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Elevator Pitch
My investment rating for Sea Limited’s (NYSE:SE) stock is a Hold.
In my earlier March 16, 2022 initiation article for SE, I discussed my assessment of the company’s outlook and valuations in view of its Q4 2021 financial results. I offer an update of my thoughts on Sea Limited with this current article, which comes after the company’s Q2 2022 earnings announcement last week.
Sea Limited’s performance in the recent quarter was mixed. SE’s non-GAAP earnings surpassed the market’s expectations, but the company also disappointed investors on a couple of key metrics. Looking ahead, SE has to deliver on improved profitability for the e-commerce business and a return to growth for the digital entertainment segment, so as to warrant a Buy rating. As for now, a Hold rating for Sea Limited is appropriate and justified based on my analysis.
What Were Sea Limited’s Expected Earnings?
Before Sea Limited reported its most recent second-quarter results on August 16, 2022 prior to trading hours, the market was expecting SE to achieve a non-GAAP adjusted net loss per share of -$1.06 for Q2 2022.
In other words, the sell-side analysts were anticipating that Sea Limited’s losses would widen on both a YoY and a QoQ basis in the second quarter of this year. As a comparison, SE recorded non-GAAP net losses of -$0.80 per share and -$0.61 per share for the first quarter of fiscal 2022 and the second quarter of fiscal 2021, respectively.
Did Sea Limited Beat Earnings?
Sea Limited registered wider losses for Q2 2022 as expected, but the extent of losses that the company suffered from wasn’t as bad as feared.
SE’s adjusted net loss per share of -$1.03 was +3% better than the sell-side’s consensus bottom line projection of -$1.06 per share. But the company’s shares didn’t react positively to the bottom line beat for the recent quarter.
The shares of Sea Limited fell by -14% from $89.97 as of August 15, 2022 to $77.43 as of August 16, 2022, and SE’s stock price pulled back by a further -13% to close at $67.67 on August 19. This implies that SE’s shares have lost a quarter of their market value in a week after the company reported Q2 2022 financial results.
In the next two sections of this article, I touch on SE’s Q2 2022 metrics and Q3/FY 2022 outlook to help readers understand why the company’s shares underperformed despite an earnings beat.
SE Stock Key Metrics
SE did deliver above-expectations earnings on a non-GAAP basis in the second quarter of fiscal 2022, but the company disappointed investors on a number of other key metrics.
Revenue for Sea Limited rose by +29% YoY from $2,281 million in the second quarter of fiscal 2021 to $2,943 million in the most recent quarter, as per the company’s Q2 2022 results press release. SE’s Q2 2022 top line came in -3% below the sell-side’s consensus financial estimate of $3.03 billion. Also, the company’s YoY top line expansion has moderated significantly, as compared to its previous revenue growth rate of +77% YoY and +64% YoY for Q2 2021 and Q1 2022, respectively.
Specifically, bookings for SE’s digital entertainment business segment or Garena (the only profitable business division for the company) declined by -13% QoQ and -39% YoY to $717 million in Q2 2022, as indicated in its second-quarter earnings presentation slides. According to the market’s consensus data obtained from S&P Capital IQ, the digital entertainment business’ Q2 2022 bookings turned out to be 8% below the analysts’ consensus bookings forecast for the quarter. The drop in bookings for Garena was accompanied by a decrease in its user base. Garena’s active and paying users contracted by 15% YoY and 39% YoY to approximately 619 million and 56 million, respectively in Q2 2022. SE acknowledged at its Q2 2022 investor briefing on August 16, that “short-term gaming industry trends remain relatively uncertain due to reopening trends.”
Also, Sea Limited’s Q2 2022 GAAP earnings were below market expectations. The company’s net loss on a GAAP basis widened substantially from -$434 million in Q2 2021 and -$580 million in Q1 2022 to -$931 million in the most recent quarter. More significantly, SE’s second-quarter GAAP net loss was 26% worse than the market’s consensus GAAP bottom line projection of -$738 million, as per S&P Capital IQ.
The key factor that was a drag on Sea Limited’s Q2 2022 bottom line is a -$177 million goodwill impairment that the company recognized in the recent quarter. In its Q2 2022 results media release, Sea Limited explained this was attributable to a decrease in the “carrying amount of goodwill associated with our prior acquisitions, mainly driven by the lower valuations amid the market uncertainties.”
