Sea Limited: Growth Monster (NYSE:SE)

Source: Sea Group Media Resources, Logos

I am long Sea Limited (NYSE: SE). In my last article on the company in late April, I called it a bargain at a 1-yr Fwd EV/S of 5.9x and mentioned it could double easily in the coming two years. Free cash flow prospects had improved significantly, making it less of a gamble at the time, and C-19 was an obvious tailwind for e-commerce in the region. There were risks involved with an over-reliance on Garena’s “Free Fire” to generate cash, but it was a well-placed bet in hindsight as “Free Fire” stuck around and has continued to be a cash cow.

The company reported some impressive Q2 results and now trades at an NTM EV/S of 12.0x. The price is up ~150% since my last article. I see this as an opportunity to take some profits and trim down due to it being less attractive in pure alpha potential compared to some of my other top stocks. That said, SE will remain in my portfolio as a core holding. I have reasonably high conviction that Sea will cross the $100B market cap. It is more of a matter of when and how long that might take.

Q2 Highlights and Commentary

“As we noted last quarter, we have been witnessing a profound structural shift to digitalization across our markets. Even as movement restrictions are being loosened or lifted in many markets, we continue to see strong user growth and deepening of user engagement across our platforms. This is well aligned with our view that the structural shift to digitalization will be long-lasting.”

– CEO Forrest Li, Q2 2020 Earnings Transcript

C-19 just accelerated the digital consumption trend of Southeast Asia by roughly two years and Sea benefitted across all its segments. I haven’t seen such growth metrics for a company of its size before and all their three segments (digital entertainment, e-commerce, digital financial services) appear to be crushing it. Here are a few astounding highlights:

  • Total Adjusted Revenue grew 93.4% yoy, higher on a GAAP basis. Adjusted EBITDA turned positive during the quarter.
  • Digital Entertainment (Garena) saw a 91.4% yoy increase in QPUs (Quarterly Paying Users).
  • For E-commerce (Shopee), Gross Orders were up 150.1% yoy and GMV was up 109.9%.
  • According to App Annie, Shopee was #1 in MAUs and #1 in Total Time in App on Android in both Southeast Asia and Taiwan.
  • 45% of Shopee’s Gross Orders were paid using their mobile wallet service in July 2020.
  • SeaMoney crossed $1.6B in GMV.

Source: Q2 2020 Press Release

Source: Q2 2020 Earnings Presentation

Let’s look at Garena, particularly “Free Fire”. Gaming across the world has gotten a boost as an alternative entertainment option due to the pandemic. “Free Fire” crossed 100 million active users at its peak and remains the #1 game in Southeast Asia and Latin America. A more nuanced understanding of how the game works would lead one to believe in its stickiness. The battle royale format has a social element to it that lets it benefit from significant network effects across players. The Garena team has done well to keep things interesting with tournaments, season passes, and in-game features that keep users engaged and mix up the experience while tailoring the game locally for each of its operating geographies. “Free Fire” isn’t a temporary success that will be replaced by the next hot game. It has positioned itself as an evolving gaming experience for mobile gamers in developing markets worldwide, especially with e-sports that adds a larger competitive and entertainment element that offers big monetization potential down the line. League of Legends, World of Warcraft, and Fortnite are similar titles that have a large, loyal, and sticky consumer base. The 91% increase in QPUs isn’t just a testament to stay at home effects but also excellent execution by Sea in building a successful ecosystem around the Garena platform and innovating by creating engaging experiences. With their in-house game development studios, there’s likely more to come for meaningful financial impact.

Source: Q2 2020 Earnings Presentation

While overall gaming might be a shorter-term elevated trend that might fade faster with recovery, e-commerce will stick as a tectonic shift in consumer behaviours is underway. Shopee’s growth was accelerating with GMV/Gross Orders pre-pandemic as a relatively underpenetrated 600-million strong population turned more towards Shopee and e-commerce in general. The pandemic made e-commerce a necessity and has introduced millions of people to the excellent convenience of shopping online and getting stuff delivered to their doorsteps. Of key interest is that Shopee is a collection of e-commerce marketplaces that are differentiated and tailored for different users across geographies and what they’re looking for. Shopee Mall, for example, that grew 210% yoy on gross orders, features top brands and sellers with higher tier authentic items. The company’s ability to tweak their marketplaces to different categories of users across 6-7 geographies has helped set them apart and gain market share in an already rapidly growing market. Shopee isn’t just an e-commerce service but also a social media service once you look under the hood. The margins are steadily improving and management is actively increasing monetization. Marketplace adjusted revenues as a percentage of GMV went up to 4.7% from 3.8% qoq. I’ve discussed the competitive landscape in more detail later in this article.

