Most Singaporeans should be familiar with the e-commerce platform, Shopee.
Catchy jingles and advertisements constantly put this marketplace at the forefront of people’s minds.
With the endless spotlight contributing to strong brand awareness, surely the company behind this e-commerce outfit is not faring too shabbily?
Unfortunately, market sentiment surrounding Shopee’s parent company, Sea Limited (NYSE: SE), remains weak.
At present, its share price hovers around US$85, plummeting 76.4% from its height of US$360.23.
A deeper look reveals that the decline started after Sea released its third quarter 2021 results in the second half of November 2021.
We discuss possible reasons for Sea’s continued struggles despite Shopee’s success.
Shopee is barely half the business
Looks can be deceiving.
Frequent bombardment of cashbacks and discounts may have cemented the impression that the whole corporate entity revolves around the online retail platform.
Yet at its core, Sea should be more accurately perceived as a gaming company under the Garena brand.
Sea’s digital entertainment segment, which encapsulates its gaming development and publishing business, has historically been the bulk of this enterprise.
Only as recently as 2020 had e-commerce overtaken the digital entertainment segment as the largest revenue contributor, with the most recent in 2022 being 58.5% of consolidated revenue.
Shopee is a cash furnace
We now turn our sights to the reasons for the company’s beaten-down market performance.
To begin, we observe that the digital entertainment segment is the only one that is positive on an adjusted earnings before interest, tax, depreciation and amortisation (EBITDA) basis.
Management hinted that adjusted EBITDA provides a proxy for the cash flow of the company – a significant metric to watch for given the majority of its business is burning through cash.
COVID-19 provided powerful tailwinds for the gaming industry, supercharging its growth.
With post-pandemic normalcy returning, companies in the gaming and esports sector have been badly hit.
Founder Forrest Li alluded to the fact that profits from Garena are channelled to fund Shopee and its financial services arm, SeaMoney.
Perhaps one of the more notable aspects in the third quarter 2021 earnings results was how Sea’s total adjusted EBITDA had flipped from the previous year’s profit of US$120.4 million for the first nine months of the year, to a loss of US$165.5 million.
This was mainly due to more than doubling of (i) cost of revenue for the e-commerce segment, (ii) sales and marketing expenses, and (iii) research and development expenses.
By itself, this may not have sounded alarm bells.
But in the same quarter, the cash-generative gaming business started to show signs of plateauing.
Its quarterly active and paying users grew at a lacklustre rate compared to the second quarter of 2021.
This scenario painted a different picture from the strong year-on-year growth the company had been showing.
Excluding the approximately US$6 billion from its shares and convertible offering, Sea’s cash stack as of November 2021 was being eroded by losses.
Meanwhile, investors are beginning to shift their priority away from growth towards profitability.
Hence, it appears that the market punished Sea for continuing its aggressive push for growth even as market participants brace for turbulence.
A grim outlook for the gaming business
The company’s woes continued as other more painful events subsequently reared their ugly heads.
Owing to China’s tech crackdown, Tencent Holdings Ltd. (SEHK: 700) sold US$3 billion of its stake in Sea, resulting in the latter’s shares falling by over 11% in a day.
Yet, this was just the start.
In management’s prepared remarks for the third quarter 2021 earnings call, Sea’s self-developed game and key intellectual property, Free Fire, was mentioned almost thirty times.
Paired with in-depth discussion about how its user base represents a growing opportunity for Sea, it is instantly evident how crucial this game is to the company.
Unfortunately in early 2022, India, the top market for both the free and premium versions of Free Fire, slapped a ban to render the game unavailable to its population.
Despite its relatively minor contribution to Sea’s net sales, the ban wiped US$16 billion off the company’s market capitalisation in one day.
Get Smart: Weak share price seems justified for now
As strong as Shopee looks in the war for market share within Singapore, the underlying picture is more complicated.
Its closest competitor, Lazada, is a subsidiary under the Chinese internet behemoth Alibaba Group Holding Limited (NYSE: BABA).
Alibaba categorises Lazada’s performance under its international commerce retail segment which also comprises other brands such as Trendyol and Daraz.
This makes it difficult to ascertain Lazada’s profitability as a standalone entity.
However, we do know that Lazada too posted strong revenue growth that is paired with narrowing losses.
The sprawling conglomerate has also guided its commitment to support Lazada’s fight in Southeast Asia.
This may be distressing to Sea as Alibaba has a strong net cash position of US$55 billion with a positive free cash flow.
While only a fraction of these funds may be funnelled towards Shopee’s contender, battling against a growing war chest that is nearly eight times the size of Sea’s shrinking coffers is indeed worrying.
This is on top of challenges that the crown jewel segment, Garena, has to face.
Sea’s fall from grace now seems much clearer.
For investors, a compelling development to watch for could be Shopee’s turnaround from a net loss to profit-making position.
There have been initial signs of this happening as Sea’s latest quarterly earnings showed the company reporting its very first quarterly net profit.
This was made possible due to management’s pivot from “growth at all costs” towards efficiency and profitability.
Some initiatives that Sea implemented to achieve this include reducing marketing expenditure and optimising logistics costs.
As a result, the 50.5% year on year increase in e-commerce revenue far outstripped the 3.8% year on year hike in cost of revenue.
Most notably, sales and marketing expenses came down by 61.2% compared with a year ago, causing the e-commerce segment to deliver a positive quarterly EBITDA for the first time.
Looking ahead, management guided that there is more room for cost improvement.
This optimistic outlook and a positive set of results may be the first indication that Sea is not far off from a consistently profitable future.
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Disclosure: Tan Ke Xuan does not own shares in any of the companies mentioned.
