Summary
Despite recent positive financial reports, Sea Limited's share price remains stagnant, leading to caution over the company's future growth trajectory across its digital entertainment, e-commerce, and digital financial services segments.
The company's digital entertainment revenue has declined by more than 50% year-on-year, while its e-commerce segment shows signs of slowing GMV growth with potential threats from competitors like TikTok Shop.
The digital financial services segment is expected to drive growth over the next decade, but slowing growth rates and a flat loan book raise concerns; the company's valuation is considered optimistic.
RgStudio/E+ via Getty Images
Despite much positive news in the last couple of reporting quarters where Sea Limited $Sea Ltd(SE)$ reported its first quarterly positive net income, and Free Cash Flow increased Q-o-Q from 168m to 505m, the company's share price is back to where it was before these positive announcements.
The company, which is one of the largest in Southeast Asia, operates in 3 main segments: Digital Entertainment (Garena), E-Commerce (Shopee), and Digital Financial Services (SeaMoney).
While it seems like the turnaround is complete and the company can only grow from strength to strength here on out, and that the current share price is a favorable entry, I remain cautious in assessing Sea Limited's future growth trajectory.
As we investigate each of the company's operating segments, followed by its valuation, I will explain why.
Digital Entertainment
The overall market for gaming investments has been bearish since early 2021 as people started to head out more for real world activities post pandemic. This is reflected in the trend we see from the Global X Video Games & Esports ETF $Global X Video Games & Esports ETF(HERO)$, an ETF for gaming stocks.
Gaming ETF Price Chart (Koyfin)
A rebound since the 3-year low in Nov last year is also somewhat reflected in SE Ltd's latest Quarter's results, with key game Free Fire, in April, achieving a new peak in monthly active users in the last eight-month period.
However, revenue is more than 50% down Y-o-y with a paying user ratio of 7.7%. What used to be the driving fuel for Shopee's expansion has now become the laggard.
Although new games in the pipeline Undawn and Black Cloud Mobile have some promise, they are still not games developed by Garena, which means plenty of revenues will flow back to the developers as licensing fees. Licensing agreements also have risks of termination as we have already seen with Riot Games taking over the publishing of popular MOBA League of Legends since January 2023.
Also, if we look at two of the key accounts related to revenue recognition for the Digital Entertainment as defined below:
Annual Report FY2022
(Additional note: 'Escrow payables and advances from customers' only had its own line item since the latest reporting. Previously, it was grouped together as 'Accrued expenses and other payables'.)
Image created by author (Data from Sea Limited's Balance Sheets)
We can see that both these accounts have dropped from the heights of end FY2021. The health of these accounts are precursors to the revenue of the DE business. Hence, it is likely we will continue to see a decline in the follow quarter's reporting.
In addition to the Bookings reported by the company, these two key accounts are important to monitor for signs of the business' turnaround.
E-Commerce
GAAP revenue increased by 31% from 1.6bn in 4Q2021 to 2.1bn in 1Q2023 even though GMV remained largely flat over the same period. This signifies an increasing take rate, which suggests that Shopee has a moat, especially given the massive cuts in sales and marketing expenses since 4Q2022.
Image created by author (Data from Sea Limited's Press Releases and Income Statements)
Alongside with the increasing gross profit margin, Shopee's adjusted EBITDA remained in positive territory for the last 2 quarters, increasing by 6% Q-o-Q.
In a report by Google, Temasek and Bain on Southeast Asia's digital economy, E-commerce was found to have achieved a more than 90% adoption rate among urban users. This means that growth rates are peaking in urban territories in Southeast Asia. However, the same research also found that E-commerce has most room to grow in suburban areas.
e-Conomy SEA 2022 Report
In order to reach these underserved areas, logistical improvements are important. By continually investing in this area, Shopee may be able to penetrate these segments. As they mention in their earnings call, 'we continue to focus on building up our long-term structural advantages in our e-commerce ecosystem. We believe this strategy will be key in unlocking future growth opportunities and making sure that we have a growing and a wide-reaching positive impact across our local communities.'. These suburban areas could be exactly what they are referring to by 'future growth opportunities. It is great to see management's focus on developing logistic capabilities as such investments strengthen Shopee's moat.
