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Website Categories have been far and away the most active VCA Industry group over the last three months, with 61 deals and over $650 million in venture capital financing. Check out the most recent rankings of all our Industry groups in the VCA Stocks screening engine.

I’ve tried to divide this large Website Categories industry into a series of investable VCA Themes. The top five thematic categories since I started tracking VC deals in January, 2006 have been Social Networking Websites (36 deals), Misc Niche Websites (30 deals), Expert Opinion Websites (24 deals), Online Retail (17 deals), and Online Travel (17 deals).

There is only one true common theme — venture capitalists are searching for the next Internet giant: the next Facebook, the next Wikipedia, the next Amazon (AMZN), or the next Priceline (PCLN).

MercadoLibre (MELI) is clearly a potential Internet giant. The company dominates the online auction marketplace throughout Latin America, leading the category in Argentina, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, Mexico, Panama, Peru, Uruguay, and Venezuela. MELI’s website and operating ratios seem very similar to Ebay. Strengthening the comparison, Ebay owns 18% of MercadoLibre.

However, my five-year analysis indicates that MercadoLibre is too expensive to purchase at the current stock price of $43. The key reason MercadoLibre looks expensive to me is that I don’t see the $1 billion target revenue numbers some others have forecast over the long term. Rather, my target revenue looking out five years is $460 million. This is up strongly from 2007 revenues of $87 million, but $460 million is not enough, in my opinion, to support the current stock valuation. Accordingly, I recommend investors wait on the sidelines until MercadoLibre moves down to the low $20’s. I would buy the stock at that point, if the fundamental story had not changed.

How I get to a $460 million target for MercadoLibre revenues

View the spreadsheet of GDP, population and Internet usage statistics used for this analysis.

What if MercadoLibre were as successful in Latin America as Ebay currently is in the United States? That is the premise driving the MercadoLibre investment case. What would MercadoLibre’s revenues be in five years if at that time they were as successful as Ebay currently is here in the U.S?

The U.S. has a Gross Domestic Product of $13.8 trillion. The combined GDP of the countries MercadoLibre currently has an active website in is $3.2 trillion. Ebay’s domestic revenues during 2007 were $3.7 billion. The prorata revenue number at MercadoLibre would be $870 million. This might be considered a valid long term revenue goal for MercadoLibre.

But wait, I believe we have to discount that $870 million by a factor of 50% due to a lower anticipated internet penetration within Latin America. Right now, MELI’s Latin American countries have an Internet usage penetration of 22%, using a weighted average. The U.S. has an internet penetration of 71%. This is partially due to the relatively lower per capita income among the Latin American countries MercadoLibre focuses on — $6,563 per capita income for MercadoLibre countries vs $45,793 per capita income for the U.S. Looking at Internet penetration and growth rates among comparable countries around the world, I think it is reasonable to expect the MercadoLibre countries to reach 35% penetration over the next five years (up from the current 22%). This is still half of the U.S. penetration rate.

If you are not on the Internet, you can’t use the MercadoLibre service. Accordingly, I think it is more accurate to discount the $870 million target to reflect the 50% lower Internet penetration expected among MercadoLibre countries. This gives me a top-down target for MercadoLibre revenues of $435 million.

From the bottom up, extrapolating out aggressive, consensus growth rates for MercadoLibre over the next five years gives me a target revenue of $464 million. The top down and bottom up analyses are arriving at a similar range, and accordingly I am comfortable with this $460 million revenue target.

Valuation

View the spreadsheet used for this valuation analysis.

You can click the spreadsheet link above to see the detail, but basically I have developed a December, 2012 target price for MercadoLibre of $52 per share. The stock is trading at $43 right now, which would imply a 4% annualized internal rate of return over the next five years. 4% is too low to warrant a Buy recommendation, in my opinion.

I’ve made several assumptions in developing this five year target value of $52.

• I am using a $464 million target revenue figure for 2012, as discussed above.
• MercadoLibre’s business mix and operating margins are remarkably similar to Ebay’s. Both companies dominate the online auction business, both companies have a rapidly growing online payment subsidiary, and both companies currently have 78% gross margins. I am assuming that MercadoLibre’s high margins remain stable over the next five years.
• I placed a 5 multiple on 2012 estimated sales and a 30 multiple on 2012 estimated earnings.

There is significant risk to MercadoLibre achieving these five year targets. Accordingly, I would want a 20% annualized rate of return before buying MercadoLibre. Discounting $52 back to today at a 20% annualized rate of return gives me a current fair value for MercadoLibre of $22. MercadoLibre is not a Buy for me at more than $22 per share. 20% is a heavy discount, and other investors may disagree with me regarding the appropriate risk assessment for MercadoLibre. Accordingly, the spreadsheet above includes a table showing annualized internal rate of returns delivered at various price points given the $52 target price.

Competitive, Operational and Political Risks to MercadoLibre’s Long Term Outlook

The biggest potential competitor for MercadoLibre is Ebay. The non-compete between Ebay and MercadoLibre expired in September of 2006, and Ebay could decide to launch a competitive product in one of MercadoLibre’s key markets, perhaps Mexico or Brazil. A lesser risk is the entrance of Google into the online auction marketplace. Google has been very successful in building their Latin American search and social network products, and they may try to leverage their strong Internet presence onto MercadoLibre’s turf.

I think it likely, however, that MercadoLibre’s online auction business will be difficult for Ebay or any other competitor to challenge now that MercadoLibre has established a dominant position.

Managing 12 separate websites, one for each country MercadoLibre is active in, poses significant operational risks. In addition to the operational and regulatory complications, there are political risks in each of these Latin American countries. The socialist agenda in some Latin America countries increases the economic and regulatory risks for any company operating in that area.

The following is a quote from the “Risks related to our business” section of MercadoLibre’s 2007 annual report.

• “We conduct our operations in emerging market countries in Latin America. Economic and political developments in these countries, including future economic changes or crises (such as inflation, currency devaluation or recession), government deadlock, political instability, terrorism, civil strife, changes in laws and regulations, expropriation or nationalization of property, and exchange controls could impact our operations or the market value of our common stock and have a material adverse effect on our business, financial condition and results of operations.
• In the past, the performance of the economies of Latin American countries has been affected by each country’s political situation. For example, during its crisis in 2001 and 2002, Argentina experienced social and political turmoil, including civil unrest, riots, looting, protests, strikes and street demonstrations. Government policies to preempt such civil, social and political turmoil affected the Argentine economy. More recently, the Venezuelan and Bolivian administrations have nationalized or announced plans to nationalize certain industries and expropriate certain companies and property, and, in Venezuela, the administration has imposed exchange controls.”

These competitive, operational and political risks are what lead me to seek a rich 20% annualized internal rate of return on the five year target value of $52 that I calculate for MercadoLibre.

Capital Structure

There are four large institutional holders of MercadoLibre stock: Ebay (18.4%), General Atlantic (8.9%), Tiger Global (9.8%) and FMR LLC (9.4%). Large holders such as these can cause volatility in the stock price and management of a company. Sometimes that can act in the shareholders’ favor, but you never know how it will play out. That in a nutshell is the problem — when you look around the table, you can be certain that there are at least four large players with more information than you.

The employee options program is very small, with only 688,000 (1.6%) outstanding options as of December 31, 2007. Marcos Galparin, MercadoLibre’s CEO, owns 13.9% of the company’s outstanding shares, while the next largest employee owns less than 1% of the outstanding shares.