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Giro Lino
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"Buy The Dip" July Idea Competition: $MELI
I thought carefully about this post. Since I took its content from paid posts in my Substack, that would not be fair to distribute it for free while competing for a monetary prize.

At the same time, there was no chance I would be out of this fantastic event organized by @commonstock.

So, the best way I figured out was to donate any monetary compensation that may come from this post to a Brazilian non-profitable organization that would have good use of the resources. I hope you enjoy the reading. Cheers!

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Outline

#When the Going Gets Tough, the Tough Get Going (Introduction)
# Winner corporate culture
# Business Model
## Marketplace
### Superior Economies of Scale
### Why will Meli outperform its peers?
### Marketplace Unit Economics
## Mercado Pago
### Payment Business
### Mercado Crédito
## Mercado Envio
## MercadoLibre Classified
## MercadoLibre Advertising
## MercadoShops
#How does Meli make money?
#Management compensation
#Valuation

###When the Going Gets Tough, the Tough Get Going

Meli's founder, Mr. Galperin, probably is one of the lowest-profile businessmen in LatAm. Many employees at Mercado Livre wouldn’t recognize his face. No glamorous annual showups to employees, nor motivational speaks.

> "I see many entrepreneurs who use their company as a platform to be famous.”

He was born in Buenos Aires, from a wealthy family, went to study finance at the University of Pennsylvania. Then, he returned to Argentina and spent three years working at YPF (the largest O&G company in Argentina).

In 1997, interested in technology, he applied to Stanford University in California’s Silicon Valley. After studying eBay, he developed his version for a company that would thrive in LatAm.

> "For us, it's exactly the opposite, we want the company to be famous. The lower our personal profile, the better."

Unlike e-commerces which were starting to thrive in developed countries, Mr. Galperin focused on simplifying the lives of LatAm users, adapting the service to their financial condition, infrastructure, internet access, and regulation.

In 1999, John Muse, a Private Equity owner (HM Capital,) made a speech to MBA students at Stanford, and Mr. Galperin volunteered to drive Mr. Muse back to the airport. On the way, he pitched his idea and got his seed money.

In November of 1999, Mercado Libre raised $7,6M in a Venture Round. Mercado Libre received $46,5M in a Series B in the following year, led by HM Capital, GS, GE Equity, Flatiron Partners, Chase Capital (JP Morgan), and Capital Riesgo. But, of course, the luck was there since the last deal was made right before the tech bubble burst.

The early days were challenging, with the company facing additional financing issues, hiring people in LatAm, and the competitive landscape evolving fast.

About the latter, DeRemate.com was offering pressure in Argentina, Lokau in Brazil, and a foreign competitor entrance was imminent (Yahoo! and eBay).

An ivy league educated founded Lokau. Knowing that the market was small for many players, their communication strategy was very aggressive. DeRemate.com was no different, receiving a $45m fund to invest in customer acquisition. By no means Mercado Libre was off the hook.

However, Mercado Libre differentiated from DeRemate.com in its operations. Meli offered an open forum where buyers and sellers could find each other, negotiate and make deals based on trust.

As more deals were made, the seller was considered more reliable inside the forum. What made the model of open space forum thrive was that, different from the offline world, the bigger the marketplace became, the easier it was to identify the best seller to make a deal with.

In 2001, eBay became the biggest shareholder of Mercado Libre, holding a 19,5% stake in the company. The deal also allowed Mercado Libre to incorporate iBazar Como, eBay’s subsidiary in Brazil, access capital, and eBay pledged not to enter LatAm for at least five years. Eventually, in 2016, eBay divested from its stake.

One of the most remarkable contributions from eBay to Meli was the “Feedback tool,” where customers were able to evaluate the seller, leaving comments about the purchase. It had a massive impact on the traction that Meli was growing.

Before, the only evidence the buyer had was the volume of deals. The Feedback enabled buyers to evaluate sellers using different qualitative metrics, such as shipping, quality of the product, contact with the seller, and so on.

Then, in 2004, Meli came up with Mercado Pago, offering a definitive solution for transaction problems in the marketplace.

If customers were skeptical about buying and negotiating the payment process with an online seller, Mercado Pago standardized the payment process internally, so clients would have to trust Meli, not the seller.

For instance, the seller receives the payment only after the buyer receives the order. If there is any problem, the buyer could open a dispute with Meli as the intermediary to get his money back.

In 2007, after a corporate round of $27,8M led by Tiger, Mercado Libre went to market, raising almost $50M in its IPO. eBay divested from Meli in 2016.

In 2011, the company transitioned its platform to open source technology. The transitions allowed APIs to expand the platform solutions. Two years later, they created the Meli Fund, private equity inside Mercado Libre focused on investing in disruptive companies that could boost the API platform solution.

### Winner corporate culture
Let’s go back to Meli Fund for a moment.
Let’s take a moment on Meli Fund. Just a sheer of investors notices, Meli Fund is such an entrepreneurial characteristic that resembles Mercado Libre.

After returning to Argentina, Mr. Galperin faced hardships looking for people with the right fit to work at Mercado Libre. He brought back from Stanford to Buenos Aires a few of his colleagues: Mr. Pedro Arnt, current CFO, Osvaldo Giménez, current Fintech President, and Mr. Hernan Kazah.

Also, it’s essential to highlight Mr. Nicolas Szekasy, CFO from 2000 to 2009. Mr. Szekasy and Mr. Kazah left Mercado Libre to found Kaszek in 2011, one of the most successful Venture Capital companies in Latin America.

In their unbelievable track record, they invested in Nubank ($NU) since the seed round, QuintoAndar (Series E), Nuvemshop (Series E), Konfio (Series E), Loggi (Series D), Warren (Series C), and so on.

More recently, in October of 2021, Mercado Libre and Kaszek created a SPAC called MEKA (MELI Kaszek Pioneer Corp), raising $287M to invest in innovative companies.

Kaszek’s and Mercado Libre’s track record teaches us their unique ability to find outstanding teams and understand the market’s demand for products. That is the most important competitive advantage Mercado Libre has: its culture.

Since it was founded, Mercado Libre invested and bought almost 50 companies (35 under Meli Funds). I’m not saying that those were successful acquisitions, but on both sides (bidder and offer), the probability of greater alignment was higher than in many other companies.

Also, it reflected in better recruiting and retention. Mercado Libre gives employees plenty of freedom to develop solutions they think would serve better clients, attracting people focused on developing the best solution into a company that offers fewer constraints as possible.

### Business Model
The company offers an ecosystem of six integrated e-commerce and digital payments services: Mercado Libre Marketplace, Mercado Pago Fintech, Mercado Envios (logistic service), Mercado Libre Ads, Mercado Libre Classifieds, and Mercado Shops (online storefront solution).

#### Marketplace
LatAm eCommerce is a US$102bn market; supported by our proprietary industry model, we forecast growth to US$250bn in 2026. In 2021, eCommerce volumes represented 13% of overall retail sales in LatAm (excluding autos, restaurants, and services).

While this was up notably from 5.9% in 2019, the secular shift toward online retail had been in place well before the Covid-driven acceleration.

Supported by our bottom-up company estimates – and supported by the top-down consensus expectations, we build to a cumulative US$250bn market opportunity by 2026, representing a 19% 5-year CAGR and a US$145bn incremental GMV opportunity.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie.

While stay-at-home trends were a driver of outsized growth in 2019-21, we see a stronger-for-longer setup of a double-digit CAGR through 2026; we believe the Covid-driven bump will not flatten the future eCommerce penetration curve.

As shown in the image below, between 2015 and 2019, LatAm eCommerce volumes increased at an 18% CAGR, with ~68bps of average penetration gains annually.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie.

Considering initial Covid impacts in 2020 and subsequent Covid-wave disruptions throughout 2021, growth accelerated to a 51% 2019-21 CAGR (69% in 2020, 35% in 2021); annual penetration gains were ~360bps over these two years.

Looking to 2021 figures, parts of the world had not fully normalized/reopened, likely benefiting the eCommerce channel. However, we also see structural and behavioral change, given the persistence of growth in 2021 on a historically tricky comparison.

Looking at 2021-26E, we forecast a 19% CAGR, with ~100bps of annual penetration gains, while the percentage growth rate is below pre-Covid levels, partly due to the more extensive base, penetration gains are more in-line with pre-2019 levels.

This is consistent with our view of a step-change in eCommerce demand, supporting the go-forward penetration curve.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie.

Further supporting our multiyear growth thesis, we highlight a trend of broad-based eCommerce gains even for the highest penetration countries and categories.

Comparative eCommerce penetration over sales by merchandise category is shown in the image below; these charts demonstrate the broad-based gains for online retail.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie.

This depth and breadth support our conviction in a stronger-for-longer eCommerce growth outlook, even though we couldn’t estimate the penetration per category for LatAm.

Also, on a relative basis, forecast growth rates are higher for lower-penetrated regions (e.g., LatAm, ASEAN, Africa) and categories (e.g., grocery, personal care).

