NTES - Sea Limited: A Deep Dive Into Garena

Summary

• Garena's in-house game development capabilities have proven to be strong as it managed to develop its own successful self-developed game, Free Fire.
• The third-party game publishing business of Garena has a solid track record with relationships with key global game developers like Tencent.
• Garena uses a freemium monetization model to monetize the business and recognizes the importance of building a strong community and the power of esports.
• Near-term headwinds from the India Free Fire ban are stabilizing and improving in 2023 as we lap their full-year impact.

This article was first posted in Outperforming the Market.

Investment thesis

For fundamentally driven investors, every selloff presents an opportunity. This is especially so when you're comfortable with the fundamentals of the company. The relatively cheap valuation of the company makes it even more attractive as an investment.

While we have seen a drastic selloff in Sea over the past year or so, I think that part of the selloff is warranted given that they have been pulling out of certain e-commerce markets that they were testing in, and Free Fire has resulted in headwinds for the gaming business in the near-term.

That said, I think that during times like these, investors looking to invest for the long-term needs to look at the big picture, dive deeper into the company and be fundamentally driven rather than be driven by sentiment. This article will dive deeper into Sea's gaming segment, Garena, to gain further confidence in the business fundamentals of Sea.

Deep dive into digital entertainment (Garena)

As mentioned earlier, Garena is Sea Limited's digital entertainment business, which mainly offers mobile and PC online games. As part of its business, Garena does game development, localization, operation, distribution, monetization and payments, as well as activities like esports and user community building.

Its games comprise of either self-developed games or games that are licensed from third party developers. Its games have a wide range of genres, including battle royale games, multiplayer online battle arenas, action role-playing games and massively multiplayer online role-playing games, amongst others.

Solid in-house game development capabilities

Although Sea Limited claims that Garena's games come from either self-developed games or games licensed from third party developers, the fact is that Garena's revenues come largely from a small number of popular games. While I think that Sea Limited has the necessary in-house game development capability, the pipeline and new game releases have failed to replicate the success of its most popular game, Free Fire.

Free Fire is a popular battle royale mobile game that's available globally. To put things into perspective, based on the 2021 annual report for Sea Limited, the company's top 5 games contributed to 97% of digital entertainment revenues, of which Free Fire is the significant contributor.

With Free Fire's huge popularity, there comes a double-edged sword. Garena's success is demonstrated by its ability to self-develop such a successful game. However, the challenge today will be to identify new games that can be as successful as Free Fire. This large concentration of revenues from Free Fire brings risks as the success of the digital entertainment segment hinges just on this one game.

In December of 2017, Garena launched Free Fire, which was the first game that it developed entirely in-house. This was the game that showed investors that Garena not only has the in-house game development capability, but also the ability to produce top global games. As Free Fire's popularity skyrocketed, Garena started to expand beyond Southeast Asia and Taiwan to other global markets.

In terms of in-house game development, this continues to be the priority for the Garena team as it looks to develop new mobile games that can diversify its revenue sources. With more than 2,000 global developers in its in-house game development studio, the team is focused not just on churning out a new pipeline of self-developed games that can be as successful as Free Fire, but also to continue to improve and enhance the gameplay and user engagement of Free Fire.

Track record in third-party game publishing

In terms of third-party game publishing, Garena has a global experience as they have the expertise needed to curate top third-party games for local markets. Garena has had success as a third-party game publisher and have strong relationships with the large international game developers. Part of the reason why these large international game developers choose Garena as their game publisher in Garena's markets is due to its leading position in core markets, solid reputation in the online game community and the strong track record of successful publishing games in its core markets.

Who are some of the major game developers that Garena publishes games for? Firstly, one of the largest game developers in the world, Tencent (TCEHY), is a major shareholder of Sea Limited and Garena has been a key partner to Tencent. This began in 2018 when Tencent first granted a right of first refusal contract to Garena for Tencent's mobile and PC games for the markets of Philippines, Malaysia, Indonesia, Taiwan, Thailand, and Singapore for five years. This was subsequently extended by another five years in 2020. This deepening of the collaboration between Sea Limited and one of its largest partners is testament to the strong publishing capabilities of Garena, especially in the Southeast Asia and Taiwan region, which it has long regarded as its core markets. Even after its recent $3 billion sale of Sea Limited, Tencent still has 18.7% stake in the company and intends to maintain the majority of its holdings in Sea Limited for the long term.

Activision Blizzard ( ATVI ), the fourth largest game developer by revenue, also partners with Garena to publish its Call of Duty Mobile game in the Southeast Asia and Taiwan region. Other top game developers Garena has published games for includes NetEase ( NTES ), Electronic Arts ( EA ), amongst others .

As such, I like that Garena is able to source quality games from the top game developers in the world, and that the partnership with Tencent is exclusive.

While the news about Riot Games deciding to self-publish League of Legends and Teamfight Tactics and ending the 12-year partnership with Garena is undoubtedly negative for Garena, the games in general are relatively immaterial to Garena in terms of contribution to the business and I think that Garena has the ability to attract more high-quality game developers to partner with it with its large user base in the region as well as solid track record in making published games successful in their key markets. The goal for Garena in the third-party game publishing segment is really to continue to work on its publishing pipeline, bring in and work with top game developers around the world.

Garena's monetization model and strength in community building

Garena uses a freemium monetization model where it allows users to download and play games for free, while revenue is then generated through sale of in-game items, which includes virtual items or certain advantages and passes. The lure of purchasing in-game items comes from faster progress in the game, social elements given that users with friends in the game will want to match each other in terms of items and skills in the game, as well as a more personalized game playing experience.

