Sea Limited was once the darling of growth investors. Sea IPO-ed on the NYSE in October 2017 at US$15 per share. Sea saw explosive growth and share prices consequently peaked at north of US$360. Today (4-Jan-2023), it closed at a measly US$55.67. Is this a case of deep value or a value trap? Is Sea’s fundamentals still intact, or is it drowning at sea? 

Overview of Sea Limited

Sea Limited has 3 main businesses. 

1. Garena: A game publishing and development business
2. Shopee: A leading e-commerce platform
3. SeaMoney: Offers digital payments and financial services. 

Sea wants to be the defining internet platform in Southeast Asia, a combination of Alibaba, Tencent and the financial businesses they’ve both set up (WeChat Pay, Ant Financial). 

In this article, I will be focusing on its twin growth engines – Garena and Shopee. 

Garena - A Cash Cow Running Dry

Sea has always been in an enviable position vis-à-vis the other regional tech giants. It is the only one with a highly profitable and cash-generating business (i.e., Garena) under its belt. In fact, it is the cash generated by Garena that has been constantly fueling Shopee's aggressive marketing.

Game publishing paved Garena’s early success but led to… 

• Started as a game publisher in 2009, with its first breakthrough in December 2011 with the launch of the highly popular League of Legends Dominion in Singapore and Malaysia. 
• The game publishing model was great for Sea, especially as a fledging business, as it allows the company to offer multiple games on its platform without needing to incur large development costs, which also risked not yielding popular games. 

…An outsized dependence on Tencent’s stream of games… 

• Benefitted from a strong pipeline of Tencent games as it has the right of first refusal to publish its mobile and PC games within Southeast Asia for 5 years starting in 2018. [Source] 
• However, this resulted in an outsized dependence on Tencent’s games (6 out of 15 currently published games are developed by Tencent) and places Sea in a highly treacherous position if Tencent chooses not to renew the partnership and distribute the games by themselves or bargain for a less favourable deal. 
• Many analysts did not see this as a significant risk given Tencent’s roughly 25.6% stake in Sea back in 2020 [Source: HSBC Analyst Report 8-Dec-22] and thus had an inherent interest in Sea’s growth. 
• However, Tencent divested 14.5m of its shares in Sea in early 2022 [Source], undermining prior confidence in the partnership. However, note that there are a host of other plausible reasons for the divestment (e.g., prudent to realize some profits, appeal to China’s antitrust regulators, etc.) 
• Nevertheless, this risk became particularly pertinent with Riot Games recently taking back the distributorship of the very game (League of Legends) that shot Garena to its prominence [Source]. 

…Resulting in a need for diversification into the cut-throat game development space 

• Indeed, Sea tried to diversify away from being a publisher and started developing its own games. 
• Free Fire, released in 2017, was a massive hit. Sea’s FY21 10-K noted that their top 5 games, comprising of Free Fire and games licensed from third-party game developers, contributed to 97.4% of Garena’s revenue, among which Free Fire contributed a “significant portion”. 
• However, all games will eventually lose popularity over time. Free Fire is already starting to lose traction and naturally (especially after a double whammy from being banned in India), heavily affecting Garena’s top line given its reliance on it as a cash cow. It certainly also did not help that there was a significant covid-19 boost (where people stopped working and stayed home to play video games) that has proved to be transient.

However, Sea does not seem to be able to launch new popular games in a timely enough manner to pick up the shortfall from the ageing Free Fire 

• Sea does not have the track record of being capable of developing hit games consistently (see table above for a list of games developed). 
• Even Free Fire, was essentially a repurposed version of Tencent’s highly successful PUBG targeted at less developed countries with less powerful mobile phones.
• If it remains unable to launch a new game title that can gain significant widespread popularity like Free Fire, Sea will lose a huge portion of cash flow it is generating to keep afloat its highly unprofitable e-commerce business. In the worst case, this may lead to liquidity issues and causing Sea the need to divest some of its assets. 
• Having said that, it has taken steps such as acquiring Canadian video game developer Phoenix Labs in 2021 to enhance their capabilities.

Shopee - Lacks moat and struggles to balance profitability and growth

Economic Moat

What the bulls think

Having built a platform with a wide variety of products and large base of merchants and consumers gives Shopee a size advantage moat. Consumers are unlikely to favour searching through multiple platforms and would thus be drawn to the 2-3 most popular platforms. Likewise, merchants will naturally gravitate towards platforms with the greatest exposure to consumers. Essentially, more consumers leads to more merchants and the cycle continues. It does help then that Shopee is the #1 e-commerce platform in Singapore, Vietnam, Malaysia, Philippines and Thailand by web visits [Source].

Consequently, e-commerce is an oligopolistic industry where the top 2-3 players take virtually all the market share. Shopee, having previously spent heavily on marketing campaigns, has an edge with being top of mind.

