2023-03-17 11:00:00 ET
Summary
- Sea Limited presented its Q4 2022 earnings last week and the results were so impressive that the stock shot up 20%.
- The company reached GAAP profitability in just a few quarters after saying it would focus on efficiency and making money.
- We look at what fueled the big earnings beat and also point out a weak point, Garena.
- For the first quarter, Garena is not the most important division, though. Shopee and SeaMoney are also profitable.
- We look at the valuation of the stock and Sea's amazingly swift move through the stages of profitability.
Last week, Sea (SE) reported its Q4 2022 numbers and the stock shot up. I have followed Sea for more than three years and this was a very impressive quarter. That doesn't mean there are no weaknesses at all. Let me explain.
The Numbers
Revenue came in at $3.45 billion, beating the estimates by $400 million. That's a revenue beat of 13.3%, which is incredibly high for revenue but even more in these difficult economic times. Very impressive.
If you look at revenue growth, the picture looks less rosy: just 7% year-over-year growth. Despite this single-digit growth, I'm still impressed. I'll talk about why later in this article.
But while the revenue beat was very impressive, what really blew my socks off was Sea's profitability. EPS came in at $0.72, while the consensus was -$0.55. That means a beat by a whopping $1.27. Wow!
What This Means
What Sea showed the market what it had said. It's that old Amazon credo: 'We can be profitable whenever we want but choose to continue investing for the future.' Amazon itself showed that to investors after the dotcom bubble burst. This is Amazon's operating income and EPS at the time.
As you can see, the company went positive on its operating income but stayed negative on EPS. It took Amazon until the second half of 2003 to become profitable on an EPS basis. And even that positive EPS was tiny, not comparable to Sea's right now.
The most impressive thing is that Sea not only did this so much more than Amazon, but also so much faster. Instead of two or three years (depending on how you look at it), it took Sea two or three quarters ! That's amazingly impressive for any company but even more for one of this size.
I have followed the market intensely for more than a decade and I have read extensively about the stock market history and companies, but I have never come across anything like this. The only parallel I see is Amazon after the dotcom era, but, as I showed, this is even more impressive.
How did Sea do This?
If we look at the visualization of the income statement, I think a lot will become clear.
Made by From Growth To Value
I have highlighted several things with red boxes and an arrow. Let's go over them.
As you can see, Garena's revenue continues to go down. It was cut by a third. But Shopee and DFS, which stands for Digital Financial Services, or SeaMoney, both did really well. Shopee's revenue was up 31.8% but jumped even 42.3% if you strip out the currency fluctuations.
SeaMoney chalked 92% revenue growth, to $380 million. In Q4 2020, quarterly revenue was just $27 million. Again, very unique.
This is how Shopee's and Garena's revenue evolved year-over-year. The image comes from Sea's earnings slides , but I added the red boxes and arrows.
Sea's Q4 2022 earnings slides
Overall, as we already saw, revenue was up 7.1%. That's not so much, but if you look at gross profit, you see it's up 29.5% year-over-year. That means the margins have improved a lot, especially from Shopee. That's what the arrow in my income statement visualization means: just 7% revenue growth, but it translates into 29.5% gross profit growth. The gross profit margin was 49.3%, compared to 42% last year.
Sea's Profitability
Also very important, Sea was net income-positive. And yes, that was on a GAAP basis. This is a grand achievement for a company losing $660 million in Q2 2022.
In one quarter, from Q3 2022 to Q4 2022, it turned around from a net income margin of -15.7% to 9.9%. That's a 25% improvement in just one quarter. Shopee's margins went up even faster, +35%, with a positive adjusted EBITDA of $196 million. If there were an Oscar for best operating margins turnaround, no one else but Sea would have gotten it!
The reason can be seen in another red box. Sales and marketing spend was down by a whopping 61.2% year-over-year. And still, Sea could grow its revenue in this quarter. You could say that 7% revenue growth is not impressive, but that is a bit misleading. Garena's revenue has been going down since the end of the pandemic.
Impressive is that Shopee's revenue was up 42.3% year-over-year and SeaMoney's revenue was up 92% despite slashing sales and marketing by 61%. That shows leverage. It indicates that Shopee and SeaMoney have something that makes them unique for consumers.
In Brazil, the loss per order went down from -$2 per order to less than -$0.50 and management said bringing this to profitability is a target, although they didn't mention a time frame.
