Summary
Sea Limited was one of the hottest stocks during the pandemic stock market frenzy.
Despite a massive selloff from all-time highs, the stock still looks overvalued, based on my analysis.
The level of uncertainty regarding the underlying assumptions is massive, and that is also the big reason I prefer not to invest.
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Investment thesis
Sea Limited $Sea Ltd(SE)$ experienced a massive selloff since late 2021, and the stock price is currently more than six times lower than all-time highs. Many investors can be tempted to buy the dip but I would not recommend it due to the unattractive valuation. Revenue growth decelerated rapidly compared to recent previous years, and the biggest uncertainty I see is the ability to achieve a high sustainable free cash flow margin. Considering all pros and cons, I assign the stock a "Hold" rating.
Company information
Sea Limited is a holding company that does not have substantive operations. The business is conducted through the company's subsidiaries. SE offers an integrated platform consisting of e-commerce [Shopee], digital entertainment [Garena], and fintech [SeaMoney].
According to the latest annual SEC filing, Garena is the only profitable segment with about 50% operating margin. But the largest e-commerce segment's operating loss fully offset the digital entertainment's success in FY 2022. The fintech segment is by far the smallest one from the revenue perspective. The company's fiscal year ends on December 31.
Sea's latest annual SEC filing
Financials
The company's revenue growth over the past nine years was staggering and compounded at a 72% rate. Profitability metrics have improved significantly over the long term. On the other hand, a 77-fold revenue growth still was not sufficient to achieve positive operating and free cash flow [FCF] ex-stock-based compensation [ex-SBC] margins.
Author's calculations
Sea's investments in R&D are substantial, but SG&A expenses are three times higher. I like that the company decreased its SG&A to revenue ratio and started allocating a more significant portion of sales to R&D. To me, this indicates a switch to a longer-term mindset focused on building sustainable competitive advantages rather than focusing on short-term growth. The above 30% SG&A to revenue ratio indicates plenty of room for improvement in the upcoming fiscal years. It is a positive sign for potential investors.
Data by YCharts
On a quarterly earnings level, we can see that a stellar revenue growth momentum is gone, with single-digit YoY growth for two quarters in a row. But the big positive sign is that the company significantly improved its profitability metrics and demonstrated two consecutive quarters of positive operating margin. The levered FCF turned positive in the last quarter, but it was not the first time in the company's history. Therefore, I cannot say it would be sustainable over multiple consecutive quarters.
Seeking Alpha
The latest reportable quarter's earnings were released on May 16; the company demonstrated a slight revenue beat but missed the bottom line substantially. Despite missing on the EPS, Sea demonstrated a solid YoY metric expansion from -$0.80 to $0.45. The strength was mainly driven by the improved profitability of the e-commerce segment, with a $207 million adjusted EBITDA compared to -$742 million the year earlier. Both e-commerce and fintech demonstrated stellar YoY revenue growth, but the digital entertainment segment pulled back mainly due to the drop in quarterly paying user ratio from 10% to 7.7%.
Sea's latest quarterly earnings presentation
From the upcoming quarterly earnings perspective, revenue growth is expected to regain solid momentum. Quarterly sales are expected by consensus at about $3.3 billion, which is approximately 11% higher YoY. The substantial expected EPS expansion is also a massive bullish sign for investors. Last year's Q2 adjusted EPS was lower than minus one.
Seeking Alpha
The company does not pay dividends nor return funds to shareholders via a stock buyback. Available capital is mainly allocated to fueling growth and repayment of debt. The central part of the total debt is long-term. It is important to emphasize that the outstanding debt amount is lower than the cash balance, meaning investors can be comfortable with a notable leverage ratio. Current liquidity metrics look healthy as well.
Seeking Alpha
Overall, I see many positive signs in analyzing the company's financials. On the other hand, the level of uncertainty regarding the future FCF dynamics is high for me. I think so because trends in the FCF margin were very volatile over the past periods.
Valuation
The share price demonstrated a 15% appreciation year-to-date, about a percentage point below the broader U.S. stock market. Seeking Alpha Quant assigned the stock a low "D" valuation grade due to very high multiples across the board.
Seeking Alpha
Multiples comparative analysis to the sector median suggests the stock is massively undervalued. But the company delivered a stellar 72% revenue CAGR over the past decade, meaning that multiples might not be a good fit for valuation analysis of such an aggressive growth company. Therefore, let me proceed with an additional valuation exercise.
Discounted cash flow [DCF] valuation approach is a good tool for Sea's valuation. Since SE is a non-U.S. company, I use a high 15% WACC as a discount rate. I have revenue consensus estimates projecting an 8.2% top-line CAGR over the next decade. I consider the projected growth rate conservative enough for my DCF analysis. Projecting the FCF margin for valuation analysis is usually the trickiest part, especially for companies like Sea, which seem to be far from generating sustainable positive FCF. I think that the company is far from the FCF break even looking at the below table.
Author's calculations
I think a zero FCF margin for the upcoming three fiscal years and further yearly two percentage points expansion for the years beyond is fair and conservative enough. Incorporating all the above assumptions into my DCF template returns me the business's fair value slightly below $30 billion, indicating a double-digit overvaluation.
Author's calculations
Sea's bulls might argue about my WACC selection since a 15% discount rate is very high. Therefore, let me also simulate a scenario with a softer WACC of 13%. I think this discount rate would be fair enough, considering the high level of uncertainty regarding the company's break-even timing. Under the lower discount rate, DCF now suggests undervaluation, but the upside potential does not look worth the uncertainty.
Author's calculations
Overall, both valuation approaches I used suggest that the current valuation is not attractive. Please also keep in mind the substantial level of uncertainty regarding the FCF expansion trajectory.
Risks to consider
To me, the company's future profitability trends are the biggest concern. The ability to generate rapid revenue growth is undoubtful, but profitability metrics were historically unstable. Ultimately, the company's ability to generate a sustainable wide FCF margin is the primary reason investors are ready to invest their money over the long term. And historical patterns give us very weak hints on the timing and the extent of FCF profitability.
It is also worth emphasizing that revenue growth has decelerated rapidly compared to a couple of previous years. Yes, the growth rate is expected to be solid in the upcoming quarter, but the massive volatility in the growth rate also does not add any certainty about future growth patterns.
Bottom line
Overall, I assign the stock a "Hold" rating. Financials demonstrate many positive trends, and two consecutive quarters with a positive operating margin is a massively positive sign. But my valuation analysis suggests that very aggressive assumptions are already priced in. Therefore, I would not recommend buying SE at the current price level.
Source: Seeking Alpha
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