MELI Every Improvement From Last Quarter Reversed at Once - And Net Income Fell for the First Time in This Coverage

The Cost Pool's One Good Quarter Didn't Last

MercadoLibre's Form 10-Q for the quarter ended September 30, 2012 reports net revenue of $97.27 million, up 19.2% from $81.63 million in the third quarter of 2011 - a sharp deceleration from Q2 2012's 28.1% and the slowest reported growth rate this coverage has measured since the free-MercadoPago pricing change. The deceleration traces mostly to a currency effect: measured in local currencies, revenue grew 37.0%, an 17.8-point gap between reported and constant-currency growth - nearly as wide as Q2's record 19-point gap - as the Brazilian real and Argentine peso kept depreciating against the dollar. But currency doesn't explain everything. Gross merchandise volume^» (GMV) grew just 6.5% in dollar terms even as items sold grew 22.4% - the widest gap this coverage has tracked between the two measures, meaning the average dollar value of each item transacted fell sharply, a currency effect showing up directly in the operating metric, not just in the revenue translation.

Here is the quarter's real story: every single improvement Q2 2012 delivered reversed at once. The unallocated "operating expenses and indirect costs of net revenues" line - the corporate-cost pool this coverage tracked growing faster than revenue in every 2011 filing, which finally reversed to grow slower than revenue last quarter (19.5% vs. 28.1%) - snapped straight back: it grew from $10.69 million to $13.80 million, up 29.1%, nearly ten points faster than revenue's 19.2% growth. Consolidated operating margin fell 2.05 points, to 34.66% from 36.71%, undoing more than 40% of Q2's 4.82-point gain in a single quarter. Segment performance flipped too: where four of five country segments improved margin last quarter, this quarter only two did. Brazil's direct contribution^» margin fell to 40.92% from 44.11% (-3.19pp), Mexico fell to 36.89% from 43.24% (-6.35pp), and Argentina - the segment this coverage has now watched decline for three straight quarters - fell to 53.20% from 60.42%, a 7.22-point drop, its worst yet after Q1's -3.00pp and Q2's -4.82pp. Only Venezuela (+6.59pp) and Other Countries (+3.60pp) improved.

Net income attributable to MercadoLibre actually fell year-over-year this quarter - to $26.04 million from $26.30 million, down 1.0% - the first time in this entire coverage's history that this figure has declined against the same quarter a year earlier. Diluted EPS fell to $0.59 from $0.60. The decline wasn't driven by operations alone: both the blended tax rate (27.5% vs. 25.1%) and the effective tax rate (29.5% vs. 25.1%) rose together this quarter, reversing Q2's coincident improvement in both measures, and a $3.28 million foreign-currency gain in Q3 2011 became a $0.19 million loss this quarter - a swing that alone erased most of the operating-income gain before tax.

The Prescription

Management now has direct evidence that last quarter's cost discipline was not a structural fix - it was a one-quarter event, and the MD&A still offers no specific target or explanation for why the corporate-cost pool swings so violently (19.5% growth one quarter, 29.1% the next). The next move should be exactly what this coverage asked for after Q2: name an actual cost-discipline target and report progress against it every quarter, rather than let a reader discover after the fact whether the "shared cost centers" grew in line with the business. A company whose corporate overhead has now grown faster than revenue in nine of the last ten quarters tracked here owes shareholders more than a footnote-level reconciliation.

What it should stop doing: treating Argentina as a growth story rather than a margin problem. Argentina's revenue grew fastest of any segment this quarter (+52.4%, again likely inflated by peso depreciation), and its margin has now fallen every quarter of 2012 - by more each time (-3.00pp, then -4.82pp, then -7.22pp). A segment whose margin decline is accelerating while its revenue growth is decelerating against the pace management itself has flagged as currency-inflated is not a segment management should keep folding into the consolidated good-news narrative. It needs its own explanation - wage inflation, competitive pressure, or something structural in the Argentine business - the same call this coverage made after Q2 and Q1, now overdue given three straight quarters of worsening evidence.

