Sea Limited

Thesis

Sea Limited’s two businesses in gaming and e-commerce will benefit from strong tailwinds and economies of scale.

What does the business do?

Started in 2009 as solely a digital gaming business named Garena, the company changed its name to Sea Limited in 2017, 6 months before it IPO’d. The primary reason for the name change was that it wasn’t the same company. In 2015, management launched Shopee, its e-commerce platform. And a year before that, the company started “AirPay”, a mobile wallet that is now named “SeaMoney.” Currently, gaming makes up about 58% of sales and e-commerce/payments account for the rest.

Moat

The interesting thing about Sea is that its three business have multiplicative properties. For instance, users can start playing Sea’s games at cybercafes (this is surprisingly common in southeast Asian countries. People will go to a specific place to play games). Here, they can pay using their SeaMoney digital wallet. Similarly, the Shopee app is modeled after the same social gamification as the Garena gaming app.

The genius of Shopee is that it was bootstrapped by the success of Sea’s gaming business. Now, Shopee’s moat is mainly economies of scale. For instance, in Indonesia, Shopee’s biggest market by orders, it attracts the most buyers and sellers. This creates an incentive system for better prices, more selection and more leverage for logistics costs. A classic example of economies of scale driven by network effects.

Growth Opportunity

Recent research predicts that southeast Asia’s e-commerce market will triple to $240 billion in the next three years. Apparently this market has the fastest rates of growth in internet penetration. In Sea’s seven key markets, Indonesia, Taiwan, Vietnam, Thailand, the Philippines, Malaysia and Singapore, there are 600 million people. In addition, now the company makes 13% of its sales from Latin America, which adds another 628 million people. To be clear, Shopee only has an e-commerce presence in Brazil at the moment. However, its first self-develop game, Free Fire, is incredibly popular in Latin America.

In its last quarter, Shopee did $20 billion in GMV. Riding the tailwinds of its market’s demographics and the general trend towards e-commerce, it’s fairly easy to envision Shopee getting to well over $100 billion in GMV in the next five years.

Further, the digital gaming business only does about $1.3 billion in revenue. In comparison, Tencent alone does $17 billion in gaming revenue. Further, the big three publishers in the US, Activision, EA, and Take-Two combine for nearly $15 billion. In other words, there is room to run for Sea. Growth opportunities are certainly not the question mark for this investment. And that’s not even including SeaMoney which recently surpassed $4 billion in total payment volume run-rate.

Business’ Economics

Just like most companies desperately trying to get to scale, the economics aren’t exactly pretty. The helpful thing is that Garena has been able to subsidize Shopee’s losses. This simplest place to start is with the gross margins.

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As you can see, Shopee has made some great progress. In two years, it is now at breakeven, where the company is not really losing money on every order. This is obviously incredibly important as that is not a sustainable business. It’s encouraging that there has been progress nearly every quarter (excluding the most recent because of COVID-related concessions).

The gaming business has also seen gross margin improvement because of Free Fire’s success. As mentioned previously, it was the company’s first self-developed game so there aren’t any revenue share agreements that are typical for the publishers to enter into.

The top-line has been impressive to say the least. For the last 7 quarters, revenue growth has been over 100%. The combination of Free Fire’s success, the company’s distribution rights for Call of Duty mobile, and Shopee have contributed strongly to the sharp uptick in revenue.

Moving further down the income statement, the company has lost over $2 billion over the past 4 years. Nearly all of that is attributable to Shopee. It’s no secret that Sea’s management team is clear about market share over monetization at this stage and I think it’s the right move. With such a large opportunity in front of it, investing makes a lot of sense. Obviously, selling dollars bills at 90 cents isn’t a sustainable business model, but Shopee’s gross margin trends are reassuring.

Competitive Dynamics

We’ll first touch on gaming and then talk more about Shopee. In China, competition is fierce. Tencent is the 800-pound gorilla. But in southeast Asia, there is more room. Interestingly, because of Shopee’s competition with Alibaba-owned Lazada, Tencent has supported Sea. Tencent and Alibaba aren’t exactly friendly so Tencent is leveraging Sea to make sure Alibaba doesn’t grow even stronger. Sea actually has the right of first refusal for publishing Tencent’s games in southeast Asia. This is a mutually beneficial agreement as Tencent gets local knowledge for distribution and Sea gets access to Tencent’s top-notch development studios. As example of this is Sea’s distribution agreement for Activision’s Call of Duty. Since Tencent has very strong ties with the US publisher, they passed on the benefit to Sea. As long as Tencent continues to support Sea, the gaming portion of its business will be fine. It’s also a good sign that Sea is not satisfied with just relying on Tencent though. I’m looking forward to more self-developed games out of Sea.

Moving on to e-commerce, the big competitor is Lazada, which was bought by Alibaba for $2 billion in 2016. The timing of that probably wasn’t a coincidence. Remember that Shopee was launched in 2015. It had an aggressive scaling strategy. It offered free shipping and no commission fees for sellers. These generous tactics allowed Shopee to quickly get to a sizable scale. Here are the most recent worldwide download numbers for shopping apps. You can see that Shopee is in the number 4 position and Lazada rounds out the top 10.

This is good data point but we went a lot deeper. We found the website data for each of Sea’s top 7 markets. Ranked by size, here are the 7:

1) Indonesia

2) Taiwan

3) Vietnam

4) Thailand

5) Malaysia

6) Philippines

7) Singapore

Before getting into the data, it excludes Taiwan and Singapore. This is because Shopee is much bigger than competitors in Taiwan so it’s urgent to look at competition. Further, Singapore is Shopee’s smallest market and not really a focus.

