Review on Sea Limited Q2 Earnings

Sea Limited's revenue growth in Q2 was below market expectations and the stock traded down a lot yesterday and is down again today. It is now below it's 52 Week low again which seems crazy to me. The last time Sea's stock was this cheap there was still a lingering fear that Sea would run into liquidity issues as it was burning cash and still trying to demonstrate that it could become profitable.

Sea's profitability was strong in Q2 as they delivered net income of $331 Million as compared to a loss of $931 million in the same quarter last year. Their cash on their balance sheet also went up $477 Million from the end of the 1st quarter of 2023 and they now have $7.7 Billion in cash. So liquidity is no longer an issue at all. So why is the stock trading like it's distressed?

I'm not sure exactly why the stock dropped as much as it it did but there are two theories I can come up with.

1. The reason that the stock dropped may be because growth in all of their three segments (gaming, ecommerce, fintech) decelerated in the quarter. This could be because of lowered Sales & Marketing spend but it could also be from increased competition from Lazada (Alibaba), Tokopedia, and TikTok which has been making a push into e-commerce in South East Asia. It's likely a combination of both. The concern is obviously that Sea will be unable to re-accelerate growth. Alternatively;
2. The stock price may have dropped because management is signaling increased spending on growth and that will lead to lower profits in the short term (though hopefully greater market value in the long term). Some investors who had bought the stock in the last year after they had become profitable were perhaps expecting profits to be continually rising and management's decision to increase spending has caused them to sell the stock.

Of the two theories, I have much more sympathy for the first concern then I do for the second. Competition is intense in South East Asia for e-commerce and Shopee needs to continually execute to maintain and increase their market share. While I think Sea is still very used to competition and is well positioned to do just fine, I do think this is a legitimate concern.

On the other hand I don't really understand the second concern. Sea is in a fast growing market which is currently still an undeveloped opportunity. In my opinion the right strategy is for Sea to pursue sustainable growth as fast as they can, while perhaps foregoing profitability now in order to create the highest value for shareholders in the long term. E-commerce does have a flywheel where increased scale leads to better logistics (faster and more reliable deliveries), a broader selection, and cheaper prices, which in turn leads to more sales and more scale. That has been Amazon's strategy and it has also worked well for other e-commerce retailers around the world. There is thus a rational reason to try and get as big as possible as quickly as possible. If they were to try to be more profitable, and slow down their growth, they may cede ground to their competitors and even destroy their business in the long term.

Regardless I think the market reaction is overdone here. Sea is currently trading at less than an 18 P/E of their current run rate. They also have over $3 Billion of Net cash (after retiring their debt) so their EV/EBITDA is around 10.

Outside of their gaming business Garena, Sea’s revenue still grew at 32.3% YoY. Garena’s business has dropped as the popularity of Free Fire has waned a bit. Still Garena seems to have stabilized as their active users actually went up QoQ by about 11% which is a strong bounce. In gaming, revenue growth always lags user growth. So if the user growth continues then the growth going forward should be better assuming they can maintain their growth in the other two segments, Shopee and SeaMoney.

That to me is the big question. They've proven that they can be profitable in e-commerce and fintech but the market doesn't seem to care as the price is back to the lowest point in the last year. What I would really like to see is stable profit margins and strong growth. I don't think they need to be showing large profits at this stage but they do need to demonstrate that they can defend and increase their market share while maintaining their sustainability.

In my opinion Shopee is doing the right things in terms of building out their logistics infrastructure and wrapping on advertising and financial services to the offering to make the users more sticky. That is the exact playbook that has worked for Amazon, Mercado Libre, and Coupang. It seems unlikely that it wouldn’t work here. There may even be green shoots of growth re-accelerating as they mentioned the order growth on Shopee was up 10% QoQ. If they could maintain that pace then these growth concerns will vanish. 

Sea has had a difficult couple of years as it was a pandemic darling which had a subsequent fall from grace in terms of the price of the stock. Management has acknowledged that they made mistakes along the way and now there has been growing pains in order to correct those mistakes. We're not looking to invest in companies where management doesn't make mistakes. That doesn't exist. We are trying to invest in companies where management can learn from their mistakes and move forward.

In addition a lot of the stock price volatility has been the result of changing perceptions in the market of what Sea is. Is it a growth company or is it pivoting to profitability? In my opinion management has been pretty clear all along that they were a growth company, but given the comments from analysts I've seen in the past couple of days, there was clearly some confusion.

Sea (and their shareholders) have had to eat a lot of humble pie in the last year and management has made great strides in terms of efficiency and making Sea's business profitable and self sustaining. Now that this has been achieved, they are going to try and prove that they can still grow even with this new focus on efficiency and sustainability. There is still work to be done but I think they are on the right track and at the current valuation, things don't have to go that well to generate a decent return. I like that asymmetry.