Key Financial Metrics

Three months ended September 30, 2012 vs. three months ended September 30, 2011 - consolidated, reported in USD (MercadoLibre reports natively in dollars; no FX conversion is needed)

Metric	Q3 2012	Q3 2011	YoY
Net revenues	$97.27M	$81.63M	⚠️ +19.2% - about a third slower than Q2's 28.1%
Cost of net revenues	$(25.69)M	$(20.06)M	⚠️ +28.1%
Gross profit (73.6% margin)	$71.57M	$61.57M (75.4% margin)	⚠️ +16.2%, margin -1.84pp
Income from operations» (34.7% margin)	$33.71M	$29.96M (36.7% margin)	🔴 +12.5%, margin -2.05pp - undoes most of Q2's gain
Unallocated corporate costs	$13.80M	$10.69M	🔴 +29.1% - faster than revenue again, reopening the gap Q2 closed
Adjusted EBITDA	not disclosed	not disclosed	⚠️ twenty-second straight filing undisclosed
Blended tax rate	27.5%	25.1%	⚠️ +2.4pp - reverses Q2's improvement
Effective tax rate	29.5%	25.1%	⚠️ +4.4pp - reverses Q2's improvement
Net income» (attributable to MELI)	$26.04M	$26.30M	🔴 -1.0% - first YoY decline this coverage has measured
Diluted EPS	$0.59	$0.60	🔴 -1.7%
Operating cash flow (derived, quarter-standalone)	~$25.22M	~$28.56M	⚠️ -11.7%
Free cash flow» (derived, OCF less capex/intangibles)	~$21.91M	~$24.71M	⚠️ -11.3%
Cash, ST & LT investments (period end)	$236.98M	n/a	-
Loans payable (period end)	$0.20M	n/a	- still Argentine car-lease obligations

Gross margin compressed 1.84 points (73.6% vs. 75.4%), continuing the multi-year trend tracked since free MercadoPago pricing began: collection fees rose $3.4 million as TPV^» penetration (now 33.4% of GMV) kept climbing, alongside a $0.8 million rise in in-house customer-support costs and a $0.6 million increase in hosting costs. Because MercadoLibre's cash flow statement is cumulative (nine months, not quarter-standalone), the quarter-only operating cash flow and free cash flow above are derived by subtracting the already-reported six-month 2012 figures from this filing's nine-month cumulative cash flow statement, the same method used in prior mid-year quarters.

The corporate-cost pool that grew 8.6 points slower than revenue last quarter grew 9.9 points faster than revenue this quarter - a full reversal in one filing. Net income attributable to MercadoLibre fell year-over-year for the first time in this coverage. See The Cost Pool's One Good Quarter Didn't Last above.

Key Operational Metrics

Three months ended September 30, 2012 vs. three months ended September 30, 2011

Metric	Q3 2012	Q3 2011	YoY
Gross merchandise volume» (GMV)	$1,436.4M	$1,348.3M	⚠️ +6.5% - sharply slower than Q2's +21.7%
Total payment volume» (TPV)	$480.1M	$368.5M	✅ +30.3%
Confirmed registered users (cumulative, period end)	77.2M	62.0M	✅ +24.5%
New confirmed registered users (in period)	4.0M	3.6M	✅ +11.1%
Items sold	17.6M	14.4M	✅ +22.4%
Take rate (net revenues / GMV)	6.77%	6.05%	✅ +0.72pp YoY, though down slightly from Q2's 6.84%

The gap between items-sold growth (+22.4%) and GMV growth (+6.5%) is the widest this coverage has tracked - the average dollar value of an item transacted on the platform fell sharply, on top of the already-disclosed currency translation drag on reported revenue. This is a second, separate currency effect: it isn't just that MercadoLibre's dollar-reported revenue shrinks when the real and peso weaken - the actual dollar prices buyers and sellers transact at on the platform are falling too, since local-currency prices haven't kept pace with the devaluation.

Five Country Segments - Only Two of Five Improved, Argentina's Decline Accelerated for a Third Straight Quarter

MercadoLibre reports the same five geographic segments adopted in Q3 2010 - Brazil, Argentina, Mexico, Venezuela, and Other Countries.

