2023-07-12 00:29:37 ET
Summary
- Sea Limited has been left out of the growth rally.
- The gaming business remains pressured, but SE stock managed to turn a profit by drastically cutting promotional activity.
- Management is confident that they could drive profitable e-commerce operations if they wanted to, but investors appear skeptical.
- I reiterate my buy rating due to a sum-of-the-parts valuation though risks remain elevated here.
Sea Limited ( SE ) is one of the few tech stocks left out in the recent growth rally. Not unlike many tech peers, SE has been able to offset decelerating growth rates with a strong push to profitability. But SE may be experiencing a combination of a delayed international discount as well as some investor skepticism regarding their ability to reaccelerate growth. While their gaming business remains an important cash generator, it is arguably the e-commerce operations which drive the long term thesis. Shares remain risky in spite of the undervaluation but I reiterate my buy rating.
SE Stock Price
The last three quarters have seen a dramatic recovery for growth stocks as a whole, but SE has been noticeably left out.
I last covered SE in October of last year where I called the stock a "high risk high reward" opportunity. The stock has underperformed both growth stocks as well as the general S&P 500 index - further improving the value proposition.
SE Stock Key Metrics
In its most recent quarter, SE saw overall revenue growth come to a standstill, with revenues coming in 5% higher at $3.04 billion.
SE nonetheless was able to show a dramatic reversal in profitability, with adjusted EBITDA swinging from negative $509.9 million to positive $507.2 million.
The biggest driver of that profit transition was seen in e-commerce, which has historically been the company's loss-generating growth engine. SE delivered $275.8 million of adjusted EBITDA in its Asian markets, up from a $408 million EBITDA loss. "Other markets" (referring to their higher growth regions) saw the adjusted EBITDA loss decline from 334.9 million to $68.1 million. These came in spite of the company delivering 46% YOY revenue growth.
Digital entertainment, the company's gaming segment, continued to see sequential weakness as bookings declined 15% sequentially. Digital entertainment is an important cash generator but a "bottom" remains to be seen.
The company's fintech segment Digital Financial Services delivered 75% YOY revenue growth with adjusted EBITDA improving from a $124.9 million loss to a $98.9 million profit.
What is driving the company's strong push into profitability? The company showed solid improvement in gross margins and slightly reduced R&D expenses, but the obvious driver was the 60% YOY decline in S&M expenses.
I note that this ironically may be one of the reasons why the stock remains pressured today - investors may be "spooked" that the company's prior growth may have been driven solely by promotional activity.
SE was even able to drive a surprise $87.3 million net profit, though I am doubtful the company will be able to sustain this on an ongoing basis.
SE ended the quarter with $7.2 billion in cash versus $3.4 billion in convertible notes. It is good to see the company finally getting religious about cash preservation.
On the conference call , management noted seeing "some initial signs of recovery" in their key game Free Fire, but did not give more disclosure than that. It is possible that the digital entertainment segment will continue to bleed in the near future. Management did not give explicit growth guidance for its e-commerce business, but stated that "generally overall the trend has been consistent in terms of seasonality trends we are seeing quarter-on-quarter with last year's first quarter." It isn't entirely clear what that means - the second quarter of last year saw marketplace growth decelerate sequentially from 75.3% to 61.9%, perhaps implying around 31% YOY growth in the second quarter? Or is management implying that growth roughly remains stable sequentially, implying around 25% growth? Either case implies some deceleration in growth and for overall profit margins to return negative (barring some upside surprise in digital entertainment). While it is clear that the company has reigned in aggressive promotional activity, management noted that they would still invest in Brazil given the attractive growth opportunity.
Is SE Stock A Buy, Sell, or Hold?
After the reset in both valuations and estimates, SE found itself trading just above 2.3x sales.
Yet unlike in past years where the stock couldn't be valued based on forward earnings, the stock recently traded hands at under 20x earnings.
Consensus estimates appear to be factoring in sustained profitability (at least on a non-GAAP basis) and while I may have some doubt, management did state confidence in being able to turn their e-commerce operations to "breakeven any time" even in their high-growth regions.
Given the various business segments at play here, it still makes sense to value this on a sum-of-the-parts basis. I am sticking with my 5x adjusted EBITDA multiple for digital entertainment, which yields around $5 billion in value. Based on around $1.6 billion in fintech revenues (probably conservative given the company just did $412.8 million in revenues this past quarter) and a 12x multiple, that segment is worth around $19 billion. For the e-commerce segment, I am reducing the long term growth rate to around 15%. Based on 10% long term net margins and a 1x price to earnings growth ratio ('PEG ratio'), we arrive at around $11 billion in value. Adding these together, we arrive at around $35 billion in total value, just slightly ahead of the $33 billion market cap. I believe that my estimates for e-commerce have incorporated some conservatism, but it is unclear to what extent the market will want to apply an international discount.
What are the key risks? As hinted earlier, it is possible that the surge in profitability is short-lived and even representative of a flaw in the growth story. The fact that SE was able to drive strong margins just by cutting promotional activity is a positive for the balance sheet, but does not yield much confidence in hoping for sustained growth moving forward. The digital entertainment business does not appear to be stabilizing and cash flows from this segment may continue to dwindle. That may cause a return to an overall cash burn especially if the company's monetization efforts in e-commerce prove too aggressive. If this were to occur, then I would expect the stock to re-rate downwards, as it would only be a matter of time before the company's net cash position turned negative. Any bullish thesis requires the company having fundamental advantages beyond the aggressive promotional activity of the past - only time will tell if such advantages exist.
I reiterate my buy rating, avoiding an upgrade to "strong buy" due to the risk, as patient investors may profit if SE can strike a balance between growth and profitability in the current environment.
For further details see:
Sea Limited: Questions Emerge On Growth Thesis As Company Generates Profit