What we think

Shopee’s moat might not be sustainable given that its defensibility was built on aggressive discounts. There is minimal brand loyalty and consumers tend to focus on price. Another well-funded player coming in, such as Shein or TikTok (whose average monthly GMV in Indonesia reached $200m) [Source] may very well buy market share away from Shopee by offering discounts and other promotions. 

Additionally, unlike successful e-commerce peers like Amazon and MercadoLibre, Shopee is asset-light with minimal infrastructure. It lacks an operating moat that drags its logistics unit economics relative to competitors like Lazada. 

Profitability

What the bulls think

Analysts expect Shopee to turn profitable around FY24 as unit economics improve and market share remains. 

• Analysts are assuming the take rate to expand to c.13% by FY25E [Source: HSBC Analyst Report 8-Dec-22] 
• Significant cost-cutting measures in place, such as the massive retrenchment exercise edges it closer to profitability 
• Shift in strategy away from heavy sales and marketing (c.32% of FY21 expenses) tactics to “buy” customers/GMV 

What we think

Analysts back in early 2018 were already forecasting Shopee to be profitable by 2021 [Source: CNBC Interview with Nick Nash]. Profitability is still nowhere in sight even after a covid-19 induced demand. Essentially, the profitability pitch is repeatedly being overpromised to investors. 

Whether the profitability dream realizes hinges on how durable Sea’s moat proves itself to be once promotional and marketing campaigns come to a further stop. A wide moat will enable Shopee to (i) be a price setter and increase take rate (like what analysts expect) and (ii) maintain market share despite cutting marketing and promotional spending. 

Growth

What the bulls think

Southeast Asia’s e-commerce industry continues explosive growth mirroring China’s growth trajectory. E-commerce GMV is expected to grow from $131b to $211b by 2025 [Source].

What we think

No doubt, growth is expected to be tremendous. However, according to McKinsey, growth is noted to already be at an inflection point [Source]. 

It is also unlikely that Shopee can capture growth as easily given that Southeast Asia is very fragmented both from a logistics and customer acquisition point of view. Nevertheless, we note that Shopee has done well thus far in localization by having a separate site for each market

Valuation

Sum-of-the-Parts Approach

We conservatively value Sea Limited based on a sum-of-the-parts approach using comparable companies analysis with the following assumptions 

• Garena: We value Sea’s gaming business at a 14.18x EV/EBITDA multiple 
• Shopee: We value Sea’s e-commerce business at a 1.53x EV/Revenue multiple based on a list of comparable companies 
• SeaMoney: We value Sea’s digital financial services at a 1.18x EV/Revenue multiple given its early stage 

We apply these assumptions to Sea’s LTM financial figures and the latest 22Q3 financial position. Thereafter, we arrive at an indicative valuation of roughly US$57.69, which is about the same as what Sea is currently trading at (US$55.67 as of the 4-Jan-23 close). 

Street Consensus

Analysts seem to be highly bullish and view Sea as a resounding buy.

Street Consensus also did not change significantly (except for a few more hold ratings) despite the volatility of share prices, indicating a consistently strong conviction in the stock.

Concluding Thoughts and Going Forward

Sea still has a massive cash war chest of US$6.25b as of the latest quarterly statements on 30-Sep-22. Sea is unlikely to be able to rely much on the capital markets to raise more cash given (1) its severely depressed stock price making the cost of equity extremely expensive and (2) the tremendously high-interest rate environment we are in now. Hence, time is limited. It has roughly 3 years (assuming no external fundraising and cash continues to be burnt at the average of FY21 and FY20) of runway to prove itself to be a profitable business model. This is not considering Sea’s convertible notes due in 2025 (US$1.15b at US$90.5 conversion rate) and 2026 (US$2.875b at US$477 conversion rate). 

All in all, this bet is 2-fold: (i) One, that Garena will retain its licensing rights with Tencent (or be able to source for similar alternatives) and be capable of consistently releasing hit games. (ii) Two, that Shopee will be able to achieve profitability by end of FY25 and ride on the Southeast Asia e-commerce tailwind. 

Analysts and the market seem to be cautiously optimistic about Sea. Indeed, I do believe that Sea has a high potential to be a high-quality compounder with consistent profit. However, with the current facts in mind, I am still not too confident of either of the 2 bets above materializing. Hence, I will be closely monitoring for further developments before potentially placing a position. 

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Annex (FYI)- E-commerce Value Chain

Flow of e-commerce logistics:

1) Overseas collection point --> 2) Overseas warehouse --> 3) Customs --> 4) Origin Airport / Port --> 5) Destination Airport / Port --> 6) Custom --> 7) Domestic warehouse --> 8) Last mile hub (sorting) --> 9) Fleet to deliver

At steps 7, 8 and 9, the options are:

• 3PL (Third-Party Logistics) >> Outsourcing company that provide storing, picking, packing and shipping service (e.g. Ninja Xpress, J&T)
• On-demand / Same Day >> Provide same day delivery (e.g. Lalamove)
• In-house >> Logs services managed by e-commerce platform (e.g. Shopee Xpress, Qxpress) 

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