Sea Limited: Market Overreaction Created A Valuable Buying Opportunity

Summary

• Although Sea's Garena may be facing headwinds of Free Fire ban in India and normalization of growth in the post-covid world, I am optimistic for Garena in the long run.

• Sea's Shopee is showing improving profitability due to better unit economies in core markets and as a result of huge scale of the Shopee platform.

• Shopee's exit from France showed discipline in executing its e-commerce playbook and its new markets, Brazil and Poland, are showing strong traction.

• Based on the new information, my revised worst case target price is $131.77, implying an upside potential of 36% from current levels, making Sea Limited attractive from a valuation perspective.

$Sea Ltd(SE)$ recently reported its 4Q21 results and there was a market overreaction to the negatives of the print, with the stock down 30% since the results release.

However, overall, I am of the opinion that the positives outweigh the negatives and I remain positive on Sea Limited's business fundamentals.

Investment thesis

As mentioned, my investment thesis in my first article remains intact, as shown below:

1. Garena, as a market leader, will serve as a cash cow with solid growth.
2. Leadership position in Southeast Asia e-commerce is currently in the early days and likely to see strong growth in the future from increasing penetration in the region brought about by multiple tailwinds.
3. The company's recent entry into the Latin America (LatAm) e-commerce market brings exposure to an underpenetrated, fast growing market. It has also more recently entered new geographies in Europe and India.
4. New emerging fintech business, SeaMoney, will bring additional high growth areas with strong digital payments tailwinds.

Garena

First, one of the negatives for Garena is thenews that Free Fire is banned in India, along with 53 other apps that are said to originate in China, due to concerns over national security. In my opinion, there is a chance of the ban being lifted given the evident fact that Sea Limited is not a Chinese company, but rather aSingapore company. Furthermore, Singapore's Ministry of Trade and Industry raised its concerns to India's authorities on the matter and it hopes that the matter "could be resolved quickly".

That said, there has been much discussion on the impact of Free Fire ban in India, but there is evidence that Free Fire Max has very quickly gained traction in India following the news on the ban on Free Fire. Other than that, Indian players are also using other means like using VPNs to continue to play the game. Although these are temporarily fixed, I am of the opinion that there is also a possibility of Free Fire making a comeback in India, either through rebranding of the game like in PUBG's Battlegrounds Mobile India, or through resolving the issue with the Indian authorities.

Second, another key negative for Garena is the near term moderation in growth due to the reopening of economies. In 4Q21, bookings for the gaming segment came in at $1.1 billion, almost 10% lower than my estimates. This was driven by weaker pay ratio trends as well as quarterly active user growth, which decreased 8% and 1.2% respectively. Further, EBITDA margins came in lower than my expectations at 55.7% due to higher cost of revenues and sales & marketing expenses.

Further, management has indicated that they expect growth to normalize in the next few quarters as economies revert back to normal pre-covid world again, as people go back to school and work. As such, 2022 guidance for the games segment was rather disappointing at $2.9 billion to $3.1 billion. On a positive note, this has already taken into account the slowdown effect of the India ban and normalization of growth from reopening of economies. This implies that the bookings in 2022 will be close to 2020 levels.

That said, in the medium to long term, I am still optimistic about the gaming segment. First, this is due to a strong franchise that has a large user base and strong e-sports community. Second, management has continued to reiterate their focus to diversify the gaming portfolio over the long run, which is good for the business as a whole. Sea Limited has been investing in gaming studios and actively expanding its global gaming footprint in the past 1 year across countries and gaming genres. For example,Korea's Hound13's focus on action RPG, which Sea Limited invested in July of 2021. Spain'sUnusuall which focuses on casual F2P, that Sea Limited invested in August of 2021.

As such, with the focus on diversifying its gaming portfolio with heavy investments into the best gaming studios in the world, the teams are working on multiple prototype games across different stages through both self development and publishing pipelines.

Lastly, Seaannounced a collaboration with prominent K-pop boy band BTS, for them to be the new global brand ambassador for Free Fire, which could bring renewed interest and new followings to the game.

E-commerce (Shopee)Disciplined approach to market expansion

Shopeeannounced that it will be leaving France and its platform will be shut down on 6 March 2022. This comes after its initial entry into France in October 2021. Recall that Shopee takes a calibrated approach to market expansion, initially testing waters in new markets, and if the conditions are right, further investments are made into the market to make it a core market.

In my opinion, Shopee's exit from France shows the management's strong discipline in expanding since the momentum in France has been rather weak, as can be seen in the Sensor Tower data below. Weekly downloads and weekly active users were not gaining much traction, implying tough competition in the France market.

France downloads has been rather weak since the start (Sensor Tower)

In addition, during the earnings call, the management explained that they would continue to be open minded in exploring new markets and do so only in a disciplined manner. I believe that this exit from France does attest to the favorable expansion strategy that follows a well tested customer acquisition strategy and playbook that works.

