MELI - Sea Limited: Positive Cash Flow Makes This An Interesting Turnaround

2023-04-17 10:00:00 ET

Summary

• Sea Limited was a ten-bagger during the last bull run and then crashed 86%.
• Hyper growth paired with high losses turned to positive cash flow in the latest quarter.
• The positive cash flows were a result of cost controls and increasing take rate.
• Sea Limited could be a promising turnaround play with the newly found profitability.

Sea Limited (SE) has been one of the hyper-growth poster children of the last bull run. After the Covid lows, the stock was a ten-bagger within one and a half years, only to fall 86% from the highs and recover slightly since then. The stock has found a bottom with many other fallen tech angels over the last year and has seen an interesting twist in its fundamentals. Even after this horrendous drawdown, the stock still massively outperformed the S&P 500 since its IPO. Let's see if Sea Limited is a compelling opportunity again.

Business breakdown

Sea Limited is a fast-growing digital business South East Asia focused on three main segments:

1. Digital Entertainment is their gaming business with the Garena brand, where they develop and distribute games. Their largest revenue driver was their proprietary game Free Fire, a battle royal game explicitly designed for high performance. This was to cater to its market primarily in developing countries where smartphones aren't usually cutting edge. They also distributed Tencent's (TCEHY) games on its platform (a deal that has expired this year). Tencent has been an early investor in Sea Limited but sold 2.6% of its stake (now 18.6%) and converted all its super-voting shares to ordinary shares in 2022. Garena was the cash cow but has recently seen sharp declines.
2. E-Commerce is the second business Sea Limited started with its Shopee brand gaining market share rapidly and growing to be the market leader in many of its home markets in Asia. The company went on a massive expansion and frequently entered new markets, predominantly in Latin America, to rival MercadoLibre (MELI) and Eastern Europe. The company also had select Western Europe operations, such as France and Spain.
3. Sea Money is the company's payments and financial services arm, a natural extension of its E-Commerce business that helps an underbanked population access financial services.

The Problems

Sea Limited was purely focused on top-line growth since its IPO and grew revenues with a 5-year CAGR of 100%. This rapid explosion in growth was led by rising losses and in Q3 22, they reported trailing twelve-month free cash flows of -$2.45 billion. During 2020/21, while Gaming was a hot market, Garena printed cash and offset most of the operating losses the E-Commerce and financial services operations were making. In 2022, as the world reopened, Garena has been struggling and its AEBITDA shrank from $2.77 billion to $1.313 billion.

The expansion was financed by cash taken in during the IPO and continued issuance of shares. We can see that the management has been brilliant in continuously issuing shares throughout the bull run and managed to pile up $11 billion in cash and short-term investments in Q3 21 versus just $4 billion in debt. This $7 billion net cash position allowed the company to expand and not go bankrupt. We can see that the dilution stopped as soon as the share price collapsed. Sea's founder Forrest Li owns around 8% of the company and has been a good leader. In 2022, while operating losses were mounting, Li also said that he and the management team will forgo their salaries until the company is self-sustaining.

Recent turnaround

A few months ago, I wrote an article about another cash-burning E-Commerce company: Jumia (JMIA). While Jumia suffers high losses, Sea Limited managed in its latest quarter to make a sharp turn in its E-Commerce profitability and showed a positive adjusted EBITDA of almost $200 million, driven by $320 million in its home markets in Asia. The company has closed operations in many of its newer markets over the last year to focus on its strongest markets. In the latest quarter, every major segment of the company reported positive Adjusted EBITDA, versus $877 million in losses in E-Commerce and $150 million in Digital Services for Q4 2021.

The primary drivers for this turnaround were a sharp decrease in Sales & Marketing expenses, which were cut by $800 million, the closure of certain regional operations and an increase in the take rate: While gross merchandise value (GMV) stagnated Y/Y E-Commerce revenues saw an increase of 44% (54% growth in the core marketplace and 29% in Value-added services).

Valuation

I usually do an inverse DCF analysis to value companies, but this doesn't make much sense given that Sea Limited has a trailing 12-month Free cash flow of -$2 billion and $700 million total stock-based compensation in the same period. We could take the $320 million in operating cash flow the company generated in Q4. Still, I am not yet convinced that these numbers are sustainable and can be annualized: The company has drastically reduced marketing spending and has aggressively raised its take rate. We need to see if this has a lagging effect over the next quarter in the revenues.

Seeking Alpha shows that analysts expect the turnaround to work and two analysts assign an FY 25 PE ratio of 17 with $4.85 EPS. I want to see more clarity before I give the stock a buy rating, but the first signs of the turnaround look promising.

For further details see: