from $8.6 billion gets us $6.5 billion in net current liabilities. Now we get $2.6 billion in net working capital. Adding that to fixed assets, we get $3.6 billion in invested capital. And lastly, $1 billion in NOPAT compared to $3.6 billion is 28% returns on capital.

We try to find companies where there is a clear line of sight to more than 20% returns on invested capital as, if we hold the business long enough, our overall return will gravitate towards that number. It’s not always easy to calculate this as there can be a lot of nuance but it’s certainly a worthwhile part of the checklist.

9. Share count/stock based comp

The company’s share count has grown, on average, at just over 1% since 2013, with most of that coming from one equity raise in 2019. The company raised a total of $1.85 billion, $1 billion of which came from investors, $750 million from PayPal, and $100 million from Dragoneer. In Q4 of 2021, the company did its second equity raise of $1.55 billion but the share price had tripled from the 2019 price so the dilution wasn’t as high. Outside of these two equity raises, the company hasn’t really grown share count. Stock-based comp was $85 million on over $10 billion in revenue and $2.5 billion in free cash flow. So the vast majority of dilution has come through those two offerings. The 2019 raise was more focused on rebuilding the cash position after the large free shipping investments and the 2021 raise was to give the company more liquidity to grow its MercadoCredito business. Overall, with the balance sheet in the position it is now, dilution will be very minimal.

As an aside, I don’t talk much about buybacks and dividends as a part of capital allocation because the type of companies we’re looking for are typically reinvesting everything back into the business. A business that is in capital returns mode has likely saturated its market or can’t find high ROI projects within the business. There is absolutely nothing wrong with returning capital to shareholders, it’s simply in the best interests of shareholders, but we prefer to find companies that have plenty of runway and high ROI ideas. After all, we’re investing in the business so that its talented team can grow our investment!

10. Implied rate of return

Now here’s where we get into the valuation piece of the puzzle. I’ll just keep it high level but there are two parts to our process, an implied rate of return calculation and a payback period. The implied rate is basically a quick, 5-year earnings model to see what sort of assumptions are priced into the business.

MercadoLibre is trading for about a $60 billion enterprise value. I think it’s quite likely that the company can do 20% margins and trade at a 20x multiple, equating to 4x sales. At $12 billion run-rate sales, we can figure out how fast revenue needs to grow to hit our hurdle rate. For example, a hurdle rate of 20% means that MELI’s value would be $150 billion in 5 years. If we divided $150 billion by $48 billion ($12 billion at 4x sales), then sales would have to grow, on average at 26% (3.1^(⅕)-1). We can also just use our bottom-up revenue growth estimate and then figure out an implied return from there. This makes the valuation process much more concrete and we can ask specific questions based on the reasonableness of each assumption. If we think sales can grow 20% annually from here on out and 25% margins are more reasonable, then our expected return would be 18%.

11. Payback period

The second part of the valuation is understanding how many years it would take to get paid back out of the free cash flow in the business. This helps us think much more like business owners. A simple way to think of this is if you bought a laundromat for $100,000 and its annual profit was $10,000. Then, imagine if, in one year, you sold it for the same price as you bought it. Your return would be 10%. That’s exactly how a one-year bond works and that’s how valuing a business works as well – but it’s just much harder because there is competition and changing profit levels. You just have to think about the return you’d like and then pull the trigger if the investment hits your desired threshold. So if we held onto that laundromat for 10 years, assuming no growth, we’d get our initial investment back. So buying a no-growth business at a 10x multiple would give you a 10% return on your money. If profit levels decrease by 30% though, your payback increases by about 4 years (from 10 to 14).

In real life, you think about how quickly you can get your money back on any type of investment, even if it’s buying a coffee machine so you don’t have to go to Starbucks every morning. We don’t typically think in terms of discount rates and WACC. We can do the same thing for businesses. That way, when the price goes down, and the profit levels stay the same or increase, we’ll be getting paid back faster.

I’m not going to go through all of the numbers for MELI but I think we can get paid back from out of the free cash flow after about 10 years. If it takes significantly more than 10 years, I start to question the valuation a little bit.

That’s a wrap for highlighting MercadoLibre and going through our quantitative checklist. As we more deeply understand the companies in the portfolio, it allows us to have more conviction in the businesses. It’s crucially important to keep our qualitative and quantitative standards extremely high so that the portfolio is getting stronger every single year.

Closing

I’m honored to have you as a partner. Thank you for your trust and support. It enables me to think long-term and will be our own competitive advantage.

The stock market, like life, will have its ups and downs. All we can do is focus on what we can control and work hard to continually raise our standards. Our strategy is simple – hitch a ride to the world’s best entrepreneurs that are running the fastest-growing, highest-quality companies at the most attractive valuations we can find. Here’s to many more years of focusing on the inputs and letting the outputs take care of themselves.

Sincerely,


Ryan Reeves


 

Disclosures


Infuse Asset Management LP (“Infuse”) is an investment management company to a fund that is in the business of buying and selling securities and other financial instruments. This information is provided for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.


Infuse may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Infuse may buy, sell, or otherwise change the form or substance of any of its investments. Infuse disclaims any obligation to notify the market of any such changes.


The S&P 500 is a U.S. equity index. It is included for informational purposes only and may not be representative of the type of investments made by the fund. References made to this index are for comparative purposes only. Reference to an index does not imply that the funds will achieve returns, volatility, or other results similar to the index. The fund’s portfolios are less diversified than this index. Returns for the index are total returns which includes dividends and do not reflect the deduction of any fees or expenses which would reduce returns.


An investment in the fund is speculative and involves a high degree of risk. The portfolio is under the sole trading authority of the general partner. An investor should not make an investment unless the investor is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits.


The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Infuse which are subject to change and which Infuse does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.


The fund is not registered under the investment company act of 1940, as amended, in reliance on an exemption thereunder. Interests in the fund have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws.


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