4Q24 letter | Variis Partners

4Q24 Letter--EM businesses with DM analogues

Dear Investors and Friends,

Imagine being able to invest, based on a future you’ve already seen. It sounds like a fantasy, but sometimes Emerging Market (EM) investing is like that: a great EM business, relatively early in its development curve, with a hugely successful Developed Market (DM) analogue providing a blueprint to follow. The Variis strategy has seven such investments that sum to 30.3% of the strategy in early January 2025. As investors in these stocks, we aren’t investing based on EM asset flows, geopolitics, or commodity prices, but rather on the expectation that a familiar story will play out analogously. For each of these eight analogue investments, we have an idea, foreshadowed by the US version, of how the story should play out.

Allegro, the dominant e-commerce business in Poland, has an opportunity to grow high margin advertising revenues, like Amazon has done.

Amazon’s Andy Jassy has described advertising as a significant and growing part of their business. Amazon began its foray in to advertising in 2015; previously ads weren’t a core part of the business. By 3Q24, Amazon generated over USD14b of quarterly ad revenue, or about 8% of retail Gross Merchandise Value (GMV). Looking ahead, the market expects ad revenue to be the fastest growing part of Amazon retail. Crucially, management has highlighted that ad revenue is some of the highest margin revenue Amazon has, implying that the operating income contribution may be like that of AWS—which means a roughly 70% operating margin on ad revenue. The operating income of Amazon’s retail business was only about USD7b in 3Q24; it’s likely that ad earnings are more than 100% of that. Amazon makes money from advertising through sponsored products that are ranked higher in search results, and, also, from sponsored brands at the top of search results. Amazon also has a demand-side platform to display ads across other sites. Finally, Amazon has ads on its streaming services.

Allegro has an opportunity, analogous to Amazon, to drive retail margins to robust levels in large part by growing high margin advertising revenues. At a mere 0.7% of GMV in 2017, Allegro has grown ad revenues to 1.7% at the end of 2024, slightly more than doubling over a 7-year period. While this is high margin revenue—broken out in reporting with a 95% EBITDA margin 3Q24—Allegro is still significantly under-earning from the advertising offering given its small relative scale.

We believe management’s announced strategic initiatives will help drive ad revenues higher as a percentage of platform sales. Allegro highlights new tools for merchants, such as display ads, sponsored ads and page banners. These paid services help merchants increase visibility of their products while directly boosting Allegro’s ad revenues. AI-driven algorithmic improvements are also boosting ads’ relevance for buyers. Management have quantified a +35% uplift in sales when sellers use one or more of these newly introduced tools.

We also expect Allegro will grow advertising revenue by working directly with the big brands. Revenues from big brands today comprise about 15% of ad revenues, but management feels the potential is significant. Allegro has a wealth of data on consumer preferences they share with brands that inform market positioning.

Allegro has also launched several new services, such as finance (Allegro Pay) and ticketing (eBillet), providing more touchpoints for ads, enhancing both the value proposition for advertisers, and the revenue potential from advertising. Finally, as the e-commerce platform has continued to scale, both in terms of merchants and consumers (20m+), Allegro’s attractiveness as an advertising platform has improved.

We expect Allegro can drive ad revenues higher as a percentage of GMV. A bull case scenario is that Allegro gets to 4.0% of GMV, i.e., half of Amazon’s current ad penetration, by 2028. Assuming the current 95% margins are sustained, that 4.0% of GMV can drive 25% uplift to total EBITDA versus our 2028 forecast base case of 2.8% ad revenue as a percentage of GMV.

In thinking through, as a pre-mortem, how we might be wrong in our ad revenue hypothesis for Allegro, we believe the risk is around competition. In Poland, Allegro competes not just with offline retail, but also with Amazon and PPD’s Temu; in response Allegro has evolved to be particularly value retail focused. Allegro’s somewhat more intense competitive situation may mean the ad monetisation opportunity is smaller relative to Amazon in the US. We feel we’ve reflected this in our estimate of 2.7% ad revenue to GMV in 2028, while consensus expects Amazon to reach a lofty 11% ad revenue of GMV.

The Variis strategy also has investments in two other e-commerce businesses, MELI and Coupang, where the ad revenue to GMV uplift logic also applies.

MELI is Latam’s leading e-commerce platform. Like Allegro, it has a high margin ad revenue growth opportunity. As Amazon has shown, these ad revenues, which carry 70% margins, can drive huge profitability improvements.
Coupang is South Korea’s dominant e-commerce business. While Amazon is well into their ad revenue and margin uplift journey, Coupang is just starting and doesn’t yet disclose ad revenue.

Like Uber, Didi has an opportunity to earn more on each ride.

Despite IPO’ing in 2019, Uber mobility was loss-making at the adjusted EBITDA level, after deducting pro-rata central costs, until 2021. The consolidated business didn’t reach adjusted EBITDA profitability until 2022. In 2024, Uber mobility will see an adjusted EBITDA margin, less pro rata central costs, of about 6.2% on gross bookings of about USD82b. Uber’s market capitalisation today is almost USD150b.