While there are headwinds (logistics and otherwise) in certain countries and verticals, we believe these barriers continue to come down; encouragingly, across the LatAm countries, we have yet to see a ceiling for eCommerce penetration.

At the country level, we estimate, on average, a five-year path from 12.5% to ~16.5% eCommerce penetration, supporting growth forecasts for markets in this phase of the eCommerce inflection.

The image below shows the eCommerce penetration curves for countries; we offer the overall penetration per country in LatAm.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie.

We understand that countries like Mexico, Peru, and Chile offer a massive logistic headwind, lagging any substantial penetration gain.

We forecast a +7% CAGR for Mexico, with 12% penetration (10% today). Nevertheless, Mercadolibre (“Meli”) achieved +70% fulfillment penetration in the country as of 4Q21, and Walmex can reach ~90% of the population in ~10 minutes from its stores.

We highlight that Brazil and Argentina lead among LatAm countries for eCommerce penetration, even though the logistics headwinds were tremendous.

Also, we see a replicable path for increases across the region, primarily driven by logistics improvements; Therefore, we believe that the market is overly conservative in its growth assumptions on LatAm.

In Brazil, logistics improvements have unlocked new categories, with companies including Magazine Luiza (“Magalu,” “MGLU”), Americanas (“AMER”), and Via (“VIIA”) investing in omnichannel logistics. At the same time, Meli continues its marketplace fulfillment center roll-out.

For the other countries in the region, both omnichannel operators (such as Falabella) and marketplace operators (led by Meli) are increasing their focus on eCommerce.

For instance, Meli opened its first fulfillment centers in Chile and Colombia in 2021, supporting our view that company-driven service improvements can drive eCommerce growth above the conservative consensus expectation.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie.

##### Superior Economies of Scale
Our industry model illustrates Meli's leading share across LatAm eCommerce; the backdrop in Brazil is competitive, while other countries are more fragmented. As a result, we see Meli leading with ~30% eCommerce market share in Brazil.

Local operators Americanas, Magalu, and Via command a combined ~49%, and Shopee (owned by Sea Ltd) has been gaining ground (~6% 2021 share).

We see Meli and Shopee as best positioned to gain share in Brazil, supported by favorable category mixes, including fewer electronics exposure, as will show soon.

Brazil-based peers lead on first-party goods and omnichannel logistics, but Americanas/Magalu/Via marketplace build-outs remain relatively earlier.

Panning out to the broader region, our LatAm market share analysis illustrates a favorable position for Meli. For instance, we estimate that only by 2026 Meli’s top competitors will reach its market share.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie.

Meli is the only major LatAm operator with a presence across all top markets, and the competitive backdrop ex-Brazil is more fragmented.

While individual countries remain competitive, we see scope for top platforms (led by Meli) to continue concentrating share from the long tail, as we’ll discuss in a few minutes.

Operations for eCommerce are primarily conducted on a country-level basis. Still, gains from platform scale, product development, and data analysis can be spread across the region, taking Meli to an entirely new level compared to its peers.

##### Why will Meli outperform its peers?
To deeply understand why we believe it will outperform its peers, we must assess the breakdown of electronics versus other (long-tail) categories to understand the implication for company-level in the eCommerce landscape.

Our channel checking process involves interviewing and talking to different market participants, asking for a mutual collaboration process, sharing resources, and building knowledge as a team.

While the companies themselves do not report category mixes for gross merchandise value (GMV), our forecasts leverage our industry views.

We cross-check the consensus bottom-up estimates versus our top-down category economic expectations, with a bias toward the macro approach, extrapolating the penetration curve-based digital tools adoption.

From a top-down perspective, we see headwinds for electronics eCommerce in 2022, while a broadening category base supports our +17% growth forecast for overall Brazil eCommerce.
From 2017 to 2020, Brazil went through an easing cycle and low inflation, boosting household indebtedness and durable consumption.

Amidst the Covid-19 outbreak, the government released an enormous fiscal stimulus through wealth distribution called Emergency Aid, boosting the growth in categories such as electronics, appliances, etc.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie, IBGE.

As a consequence of such a fiscal stimulus package, we now see a combination of high inflation and difficult comparisons (lapping stimulus payments) contributing to the pressure.

From an eCommerce perspective, electronics/appliances/video games/media products account for ~15% of the Brazilian retail market but for ~50% of eCommerce GMV (versus 17%-25% in countries like the UK, China, and the US).

We see long-tail / other categories (including apparel, beauty care, and food) as the critical eCommerce drivers for the following years. Accordingly, we forecast a modest CAGR growth for these categories and an acceleration for long-tail categories.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie, IBGE.

Our model points to a competitive market for electronics, with Magalu at ~25% 2021E share and each of Meli / Americanas / Via in the high-teens range.

In 2021, according to our estimates, the low recurrency GMV mix (including appliances and accessories) at 84% for Via, 71% for Magalu, 49% for Americanas, and 29% for Meli.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie, IBGE.

While Meli has been diversifying away from the category — a company fact sheet shows 33% electronics mix in 2021, down from 65% in 2009 – the broadening initiatives for other platforms are earlier-stage in comparison.

Disclosure in Magalu's earnings illustrates ~57% purchases in long-tail categories for the 2021 cohort versus 14% for the 2017 cohort. On the overall GMV, the long tail categories accounted for 45% of Magalu’s GMV in 2021.

While Magalu's marketplace has quickly ramped from a base of zero in 2016, first-party merchandise still represents 63% of MGLU 2021 online GMV; the 1P business over-indexes for electronics.

We see similar trends holding for Via, with 73% 1P penetration and an earlier-stage marketplace roll-out. Americanas, with 42% 1P penetration, have the lowest estimated electronics exposure of Brazil-based peers.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie, IBGE.

While the category screens are competitive, we believe rationality is a bright spot. However, all players suggest more focus on margin for 1P operations, which will lead to lower growth, considering the incremental headwind from inflationary pressure.

On the other hand, our model shows Meli's wide-scale advantage and Shopee's recent gains for longer-tail categories.

Looking at the Brazil eCommerce high recurrence categories, we see Meli as the scale leader with a 45% share; MELI's presence in long-tail categories over-indexes versus the company's ~30% total Brazil eCommerce share for 2021.

Source: Giro Lino, BCB, Bloomberg, Mercadolibre, Americanas, Via, Magalu, TIKR, FRED, MCC, Compre&Confie, IBGE.

##### Marketplace Unit Economics
Most analysts use GMV and Gross Profit multiples to value marketplaces. We respectfully decline to use it.

There has been a widening charm between financial information and stock prices. Until the 70s, there was a strong correlation between earnings and stock return.

The 1980s saw the beginning of the growth and importance of intangible assets. However, even if extraordinary, revolutionary changes did not cause any change in accounting standards.

Entire industries, which are immensely dependent on intangibles (central industries, as Alan Greenspan called them), including software, biotech, and internet services, began to emerge between the 1980s and 1990s.

And for all other businesses, the main drivers of value have moved from property, land, machinery, and inventory to patents, brands, information technology, and people.

This group, which is not present in any balance sheet, is treated in accounting as an expense, generating distortion in both the balance sheet and financial statements.

These three factors — intangibles, the proliferation of managerial guidance, and delays in recognizing important corporate events — explain the distortion.

For its business nature, Meli acquires its customer through its marketing expense and, therefore, doesn’t capitalize it on its balance sheet.

Although we’ll not present our Earnings Power Value for Meli, capitalizing back its intangible, in this post, we believe it’s essential to understand the simple unit economics, as we did for Shopee previously.

In that case, the image below illustrates the first evidence that Meli enjoys a superior competitive advantage versus its peers, generating a lot of cash for its marketplace business.

Source: Giro Lino, Mercadolibre

Second, after almost a dozen industry channel checks, we have enough confidence to estimate the marginal capital invested and, therefore, the ROIC for mature cohorts, as the image below shows.

Source: Giro Lino, Mercadolibre

However, as we didn’t capitalize back the marketing expense, this figure is overestimated, taking us to the third metric, the return on incremental invested capital (ROIIC).

The ROIIC is a much better indicator of profitability since it considers the immediate return from new cohorts. Even though 2020 was an outlier due to mobility restrictions, the 2021 profitability for the new cohorts is outstanding.

Source: Giro Lino, Mercadolibre

Yet, it’s worth mentioning that Meli historically invested all its cash generated in the marketplace business to acquire customers and new ventures, leading unaware investors to believe that Meli operates an inferior business.

For the seller, the most significant advantage is access to more customers. Also, Meli offers delivery, funding, and inventory solutions. As a result, the service provides higher margins than different online channels from a profit and losses perspective.

Source: Neotrust, IBGE, Sequoia Logística, Iguatemi, Multiplan, Sonae, Stone, Mercado Pago, Mercado Libre and Giro Lino estimates.

The image above estimates retailers’ operational performance based on their selling channel. Marketplace offers a good value proposition when customers focus solely on volumes.

Furthermore, channel checks suggest that one of the most important advantages for sellers is not necessarily higher sales. Instead, more significant sales volumes are translated into better conditions for financing operations and suppliers, boosting cash flow.