As mentioned earlier, Shopee pulled out some pretty aggressive tactics to gain market share and it worked. It also created 7 distinct apps for each market. This customized strategy took more work, but the results have been superior to Lazada’s strategy of just one app. Morever, Shopee has been laser-focused on a great mobile experience from day 1. It didn’t even have a desktop version until a little while after it launched. The combination of these aspects have contributed to Shopee’s strong market share gains.

Ok, now for the data in those 5 markets.

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You can see that Shopee has taken market share in every market, some more than others. The only two markets where it is not the leader are the Philippines and Thailand. However, I don’t think it’s far-fetched to see Shopee catapult ahead in those two markets in the upcoming couple of years. The impressive thing is the loss of Lazada’s market in every single one of these markets. This is such a good sign! Clearly, Shopee’s strategy is a sound one. Assessing competition here is very important because the winners tend to keep on winning. Lazada didn’t quite get to exit velocity and our bet is that Shopee will get there.

Key Risks

The investment thesis for Sea faces two main risks:

1. Too many plates

I prefer companies that are very focused. It allows them to carve out a superior product or service that encourage customer loyalty. However, Sea has a lot going on. From video gaming publishing and development to operating 7 different e-commerce sites to a digital wallet, there are a lot of business units. The core problem I see is that southeast Asia is geographically distributed. I’m not sure if Sea will ever have great economies of scale in logistics, which will likely be a key differentiator for Amazon in the future. Since each marketplace is operated separately, I doubt there will be many meaningful synergies. While maybe this won’t be material to the thesis, it will likely limit the moat that Sea ultimately has in e-commerce.

2. Deep-pocketed competition

While this hasn’t come to fruition yet, it’s a legitimate concern. On Alibaba’s last earnings call it mentioned that Lazada grew more than 100%. If Lazada can claw its way back, we need to aware of it. However, structurally it probably doesn’t make sense at this point. Over the next 5 years, Alibaba will have a $2.5 trillion e-commerce opportunity in China. In this context, $300 billion for southeast Asia doesn’t look as attractive.

Further than this though, venture-backed competitors like Tokopedia in Indonesia and Gioi Di Dong in Vietnam aren’t going to back down without a fight. It’s reassuring to see Shopee’s gross margins reach a breakeven point but there’s always a price war risk. Especially with a large market opportunity, if a competitor can create an experience that is comparable and be willing to lose money for longer, Shopee could face pressure. This is why focusing on Shopee’s gross margins will be important for the investment thesis. It feels like an inflection point where Shopee is beginning to pull ahead. And the website data testifies to that.

One advantage that Sea has had is its gaming business. Rather than diluting itself through more venture-capital, it has been able to subsidize Shopee’s losses through Garena’s cash flow. We can see evidence of that in the high insider ownership as well.

Management

The company is still run by its three co-founders. Forrest Li is the CEO, Gang Ye is COO and David Chen is CTO of Shopee. It’s great to see that, 11 years later, each of the co-founders are still going strong.

Mr. Li is the biggest shareholder, owning more than 30% of the shares outstanding. The other two co-founders combine to own about 10%. So together, the co-founders own roughly 40% of the business. Tencent owns another 25%. We don’t have to worry about skin-in-the-game. These founders have plenty.

The company is purpose driven as well. It outlines its “five core values” as follows:

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We serve. Our customers are the sole arbiter of the value of our products and services. We strive to meet unmet needs and serve the underserved.

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We adapt. Rapid change is the only constant in the digital age of ours. We embrace change, celebrate it and always strive to be a thought leader that influences it.

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We run. We are in a constant race to success while grappling with rapidly shifting forces. We move faster, better and with more urgency every day.

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We commit. Our work is our commitment. We commit to our values, institution, customers and partners. We commit to each other. Above all, we commit to doing the best we can and being the best we are.

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We stay humble. We have traveled a long way from our humble beginning and yet, we never lose our humility in our continual quest for greater heights.

I think management has done a great job. Barging into a crowded e-commerce space and rapidly gaining share against Alibaba and homegrown marketplaces is not easy. And this is on top of running a successful gaming publishing business. High insider ownership, a history of successful execution and founder-led management is all I can ask for.

Valuation

Shopee is currently doing $20 billion in GMV, or roughly 10% market share in southeast Asia. Right now, the take-rate (e-commerce revenue/GMV) is about 4.5%. This is pretty low considering that for third-party sellers, Amazon is around 25%. So let’s run through a scenario. We mentioned earlier that it is foreseeable that Shopee could reach $100 billion in GMV in the next 5 years. If the take-rate reached 10%, less than half of Amazon’s mature levels, Shopee revenue would be $10 billion. At 2x sales, Shopee alone would be worth $20 billion.

At $80 per share, the current enterprise value is about $32 billion. The gaming business is at a $1.5 billion revenue run rate, growing 100%, with 40% EBITDA margins. It’s hard to put a specific multiple on this but Activision is a reasonably conservative comp. Right now, it trades for 8x forward sales, with a similar margin structure. But mind you, Activision is growing nowhere near the rate of Garena. At 8x forward sales, Garena alone, would be worth $20 billion. With those assumptions, the market is ascribing a $12 billion value to Shopee. This would be a valuation of 0.6x GMV which is actually pretty reasonable when you look across other marketplaces. Shopify is about 1.5x GMV.

The point with all of these comparisons is just to reveal that even though Sea’s stock price has run up, it’s not irrational to think it could keep going. While I think it’s futile to ferret out an exact forward return from here, I think there is still a solid opportunity.

Conclusion

Sea Limited is a three-sided business with a huge market opportunity and tons of optionality. The strategy is subsidizing its growing e-commerce operations with its cash-cow gaming business has been executed brilliantly. The data shows that Shopee is taking share from its competitors as strong founder-led management continues to take charge.

No, Sea is not Amazon. But it sure does have potential.

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