Segment	Q3 2012 Revenue	YoY Revenue	Direct contribution margin, Q3 2012	Direct contribution margin, Q3 2011	Margin change
Brazil	$46.20M	✅ +0.4%	40.92%	44.11%	🔴 -3.19pp
Argentina	$24.12M	✅ +52.4%	53.20%	60.42%	🔴 -7.22pp - third straight decline, worst yet
Mexico	$6.74M	✅ +20.1%	36.89%	43.24%	🔴 -6.35pp
Venezuela	$14.21M	✅ +57.1%	71.44%	64.85%	✅ +6.59pp
Other Countries	$5.99M	✅ +16.5%	52.32%	48.72%	✅ +3.60pp
Total	$97.27M	✅ +19.2%	48.85%	49.80%	🔴 -0.95pp

Brazil's revenue growth essentially stalled this quarter (+0.4%, against a strong Q3 2011 comparison base) while its margin fell for the second time this year, and its share of consolidated revenue slipped to 47.5% from Q2's 49.8% as Argentina grew faster. Argentina is now the clearest deteriorating story in this coverage: its revenue growth (+52.4%, almost certainly inflated in dollar terms given the currency effects discussed above) is the fastest of any segment for a second straight quarter, while its margin has fallen every quarter of 2012, and by a wider margin each time - the opposite of a segment stabilizing after Q1's first-ever decline. Venezuela's dollar-functional-currency, highly-inflationary accounting treatment continues to produce the largest positive margin swings in the portfolio (+6.59pp this quarter, +9.32pp last), though at 14.6% of consolidated revenue it can only partially offset Brazil and Argentina's combined 72.3% share.

Target Valuation Range

DCF fair-value enterprise value of roughly $1,820.9 million (base case) to $3,637.8 million (bull case), against an actual enterprise value of $3,407.9 million - the valuation gap this coverage has tracked narrowing since Q2 2012 reopened this quarter: the base-case DCF now covers roughly 53% of enterprise value, down from Q2's ~68%, and the reverse-DCF implied perpetual growth rate rose back to ~9.9% from Q2's 9.5%. Unlike Q2, where the stock got cheaper while the business held steady, this quarter both moved the wrong way at once: the stock rose 8.9% while trailing free cash flow growth turned negative.

The $82.55 September 28, 2012 close pushed market capitalization up 8.9% from Q2 2012.

Market cap → enterprise value	Q3 2012
Share price (period-end)	$82.55
Shares outstanding	44,150,920
Market capitalization	$3,644.7M
Plus: loans payable	$0.20M
Less: cash, ST & LT investments	$236.98M
Enterprise value	$3,407.9M

Peer-multiple sanity check	Q2 2012	Q3 2012	Change
TTM Net revenue	$340.67M	$356.31M	-
Enterprise value	$3,126.5M	$3,407.9M	⚠️ up 9.0%
EV/Sales	9.2x	9.6x	⚠️ up
P/E	36.0x	39.3x	⚠️ up
TTM Free cash flow	$98.79M	$95.98M (26.9% margin, down from 29.0%)	-
EV/FCF	31.6x	35.5x	⚠️ up - higher EV and lower FCF margin pushed the multiple up from two directions at once

DCF (base/bull, illustrative) - base case starts from TTM revenue of $356.31 million, projecting growth decelerating from 20% toward 10% over five years (a step down from Q2 2012's 26%-to-12% path, reflecting this quarter's much cooler 19.2% reported growth) with FCF margin expanding from 26.9% to 29% by year five, a 13% discount rate, and 4% terminal growth. Bull case holds growth at 26%/22%/19%/16%/13%, FCF margin expanding to 33%, an 11% discount rate, and 5% terminal growth:

Scenario	Key assumption	Implied enterprise value
Current (Q3 2012 close)	— actual market price, for reference	$3,407.9M
Base	Growth decelerating 20%→10% over 5yrs; FCF margin to 29%; 13% discount rate, 4% terminal growth	~$1,820.9M (~53% of current EV)
Bull	Growth held 26%→13% over 5yrs; FCF margin to 33%; 11% discount rate, 5% terminal growth	~$3,637.8M (~107% of current EV)

The base case's 53% coverage is down sharply from Q2's ~68%, on both a lower assumed growth path and a higher stock price. The bull case still clears actual EV, but by a much thinner margin than Q2's ~131%.

Reverse DCF: holding the 13% discount rate and solving for the perpetual FCF growth rate that would justify today's $3,407.9 million enterprise value on the current $95.98 million TTM FCF base gives roughly 9.9% growth, forever - up from Q2 2012's 9.5%, reversing the one decline this measure has ever shown after four straight rising filings before that (9.6% Q3 2011, 10.6% FY2011, 11.0% Q1 2012).

