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eBay's Shadow Clouds MercadoLibre's Future

The e-commerce IPO rises, but competition with its better-known partner could limit growth.

It takes nerve these days to venture out into the volatile publicmarkets with a stock offering.

Already two companies on the slate for anIPO last week -- alt-energy company

NanoDynamics

and fingerprinting-device maker

Cross Match Technology

-- have formally postponed theirplans for an offering.

One that did push forward is

MercadoLibre

(MELI) - Get MercadoLibre, Inc. (MELI) Report

, anArgentina-based online-commerce company in which

eBay

(EBAY) - Get eBay Inc. Report

owns a 19.7% stake.

MercadoLibre priced its shares Friday at $18 and has nearly doubled to $34.75 in recent trading.

Since launching its initial operations in Argentina in 1999, MercadoLibre has expanded into 12 countries throughout Latin America, including large economies such as Mexico and Brazil and, most recently, Costa Rica, Dominican Republic and Panama.

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MercadoLibre's market is still somewhat small. Its gross merchandise value (the total value of goods and services bought and sold through its sites) was $1.1 billion last year, and $313 million in the first quarter of 2007. By contrast, eBay's GMV last year was $25 billion in the U.S. alone.

But that leaves lots of room to grow. Latin America's combined gross domestic product is $3 trillion (about 6% of the world's) vs. $13 trillion for the U.S. The number of Internet users in Latin America has been growing 31% a year this decade, compared with the 13% annual growth in North America, according to InternetWorldStats.com.

That explains why MercadoLibre's revenue and profit have beengrowing at a much faster rate than eBay's. Revenue grew 85% last year to$52.1 million. In the first quarter, it grew 50% to $16.5 million.

Operating income, meanwhile, grew more than threefold in the first quarter to $2.8million from $800,000 in the year-ago quarter.

To the degree that eBay has been active in Latin America, it's beenthrough MercadoLibre. In 2001, eBay bought Paris-based iBazar to bulk upits European presence, and it took control of iBazar's Brazilian unit aswell -- until eBay sold the Brazilian operations to MercadoLibre inexchange for the equity stake. As a result of the offering, in whicheBay isn't selling any of its shares, that stake will be diluted to18.5%.

eBay has been much more than a passive stockholder, lending thecompany $12 million in 2005 -- $9.3 million that MercatoLibre is raisingwill repay the outstanding balance -- and, as the IPO prospectus notes,"access to certain know-how and experience, which accelerated aspects ofour development."

What's more, eBay's agreement to not compete withMercadoLibre for a number of years expired lastSeptember. "Even though eBay is one of our stockholders, with thetermination of this agreement, there are no contractual restrictionsupon eBay becoming one of our competitors," the IPO filing notes.

If that happened, the company says in the risk section of thefiling, "it would have a material adverse effect on our results ofoperations and prospects." This is more than your typical risk-factorboilerplate -- such a move is a part of eBay's playbook: Despite its 25% stake in Craigslist, eBay recently began competing with the online classifieds site through the launch of its Kijiji.com service in the U.S. market.

Another small but still troubling red flag is in the offering itself: MercadoLibre planned to raise $44.8 million from the offering beforeexpenses, compared with the $231.5 million that will be raised bycurrent stockholders selling their shares. That 5-to-1 ratio is normallyreversed in IPOs.

It makes you wonder: Why the rush? If the company's prospects are sogood, why not wait until the lockup expires and the company can sell shares inthe market at a profit? A prudent investor can only hope this isn't anattempt to cash out before eBay muscles into its market.

A bigger red flag is waving above the valuation of the deal. If you conservatively take into account the stock at its $18-a-share pricing, its market cap would be $797 million. That's more than 15 times revenue lastyear. If 2007 revenue continues to grow at the same rate it did in thefirst quarter, that's still a future price-to-sales ratio above 10.

On an EPS basis, the historical valuation is even more absurd.MercadoLibre posted a profit of $1.1 million last year. So the IPOis valuing the company at 725 times its earnings. The company would needto grow its profit to $8 million this year in order to get its

P/E ratio below 100.

MercadoLibre is a promising company with impressive revenue andprofit growth. It's a leading player in a growing market, and its closeties to eBay strengthen its position all the more.

But there are warning signs that would-be investors should studyclosely if they want to invest in this stock: the looming threat of eBayas a competitor; the seeming lack of confidence exhibited by the sellingshareholders; and, most ominously, the surreal valuation.