Improving profitability for Shopee

One of the positives for Shopee that was announced in 4Q21 for me was the emphasis on achieving positive adjusted EBITDA for Shopee's core ASEAN and Taiwan markets by 2022 year end. This is brought about by the better unit economics from higher monetization and huge scale of the Shopee platform. In my opinion, that is a huge plus for Sea Limited given that the current environment of rising rates puts larger emphasis on profitability and with what is happening with Garena, it is important for Shopee to be EBITDA positive for investors to be assured that the business is sustainable in the long term.

First, as mentioned, Shopee saw unit economics improve in several countries. In ASEAN and Taiwan, adjusted EBITDA loss per order improved from -$0.21 in 4Q20 to -$0.15 in 4Q21, roughly an improvement by 25% from a year ago, signaling improving unit economies in these geographies. Also, in Brazil, adjusted EBITDA loss improved by more than 40% from a year ago, to -$2 in 4Q21. There is no doubt that the increased disclosure by Shopee's management into the improving unit economies is a way for management to signal its confidence in Shopee being a sustainable and profitable business unit, which will continue to improve as the market leader and with increasing scale.

Second, there is increasing evidence of higher monetization in Shopee's core markets. In Indonesia, Shopee's take rates for marketplace increased from 1.25% - 2% to 1.75% to 3.20% for star sellers and 0.75% - 1.6% to 1.25% - 2.5% for non-star sellers. In addition, it has introduced a fixed commission fee of 1% for all Vietnam sellers in 5 Jan 2022.

Recall that Shopee's strategy is to only start to charge seller commissions in more mature markets, while in new markets, the near-term goal would be to increase traction in its platform and thus, seller commissions are not charged. This strategy was Shopee's initial strategy in ASEAN and Taiwan, which it is employing in its new markets as well. In my view, the increasing monetization in its core markets signals a healthy competitive landscape in its core markets of ASEAN and Taiwan and thus, further room to grow in the future.

All in all, this could be a pivotal period for Shopee with the improving profitability a visible path for Sea Limited to be a sustainable global leader in e-commerce.

New markets

Another positive is the traction that I am seeing in the new markets that Shopee is targeting. Below, we can see based on Google Trends search that Shopee is doing well in Brazil, having caught up to many players in the market. Noticeably, Shopee is gaining search share from most players, including MercadoLibre (MELI), the current market leader in Brazil. This gives me greater confidence in Shopee's strategy in Brazil and the effectiveness of theirinvestments made in Brazil.

Furthermore, in 4Q21, Shopee Brazil had 140 million gross orders, which was up 400% over the past year, while MercadoLibre's Brazil orders only grew 33% over the past year, but of course at a higher base.

Shopee Brazil has seen meaningful traction since launch (Google Trends)

Another new market that is showing great promise is Poland. Most of Shopee's competitors in Poland are cross border competitors and Shopee has seen great traction in interest from consumers since its launch in September 2021.

Shopee Poland quickly gaining traction after launch (Google Trends)

To sum up, I think that we are seeing great initial signs for Shopee's new markets in Poland and Brazil and I will continue to track these new markets as well as its other new markets over time to evaluate how well is Shopee's playbook working in other newer markets. At the current moment, it looks to me that things are working well for Shopee in these two markets.

Early competition

It is important to note that I think that we need to take into account the threat ofTikTok's entry into social commerce in ASEAN, with the TikTok Shop feature introduced in Malaysia, Indonesia, Thailand and Vietnam. The TikTok Shop feature utilizes livestreams conducted by either influencers or merchants and users are allowed to purchase during these livestreams.

Although based on several channel checks in the industry, their reach is relatively limited but it is still important to take note of the potential that given how strong an opponent TikTok is, especially forGen Z consumers.

Valuation

As mentioned earlier, I think it is important to adjust the worst case target price for Sea Limited to take into account the new information from 4Q21 and recent news about Sea Limited.

As highlighted below, my worst case SOTP target price for Sea Limited is now $131.77, with an upside potential of 36% to the worst case target price. This takes into account:

1. Slowdown in gaming business and slightly lower profitability
2. Focus on core markets and viable new markets for Shopee
3. Multiple contraction of the e-commerce business from overall comparables multiple compression.

Conclusion

To sum up, from the recent 4Q21 results Sea Limited posted, there were more positives, in my view, than negatives. Firstly, I think that although the moderation in growth of Garena may be scary at first sight, this is part of the normalization trend as economies move back to the pre-covid world. That said, I am optimistic on the gaming segment and believe that with the investments into gaming studios in place, we could see greater diversification from Free Fire over time and this is good for the gaming business in the long run. Secondly, I think that it is increasingly becoming clear that Shopee's market leadership in e-commerce in its core markets of ASEAN and Taiwan is reaping fruits as profitability improves and Shopee demonstrates its ability to be a self-sustaining business. Furthermore, I respect the management team for making the hard decision to exit France before it made any substantial investments and as such, I am ever more confident in the management's ability to make good business decisions and execute well. As such, I maintain the buy rating for Sea Limited and have a worst case target price of $131.77, implying a 36% upside potential from current levels. However, note that this is not the base case, which could imply further upside.$Sea Ltd(SE)$