Most sellers rely on Mercado Libre to access financial and operational conditions that enable better operational performances, taking us to the jewel of the crown, the payment/credit business.

#### Mercado Pago
The company created Mercado Pago in 2004 to offer online payments solutions designed to facilitate transactions both within and outside of the marketplace product.

Mercado Pago operated similar to Paypal when it was launched, offering a digital wallet. Customers could add their payments after linking a valid credit/debit card or depositing the fund in the account.

Mercado Pago was initially designed to facilitate transactions on Mercado Libre’s Marketplaces by providing a mechanism that allowed users to securely, quickly, and promptly send and receive payments.

Mercado Pago is a whole ecosystem of financial technology solutions in the digital and physical world, more significant than the Marketplace itself.

The digital payments solution enables any Mercado Libre registered user to securely and efficiently send and receive digital payments and pay for purchases made on any of Mercado Libre’s Marketplaces.

Beyond facilitating Marketplace transactions, MELI has expanded the array of Mercado Pago services to third parties outside Mercado Libre’s Marketplace over the years.

The company began first by satisfying the growing demand for online-based payment solutions by providing merchants with the necessary digital payment infrastructure for e-commerce to flourish in Latin America.

Today, Mercado Pago’s digital payments business not only allows merchants to facilitate checkout and payment processes on their websites through a branded or white label solution or software development kits.

It also enables users to simply transfer money to each other through the Mercado Pago website or the Mercado Pago app.

Through Mercado Pago, MELI brought trust to the merchant customer relationship, allowing online consumers to shop quickly and safely while giving them the confidence to share sensitive personal and financial data.

As MELI deployed their digitally-based payments solutions, they also observed that SME companies in the physical world were being underserved or overlooked by incumbent payment providers.

Mercado Pago is a powerful disruptive provider of end-to-end financial technology solutions that will generate financial inclusion for segments of the population that have been historically underserved and operate in the informal economy today.

  • In-store physical payments by selling mobile point of sale (“MPOS”) devices and through quick response (“QR”) payment codes;

  • Digital payment solutions for utilities, mobile phone top-up, peer-to-peer payments, and more through the mobile wallet;

  • Pre-paid cards and debit cards for users to spend and withdraw their account balances from their Mercado Pago wallet;

  • Merchant and consumer credits, both on and off the Mercado Libre Marketplace, and credit cards.

Mercado Credito, the credit solution, leverages the user base, which is not only loyal and engaged but has also been historically underserved or overlooked by financial institutions and suffers from a lack of access to needed credit.

Facilitating credit is a crucial service overlay that enables us to further strengthen the engagement and lock-in rate of Meli’s users while also generating additional touchpoints and incentives to use Mercado Pago as an end-to-end financial solution.

The distribution capabilities and in-depth understanding of merchants’ sales on the Mercado Libre Marketplace have also allowed MELI to develop their own proprietary credit risk models with unique data that differentiate the scoring from traditional financial institutions.

Meli offers credit lines to both online merchants and MPOS device users. Because online merchants’ business flows through Mercado Pago, MELI collects principal and interest payments from their existing sales on the Marketplace, meaningfully reducing the risk on the loans.

Consumers can access credit lines through MELI once they score and approve them through Meli’s proprietary models.

Loans can be used for a purchase on the Marketplace or for a payment on another website where the payment solution is available at checkout.

Since 2019, MELI also has extended personal loans to recurring consumer credit borrowers, allowing them to buy products and services outside the platform.

In 2021, MELI launched the first Mercado Pago credit card in Brazil, which is free, internationally accepted, and digitally managed.

The credit card allows users to pay additional installments for purchases on the Marketplace and accrue extra points to their user loyalty program. In the following two topics, we’ll break down the payment business and Mercado Crédito.

##### Payment Business
The payment business aggregates the processing business (in/off-platform and wallet) and the prepayment operation.

In this case, the closest peers would be the Brazilian acquiring companies, such as Stone, Pagseguro, Cielo, and Getnet.

Initially, the Marketplace's success generated colossal traction for its payment business through in-platform transactions.

For the following years, we believe that most of the growth will come from off-platform volumes, such as QR Code payment and merchant solutions, pushing Pago as one of the dominant players in the market in the following years.

However, unlike traditional acquirers, which are asset-heavy, Mercado Pago is an excellent business, presenting an unparalleled competitive advantage.

A significant portion of the superior profitability comes from the products mentioned in the previous section.

Through the Marketplace, the company leverages its payment business enabling more customers to access online items.

So, Mercado Pago has had an impressively stable take-rate throughout the years, remaining very competitive in traditional acquiring (minimize churn) while yielding juicy profitability in different products.

By maintaining a competitive fee in traditional acquiring, and higher fees in the different products, the company minimizes its churn, reducing friction in higher rate periods and, therefore, the CAC.

We diverge from the consensus when they mention the company charges higher fees for its clients. Instead, we believe that Mercado Pago generates a considerable gain for society, creating means for allowing new customers to join the system.

Also, Mercado Pago has been sharing gains of scale with its customers, offering a similar yield to Stone, for instance.

Even though the cost for the final customer is the same, Mercado Pago manages to keep its take rate above its peers through innovative products.

The take rate is superior, and the company is the lowest cost provider in the industry, distributing the product through the most significant Marketplace business in LatAm.

We believe the company operates with unparalleled competitive advantages, with higher profitability and lower cost to distribute its products, pushing the ROIC.

##### Mercado Crédito
Until recently, Mercado Credito was a smaller business inside Mercado Pago, with minimal disclosure. It took us a lot of time to uncrack this one.

By the end of 2020, when $MELI received its IF license (Financial Institution), which allowed the company to collect deposits to fund its lending business through RDBs, the business gained traction.

In the past couple of years, the credit portfolio grew from US$180mn to ~US$2.5bn in the 1Q22. So naturally, that raised questions from investors regarding the soaring provisioning.

In our opinion, Mercado Pago is executing its credit portfolio well, and NPLs will improve from 2023 onward. As a result, we believe it’ll be essential growth leverage in the following years.

First, we need to consider the product mix is evolving. The company has been slowly introducing new products, such as credit cards and personal loans, and testing them.

The credit card strategy, in particular, reminds Nubank’s approach, releasing a small credit limit for new customers and increasing it as the customer proves himself as a good payer.

Second, we can’t evaluate Mercado Pago’s credit business without a broader context on how the company reports its provisioning since the company adopts different accountant practices compared to Brazilian banks.

Under accounting practices adopted in Brazil applicable to institutions authorized to operate by the Central Bank, loans are generally carried at cost and report losses under IAS 39.

As of March 31, 2000, loans should be categorized into 9 categories, and the minimum allowance is determined by applying specific percentages to each category.

Loans are classified following management’s judgment of the risk level, considering the economic situation, past experience, and specific risks concerning the transactions, the debtors, and the guarantors.

The regulation requires a systematic analysis of the portfolio and its classification, by risk level, into 9 categories between AA (minimum risk) and H (maximum risk - loss).

The minimum allowance is determined by applying specific percentages to the loans in each category, which vary on the product and customer.

Income from credit operations overdue for more than 60 days, independent from risk level, is only recognized as revenue when effectively received. Operations classified as level H remain in such classification for nine months.

After this time, the loan is charged against the existing allowance and remains controlled in memorandum accounts for five years, no longer appearing on the balance sheet.

Suppose there is objective evidence that an impairment loss on loans and receivables investments has been incurred.

In that case, the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows discounted at the financial asset’s original effective interest rate.

The carrying amount of the asset is reduced through an allowance account, and the amount of the loss is recognized in the income statement.

However, Mercado Pago doesn’t report under IAS 39 but through IFRS 9, using ECL (expected credit losses), which is entirely different.

As commented, under IAS 39, impairment allowances were measured according to an ‘incurred’ loss model wherein the recognition of credit loss allowances was triggered by loss events after origination.

Losses ‘incurred but not reported’ were evaluated using diverse provisioning approaches, varying between banks and countries, such as we commented for Brazil.

The IFRS 9 impairment model requires impairment allowances for all exposures from the time a loan is originated, based on the deterioration of credit risk since initial recognition.
If the credit risk has not increased significantly (Stage 1), IFRS 9 requires allowances based on 12-month expected losses.

If the credit risk has increased significantly (Stage 2) and if the loan is “credit impaired” (Stage 3), the standard requires allowances based on lifetime expected losses.

The assessment of whether a loan has experienced a significant increase in credit risk varies by product and risk segment. It requires the use of quantitative criteria and experienced credit risk judgment.

Mercado Pago’s approach is ultimately quantitative since they’ve been gathering and processing data since 2004. It means that the company has an entire credit bureau at its disposal.

Primarily operating in countries such as Argentina and Brazil, Mercado Pago understands how default rate behaves under different economic scenarios, which is an advantage that will take years for many players to replicate.

Finally, as opposed to IAS 39, which required a historically estimate approach, IFRS 9 requires multiple forward-looking macro-economic and workout scenarios to estimate expected credit losses.

