Summary
- Based on my sum-of-the-parts valuation, Sea's e-commerce segment is worth $38 per share, which is roughly where the stock is currently trading at.
- This implies that Garena and the fintech business come for free, which demonstrates the overly pessimistic view and negative sentiment on Sea, presenting an excellent opportunity for contrarian investors.
- Sea continues to prioritize the long-term sustainability of the business by reaching positive cash flows as quickly as possible in the next 12 to 18 months.
- Cost cutting has been in overdrive while the management has been quick to exit non-core markets to preserve capital.
- Lastly, Sea is still growing strongly, at a 20% CAGR, in my view, as it benefits from the tailwinds of gaming, e-commerce and fintech in under-penetrated markets.
As an individual who loves looking for contrarian ideas, the current stock market is an ideal environment, especially in markets and companies that have so negative sentiment that the downside is protected while the upside can be significant.
When the market gets overly pessimistic about a stock, that's when I would start to add to my positions. This is the basic idea that with poor sentiment around a stock, most if not all the bad news and perhaps even more has been priced into the stock. In fact, I think that fear and negative sentiment is a clear sign that the stock is actually very much less risky compared to a stock with high valuations and with overly optimistic projections.
Investment thesis
I think that the selloff in Sea Limited ( SE ) is overdone at the current valuation. To summarize, the market has essentially only priced in the value of Shopee, Sea's e-commerce business, into the stock price. Based on my sum-of-the-parts valuation for Sea, the e-commerce business is worth roughly $38 per share, which is where the stock price is at right now. As a result, the current stock price values Sea's Garena and fintech business at zero, which seems to me like extreme negative sentiment and thus, a contrarian buying opportunity.
At the same time, management is taking the right step to prioritize reaching positive cash flows as quickly as it can in the next 12 months to 18 months and taking multiple measures to cut costs and improve operating efficiency of the company.
Cost cutting in overdrive
The main theme in the past year for Sea has been to cut costs and the company was one of the first to do so as the top management knows that they have to be prudent, reach self-sufficiency as soon as possible in order to eliminate their need for new external capital, which will be hard to come by in the near-term. This cost cutting is also necessary as the global macroeconomic environment is increasingly uncertain, especially for companies like Sea that has benefited tremendously from the pandemic.
As stated, and continuously reiterated by management, Sea's top priority and main objective in the next 12 months to 18 months is to reach positive cash flows as quickly as it can.
To signal their intent to drive cost savings from a top-down level, the top management team in the company has decided to forgo their salaries until the company reaches a self-sufficient level.
In addition, there were also some tightening of the company's expense policies as business travel is now limited to economy class airplane tickets while there are limits to spending on hotel stays, meals and other travel expenses.
Sea was also one of the first to announce job cuts to improve operating efficiency and balance growth and costs. It announced that it will be cutting about 3% of its workforce in Indonesia, as well as laying off some of its workers in Singapore and China. Needless to say, these job cuts were necessary to improve and optimize its operating efficiency, which is its key focus in the near-term.
With its cost cutting measures in overdrive, it was encouraging to see in 2Q22 that the Southeast Asia and Taiwan markets for the Shopee achieved an $0.01 EBITDA loss per order before HQ costs, which is on track to reaching management's goal of positive adjusted EBITDA before HQ costs for the Southeast Asia and Taiwan markets for Shopee by 2022. We are seeing Shopee benefiting from operating leverage and operating efficiency improvements as the business scales up and management cuts back on less-than-optimal spending.
Exiting non-core businesses to preserve capital
First it was France in early March, then it was India in the later part of March. That was the beginning of Shopee's exit from countries and regions it deems non-core as Shopee management wanted to be disciplined in their approach in exploring new markets, while at the same time being prudent to ensure that capital is not spent unwisely. Since then, Shopee has also announced that they were exiting other markets like Spain , and to downsize some of its businesses in Chile, Mexico and Columbia.
On hindsight, management's early exit from some markets since March does show their commitment to preserving capital and cost discipline as many of the markets that they exited had tough competition or required significant cash burn, which would have been disastrous if Shopee still held on to these markets today.
Furthermore, with its markets that it has retained today, these are core market that are seeing improving unit economics, increasing operating leverage and efficiency as the business scales up.
As such, the Shopee business looks well positioned to improve its unit economics, efficiency and cash flows in the near-term as these are Shopee's key markets in which they are largely dominant in.
Growth will continue
Most importantly, while cost remains a focus and negative sentiment around Sea brings doubts about future growth of the business, I expect that Sea has multiple growth drivers in the long-term, and in my view, the company can still grow at a revenue CAGR of 20%.
For Garena, this is still a fundamentally strong business, although a longer-term view and patience is needed. We will need time for the games pipeline to develop new game releases that over time, will drive a more diversified game portfolio, while I expect that in the near-term, the fall in revenues from 2022 will bottom in 2023.
