2023-03-14 10:04:01 ET
Summary
- Sea Limited posted a very strong fourth quarter 2022 results, reaching its first ever positive EBITDA and positive net income quarter.
- In the fourth quarter of 2022, Shopee generated $258 million in adjusted EBITDA, compared to the prior year's adjusted EBITDA loss of $878 million.
- Despite more than 50% decline in sales and marketing spend, Shopee grew GMV by 7%, indicating a sticky user base and strong ecosystem.
- Digital entertainment business stabilizing while margins are still higher than the industry average.
- My worst-case SOTP price target for Sea Limited is $79, which implies 8% upside even in the worst-case scenario. This indicates to me that the risk reward perspective for Sea Limited remains attractive at current levels.
Sea Limited ( SE ) just posted its fourth quarter results last week. The stock was up +22% in the day of the release as the company posted a big surprise to investors in the form of its first-ever quarter with positive adjusted EBITDA and net income.
I shared with members of Outperforming the markets that I think Sea Limited is still undervalued even with the surge in the stock price post its earnings result.
In this article, I aim to show you why I think Sea Limited is still undervalued based on my worst-case scenario SOTP valuation for the company.
Overview of the fourth quarter
Sea Limited posted a very strong fourth quarter 2022 results , reaching its first every positive EBITDA and positive net income quarter. Adjusted EBITDA came in at $496 million, compared to the adjusted EBITDA loss of $492 million in the prior year. In the fourth quarter of 2022, Sea Limited generated $423 million in net income, compared to its net loss of $616 million from a year ago.
Even the fourth quarter total revenue of $3.5 billion was 13% above the market consensus of $3.05 billion. Revenue from the digital entertainment segment was $949 million, higher than the sell side expectations by almost 45%. For the e-commerce segment, revenues were in-line while adjusted EBITDA beat expectations as the market expected an adjusted EBITDA loss for the e-commerce segment this quarter. The improving monetization of the e-commerce business was also a positive surprise that offset the slightly softer GMV and order numbers for the quarter.
As a result of its focus on profitability, Shopee had to exit non-core markets to focus on its core markets, while scaling back sales and marketing spend and higher basket sizes helped bring Shopee to positive adjusted EBITDA territory.
On the other hand, management's focus for the digital entertainment segment is really to stabilize its core existing business while improving margins.
Even the digital financial services segment turned positive adjusted EBITDA in the quarter as a result of removal of user acquisition subsidies for its mobile wallet. Although it will be ramping up the digital bank portion of the segment, management sounded confident in being able to sustain its positive adjusted EBITDA trend for the digital financial services segment.
Shopee turned profitable
Management did what no one in the investment world thought was possible.
In the fourth quarter of 2022, Shopee generated $258 million in adjusted EBITDA, compared to the prior year's adjusted EBITDA loss of $878 million. In absolute terms, this was an improved in adjusted EBITDA by $1.1 billion.
This came from all aspects of Shopee's business, as management stated.
There were improvements made like more selective sales and marketing spend, increasing monetization and cost structure optimization that resulted in the first ever positive adjusted EBITDA for the quarter.
Sales and marketing costs for Shopee fell more than 50% year on year despite GMV still increasing 7% year on year. The ability to cut sales and marketing costs by more than half and still grow the GMV is very impressive, in my view. This indicated to me that the Shopee platform is actually rather sticky and resilient as customers continue to use the platform despite less incentives. Management also saved more money from reducing research and development expenses as well as general and administrative expenses to reduce costs.
At the same time, Shopee increased take rate in the quarter, and improved monetization across different business lines, including core marketplace revenue and other types of revenues as Shopee finds that sellers are investing more on the Shopee platform to grow with the company.