As highlighted previously, we believe that Mercado Pago’s short NPLs are impacted by a product mix change. According to our estimates, credit card accounted for 19% of the credit portfolio in the last quarter, from 1% last year.

Nevertheless, we’ve seen a tremendous improvement in long NPLs, which is a great leading indicator for the personal loan business, launched last year.

Still, we believe credit card will increase to ~25%, so we think that short NPLs will be pressured in the following quarters, but with promising expectations for the following cohorts.

Surprisingly, Mercado Credito already presents a very profitable operation, with a ROA close to 6%. We’ll keep to our conservative stance and not consider any profitability gain, even though all evidence suggests otherwise.

> For curiosity, our ROE estimates for Nubank’s personal loan and credit card business are 60% and 80%, respectively. For Meli, we don’t see the company managing risk as well as Nu, but our ROE ranges from 30%-40%, which is also great.

#### Mercado Envio
Meli shines out in logistics. Suppose you’re selling in Meli’s marketplace. In that case, there are two options: first, you can take advantage of Mercado Envios Full (“MEF”), a comprehensive fulfillment service, such as Fulfillment by Amazon (“FBA”), allowing the seller to store the items in Meli’s warehouses, where they handle the entire process.

The second option is through Mercado Envios Diretos (“MED”). The seller is responsible for storing the item and for the delivery processing, hiring, or realizing the delivery to the client.

A condition to hiring MEF’s or MED’s services is that the seller must be connected in the marketplace, register the invoice for each order, and fit the accepted dimensions. Meli had a liability with sellers dealing without invoices in the past, though they solved the problem many years ago.

Going deeper in MEF, the fully integrated service has no cost seller, and it’s collected by the Mercado Coletas, managed by Meli then.

The constraint for sellers is the coverage area. Again, MEF is a no-brainer, but the coverage area is limited to certain areas, established according to the distance between the seller and the distribution center (“DC”).

Source: BTG Pactual.

Quantitatively, Meli has fewer DCs than all of its competitors, but this isn’t entirely true from a qualitative standpoint. For example, Magazine Luiza, Americanas, and Via are older companies, and not all their DCs enable fulfillment service.

Via, for instance, recently launched its first fulfillment center to sellers, although they have the most significant number of DCs. Older DCs have lower productivity sorting items and more significant recurring Capex, though many companies don’t repair properly.

The process of opening new DCs is highly reliable on data. First, they gather and process a vast amount of data, turning then into analytics. Second, an analysis of areas with sufficient demand.

Third, Meli partnered with a company specializing in DC to execute the project (including Capex) in exchange for a long-term leasing contract. It's genius. They don’t have Capex investing in new DCs, minimizing the risk.

Beyond that, Meli launched an initiative to offer logistics as a service (“LAAS”), setting its first partnership with Pão de Açúcar ($CBD), which operates over 5,000 SKUs.

Meli can offer same-day delivery for 10 million items, from electronics to supermarkets, with no additional cost to the buyer.

The shipping policy is the same, with free shipping for purchases at R$79. Currently, the company can deliver on the same day for almost 25% of all zip codes in Brazil.

More recently, Meli launched an app called Mercado Envios Extra, connecting self-employed delivery drivers to the e-commerce platform, similarly to delivery apps, such as Rappi and iFood.

The driver can define deliveries pick-up locations in the app and notify the buyer that the package is on the way. Drivers are paid weekly through Mercado Pago.

Meli has over 600 enveloped vans, 10,000 third-party vans, four planes, 600 trailers, and 51 electric vehicles for the last mile.

According to Gustavo Pompeo, Logistic’s Director, Meli delivers 90% of its orders in less than 48 hours. Out of those, 75% are delivered within 24h.

####MercadoLibre Classified
It’s the service where sellers can list and buy motor vehicles, aircraft, real estate, and so on. The service is irrelevant compared to the marketplace and differs because the seller pays the fee upfront, not the usual take rate.

#### MercadoLibre Advertising
The service enables sellers and large advertisers (not necessarily sold on the marketplace) to display ads on a CPC (cost-per-click) basis.

It won’t surprise me if Meli adopts Alibaba's same strategy to replace the standard take rate for advertising revenue. Then, of course, there would be a discussion regarding scale and investment in clicks, but this is something to keep in mind if the commerce take rate starts reducing more aggressively somewhere in the future.

Last year, in LatAm, 7 of 10 searches for products began in a marketplace, so they became a mandatory media for agencies and companies.

Using analytics tools, Meli offers performance marketing for brands and products. Unlike Mercado Envios, customers grom Advertising don’t have to sell on the platform necessarily.

#### MercadoShops
MercadoShops (“Shops”) was the last initiative launched by Meli, designed to offer SMEs and longtail to create their website inside Meli’s environment, integrated with Meli’s universe of services.

Source: Mercado Libre.

The first thing that comes to my mind is Amazon Webstore. For those who don’t remember, in 2010, Amazon launched its own web service company, called Amazon Webstore (“Webstore”).

However, Webstore was a complete failure. After five years of operating, Amazon decided to shut down the operation, suggesting that clients migrate to Shopify.


In my opinion, the product was horrible. First, Amazon charged $79/m for an interface identical to Amazon’s website (competitors were charging ~$30/m). Initially, Webstore was much cheaper (under $40/m), but Amazon hiked prices quickly.

Second, the value proposition was worse. Besides being more expensive and less customizable, Webstore charged sellers 2,1% to 3% to process payments.

On the other side, Shops offers a considerable value proposition to customers using their scale to offer most services for free or at a very competitive fee.

Source: Mercado Libre, Shopify, Numvemshop, Vtex, Loja Integrada, and Giro Lino, on 2022-01-25.

Shop’s strategy is to attract SMEs and longtail. In the layer behind, Meli is boarding clients in its ecosystem for a low CAC (Customer Acquisition Cost) to offer different financial and logistic services.

###How does Meli make money?
In its public filing, Meli identifies two main revenue streams: revenue linked to the marketplace operation and non-marketplace operations, where the company offers different services to clients.

  • The commerce business is comprised of revenue streams that are mainly generated from marketplace fees that include final i) value fees and flat fees for transactions below a specific merchandise value, ii) shipping fees net of third-party carrier costs (when we act as an agent), iii) classifieds fees, iv) ad sales up-front fees; v)sales of goods and vi) fees from other ancillary businesses.

Source: Mercado Libre, Giro Lino estimates.

  • 1) The fintech business is comprised of revenue streams that come from the Mercado Pago business. Concerning Mercado Pago, fees are attributable to commissions that are charged to sellers representing a percentage of the processed payment volume in connection with off-Marketplace transactions;

Source: Mercado Pago and Giro Lino, on 2022-01-28

  • 2) Commissions from additional fees are charged when a buyer selects to pay in installments through the Mercado Pago platform for transactions that occur either on or off-platform;

Source: Mercado Pago and Giro Lino, on 2022-01-27

  • 3) Commissions from additional fees are charged when sellers elect to withdraw cash, cash advances, fees from the merchant and consumer credits granted under the Mercado Credito solution, and revenues from the sale of MPOS products.

Source: Giro’s estimates consulting app and website on 2022-01-17.

###Management compensation
Probably management’s long-term alignment is one of the most undervalued elements in a company.

However, one of the best ways of verifying your thought about the company’s focus is looking where compensations are coming from.

A heuristic that has been working fine to me is that a company whose management doesn’t have skin in the game is doomed to a failure somewhere in the future.

From 2011 to 2017, Meli’s compensation and performance measuring looked much like a commerce company, with a greater focus on revenue growth and net income.

In 2018, Meli hired Mercer Consulting to establish better compensation peers and draw better weighting performance measures.

Source: Mercado Libre and Giro Lino. *In 2020, Net Income was replaced by Ebit.

The relevant highlights are the inclusion of “2-Day Shipping (%),” “TPV,” and changing “Net Income” criteria to Operational Income.

There is a circular reference from “2-Day Shipping (%)” to NPS and from “TPV” to Net Revenue, meaning that Meli kept Net Revenue importance unchanged, increasing the priority for better “NPS” using an operational metric, instead of a subjective metric. NPS has an inherent problem because it is affected by external factors that management might not interfere with.

In 2020, 98.5% of our chief executive officer’s total target direct compensation for our 2020 fiscal year was performance-based, and 93.8% of our other named executive officers’ average total direct target compensation was performance-based.

Source: Mercado Libre.

The vesting for the Long Term Retention Plans (LTRP) is six years, meaning that every year management receives 16,67% of the nominal target value for the LTRP if there is any.

Historically, Meli’s management beats its operational targets year over year, receiving greater LTRP.

Source: Mercado Libre.

Source: Mercado Libre and Giro Lino.

Also, the Chairman of the Compensation Committee is Mr. Meyer Malka (“Micky”), who has been on Meli’s board since 2013 and founded Ribbit Capital, a Venture Capital company focused on Fintech companies.

The ultimate evidence that Micky has no conflict of interest with other stockholders is that he is a stakeholder, having more shares than most directors.

Source: Mercado Libre

### Valuation

### Disclosure
###### All posts on Giro’s Newsletter are for informational purposes only. This post is NOT a recommendation to buy or sell securities discussed. So please, do your work before investing your money. Giro’s Newsletter makes no representation, warranty, or undertaking, express or implied, regarding the accuracy, reliability, completeness, or reasonableness of the information contained in the piece. Any assumptions, opinions, and estimates expressed in the article constitute the author’s judgments as of the date hereof and are subject to change without notice. Any projections contained in the information are based on several assumptions about market conditions, and there can be no guarantee that any projected outcomes will be achieved. Giro’s Newsletter does not accept any liability for any direct, consequential, or other loss arising from reliance on the contents of this presentation. Giro’s Newsletter is not acting as your financial, legal, accounting, tax, or other adviser or fiduciary capacity.
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$MELI Opportunity in LatAm
Although LatAm accounts for ~9% of the global population, the market expects that $MELI will have only 1% of the global GMV. This is the size of the opportunity.

IMO, while consensus estimates their GMV in USD for having higher inflation, the actual growth is always above expectation.
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$MELI is one I've owned for a while--and have added to recently. They consistency beat expectations. And aside from ecommerce they of course have MercadoPago
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Stock performance in LatAm

On Apr 10th, we dig up the fundamentals that explain a bull market for Brazilian Equities, splitting it between “tactical bull market” and “structural bull market.”

Even though the EWZ was registering a +35% YTD performance, we highlighted that election, global turmoil, higher expected rates increase, and funds’ technical positioning was terrible.

Fortunately, the timing was right, and most of LatAm’s ETFs are now performing in the negative territory in 2022.

Although we were not expecting a swift move in such a short time, let’s recall what we wrote about market cycles on Mar 6th:
That are multiple interrelated and overlapping cycles affecting markets:
  1. Structural cycles, long-term condition expectations of trend growth and inflation, and other factors might affect the long-term outlook.

  1. The global and business cycles, such as changes in growth and inflation relative to trend, impact returns in the medium term.

  1. Mini-cycles in risk appetite are often driven by a material change in growth rates or rate shocks caused by geopolitical or political risks or material shifts in monetary policy.

On Apr 10th, we dissect what a structural bull market looks like in Brazil. For every structural bull market that has ever happened, there was a particular combination of i) falling local interest rates, ii) accelerating growth rates (Brazil’s CAI), and iii) stable global markets.

EM equities and local bond yields are typically negatively correlated (especially for high-yielding EMs), so unsurprisingly, Brazilian interest rates rally during equity bull markets. For example, in the previous bull market, between 2016 and 2018, Brazilian equities had a 170% positive return.

The starting level for the Brazil 5y rates was 16.8%, dropping by 7.8% to 9%. This interest rate level is so monstrous that the Equity Risk Premium (Equity Yield - Bond Yield) is negative, meaning that index investing is not worth the risk.

Just considering the negative 7.8% impact on rates would be translated into a ~90% increase in equity value, partially explaining the 170% bull market rally. This is true for the previous cycles as well.

Nowadays, even though profits are skyrocketing with commodity prices, the Brazilian Federal Funds (“Selic”) increased from 2% to 13.25%, so it was hard to imagine equities overperforming bonds during the hikes.

Brazilian equities can post a bull market somewhat independently of US rate moves. However, there is a clear pattern that long-lived rallies coincide with significant US Dollar downside and large rises in global equity and commodity prices.

Currently, ~50% of Brazil’s Stock Exchange comprises companies benefiting from the higher global inflationary period, highlighting metals, mining, and oil and gas industries.

The Brazilian Commodity prices index hit its all-time high in 2022, with its five years annualized return also reaching its historical maximum.

However, it’s important to highlight that commodity prices without a supportive interest rate and supportive Dolar performance are insufficient to trigger a bull market or sustain it for long.

On January 30th, we wrote about how the FED suggested that near-term risk increased, and prices should adjust to that given the uncertain path ahead, indicating consecutive hikes ahead and a sizeable opportunity in the Oil and Gas industry.

Although Chair Powell clarified that FED’s job isn’t to set a floor to stock prices — the so-called FED Put, their decisions are influenced by stock prices and volatility.

In our last Food for Thought (“FFT”) edition, on July 3rd, we raised the possibility of gears changing. After collapsing the stock market and consumer confidence, the FED might turn to a dovish stance — more details in the following weeks.
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Food for Thought #23
Fintech dilemma and the base case for 2H22

Outlook for 2H22
For the 2H22, there are a few charts investors should keep warry of. The S&P 500 Index tries to build upon the initial rebound from the extreme oversold conditions realized last week.

The deeply oversold conditions and bullish momentum divergence signals already in place imply an increased probability for additional upside into July.

We recognize the divergence only plays for weekly charts, nevertheless. As in 2007, we should keep cautious without the confirmation of the monthly chart.

Slowly, we’re turning our attention back to gold companies. In January, we wrote about how the FED suggested that near-term risk increased, and prices should adjust to that given the uncertain path ahead, indicating consecutive hikes ahead.

Chair Powell clarified that FED’s job isn’t to set a floor to stock prices — the so-called FED Put. The problem is that, historically, FED’s decisions are influenced by stock prices and volatility.
In the following month, we wrote about the spread between 10yr and 2yrs maturity USTs have been pricing lower growth ahead.

Historically, if the curve stays under pressure, the FED creates the narrative that lower growth will help with inflationary pressure and, therefore, overblowing the hike's narrative.

In our opinion, and it’s no secret, the FED is screwed. Either the bond market will collapse with skyrocketing yields, or the currency will vanish because of money printing to support bond purchases.

The market has given the first sign we need.

After significant price moves throughout the year, the UST10Y closed well below the intra-month high, forming a pattern in the monthly chart called “inverted hammer.”
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Food for Thought #3
Your Sunday morning meditation 2022-02-06

Fintech Dilemma
This is a passage from my weekly newsletter. If you're interested in this content yet didn't sign-up for free, here's the link.

---

After being valued at US$45.6 billion in June of 2021, WSJ reported that Klarna is close to announcing a new offering at a US$6.5 billion valuation — ~85% permanent impairment of capital in a year.

After failing to get significant traction, trying an offer at a US$20-US$25 billion valuation and cutting 10% of its more than 7,000 workforces, the management finally accepted a realistic valuation.

Contrary, in a rare appearance, David Vélez, Nu’s CEO, gave an interview to the FT. While many fintechs appear desperate to raise cash, Nu is out hunting for accretive M&As. According to the CEO:

> “Some of the M&A conversations we had 12 months ago are coming back at a 70 percent discount . . . We’ll be looking to do more M&A.”

For the market, the reduced valuation reflects a more comprehensive route in the fintech space. In addition, surging inflation has led investors to take a more cautious approach, stemming the flow of easy money.

However, operating in LatAm has always been the survival of the fittest. Those companies never saw more than four years of stability without inflationary pressure and wealth destruction.

Nu issued its first transactional card in 2014. It took four years for them to get a financial institution license, which happened by presidential decree.

Yet, the Brazilian Central Bank obligated Nu to keep an RWA above incumbent banks, even though the company reports under the IFRS9, which binds them to provision losses upfront. For thriving for almost a decade, being average isn’t enough.

Most credit fintechs that received massive funds after Covid-19 underestimated the risk of scaling up a credit operation.

Unintentionally, the regulatory constraints might have helped Nu. It took so long for them to operate the credit business that they had enough time to streamline the underwriting policy and build up their own credit bureau. Ironic.

Nevertheless, focusing on developing the product before investing aggressively in growth was right. Still, management takes only half of the blame.

The modus operandi in the VC industry is very well known. You invest in a company wondering about the subsequent funding round.

For early-stage companies, that makes perfect sense. Otherwise, if you seed a company that never raises funds again, it’s worth zero.

What changed in the last years was how capital market analysts analyze growth stocks. They started evaluating those firms as VCs. That is a gross mistake.

But analysts are not totally wrong. As a buy-side analyst, you have 15-30 companies under coverage. How the heck will look each one individually with the necessary granularity and short deadlines.

The industry is wrong. The complexity of evaluating companies increased significantly in the past decade, although deadlines became shorter year after year.

Honestly, no idea what the solution is, but we hope the recent drawdowns might have worked as a wake-up call for PMs and GMs. EV/Sales is a joke.
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www.ft.com
Brazil’s Nubank plots consolidation in Latin America’s booming fintech sector
Chief executive says digital lender is on the hunt for bargain acquisitions

As destructive as the PE market has been, and the public markets, this is all good for the LT. Every period of mania has to come to and end, and expectations have to be reset.
+ 2 comments
$MELI increase shipping for sellers
$MELI announced a new pricing policy for free shipping from July onwards and increased the free shipping for CPG from R$79 to R$200. In Apr, I highlighted that $MELI would increase monetization for its commerce biz.

Also, the company announced a significant increase in heavy items, such as fridges, TVs, and so on. Personally, I believe the company is on the right path to achieving substantial operational leverage.

Fuck yeah! Long runway baby! I am starting a position!

Any thoughts on their credit business? what do you think about the short term problems and the long term prospects?
+ 1 comment
You Heard This Lie Before
=========================
### The Biggest Myth Related to Competitive Advantages

"Long-term consistency trumps short-term intensity."
Bruce Lee

To read the entire post, access our blog.

This quote embodies what many fail to realize, that being a successful and high-achieving person results from the consistent effort. Success is a marathon, not a sprint.

One of the most important, though undervalued, aspects of evaluating performance is the environment.

I think one of the reasons the environment is so powerful is that it communicates with your subconscious and has a conversation that you’re not privy to in your conscious mind.

This may sound ridiculous, but if I’m trying not to eat potato chips and I see them, it’s easy for me to eat them.

And so, nudging your physical environment can shape your behavior because it’s having a conversation with your unconscious self.

For instance, especially in the new year, we have these desires to set goals and achieve these huge goals and change our lives, work out more, start a new relationship, and travel to different places.

And we have to overhaul everything. Now, that takes a lot of energy. That takes a lot of attention.

And when you set out to do that, the moment you achieve something like that, you also sign up for the process that’s going to get you there.

You also sign up for the effort that will get you there. And what happens to many people who try to make these enormous overhauls of time and energy and introduce challenging habits.

And I think it is often misunderstood because people over-index its importance. And what I mean by that is they overestimate how important confidence is.

I have learned from talking to professional investors how many lack confidence. Considering their career, it’s something really awkward to hear.

If you ask them how they succeeded for years, they’ll tell you that they don’t care about how they feel. Instead, they focus on their actions.

Confidence is often misplaced. Instead of being placed on the ability to bounce back, to learn from failure, its belief is based on something that might not be there when it needs it.

In the market, we go across similar experiences a lot of times. For example, have you ever got in a position/trade extremely overconfident and ended up losing money?

On the other hand, have you ever got in a position/trade where you didn't feel comfortable but ended up making a lot of money? That's happened to all of us. Confidence isn't an accurate predictor of success.

### It’s all about it
I think the primary thing is that in any organization, the whole premise of organizational life is that together you can do more than you can do in isolation, but that only works if people are connected.

It only really works if they trust each other and help each other. But unfortunately, that isn’t automatic and requires effort from leadership.

I mean, obviously, it’s imperative who you hire. So the signals you send to them and the kinds of behaviors you want are really important.

I think that having kind of critical people who appreciate generosity is a business characteristic for thriving companies.

It’s not something you just save for out-of-work time. I think that’s a really fundamental yet rare characteristic to find in different businesses.

Suppose you really believe that the value of collaboration lies in the aggregation or compounding of talent and creativity.

In that case, you have to have an environment where people are really prepared to help each other.

People are only really going to be prepared to help each other if they feel they will be supported when needed. If you think that, not egregiously, but respectably, you might get some credit for your contribution because people don’t like to feel invisible quite widely. Stanley Milgram wrote about this brilliantly.

He talked about how when we go into an organization, our moral focus shifts from wanting to be a good person to a good job, and we implicitly assume that doing a good job is doing what we’re told.
The person you work with is not identical to the person you are at home, which is probably not entirely consonant with the person you are on the golf course or the gym.

Identities are not as absolute and fixed as we used to imagine, so we have to be very alert to how we change in different environments and pay attention to what we leave behind and what gets amplified.

Organizations are much more complex than a single human being. Dealing with people from different cultures, economic backgrounds, gender, and so on is challenging.

### Reduce Friction
After years on the road, interacting with different organizations, you figure that most companies are equally competent, though just a few thrive.

For Company A, even though they deliver good results, the management relies on complex and dizzy internal processes to make decisions. Company A just can’t keep track of what they need to do.

Meanwhile, Company B shows up knowing what they need to do, and they simply execute. Moreover, they deliver without any complex internal processes, which is excellent!

From Company A’s perspective, even though they’re competent, they see themselves in the position of not taking “reckless” and “hurry up” decisions.

From Company B’s perspective, they’re equally competent and wondered why investors compare them to Company A, as it was a close peer.

From investors’ perspective, they’re both valuable and competent firms, but not equally valuable. Company A is much more valuable.

This is interesting because it's a "what to add?" situation. Many employees believe the secret to gauging a career is delivering more value to the company.

This is not true. A substantial value could be collected using your boss's perspective, such as reducing friction.

You don’t need to learn any new skills for this; you have to shift your perspective to your boss’s point of view and see how hard it is for them to get you to do something.

Then, like in nature, which removes mistakes to progress, you can draw things to survive and thrive.

Think about it this way. The C-level management has a limited unit of energy throughout the day to accomplish something.

Suppose your internal process spends much more on delivering execution due to constraining internal processes.

In that case, it’ll always be significantly less than a company with streamlined internal processes, despite their diligence in executing the strategy.

When we think of improving our value to an organization, we often think about the skills we need to develop, the jobs we should take, or the growing responsibility.

But, in so doing, we miss the most obvious method: reducing friction.

### The first-entrant bullshit…
In the classic about corporate strategy, most start-ups advocate a competitive advantage being the first entrant and gaining scale faster than competitors.

To continue reading the post for free, access our blog.
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The Narrative's Power
To read the entire post, access our blog.

As we commented on Twitter on Saturday, we’re releasing a new post about Stone, its valuation process, and how each engine affects the overall picture.

So far, between updates, and deep dives, we have written twelve posts about the company, totaling over 180 pages in content.

Even though we’re proud of creating that amount of content in such a short time, we haven’t had such much about our thoughts on how to evaluate our writing.

Regardless of how careful we’re researching and reading someone else’s write-up, we might be charmed by a good storyteller, although we theoretically know how to shield our minds.

If you have been following us since our inception, you probably noticed that we are left-brainers (logical). More recently, we’ve been developing a new set of skills for storytelling.

For that, we see ourselves in the position of helping investors and equity research analysts to develop a set of soft skills when reading someone else’s writings.

We Are Irrational
We inevitably have to deal with various individuals who stir up trouble and make our lives difficult throughout our lives.

They can be aggressive or passive-aggressive, but they are generally masters at playing on our emotions. They often appear charming and refreshingly confident, brimming with ideas and enthusiasm.

Only when it’s too late, do we discover that their confidence is irrational and their ideas ill-conceived.

What inevitably happens in these situations is that we are caught off guard, not expecting such behavior. Often this type will hit us with elaborate cover stories to justify their actors or blame handy scapegoats.

We might protest or become confused and drawn into a drama they control. We might protest or become angry, but we feel somewhat helpless in the end — the damage is done.

We catch ourselves falling into self-destructive behavior patterns that we cannot seem to control in these situations.

If we really understood the roots of human behavior, it would be much harder for the more destructive types to continually get away with their actions. We would not be charmed and easily misled.

But why? What if we could see the source of our more troubling emotions and why they drive our behavior, often against our wishes?

Understanding that stranger within us would help us realize that it’s not a stranger at all but a very much a part of ourselves.

And with that awareness, we would be able to break the negative patterns in our lives, stop making excuses for ourselves, and gain better control of what we do and what happens to us.

Having a clear understanding of ourselves and others could change our lives. But first, we must clear up a common misconception: we believe ourselves as rational.

Look at greed, for instance. We usually identify a specific excuse or a group as the cause of this emotion. But if we were honest with ourselves, we would see that what triggers our greed has deeper roots.

We can discern the patterns if we look — when this or that happens, we get greedy. But at the moment, in getting greedy, we are not reflective or rational — we merely ride the emotion and take unnecessary risks.

Nevertheless, we like to imagine ourselves in control of the situation, planning the course of our investments as best as we can. But we are largely unaware of how emotions drive us.

To continue reading the post for free, access our blog.
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"Having a clear understanding of ourselves and others could change our lives. But first, we must clear up a common misconception: we believe ourselves as rational." <- THIS!. Thank you for this post. Love behavioral economics and constantly learning about why we do the things we do
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Clash of Titans (AWS vs. Azure)
Hi. Every week, I post a couple of my Daily Posts on Commonstock.

In the early days of the cloud IaaS (Infrastructure as a Service) market, customers ran workloads that consumed compute and storage resources with few constraints and little visibility into usage and costs.

As a result, many customers experienced bill shock. In response, the cloud companies introduced options such as i) reserved instances, ii) advancements in more powerful chip sets (read Graviton), and iii) more efficient storage.

The implication is that data platforms that position for the long-term budget opportunity can capture huge gains. At the same time, those who don’t strike the right balance will yield inferior returns with subdued investments.

In the 4Q21, Snowflake announced that hardware and software improvements would yield more efficient consumption of their data warehouse service resulting in a near-term headwind to revenue.

On one side, we saw service providers arguing the right approach to maximize long-term growth would be doing the contrary. Personally, we disagree.

We believe the companies are looking for products, such as analytics, data management, and monitoring services.

Since we believe the IT spending for companies will remain unchanged, penetration should increase better than expected. For companies such as Snowflake, if they genuinely own pricing power, this should result in better profitability.

It isn't clear who the winner is for cloud providers, such as AWS, GCP, and Azure. However, the discussion prevails that AWS or Azure should rank number one.

Again, we disagree. We believe each has its nuances, offering different solutions for customers. But, all in all, we believe both could co-exist.

So, in today’s post, we bring light to the discussion regarding public cloud service providers and the industry.

We explore the concepts behind IaaS and PaaS (Platform as a Service), moving to Azure’s architecture, limitations, and a brief comparison to AWS.

Brief Overview
IaaS and PaaS are the most popular types of cloud service offerings. IaaS is on-demand access to cloud-hosted virtual and physical servers, networking, and storage, while the backend infrastructure tun the applications and workloads.

> IaaS customers use the hardware via an internet connection and pay for that use on a subscription or pay-as-you-go basis.

> Typically IaaS customers can choose between virtual machines (VMs) hosted on shared physical hardware (the cloud service provider manages virtualization) or bare metal servers on dedicated (unshared) physical hardware.

PaaS, or platform as a service, is on-demand access to a complete, ready-to-use, cloud-hosted platform for developing, running, maintaining, and managing applications.

There is a misunderstanding that services are exclusionary. However, IaaS and PaaS are not mutually exclusive. Most SMEs and enterprises use them both.

'As a service' refers to how IT assets are consumed in these offerings and the essential difference between cloud computing and traditional IT.

In traditional IT, an organization consumes IT assets by purchasing them, installing, managing, and maintaining them in its own on-premises data center – without mentioning the expenses related to the IT team.

In cloud computing, the cloud service provider owns, manages, and maintains the assets; the customer consumes them via an Internet connection and pays for them on a subscription or pay-as-you-go basis.

So the chief advantage of IaaS, PaaS, or any 'as a service' solution is economic: A customer can access and scale the IT capabilities for a predictable cost, without the expense and overhead of purchasing and maintaining everything on its own data center.

But there are additional advantages specific to each of these solutions. Before breaking it down, we illustrate in the image below which steps of the process are managed by the service provider:

Research Amazon using Stratosphere

The Right Customer
Even though the PaaS and IaaS solutions offer similar solutions, a few nuances make each the right choice for specific industries.

For instance, perhaps, the most obvious usage for IaaS is deploying a disaster recovery solution to the cloud provider, which is easier to manage and cheaper.

Also, IaaS is an excellent option for clients looking for event processing, such as IoT, AI, eCommerce operations, and many others that don’t require real-time data processing.
Service providers make it a lot easier to set up data storage and computing resources for these applications that work with a massive volume of data.

Finally, the flexibility of increasing capacity and scaling up during high demand periods without losing service level is a huge advantage.

On the other hand, with its built-in frameworks, PaaS makes it easier for teams to develop, run, manage and secure APIs for sharing data and functionality between applications.

For clients relying on real-time data processing, PaaS is the place to go since its solutions support cloud-native development technologies, such as Kubernetes, that enable developers to build once, then deploy and manage consistently.

Azure VM Architecture
As mentioned, Azure began as an IaaS company, then it added PaaS solutions, so it’s essential to understand why, in our opinion, start-ups and larger customers than require a real-time data-processing end up picking AWS instead.

The easiest way to do that is by going through Azure’s VM instances, which the company offers two services, the subscription (which Azure calls spot VMs) and the pay-as-you-use.

Azure lets you buy spare capacity at a lower price—up to 90% less than the pay-as-you-go market price. However, once Azure needs this excess capacity back, your spot instances will be terminated, with an advance warning of only 30 seconds.

Using this Azure pricing model for mission-critical and production workloads can be challenging.

Because of their unreliable nature, spot instances are typically used for stateless applications, batch processing, or development and testing scenarios, where it is acceptable to have an application instance fail.

It is possible to use spot instances on Azure for stateful and mission-critical applications, but this requires careful management and automated cloud optimization tools.

Spot instances are a very compelling pricing option on Azure. The obvious pro of spot instances is their low price, which may be discounted at 90% of pay-as-you-go rates.
Also, you could run a spot instance to improve reliability for a specific service, which is a considerable advantage, especially for enterprises.

For instance, if you own a complex eCommerce operation, you could run a couple of pay-as-you-go VMs to guarantee the baseline capacity and add a spot instance for helping in a peak capacity situation, such as during Black Fridays.

However, spot VMs have a few limitations. For instance, Spot VMs don’t provide availability guarantees, and after a VM is evicted, it’s not automatically turned back on, then capacity is available, limiting reliability.


Limitations
If you read our previous topic about AWS, you’re probably connecting the dots on how Azure is inferior to AWS for PaaS.

Microsoft focused on creating powerful VMs, alongside storage services for its products, then the microservice functions in Azure, which led to several changes in the infrastructure.

So, even though Microsoft has all the technology, the scalability and the architecture of the AWS platform are excellent.

In our opinion, that’s why AWS is superior. Microsoft did it backward, presenting challenges around scalability and reliability.

We’re not saying that Azure is not a good solution. We’ve never heard it. However, it is a usual complaint with certain limitations and restrictions in the service, resulting in some trust issues for a few clients.

The complexity of implementing and running microservices on Azure is enormous. Except if you’re an enterprise, it’s hard for you to do so.

AWS, on the other hand, every start-up uses its service. So the answer is always easy to use, scalable, and reliable.

Distribution is Key
We believe that Microsoft distribution is one of its powerful, though underestimated, competitive advantages — or it was for many.

Even though most clients don’t realize it, there is a vast network effect in their products, and once you’re in, it’s almost impossible to get out.

Think that you’re a regular client, owning a complex SAP, looking at which cloud provider provides that exact specification for their SAP environment in terms of actual memory configuration.

That would be a good fit for them and at a reasonable price point. They'll take AWS over Azure or vice versa, depending on what they have on-premise and the workflow they’ll allocate on each.

We frequently heard that the cloud is about pricing, though I’ve never heard it from anyone who used it. Indeed, price is a huge factor, but it’s more complicated than pricing.

If you’re an enterprise and somehow end up moving to Office 365, I bet you’d migrate to Azure. They’ll offer a bunch of services nobody else could match because it’s Microsoft.

So, in 2020, many enterprises began migrating to the cloud, leaving their legacy data center. Since it could take years to migrate an entire operation, Azure has gained market share in the past years.

Sharing Scale
We gathered information with tech vendors. Since they all expressed the same opinion, we believe it may be how the market is configured.

Today, there are vendors focused on two different models: tech-first companies and those focused on enterprise IT.

In almost 90% of the competitive process, AWS wins tech-first clients, such as Twilio, Datadog, Twitch, ESPN, Netflix, etc.

On the other hand, Azure wins more than 50% of the dispute versus AWS and peers for having a considerable penetration of enterprise.

For us, it’s a consensus that AWS is the preferred solution for tech companies, while Azure is for enterprises. However, that doesn’t mean that one will thrive and the other will fall.

Also, as happened in the past couple of years, we believe that Azure and Amazon could boost their efficiency, pass through prices, and maintain high profitability on reinvested capital.

Even though we heard that would harm margins, several industries proved the benefits of sharing economies of scale with clients.

For instance, in 2021, Microsoft announced a useful life extension for its equipment, extending depreciation from 5 years to 6.7 years.

Even though that could be translated into a 13% gross margin gain for the specific year, we believe the company shared scale with clients, a practice we expect to continue in the following years.

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Apples-to-apples
Bag a pardon, my readers, for I’ll switch to the first person again. Since the idea is to present a few calculations, objective sentences and images should work better.

Fine, I told you the qualitative differences between AWS and Azure so far. However, I recognize it’s essential to explore the quantitative stance a little more.

That was challenging since Microsoft is stricter in presenting Azure’s operational figures, so I had to figure out how to solve a few puzzles.

First, figuring out gross margin is the easiest. You can estimate it by calculating the gross dollar, then the gross margin dollar contribution.

Research Amazon using Stratosphere
The second is the SG&A. I must confess I didn’t consider the SBC. It became too complex. Then I had the idea of comparing the number of employees.

It doesn’t work. I believe Azure requires much fewer engineers than AWS, and the sales effort could overlay with different segments.

I did the following: go back to 2014, when Azure was nothing, consider that SG&A as ground zero, and deflate the forward SG&A to see the growth in expenses in real terms.

Then, attribute Azure accordingly to its contribution to the gross dollar margin. Then, add back the CPI. Why deflating first, then adding back inflation?

Not deflating the SG&A, I may, unnecessarily punish Azure if Microsoft’s SG&A grows below inflation. Even though that only happened twice in the past eight years, I would be transferring SG&A from a different segment.

Then, voilà: operational margin.

Research Amazon using Stratosphere
Going forward, I see an SG&A as a percentage of revenue flat, with efficiency gain boosting margins.

However, you cannot compare this margin to AWS’s. This is because the capital need for each business is different, and depreciation is a factor that must be considered.

For instance, in 2020, AWS reported a substantial benefit from increasing useful life, which hit its earnings, and, in 2021, an increase in the useful life of its equipment from four to five years
.
Personally, I believe they are overdepreciating their assets, suppressing o good chunk of profits. However, since they indicated an acceleration in AWS’ Capex, it will be hard to identify this in 2022, though we’re using 5.9 years in my cash flow.