Shopee remains to be well positioned in under-penetrated markets like Southeast Asia and Latin America. With Southeast Asia, the e-commerce market in the region is expected to grow at 15% CAGR in the next 5 years, and I expect that with Shopee's dominant market position and competitive advantage, it will likely outperform the industry average over the period. In addition, the fintech business remains to be growing very rapidly over the next few years as it is starting off a small base. The fintech business will drive further growth in the business in the longer term as Sea drives synergies between its Shopee and fintech businesses.
Valuation
A large part of the investment idea for Sea lies in the valuation. I have separately done a DCF model for Sea which does imply that current price levels are at a discount to intrinsic value. But today, my focus is on the sum-of-the-parts valuation for Sea.
The whole idea behind the sum-of-the-parts valuation is that you sum up different segments or parts of the business to come up with a valuation for the company. I would typically use this for companies with multiple business segments and will use this sum-of-the-parts valuation model to supplement other methods like my DCF model or relative valuation.
For Sea, by using a sum-of-the-parts valuation, I can price each business according to what I think they should be valued today. For the Digital Entertainment business, I have applied a conservative 11x P/E on the business's 2023 earnings to derive a value of $21 per share for the Digital Entertainment business. I think that 11x is conservative because this is at a 30% discount to the global peers multiple and with the challenges faced at Garena with its Free Fire concentration, I think that this multiple is fair for the business. For Sea's e-commerce and Digital Financial Services segments, I valued these at a 2.5x and 4x price to sales multiple respectively. These multiples reflect the long-term revenue growth potential for the respective businesses while accounting for some conservatism in the multiples as I have not applied any premium on these multiples.
Put together, we can see that the e-commerce business is valued at $38 per share today, which is roughly where the share price is today. As such, if the stock were to continue trading in the 40s and even the 50s range, I think that the current stock price does not actually put any value on the Digital Entertainment and Digital Financial Services business, which in my view is overly pessimistic as these are businesses with moats and will continue to grow in the longer term.
Sea Limited sum-of-the-parts valuation (Author generated)
Risks
Profitability and cash flows
Profitability and cash flows are key, and management knows that too. Sea needs to prove to investors that they are able to control costs and grow the business to ultimately run a profitable business that generates healthy cash flows. The risk is that Sea may miss expectations for profitability and cash flows as it tilts towards growth as a goal. That said, management has reiterated that the main goal is cost efficiency and sustainability and that growth will be an output of that. It remains to be seen if Sea is able to turn around its business to become profitable or generate positive cash flows in the next 12 months to 18 months.
Competitive pressures
The e-commerce space is crowded today with large companies vying for market share in the global e-commerce market. Players with large financial resources like Amazon ( AMZN ) and Alibaba's ( BABA ) Lazada can continue to run these e-commerce businesses sustainably given their strong financial position, positive earnings and cash flows. As a result, there is a risk that competitive pressures may increase in Shopee's key regions, resulting in poorer industry dynamics, slower growth and weaker margins. More importantly, if this is the case, the company may not be able to reach positive cash flows and profitability in the near-term given the potential intense competitive pressures from other large players with strong financial resources.
Concentration risk in gaming segment
With Garena's heavily reliance on blockbuster game Free Fire, the company needs to find its next game that could be the next Free Fire. It needs to focus on creating new games to diversify its current games portfolio to ensure that with the steady pipeline of new games, Garena could potentially see growth drivers from other newer games as Free Fire matures. Eventually, if successful, Garena could have a multiple expansion opportunity given the depressed levels at which the gaming business is trading at today. I think that this diversification of gaming revenues and new games pipeline is key to reducing the concentration risk in the gaming business today.
Political and regulatory risks
While I think that political and regulatory risks going forward are low for the countries in which Sea is operating in, the fact that Indian banned Free Fire does bring some element of political and regulatory risk to the investment story for Sea.
Conclusion
The sum-of-the-parts valuation shows an opportunity present today that actually presents investors a chance to invest in Sea at a discount to fair value. While investors were chasing Sea when it was trading at crazy multiples in 2021, these same investors are now unwilling to invest in Sea when it looks attractive at a valuation perspective.
With where the stock has been trading for the past month near the 40s and 50s level, this implies that the current valuation only takes into account the value of Shopee, which I estimate to be at $38 per share. With the implied value of Garena and the fintech business at zero, I find that the stock is under very poor sentiment and the discount at which Sea is trading at today presents an excellent opportunity for contrarian investors. Likewise, with weak sentiment around the stock, I think that this makes the stock less risky than it was in 2021, with expectations at rock bottom. In addition, I highlighted that the company continues to focus on achieving positive cash flows and improve operating efficiency, while exiting non-core markets to preserve capital. Lastly, the stock is trading like growth has disappeared, but Sea's business continues to benefit from the strong tailwinds in the gaming, e-commerce and fintech segments in under-penetrated markets.
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Sea Limited: Garena And Fintech Priced At Zero At Current Valuations