Lastly, Garena also recognizes the importance of building a strong community and the power of esports. In its core markets of Southeast Asia and Taiwan, Garena is a key driver of the esports scene as a major organizer of esports events as well as the operator of the largest mobile game professional league in Southeast Asia, Taiwan and Brazil.

In particular, Garena's Free Fire also is one of the key reasons for its involvement in esports as it has a large and growing esports community that has provided a strong community and user engagement element for Free Fire that has enabled rapid growth in the game. As a result, Free Fire was named the Esports Mobile Game of the Year at the Esports Awards 2021. I continue to think that the involvement of Garena in esports is crucial in cementing its position in the industry as it helps to improve user engagement in the games that they either develop internally or publish from third-party developers.

Garena's key metrics

The figure below shows seven quarters of Garena's performance. Garena's business has really taken off and this is not quite shown in the figure, but in 1Q19, Garena had 272 million quarterly active users and 21 million quarterly paying users. Fastforward 3 years later, the quarterly active user metric grew by 109% and the quarterly paying user metric grew by 148%.

That said, Garena is struggling today as a result of a few factors. It started with the normalization of one of the fastest growing periods for Free Fire in the COVID-19 pandemic period as a result of movement restrictions. As a result of COVID-19 restrictions and lockdowns, gaming was one of the key beneficiaries as people started spending more time at home playing games. It was estimated that there was an increase of 39% in the time spent on gaming during the pandemic and Garena was benefiting from strong growth as a result of it. With countries all over the world opening up and restrictions gradually relaxed, the gaming trends started to normalize as people spent less time on gaming, which resulted in moderation trends for Garena starting 4Q21. To add salt to the wound, India announced the banning of Garena's Free Fire in India, which was done so along with 53 other Chinese apps. This brought a fairly significant impact to Garena given that India accounts for about 30% of all Free Fire users and about low teens gross contribution as a result of India's users having lower ARPU and paying ratio. That said, the Indian market is no doubt an important one for Garena for future growth and this ban certainly brought significant pain to the digital entertainment business. For these two headwinds, the positive thing is that we are lapping the full year impact in 2023 and I expect the trends to stabilize and improve in 2023.

Today, I think that while the trends for gaming may still remain weak in the near-term, much of the worst is likely over as the numbers have reflected the re-opening trends of people going back to work and school as the pandemic subsides. The key for Garena is now to stabilize its key games and ensure solid user engagement under this new business environment.

Final thoughts about Garena

At the end of the day, Free Fire is Sea Limited's crown jewel and prized procession. The success of Free Fire would directly translate to improved shareholder value given the accretive earnings it brings. The key near-term would be to stabilize the game with the changing trends to ensure that coming out of the pandemic, Free Fire remains relevant, and the users remain engaged in the game. Given its huge popularity and success, Free Fire is also one of Sea Limited's key intellectual properties. There's a need to ensure that user base remains engaged to make Free Fire relevant in a fast-changing gaming world for as long as possible before the next blockbuster self-developed game arrives.

At the same time, Garena needs to look at what is next. As Garena had at least one successful self-developed game, this does pave the way for future games in the company's pipeline to have what it takes to be the next Free Fire. Garena needs to strengthen its gaming portfolio by boosting and working on its development pipeline and publishing pipeline. The company is utilizing a more selective approach to develop and launch new games as it is adopting a more selective approach to developing and launching new games to prioritize the highest potential titles in its pipeline. With the necessary talented global developers that have a track record of developing successful games like Free Fire, while Garena's pipeline remains to be only announced when published and launched, I think that we will continue to see new games published and released to diversify the game portfolio.

Risks

Political and regulatory risks

Possibly one of the biggest, unexpected risks for Sea in 2022 was the ban on Free Fire in India. While these are extreme left tails in the business that are difficult to predict, I think that investors are going to be increasingly wary about this potential risk going forward.

Profitability and cash flows

With Free Fire seeing weakness and the e-commerce business not yet profitable, the concerns surrounding Sea has been mainly on the profitability and cash flow front. I like that management has been focusing on self-sufficiency and profitability in recent times and with the losses in Shopee narrowing and the segment expected to break even based on adjusted EBITDA by end 2023, I think that the company is heading in the right direction. However, as the cash cow of the business, Garena needs to continue to sustain its business performance to generate the overall profitability and cash flows that Sea needs.

Free Fire concentration

As a result of Free Fire's success, Garena is burdened with developing the next game that could replicate the success we saw with Free Fire. With the gaming portfolio in Garena heavily tilted toward Free Fire, management has been mentioning in several earnings calls about the need to diversify the gaming portfolio and the work that the team has been doing to make sure that high potential new games are launched.

Conclusion

At the end of the day, I think that while there remains uncertainty about Garena's pipeline of games and their likelihood of success, the necessary steps are being taken to bring the business to the next level. The management team continues to be committed to investing in the business, ensuring that innovation and new developments are brought into Free Fire to ensure relevance and engagement in the game. At the same time, there are more than 2,000 in-house game developers in its own game development studio working to launch new self-developed games to diversify the gaming portfolio. Apart from developing games in-house, Garena has had a solid track report of publishing games from third-party developers and its relationship with Tencent and other globally renown and large game developers ensure that its third-party game publishing pipeline remains strong.

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