Sea Money has begun meaningfully impacting financials. 45% of payments on Shopee were executed through Sea’s mobile wallet. This is impressive and shows that the division is growing rapidly, at least in adoption. Sea Money remains a cash-burning wild card that’s been funded by their other operations. It is the smallest division under the group’s umbrella but theoretically can have the biggest impact as the future of digital financial services for a massively underbanked Southeast Asian population. The Fintech field is very crowded in the region and I’d only look at Sea Money from a latter-round venture capital lens. The group is again swinging very big and taking full advantage of their existing user base and network effects to expand. Profitability is nowhere in sight, but investors need to consider this division as a high-risk, high-reward play in my opinion and think long term.

Spotlight On Shopee’s Widening Lead

I put the following charts together from some free web traffic data for Shopee and any notable competitors by iPrice Group. Note that the Shopee mobile apps rank as #1 across every geography for App Store for iOS and Android and isn’t included below.

Source: Author, Data from iPrice Group

The web traffic data for the six countries above, in millions of visits, is a bit more indicative of Shopee’s momentum. Note that the data isn’t completely clean as some Q3 and Q4 2019 figures are identical. The idea behind the charts was to add some colour rather than exact accuracy to what management already remarked on during their call. The data labels in percentages show sequential growth in visits from Q1 to Q2 2020. Shopee has leapfrogged its competitors in growth over the last quarter (+82% in Singapore, +42% in Thailand, and so on).

The closest Southeast Asia competitor is Alibaba (NYSE:BABA)-backed Lazada. After summing up data for the quarter across the six countries, Shopee had 272m visits and +33% qoq growth versus Lazada’s 131m and +5%. Going off the data, Shopee maintains a healthy lead across all its geographies except its largest market Indonesia, where SoftBank (OTCPK:SFTBY) (OTCPK:SFTBF)-backed Tokopedia is fighting a closer battle and slightly losing out (Q2 sequential growth was 31% for Shopee vs. 23% for Tokopedia).

“And that also goes to the competitive landscape in our markets. I think it’s been quite clear from the past performance that we are, in fact, gaining market share. And while the deepening of penetration is ongoing as the clear market leader taking a disproportionate share of the market growth. And this also manifest in our ability to further deepen the monetization during this period of time.”

– COO Yanjun Wang, Q2 2020 Earnings Transcript from Seeking Alpha

The takeaway here is that Shopee will benefit from economies of scale, efficiently utilized logistics and distribution networks, and end their e-commerce cash burn race faster by increasing monetization. Sea is backed by Tencent (OTCPK:TCEHY), while its competitors are also backed by deep pockets such as SoftBank and Alibaba. The great advantage they have here is that the positive cash flow from Garena and potentially countries where they have a stronger moat (perhaps Vietnam and Malaysia) can fund crushing Tokopedia in Indonesia by aggressive pricing. These pricing war dynamics have been repeated all over the US (Amazon (NASDAQ:AMZN)), India (Flipkart and Amazon), China (Alibaba & JD.com (NASDAQ:JD)), and Latin America (MercadoLibre (NASDAQ:MELI)). One or two winners conquer most of the pie, and Sea is well-positioned to capture all of Southeast Asia + Taiwan and eventually deliver us, shareholders, some long-anticipated profits. In my opinion, investors need to be patient for this transition and follow the company’s competitive strength as an indicator of future profitability.

Where To From Here?

Sea’s history tells me they’ll continue burning cash and posting losses as long as they’re growing at +60-70% yoy, although at improving margins. They’ve amassed cash from convertible note offerings over the years and appear to be putting it to use relatively quickly. Investors may be concerned that they’re playing the market capture game a bit too close for comfort, and are thus shying away from taking a swing at the stock. I hold the view that it’s fair for them to do so when they’re growing close to triple digits and are competitively positioned to eat most of their addressable markets. Gross margins are expanding while the company turned Adjusted EBITDA positive during the last quarter. The TTM FCF margin stands at -8% which is reasonable considering a +90% yoy sales growth. FCF was calculated as “Operating Cash Flow – CapEx” using data on Koyfin.

There is a long runway to go for sales and profit margins to keep improving. The whole business is a large growth equity investment that you’d often see in the private markets but is instead offered to us to invest in. We aren’t used to $70B companies that are burning cash. This has led to some discomfort among investors and appropriately comes with some risks. Large companies need to be compared with their large opportunities, though, and in this case, the opportunity is still large.

