Sea Ltd. - Poor Operating Fundamentals And Extremely High Valuation Support A Short Position

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About: Sea Limited (SE)
by: Acutus Investment Research
Summary

Our analysis suggests that Sea Ltd.'s consistent poor unit economics is expected to continue in the near future.

Our analysis suggests that the company's profitability is expected to continue to bleed in the near future.

There are no compelling reasons for Sea Ltd. to trade at a premium significantly higher than the sector's average.

We recommend short on the company with a target price of US $16.02.

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Although Sea Ltd. (SE) stock price increased by 233.13% YTD, we believe that the company is overvalued due to its consistent weak operating fundamentals, lack of visible profitability, and undeserving high price-to-sales multiple. We believe that the upside potential for the company is minimal.

Our SOTP valuation model suggests that the company should be trading at the only US $9.83. Even if we account for Sea Ltd.'s exposure to an underpenetrated Southeast Asia and use a higher than average price-to-sales ratio, the potential downside of this company remains high. We recommend a short position on Sea Ltd. with a price target of US $16.02.

Chart Data by YCharts

Investment Thesis

Given the consistent weak operating fundamentals and lack of profitability of this company, it is to our belief that the risk of owning the company is significantly higher than other growth companies. Currently, we do not have information on how the company intends to turn into profitability. We will explore the company's operating fundamentals in the following segment.

Sea Ltd. is currently trading revenues. The increase in its share price early this year is a reflection of its better than expected 1Q19 revenue performance. However, the current price-to-sales ratio of the company is more than 15x (US $37.7) whereas other global mobile gaming and global e-commerce peers are only trading at a 2.54x and 2.21, respectively. We found no compelling reasons to justify Sea Ltd.'s current valuation multiple. We will explore more on the valuation of the company in detail at the end of the article.

Company Profile

Sea Ltd. is an internet and mobile company that engages in the provision of online gaming and e-commerce services. It operates through the following segments: (1) digital entertainment and (2) e-commerce and other services. The digital entertainment segment offers access to game-related content on the Garena mobile app and desktop application. While the e-commerce segments manage a third-party marketplace through the Shopee mobile and web app.

Digital Entertainment Segment (Garena)

Call of Duty Mobile has opened for pre-registration in Asia and already achieved 1,000,000 registration. The game contains both MOBA and Battle Royal elements and is expected to gain a massive mobile player base in ASEAN, significantly contributing to its active users. We are expecting Call of Duty Mobile to launch in 3Q19 officially. The outlook for the segment remains favorable as performance as growth will continue to be supported by Call of Duty Mobile and Free Fire.

Sea Limited Active User Base

Source: Created by the author using company filings

Based on company filings, quarterly user growth has been stagnating at the 20+% mark since 4Q18. The last time we saw a significant increase was in 1Q18. With the Call of Duty Mobile launch in 3Q19, we are expecting quarterly user growth to increase significantly in 3Q19 and normalize to the 20+% mark beyond FY19.

Sea Limited - Quarterly Paying Users

Source: Created by the author using company filings

Accounting for the Call of Duty Mobile launch, we expect revenues for the digital entertainment segment to hit US $1.06B driven by an increasing quarterly paying user base and quarterly active user base for FY2019.

Sea Limited - Contribution Margin (Revenue, Cost of Goods, Sales and Marketing)

Source: Created by the author using company filings

Despite significant growth, Sea Ltd.'s digital segment has been improving its efficiency and acquisition since 4Q18. Contribution margin improvement is not only driven by reduced cost margins but also by increasing revenue growth.Sea Limited Digital Entertainment Expense MArgin

Source: Created by the author using company filings

Acquisition Cost - Sea Limited

Source: Created by the author using company filings

The efficiency of acquisition costs for quarterly active users has been improving significantly and is expected to remain below the 0.10 mark for the remaining quarters. It is safe to say that the company is not using cash burn to grow revenues and expand the user base. This cash-burning is not surprising given that the Digital Entertainment segment quality of games and strategic position has been increasing in quality. Moreover, Garena has been pivotal to Tencent and has already published some of Tencent's more successful games such as Arena of Valor and League of Legends.

E-Commerce and Other Related Services (Shopee and Other Services)

The e-commerce and other related services segment are starting to show signs of deteriorating growth. Based on company filings, GMV quarter-on-quarter growth for 1Q19 was only 3% as compared to 23% in 1Q18. Previously, GMV growth in 2018 was in the 20% range. We expect the deteriorated growth to continue into 2019. We are expecting the other e-commerce giants in Southeast Asia, such as Lazada, Tokopedia, and Bukalapak to ramp up their market expansion campaigns.