More Details on Debt
One of the worries the market previously had about Sea Limited is that at the rate it burnt through money until the previous quarter, it would not be able to pay back the convertible bonds due in 2026. As the stock price has decreased so much, most of these bonds would have to be repurchased.
The last quarter showed that the company had already made a switch and I called out the turnaround in my analysis of the Q3 2022 earnings .
The company had $3.74 billion in convertible notes. The most significant part, $2.5 billion, was issued when Sea's stock price was much higher. They were offered at $318 per share and have an interest of 0.25%. The conversion price is $477. The company now repurchased $817.2 million of that debt for $611.3 million in cash. If you look at that, you can see that Sea could buy back this debt cheaper than the money value. It actually made $199.7 million in gains there. Sea took advantage of the higher-interest environment here. Well played!
That means Sea now has just $2.1 billion debt outstanding in the 2026 convertible notes and in total it has $3.34 billion in total debt, while it has $6.9 billion in cash and equivalents. That means a net cash position of $3.56 billion. Many companies would sign with both hands for such a strong financial position. And now that Sea is profitable, it can use that money to continue to pay down debt if it wants. Especially if it can buy back the notes so cheaply.
Insights from the Earnings Call
Sea shut down many of its new initiatives, like Shopee's launch in Europe, some Latin American countries and many other 'non-core' initiatives. Forrest Li about this on the conference call:
As we continue this transition and manage sustainable growth going forward, we have adopted the approach of doing less, but doing this better.
He also warned investors that it won't be an easy ride from now on.
Given the macro uncertainty and our recent strong EBIT, we continue to closely monitor the market environment and adjust our and fine-tune our operations accordingly. As a result, there may be near-term fluctuations in our results and performance. However, we remain highly confident in the long-term growth potential of our markets and highly focused on capturing these opportunities.
I know some bears now claim that it's due to one-time gains that Sea is profitable, but they leave out the one-time losses, in particular the impairment. If you leave out the one-time gains (which is definitely defendable) you also have to leave out one-time losses. It's both or none. If you would exclude all in this quarter, the profitability would be about $200 million, still strong enough in my book. But that's also why management warns about the variability of the quarters. The details may change but the fundamentals are there to remain profitable.
Just like any other company, Sea sees that the economic times are tougher now than they have been in a very long time.
The macro environment remains uncertain and there are still headwind on consumption in our market.
Many analysts asked about weighing growth and profitability. Management said that growth opportunities are not gone, on the contrary. This was said nowhere literally, but I got the feeling that management meant something like: "Look, we are focusing on profitability now, but growth will return and we will be able to use our profits to invest in sales and marketing." I suspect , the convertible notes will be bought first if possible and especially if this can be done on the cheap.
Management also pushed back on the idea that it needed to spend to get revenue growth.
If the business is -the growth- is driven only by investment in sales marketing, it's not a good business we want to be in to begin with.
If you know the Asian market, you know this makes sense. Shopee has fierce competition from Alibaba's ( BABA ) Lazada and GoTo, the merged company of Shopees biggest competitor in Indonesia, Tokopedia, and Gojek, a big ride-hailing platform in Indonesia. Indonesia is by far the biggest market in Southeast Asia. But GoTo is in financial need and looking for investment capital, which is a very tough challenge now.
Lazada, the other competitor, is also cutting costs dramatically. That could even mean that Sea will gain market share. I understand management's comments. After all, Southeast Asia is the market developing fastest after Latin America regarding e-commerce and digital payments. SeaMoney starts to look like MercadoLibre's ( MELI ) Mercado Pago of a few years ago. And if you know how well that turned out, you can see the potential.
Management also said it wouldn't share quarterly GMV numbers anymore. While I don't really like that, I understand to a certain point. Lazada and GoTo also don't share these numbers on a quarterly basis and that's what management points out. But of course, we shouldn't be naive; this is also because GMV growth will be low and probably even decline on a quarterly basis every now and then. That's not strange. Sea has jacked up contributions from merchants aggressively, sometimes doubling them. Add the economic headwinds and the e-commerce sector going through a rough patch and you know most you need to know.
I care more about revenue growth, profitability and margin expansions. Above all, I prefer a management team that does what it says it will do and does it much faster than anyone had expected.
