Sea Limited: Executing Well Towards Profitable Growth (NYSE:SE)

This article was first posted in Outperforming the Market on May 16, 2023.

Sea Limited (NYSE:SE) just reported its earnings on 16 May and I will delve deeper into its 1Q23 results to provide insights into the company, its fundamentals and where it is about to head next.

I continue to believe that Sea Limited is executing well towards growing profitably and sustainably, while investing in its business to continue to maintain and grow its leadership position in multiple markets.

A brief introduction

For readers who are unfamiliar with Sea Limited, I have shared with members of Outperforming the Market a deep dive into Sea Limited, which goes deep into the company’s three business segment, competitive landscape and valuation, amongst others.

Sea Limited has three main businesses. First, it has a gaming business, the Digital Entertainment business, and its revenues are largely contributed by Garena’s top game, Free Fire. Second, it has an e-commerce business, Shopee, which is a leader in Southeast Asia and Taiwan and growing rapidly in Brazil. Lastly, it has the digital financial services business, which is called SeaMoney, providing users with fintech solutions.

Summary of Sea Limited’s 1Q23

During the first quarter of 2023, Sea Limited generated $3.04 billion in revenues, which was similar to the $3 billion the market was expecting.

However, the EPS figure disappointed as Sea Limited generated 15 cents per share, lower than the 73 cents per share that the market was expecting.

I created the table below to show a few key things:

1. As of 1Q23, revenue growth in e-commerce accelerated to 36% while adjusted EBITDA margin improved from -49% in the prior year to 10% in 1Q23. This implies Sea Limited’s e-commerce segment can continue to grow despite its focus on profitability.
2. Revenue mix of Digital Financial Services has increased dramatically from 4% of revenue in 2Q21 to 14% of revenue in 1Q23, almost catching up to the revenue contribution of the Digital Entertainment segment.
3. Digital Entertainment segment continued to post weak growth but adjusted EBITDA margins remain high at 43%. In addition, we can see that increasingly, the valuation of Sea Limited is driven by the e-commerce segment given the increasing revenue and adjusted EBITDA contribution it will bring.

e-Commerce segment continues to grow more profitably

In the first quarter of 2023, Shopee revenue grew to $2.1 billion, up 36% from the prior year. This comes as the company increases monetization. Core marketplace revenue grew to $1.2 billion, up 54% from the prior year as a result of higher advertising revenues and transaction-based fees.

Adjusted EBITDA improved to $208 million in the first quarter of 2023, compared to the $743 million loss from the prior year. This is a huge improvement, in my view, and is a result of monetization efforts and continued improvements in operating efficiencies

Specifically, adjusted EBITDA for Shopee’s Asia markets improved from a loss of $408 million in the prior year to a positive adjusted EBITDA of $276 million in the current quarter. In its other markets, adjusted EBITDA losses continue to narrow significantly, in my view, from the prior year’s $335 million adjusted EBITDA loss to the current quarter’s $68 million adjusted EBITDA loss. Specifically, the contribution margin loss per order in Brazil improved by 77% compared to the prior year to reach $0.34 per order. This was a result of a more efficient sales and marketing spend and also improving monetization.

I am of the view that the revenue growth for the e-Commerce segment remains surprisingly resilient despite a dial down on sales and marking spend. In addition, the continued improvement in profitability is encouraging, highlighting to me that this improvement is sustainable in the longer term.

Focus for Shopee in the quarter

One aspect that Shopee is focused on in the quarter is to improve its logistics cost leadership and delivery experience. It is looking to improve its logistics capacity and increase integration in its in-house logistics arm and its third-party logistics partners. As a result of the use of more automation within its delivery process, this has led to Shopee reducing its average delivery time by more than half a day across its markets in the first quarter.

In addition, Shopee also improved and expanded on its buyer coverage of its logistics services in the first quarter, with more than 95% of Shopee’s buyer base now being covered by Shopee’s delivery services. In Brazil, management shared that it continues to expand on its first and last mile hubs in the country and also has eight distribution and sorting centers in Brazil today. Shopee also recently opened 15 new hubs in the past few months in an effort to improve its logistics capabilities.

Another aspect management is focusing on for Shopee is to increase its AI capabilities to improve not just user experience, but also drive operating efficiencies. Shopee is also to use AI to recommend users more relevant products on its platform and this has led to higher order conversion rates as it improves the product discovery on the Shopee platform. Shopee has also adopted large language models to improve its own AI powered chatbot, with the aim to provide users with a better user experience, improved resolution of issues and shorter waiting times.

Digital Entertainment

The Digital Entertainment segment presents a headwind to Sea Limited’s total revenue and EBITDA today, with revenue from Digital Entertainment down 52% from the prior year, and adjusted EBITDA from Digital Entertainment down 47% from the prior year. This was a result of weakening monetization in the segment as paying user ratio continued to be weak.

