Sea Ltd. Stock: Steering Steadily Through Choppy Waters (SE)

Sea Limited (NYSE:SE) started its descent from dizzying heights almost 1 year ago and as such, I thought it is apt to relook into the company. Since it recently reported its second quarter results for 2022, I will dive deeper into the results of the individual segments and revise my estimates for Sea accordingly. In general, I think that we are seeing the stabilisation and turnaround of the gaming business in the current quarter and that the e-commerce and fintech businesses are growing well and profitability is improving. This should in turn pivot the business towards one that is focused on quality and sustainable growth for the long run.

Investment thesis

I have written multiple articles on Sea, which can be found here. Over time, the investment thesis for Sea has been largely intact:

1. While there are some concerns about Garena and Free Fire currently, I think that these concerns are merely short term concerns. Garena will, in my view, still continue be a market leader and serve as an effective and important cash cow for Sea. With effects of high base and the India ban slowly moving out of the rear view mirror, I think that we will continue to see solid growth from Free Fire and hopefully other new games as well.

2. Shopee has evolved in its core markets of Southeast Asia and Taiwan, grabbing market share and now being the top leader, is shifting its focus on profitability and sustainability of the business, with revenue growth as an output. This, in my view, is definitely a wise strategy in the current environment and I think that Shopee is headed in the right direction in this regard. In addition, there are strong structural tailwinds for this core market as penetration remains low.

3. With increased discipline on market expansion, Shopee is focusing on the Latin America (LatAm) e-commerce market and with that, it is exposed to an under-penetrated, fast-growing market.

4. SeaMoney, its emerging fintech business, will be the next driver of growth for the company as there are strong tailwinds for digital payments and there are lots of synergies to be reaped between SeaMoney and Shopee.

E-commerce heading in the right direction

For Shopee, revenues grew 51% year on year to $1.7 billion and gross merchandise value (GMV) was up 27% year on year to $19 billion in the second quarter. It is important to note that there was a negative impact of 4 percentage points in the current quarter’s results due to negative currency movements. Shopee continues to drive monetisation improvements in the second quarter as more sellers are investing in the Shopee platform to drive their own growth and as a result, the market place revenue as a percentage of total GMV is now at 7.7%. This came mostly from Shopee’s higher margin business streams like advertising. I think that this really shows how successful the Shopee platform is as the company is able to leverage and monetise the platform with a large number of users to use the large scale that it has to provide services to its sellers.

Shopee also grew gross profit by an accelerated pace of 85% year on year. In addition, Shopee’s adjusted EBITDA loss improved by 13% sequentially quarter on quarter. In particular, the Southeast Asia and Taiwan markets actually achieved an EBITDA loss per order of $0.01 before accounting for HQ costs. As a result, I am of the view that the company is on track to achieving its goal of positive adjusted EBITDA before accounting for HQ costs in the Southeast Asia and Taiwan markets. Management reiterated the breakeven target will be achieved for these markets next year. Even in Brazil where revenues are still growing rapidly, the company is seeing adjusted EBITDA loss per order improving to $1.42 while revenues grew at 270% year on year.

I think we are starting to see a Shopee that is focused on a more rational and sustainable e-commerce strategy. This is evident from the fact that both gross profit and adjusted EBITDA margins are improving year on year and this is occurring while the revenue is still growing at a respectable 51% growth rate. I think that with the current macroeconomic backdrop, Shopee’s strategy be streamline and rationalise its operations is actually the right move forward as the company needs to ensure that its business and operations are able to sustain in the long run and in prolonged downturns in order to show that the company is indeed a quality company.

Shopee continues to be ranked top globally in the shopping category by total time spent on the app and second by average monthly active users, according to data.ai. The company is also ranked the top in the shopping category by average monthly active users and total time spent in Taiwan, Brazil, and Southeast Asia. I think that this bodes well for the company given that it is able to sustain mind share and market share in the e-commerce space while spending less on subsidies and while rationalising the cost structure of its business. This also shows that the strategy that Shopee has taken is effective in maintaining its leadership position even without subsidies.

As we move into the second half of the year, the management is suspending full year revenue guidance for Shopee. This will be elaborated in the next section, but the reason for this was two pronged. First, the external environment is becoming highly volatile and uncertain as the macroeconomic environment weakens. Second, the company is shifting priorities internally by focusing more on efficiency improvement and long term sustainability as well as profitability rather than just focusing on high revenue growth rates. An analogy that the management gave that I thought was rather apt was that this shift is akin to running the business more like a marathon than a sprint. I think that Shopee, with this shift and with the improving profitability profile shown in the second quarter along with respectable revenue growth, is headed in the right direction.