Still, at the moment it is concerning that GMV is not increasing despite the SEA E-commerce market set to expand to increase at a pace of 17% CAGR from 2022 to 2025.
e-Conomy SEA 2022 Report
On a full year basis for FY2022 Shopee's GMV did increase by 17% over FY2021 which is in line with estimates. However, when we see Q4's GMV of 18bn, it was a drop from 18.2b in the same quarter a year earlier, albeit still up 7.7% on a constant currency basis. Unlocking the value in suburban areas might be the key to further increasing GMV.
Since SE will not be reporting that figure until the year-end, I would at least want to see revenue continue to increase, and gross profit to head towards 50%+.
TikTok Shop is also a possible threat. Although still insignificant from an absolute GMV standpoint, they are seeking to grow aggressively, and it is important to keep an eye on their performance and impact on Shopee's market share.
Digital Financial Services
Image created by author (Data from Sea Limited's Presentation Slides))
This segment is the real growth driver for the next decade. It has already increased almost 20 times from when GAAP revenue was first reported in 3Q2020, representing a Compound Quarterly Growth Rate (CQGR) of 36.9%. The share of total revenue has also increased from 1% to 14%.
e-Conomy SEA 2022 Report
Payments and lending are two sectors which would see massive growth over the next decade, with payments forecasted to grow to $2 trillion Gross Transaction Value (GTV) by 2030. A related metric for SE, Total Payment Volume for the mobile wallet was 5.7bn in 2Q2022, up 35.7% year-on-year. Since then, the company has shifted to reporting on its loan book, with the change in loan receivable shown below.
Image created by author (Data from Sea Limited's Financial Statements)
It appears that even though this segment is also adjusted EBITDA positive, top line growth rates are slowing tremendously despite this sub-sector too slated to grow at 23%+ CAGR till 2030.
A question was also raised by an analyst during the earnings call: 'why revenue continued to increase despite seeing your loan book largely flat quarter-on-quarter?' The answer, "we have been diversifying the sources of our funding and in collaboration with third-party financial institutions to fund growth of the loan book." Moreover, management also in another answer said that they don't 'anticipate significant increase in loan book size quarter-on-quarter immediately. Given, as I shared before, overall, our approach to the credit business is focused on risk management building up a resilient underwriting capabilities and also better user experiences.
This is an important segment of the business where I will be monitoring proceedings closely as management's response to the questions do not provide added color. Additionally, further reporting on Insurtech, which the company is also involved in, would be positive too as the sector is also set to grow at a fast pace.
Valuation
Now that the company is generating FCF, I use the reverse DCF calculation to determine if the current price is fair.
Parameters:
Free Cash Flow: $2,000 million per annum, assuming that based on last quarter's FCF of ~$500mil, the company will achieve similar numbers for the rest of the year.
Terminal Growth Rate: 3%, Discount Rate: 12%
The company is assumed to grow FCF at about 9.5% per annum to justify today's price of $63/share.
I feel the market is still pricing the company too optimistically as SE Limited may not be able to maintain $500 million+ FCF every quarter. Furthermore, investments are likely needed in DFS especially to gain more market share in the fast-growing market. Even if profitability improves and FCF margin expands, SE limited still must grow its top line.
The Positive
Nevertheless, management of Shopee is a huge factor of consideration. It is not easy to grow a company to such a size and to profitability in less than 15 years. Some of their astute decisions made in recent years include:
1. Raising funds at perfect time in 2021 September when shares were still riding high.
2. Aggressive cost-cutting measures in 2H2022 to achieve profitability. Including use of the now famous term 'single-ply toilet paper'
3. After achieving profitability, promptly raising staff salaries
SE Limited is founder led and Mr. Forrest Li owns majority control. Through articles and interviews, I am confident that the company is in safe hands for the long run.
Conclusion
SE has done well to achieve its first 2 consecutive quarters of profitability.
However, slowing growth in all of its operating segments is putting a dampener on its stock price, leaving little excitement upon deeper analysis.
Still, I have faith in the leadership team to move the company forward in the right direction, hence I would continue to add slowly to my existing position, remaining patiently optimistic.
Source: Seeking Alpha
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