However, it was positive to see constructive commentary on Garena from management during the earnings call.

Management suggested that they were seeing initial signs of improvements in Garena’s quarterly active user base, which increased 1% sequentially from 485 million in the prior quarter to 492 million in the first quarter. There were also positive user trends cited for Free Fire in April as management noted that Free Fire actually achieved a new peak in monthly active users over the last 8-month period. In addition, as a result of ongoing efforts to improve gameplay and user engagement in Free Fire, there were positive responses to the recent improvements made to Free Fire.

On top of that, management also highlighted that Arena of Valor, its second largest game, reached a new record with quarterly active users and bookings in the quarter. This comes after more than six years since the game was launched and continued efforts to engage with users and improve monetization.

Lastly, management highlighted several new titles it is launching, with the Undawn expected to be published in Southeast Asia in the next few months, as well as the publishing of Black Clover Mobile in several global markets. Management has been using AI to improve the efficiency of its game operations as it looks to use AI to localize some of the content in its games to improve execution in the long run.

Given the commentary on Free Fire and the new launches expected in the next few months, along with the lapping of the full year since Free Fire metrics started to worsen, I think that we could be seeing Garena bottom either this quarter or the next, if Free Fire trend continues to stabilize or improve.

SeaMoney’s growth continues

SeaMoney posted a solid quarter, with revenues reaching $413 million in 1Q23, up 75% from the prior year. Importantly, SeaMoney generated $99 million in adjusted EBITDA, compared to an adjusted EBITDA loss of $125 million in the prior year. This improvement in the adjusted EBITDA was a result of solid revenue growth, along with continued efforts to optimize costs as well as efforts to improve efficiency, including optimizing sales and marketing spend.

SeaMoney’s credit business continues to grow. Sea Limited’s total loans receivables on its balance sheet reached $2 billion in the quarter, and net of allowance for credit loss is $281 million.

In addition, the non-performing loans past due for more than 90 days remained stable at 2% as a percentage of total gross loans receivables.

I would also note that management has been looking to diversify its sources of funding, which includes Sea Limited’s own bank deposits, channeling arrangements and bilateral asset-backed facilities with local and regional banks and the company is looking to diversify this further by bringing in more financial investors. Majority of SeaMoney’s loan book is currently already being funded from alternative sources other than its own cash on its balance sheet.

SeaMoney also uses AI to improve on its risk management capabilities to assess the fraud and credit risk of its users and to improve the KYC process of its products.

On top of that, management continues to expand its offerings at SeaMoney as it has piloted new insurtech products and more features and services in its banking apps. I also like that the team is looking to integrate and synergize its SeaMoney and Shopee business to make it more seamless for users to use either offering.

Last but not least, management remains confident in SeaMoney’s long-term potential and is expanding the SeaMoney business in a prudent way to manage the uncertain macroeconomic environment.

Cash

In 1Q23, Sea Limited achieved a net cash inflow from operating activities of about $606k, a vast improvement from the cash outflow of about $724k in the prior year.

As a whole, Sea Limited added $40 million in cash during the quarter. I continue to be amazed by Sea Limited’s ability to turnaround its cash flows from the prior year’s total negative cash outflow of $1.7 billion to positive total cash flow of $40 million in the current quarter.

Valuation

I reiterate my 1-year price target set for Sea Limited in my Sea Limited deep dive after this 1Q23 earnings report.

My 1-year price target for Sea Limited is based on a blend of DCF and P/E method. For the P/E multiple method, I assume a 32x 2024F P/E for my estimate of Sea Limited’s 2024F EPS. For the DCF method, I assume a 20% cost of equity and 20x terminal multiple.

Therefore, my 1-year price target for Sea Limited is $94.51, implying 30% upside from current levels.

I would highlight that the way Sea Limited should be valued is vastly changing as it used to be valued as a gaming company as Garena formed a bulk of its business, but today, the e-commerce and digital financial services business is increasingly becoming significant to the business.

Conclusion

All in all, I think that the 1Q23 quarter was a strong one for Sea Limited as it demonstrated that it can still grow at a fast rate despite focuses on operating efficiencies and profitability. The company showed strong improvements in adjusted EBITDA margins for its Digital Financial Services segment and E-commerce segment. While there continued to be monetization headwinds in the Digital Entertainment segment that resulted in revenue headwinds, adjusted EBITDA for the segment was still rather solid.

The first quarter of 2023 was another strong quarter for us across our businesses. We’re focused on maximizing operational efficiency and improving user experiences. We continued to make meaningful progress on both fronts. We deepened our commitment to achieving strong cost leadership for our ecosystem. We believe this will reinforce our structural advantages in driving profitable long-term growth in our markets. As a result, we continued to see significant year-on-year improvement in profitability of both Shopee and SeaMoney.

Therefore, my 1-year price target for Sea Limited is $94.51, implying 30% upside from current levels.