Gross Merchandise Value

Source: Created by the author using company filings

Revenue growth in this segment has been waning. The depressed growth is not surprising, given that Shopee's aggressive expansion plan is expected to be slowed significantly by the other e-commerce giants in Southeast Asia. All of these companies still have a significant cash position to burn to retain and expand their market share in the region. Quarter-on-quarter revenue growth for Shopee was only 17.44% in 1Q19 as compared to 142.8% in 1Q18. We expect this slowdown in revenue to persist in FY2019.

Sea Limtied Revenue Growth

Source: Created by the author using company filings

Margins for the e-commerce & other services segment has been improving quarter-on-quarter; however, the improvement must be expedited and is currently not fast enough. The segment's margins currently do not make sense and contribution margins are atrocious. We understand the Sea is attempting to capture market share by hiking up sales and marketing efforts. However, the cash burn of the company has been happening for far too long without any improvements in operating fundamentals.

Contributing Margins Sea Limited

Source: Created by the author using company filings

Although both the costs of goods and S&M margins have been improving, the contribution margin of the segment is still negative. We expect the contribution margin of this segment to continue to be miserable for the year FY2019. Management needs to address how they can sustain growth and capture market share and at the same time, optimizing and improving their costs of acquisition. However, given the e-commerce landscape in Southeast Asia, we remain pessimistic that Sea Ltd. can emerge as one of the champions without burning cash, resulting in poor expense margins.

Sea Limited cost Margins

Source: Created by the author using company filings

Company Valuation

Given the entire investment landscape surrounding e-commerce and mobile gaming, we have a firm conviction that Sea Ltd. is significantly overvalued. We also do not find any compelling reasons why Sea Ltd. deserves to trade at such a high premium as compared to its peers.

Mobile Gaming Price / Sales Valuation

Source: Created by the author using data from company filings and Investing.com

Mobile Gaming Peers are only trading at an average of 3.07x, whereas the upper quartile of the entire comparable set is not more than 3.5x. Nexon Co Ltd., one of the more established mobile gaming company in Japan, is trading only at 6.07x. Given that Sea Ltd.'s Garena is not as established as these companies, we fail to see why Sea Ltd.'s gaming arm deserves to trade higher than these companies.

E Commerce Price to Sales Valuation - August 5

Source: Created by the author using data from company filings and Investing.com

E-commerce peers are currently trading at an average of 2.77x, whereas the upper quartile is trading not more than 3.93x. Currently, Alibaba is trading at a 7.481x. We don't see any reason why Shopee should be valued higher than Alibaba. The e-commerce space in Asia is currently saturated with intense competition. Moreover, the other e-commerce giants such as Lazada all have the ammunition to capture market share aggressively.

Sea Limited Valuation

Based on our SOTP valuation, we firmly believe that buying into Sea Ltd. currently carries no potential upside. Fundamentally, we believe that the company should be valued at around US $9.83 per share using the median price to sales from global mobile gaming and e-commerce. Even if we use the upper quartile price-to-sales ratios to value Sea Ltd., the computed share price is only US $16.02, representing a more than 50% downside.

Therefore, we have a firm conviction that the company is significantly overvalued and upside potential for this company is non-existent fundamentally.

Conclusion

We are optimistic for the digital entertainment segment due to the healthy pipeline and performance of Free Fire and upcoming Call of Duty Mobile. Margins for the Digital Entertainment Segment is also healthy now. However, we remain cautious due to the e-commerce segment, poor expense margins. Overall, we do not see the company achieving profitability anytime soon this year. It is important to note that the company has accumulated -1.7B retained deficit and consistently delivering negative net profit since its IPO.

Source: Created by the author using data from company filings

Our SOTP valuation suggests that upside potential for the company should theoretically be non-existent. Even if we account for a reasonable higher than average price-to-sales multiple, the fair value of the company still falls short of its current market capitalization.

Sea Limited Key Select Data

Source: Created by the author using data from company filings

Additionally, given the current global market conditions call for a risk-off environment, we expect current investors to start offloading pricey growth companies with depressed revenue growth. An upcoming catalyst for investors to note would be its 2Q19 earnings release on 20th August 2019. Therefore, we reiterate our recommendation to take up a short position on Sea Ltd. with a price target of US $16.02.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SE over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.