Meanwhile, Microsoft is tougher. The company reported a five-year depreciation but recently reported a new “improvement”. I checked with people related to the industry and got a range between 6.2 and 6.7.

With those adjustments in the depreciation in mind, I set a 21% tax rate for both to maintain comparability. So then, this is what I got.

Research Amazon using Stratosphere
So, both companies present a ROIIC above 20%. That tells me that both are doing extraordinarily fine regardless of how much people yell that competition is increasing.
Let’s move on… We have a curious table ahead.

Even though I hate using tables, this one is interesting. I estimate the PP&E for Azure and AWS. AWS is helpful. There aren’t many personal inputs.

Azure is a problem. I applied a similar methodology to what I used for the SG&A to be consistent. The depreciation was tricky, though. I had to build a waterfall depreciation, considering changes in depreciation policy in 2021.

Research Amazon using Stratosphere
Yeah, when I finished Azure’s table, I instantly remembered AWS’. So I thought, “wow, that remembers AWS… wtf…”. Interesting, right?

Since AWS revenue is twice Azure’s, we may conclude that Azure’s business is more capital intensive than AWS’. So if both have similar operating margins, though Azure is more capital intensive, then AWS’ ROIC is superior.

The million-dollar question is, why? I’m not gonna lie; I haven’t found academic papers, experts, or comments in the transcript giving a hint.

However, I have a theory to share. I believe that PaaS is a business with higher barriers to entry, while IaaS is more capital intensive, considering storage and network investments.

This is a very logical theory, even though I can’t prove it because I don’t have the exact breakdown between IaaS and PaaS.

Finally, I was personally excited about writing this post. I had no idea what I would find, even though I knew it would be interesting. I hope to keep investigating and bringing more exciting content to my readers.

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Brazil May Wrap-Up
Hi. Every week, I post a couple of my Daily Posts on Commonstock.

Strong May

After a weak performance in April, the Brazilian Stock Exchange (“Ibovespa,” “Ibov”) was back in positive territory in May (up 3.2% in BRL and 7.8% in USD), remaining one of the top-performing equities.

Considering Ibovespa’s relative performance in the year, mainly to local peers in LatAm, we checked the market consensus and evaluated what was priced.

First, though, we’re over the 1Q22 earnings season, which is particularly strong for LatAm. Nevertheless, we highlight that most countries did well due to local currency performance, not local economic performance.

Earnings Season

1Q22 earnings season in LatAm was strong despite the disparity versus consensus estimates: 38% of companies beat the consensus(historical avg. is 27%) while 29% missed (vs. historical avg of 31%).

The net income expanded by 70% YoY in USD with robust numbers led by Brazil, Mexico, and Colombia, boosted by FX gains, while sales and Ebitda increased by 25% YoY.

Good numbers were supported by higher commodity prices. This season's highlights were Energy and Telecom, beating estimates by 64%, while Tech, Healthcare, Discretionary, and Staples missed by 50%.

We saw a clear reflection of this strong earnings season, coupled with currency appreciation, on consensus earnings expectation which stood at +18% for LatAm (from +10%) and increased significantly for Brazil at +16% (from +7%) due to stronger than expected currency performance.

Despite several companies reporting below consensus expectations, local currency performance leads to upward earnings revisions in the region.

In Brazil, 41% of companies beat and 37% missed consensus numbers. Ebitda for energy jumped by 56%, and materials fell by 19%. Only discretionary saw a contraction in net income YoY.

Despite the upward revisions, operational performance in local currency has weakened in relevant industries, such as retail and banks, leading us to believe that currency was the only upside surprise in the season.

Net Flow Equity Funds

Local equity funds suffered a sequential month of redemption, leading to forced selling in stocks with lower liquidity amidst a market with low liquidity and sequential sell-offs in specific names.

Put yourself in the context. In Brazil, you could buy a bond issued by a top-tier bank, such as Bradesco, paying 15% p.a. in local currency. The risk-adjusted return for fixed income products is superior, so why bother holding the equity?

Even though stocks may look cheap, we need to consider the greater context. We have populist candidates running for elections in Brazil, surging public spending, and a global crisis on our hands.


Context is Important

At a glance, Ibovespa looks like the cheapest exchange in the world, trading today at 112k, with the sell-side estimating a YE Target of 140k, implying a juicy 25% upside.

Looking at multiples, the Ibovespa is negotiating at 6.9x price to earnings for the next twelve months, a 2-st deviation below the 10yr average, which sounds like a screaming buy opportunity.

However, in our opinion, investors should consider the context:
  1. 33% of the Brazilian Exchange is composed of commodities companies, trading at contracted multiples due to higher commodity prices;

  1. Looking forward, the sell-side expects a contraction in earnings growth, assuming earnings normalization;

  1. Brazil is going through tough elections in 2022 that could change the entire space in the subsequent four years;

  1. By the end of May, real long-term rates in Brazil were trading at 5.7% versus a yield barely above 0% in the US, suggesting that something isn’t right.

Even though we understand the thesis that Brazil is partially shielded against a monetary tightening in the US, and a challenging geopolitical environment, for being a commodity exporter, that is partly true.

The above statement would be entirely accurate if Brazil was a rich country. However, Brazilians are eating less year after year, creating a fragile social condition to be dealt with.

For instance, from 2011 to 2018, the expenditure on food per capita dropped from US$3.4k to almost US$400 per year. In the same period, the household income collapsed from US$13.2k to US$9.2k.

Also, this is not useful only for Brazil. Most emerging countries face the same situation, with expenditure on food as a high percentage of household income.


That Matter

A reasonable question would be: why does it matter? The answer also explains the current valuation. As flagged in the previous section, real long-term rates in Brazil are at 5.7%.

First, Brazil is a populist country. Politicians are always waiting for their time to urge miraculous, though impossible, solutions and to blame someone for that.

Second, Brazil lived with higher than expected inflation in the past decade. So because public spending is misallocated and the productivity deteriorates year after year, we have a country with low growth and higher inflation.

Consequently, investors require a higher premium for financing the public treasury. So, do not believe that rates in Brazil are a non-brainer because the country exports commodities.

We’re not sure if the 2006 supercycle should happen again. But unfortunately, former President (and inmate) Lula wasted Brazil's most significant opportunity to increase public spending, create new companies, and subsidize companies that approved his government.

So, Brazil not only spent a relevant stake from the surplus, but also the poverty, corruption, and bureaucracy worsened during the period.

Perhaps, a new commodity cycle gives more oxygen to the Brazilian economy, though its effect should not last long.


Skeptical on Valuation

In our view, LT real interest rates at 5.7% imply significant political and fiscal risks. As most economists have advocated, there is room for improvement in the LT real rates.

That would take someone to win elections and commit to fiscal discipline. So naturally, falling LT interest rates are the critical trigger for stock prices in Brazil.

We constantly ask ourselves “why”. So, it's no different when we go over the sell-side consensus estimating almost 30% upside for the leading stock market in 2022.

Their pitch sounds good, but the math is entirely wrong. First, according to most sell-side analysts bull in Brazilian equities, the stocks look cheap, so we agree with them.

Second, they use a historical price-to-earnings chart with a 10-year average to demonstrate their point. This is a huge bias, but we could overwatch this.

Third, they imply a return to average, supporting their view that the market expects a 15%-20% ROE for the Ibovespa in 2022, trading below the 10x price to earnings multiple, so it’s cheap. This analysis is wrong.

They’re perpetuating a 20% ROE in a commodity peak cycle, which is stupid. Sorry, but that’s the word. This is ridiculously aggressive.

### How to Value the Ibovespa?

In our opinion, the conservative approach to evaluating the Ibovespa is not considering a re-rating. This is important because we do not know who will win the elections this year.

As mentioned, we do not take sides in politics. Instead, we examine the evidence, giving our best assessment of the situation. So, no comments about election odds or anything like that.

In the sell-side modeling, they are considering real rates 270bps below where it stands today. This is aggressive.

So, we built a comprehensive model for the Ibovespa, valuing only dividends and not considering multiple expansions, reaching 115k for the next twelve months.

We also estimated a few scenarios:
No re-rating
  1. Bear (95k): commodities rally is over in 2022, and Brazil replicates historical growth and inflation figures;

  1. Base (115k): the image above;

  1. Bull (126k): commodity still rallying in 2023 and partially in 2024, with a higher long-term ROE and payout.

Considering re(de)-rating
  1. Bear (117k): The same scenario, considering 200bps compression in real rates;

  1. Base (140k): The same scenario, considering 250bps compression in real rates;

  1. Bull (167k): The same scenario, considering 250bps compression in real rates;

Why not shorting Ibovespa? Easy. Check our bear case, considering the re-rating. Even though we’re pessimistic on fundamentals, we lose if the market gets optimistic for any reason.

If you’re shorting the Exchange in local currency, there is a 0.5:1 skew in this trade, which doesn’t sound good. However, we’ll likely sell coverage calls for our positions if the market goes up.

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