The Bad News: Garena
Maybe it's a bit of a bummer after all this good news, but there was also bad news and it can be summarized in one word: Garena. Just look at this slide and you will know what I mean immediately.
Sea's Q4 2022 earnings slide deck
The declines already look bad like they are but if you look, these numbers are quarter-over-quarter. If you look at the year-over-year comparison, Garena's bookings are down 50%, and quarterly active users by 25%. Nevertheless, Garena still accounts for $258 million in EBITDA.
Reopenings and high inflation were a double whammy for Garena. There is no improvement in sight yet. Garena is now almost back to its pre-COVID level and management hopes there is some baseline in that number. They say there is still potential in the users, but I think it won't come from Free Fire, although there have been examples of revitalization in other games, with new elements or a new look.
But also more importantly, the key focus in the near term, still on the core games and in particular, Free Fire that we want to turn into a strong evergreen franchise. Although we continue to see some weakening in user trends in comparison to the significant growth it achieved during the COVID times, we do believe that there is a core defensible user base we can achieve, and it is a long-lasting franchise.
It's true, of course; despite the recent slump, Free Fire is still one of the most-played games and it still gathers a lot of revenue. But if Garena really wants to turn around, it will have to come from new games. It's now generally expected one or maybe two will come out in the current year. Sea is always very cautious with these announcements. They know it can go wrong in the last phase before launch.
Overall, I think Garena has played a vital role for Sea. For years, it has been the profit center that fueled Shopee and SeaMoney. Now both those businesses are profitable too, Garena's slowdown is not as bad as it used to be. E-commerce and digital financial services will take over as the most important businesses within the SEA Group.
Of course, that doesn't mean Garena is not necessary anymore. But right now, Garena's revenue can continue to slide and Sea will still do well. That was not the case just a quarter ago. And who knows, maybe Garena has an ace up its sleeve with another hit game in the current year or one of the upcoming years.
Valuation
Now that Sea is profitable, it doesn't mean it's easy to value. This quarter's net income of $342 million provides some help but not too much. Sea's management has said the quarters will be lumpy. There were also some one-offs in Sea's advantage this quarter.
With these caveats, if you annualize this Q4 profit, you get $1.37 billion in earnings. After the big jump in its stock price, Sea now trades at a market cap of $45 billion. That means a forward PE of 32.8. Now, again, this is just an exercise. It also shows how fast things can change in investing. If you invest for the next decade, valuation will matter less as long as the company executes and it's safe to say that Sea impressively did that.
I also want to point out that SEA moved up fast in the Stages of Profitability. Here's a quick overview if you wouldn't know what I'm talking about. You can read more in this article .
Made by the author
Just two quarters ago, Sea was in Stage 1; in the previous quarter, it moved to Stage 2 and with this quarter, it's already in Stage 3. That's a high-speed development. Usually, this takes years.
Is Sea Limited Stock a Buy?
If you pay attention to it, many interesting questions can be answered by 'it depends' and that's also the answer here. I'm pretty sure Sea's stock price will remain volatile and if the next quarter shows much less profitability, then the stock could be down 20% like it was up 20% now. That's just the nature of this category of stocks. Some investors freak out by these sudden moves. Others, myself included, don't flinch. So, you should know what kind of investor you are.
For calm investors for the long term, I believe Sea's stock is a buy now. The company has now proven that it can not only grow its revenue by triple digits, as it did in two consecutive quarters in 2021, but also that it can pivot to profitability in a very short amount of time. CEO Forrest Li has stated many times he sees Sea Limited as a big ship he wants to steer with the agility of a speedboat. That's a great soundbite but without proof, it's not more than that. In this quarter, Sea astonished everyone with these results. I'm pretty sure that when the macroeconomic headwinds are gone, growth will return and Sea will come out as a much leaner and more efficient company.
I started investing in Sea in 2020 when the stock price was $54 and I will stay invested as long as management executes so incredibly well on what it promises.
Conclusion
Sea's management showed again that it's worth trusting, as it did what it said it would do. And then some. This bodes well for the future of the company. While Garena is evolving in the wrong direction and could be a drag for a while, Shopee and SeaMoney are profitable now, too, and that's why Garena's decline now is less significant than a quarter ago.
Overall, Sea chalked an impressive quarter and it's great to see that the long-term thesis is more intact than ever.
In the meantime, keep growing!
For further details see:
Sea Limited Stock Gets The Oscar For Best Turnaround