In summary, SE didn’t do well on several key financial metrics for Q2 2022, even though its non-GAAP adjusted EPS for the recent quarter was ahead of market expectations.
What To Expect After Earnings
Besides delivering worse-than-expected revenue, digital entertainment bookings, and GAAP losses, Sea Limited also surprised the market with its decision to do away with top line guidance for its e-commerce business segment in the current fiscal year.
In mid-May this year after reporting Q1 2022 results, SE had previously guided for its e-commerce segment revenue to increase by +71.8% to $8.8 billion (mid-point of guidance) for full-year FY 2022. Apart from suspending revenue guidance for the e-commerce segment now, Sea Limited hasn’t decided if the company will reinstate the e-commerce top line guidance in the future. This makes it difficult for investors to assess the near-term revenue growth prospects for the e-commerce business.
On the flip side, it is reasonable to expect an improvement in profitability for the e-commerce business segment and a more stable performance from the gaming business segment going forward.
Sea Limited emphasized at its Q2 2022 results briefing that the current focus of the e-commerce business is to “improve efficiency by both deepening monetization and optimizing our cost structure.” It also stressed that “top line growth” for the e-commerce segment is “more as an output” rather than “a target” as it stands now. I highlighted earlier in this article that SE’s digital entertainment business is currently the only profitable segment for the company. As such, it makes sense that SE is trying to strike a good balance between growth and profitability for its other significant business, the e-commerce segment or Shopee.
Separately, the slowdown in the growth for Sea Limited’s digital entertainment business appeared to have reached an inflection point. The number of active users for SE’s digital entertainment segment increased by +0.6% QoQ in Q2 2022, which represented a reversal from two consecutive quarters of QoQ contraction for Q4 2021 and Q1 2022.
The mixed outlook for SE is reflected in the sell-side’s consensus numbers. As per S&P Capital IQ’s consensus financial data, Sea Limited’s YoY revenue growth is projected to further slow from +29% YoY in Q2 2022 to +18% and +10% for Q3 2022 and Q4 2022, respectively. This is a reflection of the expected slowdown in the e-commerce segment’s top line expansion and some form of stabilization in terms of the digital entertainment business’ revenue and user growth. On the other hand, SE’s normalized net losses are estimated to narrow from -$572 million in Q2 2022 to -$548 million for Q3 2022 and -$476 million for Q4 2022, which should be largely driven by the renewed focus on profitability for the e-commerce business.
Is SE A Good Investment Long-Term?
SE shouldn’t be considered as a good long-term investment candidate yet. There needs to be more concrete signs of the e-commerce business turning the corner in terms of profitability with specific quantitative targets provided by the management. Also, SE should seek out new growth avenues for the digital entertainment business, so that the segment can reduce its reliance on its flagship Free Fire game over time.
I mentioned in my mid-March 2022 article for the stock that “Sea Limited will be a Hold for me, unless it can either drive a substantial improvement in profitability for its e-commerce business or prove that its gaming (digital entertainment) business’ growth is sustainable even if its flagship game Free Fire eventually peaks.” I still stand by my earlier view.
On the positive side of things, it is encouraging that SE is now in a good position to focus on enhancing the profitability of its e-commerce business, without being bound by the need to meet revenue growth guidance. The next step will be for Sea Limited to provide some form of quantitative outlook with respect to the future profitability of the e-commerce segment and the company as a whole.
On the negative side of things, it is hard to imagine that there will be any substantial drivers that can reignite the growth of the digital entertainment or gaming business segment anytime soon. Sea Limited acknowledged at its second-quarter results call that “from a financial perspective, we don’t think there will be anything that will have an immediate meaningful significant impact like that on Free Fire in the immediate future.” In other words, finding new growth drivers for the digital entertainment segment remains a work-in-progress.
Is SE Stock A Buy, Sell, or Hold?
I maintain my Hold rating on SE stock for now. I need to watch the profitability of the e-commerce business segment and the growth trajectory of the digital entertainment business closely in the quarters ahead, before I am able to assign a clear Buy or Sell rating to its shares in the future.
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