Management also shared that the Asia markets are all positive adjusted EBITDA and even the Brazil market saw significant improvement in profitability in the quarter. Specifically, management stated that they saw improvement in unit economics for Shopee in Brazil as its contribution margin loss per order fell by 54% from the prior quarter to $0.47. This comes from Shopee's improvements in logistics costs in Brazil and will continue to drive further improvement in profitability going forward. Management continues to see a huge opportunity for this new market and will focus driving the business to profitability.
Sea Limited e-commerce (Sea Limited IR)
Shopee is focused on its long-term opportunity and thus, its recent focus on sustainable growth and profitability paves the way for long-term e-commerce operations in these markets. Management continues to see that e-commerce penetration in its core markets are low and will benefit from positive trends in demographics as the population becomes more digital and wealthier. As a result, I think that Shopee is well positioned today as a result of its focus on sustainable growth and the strong platform and ecosystem it has today to capture the market share of tomorrow.
Above all, I think that the fast turnaround of Shopee into the positive adjusted EBITDA territory speaks volumes about the quality of the management team managing Sea Limited. Their strong execution capabilities led to this rapid turnaround, and in just a few months, Shopee was turned into a company that contributes to the bottom line of Sea Limited. This also will go a long way as the management's team focus on sustainability of the business will be crucial in the current uncertain macroenvironment. All in all, I think that Sea Limited is under a high-quality management team, and I find myself more confident in the company's ability to go through different market cycles and challenges.
Stabilizing Digital Entertainment business
The digital entertainment bookings fell by 50% year on year to $544 million , while digital entertainment revenue fell by 33% year on year to $949 million.
The reason for the decline in bookings was a result of:
- Fall of 26% year-on-year in quarterly active users.
- Quarterly paying ratio fell by 2.8 percentage points.
- Moderation in performance of Free Fire in Southeast Asia as a result of normalization in trends in a post covid-19 world.
Digital Entertainment operational metrics (Sea Limited presentation)
As can be seem below, we have seen a flat quarterly paying ratio over the past three quarters, which tells me that we are starting to see stabilization in the digital entertainment business after the quarterly paying ratio fell from its high of 12.8% in the third quarter of 2021.
Garena QPU and QAU metrics (Sea Limited company reports, author generated)
In terms of how much each paying user was contributing to revenue, the quarterly ARPPU fell from $14 one year ago to $12.5 in the current quarter. I am of the view that as the quarterly paying ratio has stabilized and the decline in active users has moderated, we will see the quarterly ARPPU numbers stabilize in the near-term.
Sea Limited' Garena ARPPU metrics (Sea Limited company reports, author generated)
Adjusted EBITDA of the digital entertainment segment fell by 57% to $258 million in the quarter. This is 47.5% of bookings for the fourth quarter of 2022. The current 47% margin level continues to be superior to the industry average, which indicates to me that Garena is able to achieve a better margin profile through gains in efficiencies as a result of cutting of sales and marketing expenses. For the fourth quarter, we saw sales and marketing being reduced to $43 million.
While management has been focused on cost cutting, they reiterated that they remain focused on ensuring the long-term sustainability of its core games by improving user engagement and rolling out targeted initiatives for their existing users as well as returning users.
In the quarter, management has done an extensive review of its publishing and development pipeline. The focus here is to do more with less and, thus, be a more efficient business. This was the reason for divestment in and closure of some projects in the digital entertainment segment and management continue to only select the best opportunities with the highest return potential for better use of its resources.
For 2023, management looks to put their focus on its core games and look for new long-term opportunities for the business as they arise. Management wants to focus on turning Free Fire into an evergreen franchise. Despite the weak user trends we have seen in the near-term, management believes the current user base is defensive to support a long-lasting franchise. As a result, they will be looking to improver user experience, deliver more accessible game packages, efficient downloading and more interesting content to users.
The game pipeline remains healthy and there are some games being tested that might be released in 2023.
While revenue increased by 7% year on year, the company was able to keep a tight rein on costs and expenses. Cost of revenue declined 8% year on year while sales and marketing expenses were reduced by 61% in the quarter, which is very impressive in my view. Research and development expenses were also down 15% year on year.