Uber management under Dara Khosrowshahi has refined the dynamic pricing model (surge pricing) to maximise revenue, cut back driver and rider subsidies, adjusted driver pay structures, added in-app advertising, and introduced new services including Uber Black and UberX Share. Ultimately it has been Uber’s excellent service and dominant position in North America, the UK and Brazil that has given the company the leverage to improve its economics, largely at the expense of drivers and riders. In 2024, Uber’s gross bookings per mobility trip will be about USD9.6, and adjusted EBITDA less central costs will be about 60 cents per trip. Over the next 5 years, consensus expectations, which we think are reasonable, are for this profitability per trip to rise to nearly 80 cents.

Didi is the Uber of China, and was founded in 2012 by Will Wei Cheng, who is now just 41. Just as Uber has mid-70s percentage market share in the US, so too does Didi in China. Despite China’s development level, ride sharing is very popular—Didi has about 34m mobility orders per day in China, far more than Uber has in the US. Didi’s app has around 90m monthly active users in China.

Didi’s profitability, however, lags that of Uber. Didi’s adjusted EBITA margin for China mobility will be about 3.1% in 2024. (We believe Uber mobility’s EBITDA margin less pro rata central costs is the best comparable metric to Didi’s China mobility EBITA margin, which includes pro rata central costs. Depreciation is a small number, less than 80bps of gross bookings, for these asset light businesses. Uber and Didi report segmental EBITDA and EBITA, respectively, as KPIs.) What Didi has not yet done, but Uber has, is pull the available profitability levers: cut back driver and rider subsidies and implement surge pricing. Didi’s net take rate on China mobility gross bookings is just under 20%, whereas Uber is around 30% - the difference is subsidies and surge pricing. While Didi is reducing subsidies, they price in a way that gives riders an exceptional deal—the per KM cost of ride hailing in China is, amazingly, lower than the all-in cost of driving your own car. On surge pricing, Didi has that in trial, but they fully pass on any surge revenue to the driver—different to Uber. We believe that Didi’s extremely strong market position is under-monetised. Management is keenly aware of this under-monetisation and has a step-by-step plan to improve it in the coming years.

The price of ride hailing in China is low. Didi’s average order value (AOV) in China is about Rmb25, or about one third of Uber’s AOV. There are several reasons for this: new cars in China are on average 45% cheaper than new cars in the US, labour is cheaper in China with about USD7 hourly earnings for a Didi driver, and Didi’s more efficient platform operating expenses per ride are half as much versus Uber. These differences are unlikely to disappear; the result is that the customer value proposition for Didi ride hailing in China is extremely compelling. We believe that Didi has a strong opportunity to improve mobility margins towards, but probably not reaching, Uber’s level in the coming years.

Assuming our forecasts for margins in 2028 prove right, Didi would make Rmb1.6 (about USD 22 cents) per ride. At that point Uber will be making 76 cents per ride—and Didi customers will still be getting a great deal. If Didi doubles China Mobility margins to 6%, we think it would be hard for the stock not to follow.

We always want to consider, pre-mortem style, a bear case that might undercut our bullish hypothesis. In Didi’s case there are two considerations. The first of these is the greater social protections in China for ride-hailing driver partners. Didi arguably needs to be more cautious about aggressively shifting the economics in its own favour. The second concern, which is the rise of autonomous robotaxis as exemplified by Waymo, applies to both Didi and Uber. Robotaxi businesses may go direct to consumers via their own app, or, even if they are on ride hailing platforms like Uber, the platform take rates for robotaxis may be lower. That said it’s equally possible that robotaxis are a huge benefit to ride hailing platforms as the addressable market is radically expanding by low cost and convenient transport.

Other analogue-style investments in the portfolio.

In addition to Allegro, MELI, Coupang and Didi, there are several other investments the strategy has made with a successful DM analogue that has shown the way.

Grab is the Asean region’s version of Uber. For Grab, the opportunity on user penetration across the vast Asean population is immense.
H World is China’s leading mid-range chain hotel business, and, like Marriott, is a franchise model market consolidator. H World has a long runway to continue to grow China room market share from its current high single digit level.
Trip is China’s leading travel booking platform. Similar to Booking.com, there is an opportunity to build a sustainably high margin business serving China’s, and Asia’s more broadly, burgeoning online travel and lodging demand.

From the above examples, it’s clear how fundamentals should develop in an advantageous way. In addition, valuations are strikingly inexpensive in comparison to what US investors are currently paying.

Some market commentators have remarked that US outperformance is justified by the value creation of new economy quasi-monopolies including the MAG 7. Our view is that in EM there are also powerful new economy businesses emerging, capable of massive value creation, that are not receiving a commensurate level of attention.

Flaws of benchmarking: word of caution.

We don’t believe that global benchmarking universally works in investing. Perhaps the most glaring example of failure is in Chinese e-commerce. Alibaba IPO’d in September 2014 at USD68 per share and is barely higher than that today. Meanwhile Amazon has gone up 11x. A more intense competitive environment in e-commerce, a more challenging cloud services market, and government actions against Alibaba explain much of the difference.

To judge between situations in which an analogy works or doesn’t, we believe that analytical insights on the width and trend of the competitive moat are crucial. Moat analysis is a critical pillar of Variis’ investment process. In Alibaba’s case, both PDD and Bytedance have disrupted Alibaba’s moat, driving massive market share losses.

Each of the examples of future opportunity above, from rising high margin advertising revenues for e-commerce businesses to greater user penetration and higher earnings for mobility businesses, needs to be understood in the unique context of that Emerging Market and the specific business franchise and moat.

Thank you for your ongoing interest and support!

Leila, Eko, Rufus and Jamie

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