All three methods agree in direction: after Q2 2012 was the first quarter since Q3 2011 this coverage's valuation gap genuinely narrowed, Q3 2012 reopened it - and unlike Q2 (where a cheaper stock did the work), this quarter a more expensive stock met a weaker underlying quarter at the same time. The stock is not dramatically higher (up 8.9%, and still well off its 2012 high of $97.79), but the business behind it grew slower, cost less disciplined, and generated less cash than a year earlier - a genuinely worse combination for the valuation case than Q1 2012's peak-overvaluation reading.

Beyond the Usual

The reasonably-possible litigation exposure jumped 50% in a single quarter, the largest jump this coverage has measured

As of September 30, 2012, the proceeding-related reserve rose to $2,486,669 from $2,163,347 (+14.9%), and the aggregate reasonably-possible exposure rose to $4,699,800 from $3,125,661 - a 50.4% jump, far larger than any single-quarter move this coverage has tracked since the reserve and exposure figures began moving together in Q1 2012. Case counts also climbed: 499 legal actions were pending in Brazilian ordinary courts (up from 492), and 2,894 cases were pending in Brazilian consumer courts, which don't require a lawyer to file (up from 2,533).

This is now three straight quarters where the accrued reserve and the reasonably-possible exposure have risen together rather than diverging, but this quarter's 50.4% jump in reasonably-possible exposure is a materially bigger single-quarter move than either of the prior two increases (2.4pp in Q1, 15.2% in Q2). Combined with the Brazilian federal and municipal tax claims already disclosed, Brazilian legal exposure is climbing at an accelerating rate, even though no individual item here is large enough on its own to change the investment case.

The Rio de Janeiro customer-service claim, open since mid-2011, was dismissed after this quarter closed

The claim filed by a Rio de Janeiro state prosecutor in August 2011 - alleging the Company's Brazilian subsidiary should be compelled to improve customer service and provide a telephone support line, first disclosed in the Q2 2011 post - was dismissed by the Lower Court Judges on October 22, 2012, in the Company's favor. The state prosecutor retains the right to appeal.

This closes out, at least at the trial-court level, a matter this coverage has tracked for five quarters. Combined with Q2 2012's closure of the São Paulo customer-service-level claim, MercadoLibre has now had two long-running Brazilian customer-service claims resolved in its favor within two quarters of each other.

A new accounting standard on intangible-asset impairment testing arrives in Q4 2012

The Financial Accounting Standards Board issued Accounting Standards Update No. 2012-02 on July 27, 2012, simplifying how companies test indefinite-lived intangible assets (such as goodwill-adjacent trademarks) for impairment by permitting a qualitative assessment before requiring the full quantitative test. MercadoLibre disclosed it will adopt the standard in the fourth quarter of 2012 and does not anticipate a significant impact on its financial position, results of operations, or cash flows.

The company confirmed it carries no off-balance-sheet arrangements

MercadoLibre's MD&A states plainly that, as of September 30, 2012, it had no off-balance-sheet arrangements that have, or are reasonably likely to have, a current or future material effect on its consolidated financial condition, results of operations, liquidity, capital expenditures, or capital resources - a clean disclosure worth noting given how much of this coverage's footnote-mining elsewhere focuses on exactly this kind of exposure.

Coverage Table

Theme	Q3 2012	Q3 2011	YoY	Why it matters
Net revenue	$97.27M	$81.63M	⚠️ +19.2%	Nearly half Q2's 28.1% growth rate; constant-currency growth (37.0%) still healthy
GMV vs. items sold growth	+6.5% vs. +22.4%	-	🔴 widest gap this coverage has measured	Average dollar transaction value fell sharply on currency effects
Unallocated corporate cost growth vs. revenue growth	+29.1% vs. +19.2%	-	🔴 +9.9pp gap - full reversal of Q2's -8.6pp gap	The one-quarter fix from Q2 didn't hold
Income from operations margin	34.66%	36.71%	🔴 -2.05pp	Undoes more than 40% of Q2's coverage-best gain
Net income attributable to MELI	$26.04M	$26.30M	🔴 -1.0%	First YoY decline this coverage has measured
Argentina direct contribution margin	53.20%	60.42%	🔴 -7.22pp	Third straight decline, each one worse than the last
Base-case DCF coverage of EV	~53%	n/a	-	Down from Q2 2012's ~68% - the gap reopened
Reverse-DCF implied perpetual growth	~9.9%	n/a	-	Up from Q2 2012's 9.5%, the first rise after that quarter's lone decline

---