Cutting of costs and expenses (Sea Limited IR)
Digital financial services still growing fast
The digital financial services segment grew 92% year on year to $380 million and turned positive adjusted EBITDA in the fourth quarter of 2022.
Management continues to see that the digital financial services segment is at a very early stage of development and will continue to expand more services to customers and offer more diversified services. Management's goals will be on quality growth and long-term sustainable growth. Management will not be investing significantly in the near-term to bring fast growth, but the focus will be on building the business steadily with a strong underwriting capability and loyal user base, with further diversification of services offered to customers.
Valuation
I came up with a worst-case sum-of-the-parts valuation for Sea Limited.
I used 7x P/E multiple for the digital entertainment business segment, which is at more than a 50% discount to the average of the global publishing and developer peers.
I used a 3x price to sales multiple for Sea Limited's e-commerce business, which is at a 25% discount to the current average of 4x price to sales multiple for global e-commerce players. This 3x price to sales multiple is conservative enough for the worst-case SOTP scenario because Shopee is growing faster than most other global e-commerce players as a result of low penetration and strong industry tailwinds.
Lastly, I applied a 4x price to sales multiple to the digital financial services segment 2024 revenue despite its huge growth for the worst-case scenario.
My worst-case SOTP price target for Sea Limited is $79, which implies 8% upside even in the worst-case scenario. This indicates to me that the risk reward perspective for Sea Limited remains attractive at current levels.
Sea Limited worst-case SOTP valuation (Author generated)
Risks
Macroeconomic environment
In my view, the biggest risk to Sea Limited is the weakening of the macroeconomic environment. While everything seems to be going well for Sea Limited, its business is likely vulnerable to any holding back of consumer spending and any worsening of consumer sentiment as all its businesses are consumer facing.
Gaming business momentum
As a result of heavy concentration of Free Fire in the gaming portfolio, we are in a vulnerable position given the contribution of Free Fire to Garena. As a result, there are risks that management's efforts to improve user engagement and make it an evergreen franchise may not work out. Furthermore, there are risks that the games in its pipeline may not be as successful as Free Fire.
Conclusion
Sea Limited is firing on all cylinders in the recent fourth quarter results. With the first ever quarter of positive adjusted EBITDA and net income as a major positive surprise, this shows investors that Sea Limited can be profitable if it wants to, and it also indicates how determined management is to turn Sea Limited profitable in a matter of months.
The growth in GMV despite a sharp reduction in sales and marketing spend was another positive surprise for me given that it shows how sticky the customers are to the Shopee platform and the strength of its ecosystem.
Furthermore, the digital entertainment business continues to stabilize and show strong margins despite a tough operating environment. Lastly, the digital financial services segment is still in an early growth stage, but I like the management is taking a slow and steady approach to the business and prioritizing profitable and sustainable growth over rapid growth.
My worst-case SOTP price target for Sea Limited is $79, which implies 8% upside even in the worst-case scenario. This indicates to me that the risk reward perspective for Sea Limited remains attractive at current levels.
Implications to The Barbell Portfolio
I think that this exercise of deriving the worst-case price target for Sea Limited based on its SOTP valuation has helped me see that the company is still undervalued even with the surge in the stock price post its earnings result.
I have an increased conviction in Sea Limited, and I think that the ability of management to fulfill its promises to investors indicate to me that the management team is one of top quality and with strong execution abilities. see the strong execution by management and the quality of the management team.
For The Barbell Portfolio, I am comfortable with the current 23% position in Sea Limited as I am still building and adding to the portfolio, which means that this percentage will go down over time and I could look to add to the position then if the opportunity arises. As a result, I will be maintaining my position in Sea Limited and continue to hold the stock in The Barbell Portfolio.
For further details see:
Sea Limited: Trading Below Its Worst-Case SOTP Price Target