Google, Bain, and Temasek’s now outdated 2019 SEA Internet Economy Report mentioned that internet businesses will comprise of a $300B opportunity in the region by 2025. (It was $100B in 2019.) I reckon the $300B has likely been pushed to 2023, after noting the structural shift in the region’s internet behaviour due to the pandemic.

Source: e-Conomy SEA 2019, by Google, Temasek, and Bain & Company

Sea is well-positioned to keep growing with these immense tailwinds. There is yet a long way to go, and I believe Shopee will continue to see some very high growth rates for a few years to come. The region has a 600 million strong population to scale across and the GMV as a % of GDP has a large room to grow until it catches up to western counterparts. We’re looking at a 3-4x or more long-term increase in the GMV percentage, as all these emerging countries get bumped far towards the right of the graph due to the structural shift caused by the pandemic. The US and China has likely seen a significant bump as well in the last few months. As of GDP growth itself, the region’s countries were growing at 5-7% yoy pre-pandemic. Economic mobility will likely be back in full swing throughout the emerging economies of Southeast Asia. The natural rise of the middle class as a result, and subsequent consumer spending, is a force that shouldn’t be underestimated and provides a steady tailwind for Sea Ltd. that is now increasingly looking like a monopoly.

Valuation

Source: Koyfin, Price & EV/S multiples

Is the valuation absurd? On an LTM basis, an EV/S of 23.7x for an e-commerce shop would provoke the question, “Is this a bubble?”. Nobody should value Sea for what it is now, though. On NTM EV/S, things appear to be slightly more reasonable at 12.4x. With some time into the future, Koyfin aggregates analyst estimates to an FY2022E EV/S of 7.1x. This is a fair valuation after applying a high market rate of return and accounting for share dilution. On a comparative basis, Tencent trades at an LTM EV/S of 9.4x while Alibaba trades at 9.0x. Both currently offer the kind of growth that we’d likely see Sea experiencing in 3 years. Note that all valuation multiples were sourced from Koyfin.

So, why am I still long SE if the price is only “fair”? For that, one has to look at Sea’s additional value creation beyond the projected growth rates. The company has excelled in exploiting network effects and adding layers of differentiated products or services that deliver additional growth while expanding its total addressable markets. Garena could have stopped as a third-party licensor of other games. They decided to create their own mobile game and succeeded at it (one of the top mobile games globally). Their Shopee digital wallet could have remained just a digital wallet. They decided to build out a more comprehensive digital financial services division. Shopee succeeded by coming from behind and overtaking its competitors in several geographies by tailoring marketplaces and introducing social engagement features, among other things. Other companies that pulled off excellent network effects are Amazon and Square (NYSE: SQ) in recent times. Amazon went from just e-commerce to offering AWS and Prime, and Square turned from offering Point of Sales payments and software to CashApp and the future of banking. These intangible qualities that turn companies into perpetual growth machines are what the markets occasionally miss and can’t be quantified in future estimates because we can’t see those future products/services yet. I hold the view that Forrest Li and his team have this kind of Bezos-like DNA going off of historical innovation. Sea’s upside potential isn’t what it was four months ago, but at the current valuation, it’s a good play to hold the stock and bank in any additional value creation.

Downside Risks

  • Systemic risks and high volatility, potentially large drawdowns.
  • Competition catches up or puts up a fight that takes away from FCF generation.
  • Free Fire loses its mojo changing the cash power Shopee has to keep expanding.
  • Icarus flies too close to the sun. The company burns too much cash fighting losing battles in difficult markets (like Amazon and Fire Phone), reducing shareholder value creation.
  • Rotation out of high-growth risk stocks and tech could lead to large drawdowns in the short term.
  • A small bump in the road in execution could lead to a rapid change in sentiment regarding the stock.
  • Growth for Sea fizzles out faster than expected.
  • Macro and regulatory risks in Southeast Asian geographies.

Conclusion

SE is a “Buy” for me. While the pure alpha prospects for Sea aren’t what they used to be, there’s still significant upside potential as a stock to hold for the long term. Profitability is negative, and the company just turned Adjusted EBITDA positive this quarter, but they’re well-positioned to rule their domains and extract profitability later. Some FCF burn is very reasonable considering the near triple-digit sales growth. I expect Sea to outperform the market and continue surprising investors by exploiting their excellent network-effect advantages. It is an exceptional company at a fair price and worth an investment in my opinion.

Disclosure: I am/we are long SE, SQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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