Suspending e-commerce revenue guidance is the right move

While it may seem concerning that management suspended e-commerce revenue guidance for FY2022, I think that this may seem less concerning than it actually is. Firstly, management is communicating to the public markets that while growth in revenues will no longer be a primary target, it sees growth more of an output rather than a target to be chased. Secondly, the shift in priority will then be towards improving the profitability of the business to ensure long term viability and improve efficiency of the platform. It is also important to note that I do believe that there are still structural tailwinds for the e-commerce industry in their core markets of Southeast Asia and Latin America and thus the case for Shopee and e-commerce in the region is still very much intact. The shift in focus by the management of Shopee is more of a prudent management shift towards profitability in a challenging period with rising inflation, weakening macroeconomics and a pandemic fuelled growth in e-commerce in the past 2 years. I am of the view that management’s shift in priority is actually a rather smart move in the current climate and one that Sea’s investors need to grasp.

Gaming business rather weak but stabilising

For the Digital Entertainment segment of Sea, in the second quarter of 2022, bookings were down about 39% year on year and 13% quarter on quarter. This is attributed to various factors, including decline in quarterly active users by 15% year on year and a decline in quarterly paying users by 39% year on year. As a result, if I were to imply the paying ratios, for 2Q22, the paying ratio dropped further to 9.1% from 10% in 1Q22 and 12.7% in the prior year.

I think that we might be seeing the stabilisation for Free Fire in the current quarter as the quarterly active users actually increased sequentially from 615 million in 1Q22 to 619 million in the current quarter. In addition, it was mentioned in the 2Q22 earnings call that as management’s focus for Free Fire has been engagement of its users, it was a positive that Free Fire continued to retain its top position in mobile games in Southeast Asia and Latin America, according to data.ai. I think that as the entire gaming industry is suffering from the tougher comps compared to the stellar run in the pandemic period, it is encouraging that Free Fire is still at the top of the charts which implies that when the cycle turns around, the game will have significant upside potential, in my view.

SeaMoney continues to show strong growth and synergies

In 2Q22, revenues for the segment grew by 213% year on year to $279 million. In addition, in the second quarter, SeaMoney quarterly active users grew by 53% year on year and the total payment volume increased by 36% year on year. While the company is in the early stages with regards to SeaMoney, there was a narrowing of EBITDA loss margins from -53% in the prior quarter to -40% in the current quarter.

In addition, there are signs that Sea is reaping the benefits from synergy between Shopee and SeaMoney as close to 40% of quarterly active buyers on Shopee in Southeast Asia have used SeaMoney’s products in 2Q22.

Valuation

I have made some revisions to the SOTP valuation for Sea that I have shared in my previous article. To be aligned with the compression in multiples, I have lowered my gaming 2023F P/E multiple to 15x, in-line with global peers, and also lowered the e-commerce and SeaMoney multiples to 3x and 5x 2023F P/S respectively. With the reduction in multiples, I think that I am being relatively conservative on the respective parts of the business and as such, the target price that I derived of $139 is skewed more towards the positive in my view. Based on the target price of $139, there is an upside potential of 136% from current levels

Risks

E-commerce competition

With e-commerce, consumers may change preferences rather easily. There is the risk that many other players like Amazon (AMZN), Alibaba’s (BABA) Lazada and even TikTok may prioritise the core markets of Shopee and cause intensified industry competition in Shopee’s core markets. This will not only slow growth in revenues for Shopee but also could result in Shopee making more losses per order as it ramps up on spending and subsidies to maintain its market share.

New game pipeline

One of the key risks for Sea at the present moment is the concern that Free Fire’s growth has peaked and may see a rather quick deceleration in the quarters to come. While the trends have stabilised in the recent months, I think that the main risk is that Garena is unable to release new game pipelines that are successful to diversify its gaming business. This is crucial as it needs at least 1 new successful game to diversify some of the revenue streams in the digital entertainment segment to ensure that it is less reliant on Free Fire.

Political and regulatory risks

While Sea Limited is a Singapore based company and the issue of political risk and regulatory risk was unheard of one year ago, the ban by Indian authorities of Free Fire has created such a risk. The risk is that other countries may impose further restrictions on Sea’s business overseas if it is seen as a Chinese company. However, I think that this is a relatively left tail risk that has a small probability given that Sea Limited is known to be headquartered in Singapore.

Reaping synergies in its key segments

As a company with 3 main businesses which includes the e-commerce, gaming and fintech business, Sea has the opportunity to leverage on the strengths of these individual businesses to further accelerate growth and increase stickiness in the entire group. This could drive greater loyalty and more highly recurring revenues if done well. If Sea is unable to reap the benefits of its dominance in all three segments, the 3 segments may end up working in silos and not become a true competitive advantage of Sea.

Conclusion

Sea has had a tough one year of operations, with many things not going its way. That said, I think that by demonstrating its ability to steer through choppy waters and coming out of it stronger, Sea can come out of this a stronger and more sustainable company moving forward. With its focus on profitability and sustainability of Shopee, I think that this is the right move to ensure long term viability of the business. Furthermore, the fundamentals of each of its business remains strong as Shopee has continued to maintain its lead in Southeast Asia, Taiwan and Brazil, as well as continued to be the top mobile game in Southeast Asia and Latin America. As we move 1 year from Sea’s descent in share price, I think that the future remains bright for the company as the effects of base starts to benefit the company. My target price for Sea is $139, implying an upside potential of 136% from current levels and I am of the view that there is a relative positive skew in its risk/reward profile at this level.