Value Investors Club / SEA LTD

Description

SEA is the combination of two businesses with very different competitive dynamics. With Garena, they are the undisputed gaming platform in ASEAN being one of the first major platforms in 2009. On the other side of the spectrum we have Shopee, their e-commerce platform, which joined late to the party in 2016, facing huge competition. I've left out SeaMoney for now as that is still in very early stage but since 2016, the goal for SEA was to combine Tencent (gaming), Alibaba (e-commerce), and Ant Financial (Fintech).

A. Unloved IPO to stock market darling

At its IPO in October 2017, there was no "IPO pop", and it largely trended downwards for the next 7 months from $16 to $10. At that point in time, SEA was seen as a gaming platform that distributed popular games (League of Legends, Arena of Valor, FIFA online, Blackshot etc) with a cash cow nature but unhappy that the company was continuously reinvesting all it's profits plus more into the already crowded e-commerce market. Many investors (including myself) thought that it would be better if they decided to divest or shutdown their e-commerce business.

So what happened? SEA's first fully self developed game, Free Fire, became one of the most successful games in ASEAN and LATAM, while Shopee gradually became the leading e-commerce player, beating out Alibaba's Lazada and Indonesian juggernaut Tokopedia over the next 2 years.

B. Garena: Social tool to gaming distributor to developer

At the inception of the company, Garena was simply a tool to connect players, allowing them to chat, challenge and play online before 2010. Keep in mind, this was years before most games had a functional online feature.

In an interview with SEA's founder in 2009, he said the favorite feature that Garena provides was network optimisation - "This is not a fancy feature at surface, but indeed something every gamer needs for playing multiplayer games online. The feature can reduce latency and data loss for online gameplay and make possible a gamer from Singapore play against a gamer from Vietnam"
The company's revenue model was mainly advertising and paid features

When League of Legends (LoL) was released, Garena partnered with Tencent (who is the largest shareholder with 24% stake) to become the sole distributor of the game in 2010. They continued to grow, partnering with developers like EA for FIFA Online and Activision for Call of Duty Mobile, and no one would blame Garena for kicking back and choosing to live off licensing rights, getting 50-70% of any game's revenue on their platform.

Back then, company's strengths were its ability to localise international games to each country Garena was present - CNY themes/skins in LoL for Singapore and Vietnam, local football stars in FIFA Online, optimising games for low-end PCs, and establishing a network to facilitate payments in a region with low credit card penetration. Even though they took the majority of a game's revenue, they were responsible for the A&P expenses, leaving them with 12-15% EBIT margin for the game distribution business.

In 2017, SEA decided to release their first self developed game, Free Fire, to reduce reliance on external developers and improve the profitability of Garena. The game is a battle royale (think PUBG or Fortnite) catered to low-spec phones which became the most downloaded mobile game across iOS and Google Play in 2019, 4th most watched game (other 3 are not mobile-only) on Youtube in 2019, and boosted their quarterly active users (QAU) and quarterly paying users (QPU). As of 2019, 60-70% of Garena's sales were from Free Fire which had an EBITDA margin of ~60%.

From 1Q17 to 1Q20, the operating metrics for Garena were:

QAU increased from 56.4m to 402.1m (+613%)
QPU increased from 6.1m to 35.7m (+485%)
Revenue per paying user decreased from $14.4 to $10.4 (-28%)

In Garena's road map for their games there are 3 phases: i) Increase the users, ii) convert users into paying users which make them stickier and increase LTV, iii) increase revenue per paying user. The beauty of online games is it can be iterated quickly and adapt to the changing environment. For example, Free Fire was in phase 3 in 2Q19 but with covid, the company saw that more people would be staying home to play mobile games. Thus they decided to pivot back to phase 1 and acquire users who might be more open to trying new games at this time.

What makes Garena appealing as a publisher?

In Nov 2018, they signed a 5-yr deal with Tencent that gives them the right of first refusal to publish their games in the region
Many studios have development strength, and that is very good for certain types of games like single-player games. However, if you want to create a deep esports brand and maximise monetisation, you need to do a lot more work on the ground like adapting to local tastes, use regional celebrities, and organise competitions in the region

Can they build their development capabilities or will they be a one-hit wonder?

The success of Free Fire exceeded even Garena's expectations and I would attribute a large portion to luck, especially the unexpected popularity in LATAM
However, the speed at which Garena reacted to establish offices, localise Free Fire events & skins to suit latin america and market research helped sustain the initial curiosity till now
Garena will mainly focus on developing mobile games, they believe now they have user data that tells them what content works and what doesn't, plus how to A/B test in similar demographics eg Brazil vs Argentina and Indonesia vs Malaysia
At the moment, Garena is focused on building their development teams, not specific games as they want the teams to have the freedom to try different genres
Furthermore, in Jan 2020, they acquired Phoenix Labs in Canada (not disclosed but estimated to be $150m), expanding their footprint to the western markets and build expertise in action-RPG games on consoles/PC

Why is Free Fire still so popular even though it's been out for almost 4 years?

Taking a page from Fortnite on PC/Consoles, Garena has made Free Fire into more of a social platform where gamers can log-in to hangout with their friends, not just to play games
Up till now, Garena said that there are very few mid-core AAA mobile games that are catered to low=spec phones. The big guys in the US/Europe are good at AAA games on the console, their mobile capabilities tend to be more casual like King's Candy Crush or Supercell's Clash of Clans or Brawl Stars. The only region with similar mobile development capabilities is China, in particular Tencent and Netease. Tencent is their ally and Netease is strong in Japan, a more technologically advanced market
According to the company, making a game with good graphics for a low-spec phone is very tough. They spend a lot of time thinking about the size of the game, the graphic quality and trade offs. Each megabyte is respected because emerging markets tends to have slower or more expensive mobile plans
In Q2 2021, I believe the market was quite positively surprised at the traction Free Fire was gaining traction in the US (I believe IR disclosed they were in the top 5 ranking for the action category). What I've learnt is that high quality companies tend to surprise on the upside, thus even know my initial thesis was that Free Fire would only succeed in regions with weaker speced phones, I'm happy to be proven wrong

C. Shopee: E-commerce latecomer to regional leader

Shopee is primarily a mobile-app marketplace e-commerce platform. By the time it arrived in 2016, Lazada (started by Rocket Internet) was the regional leader while the biggest market, Indonesia, was a battlefield between Tokopedia, Bukalapak, Lazada, Blibli and JD Indonesia. Before I delve into the fundamentals of Shopee, it is imperative for me to show the broad overview of the e-commerce market and potential growth rates of the key markets in the region, where most markets are expected to grow ~4x by 2025.

As Indonesia is the largest market, competition to be the country's leader is the fiercest. Shopee has started pulled away from the competition on the app downloads, and has firmly entrenched itself as the #1 e-commerce platform in terms of GMV, MAU and time spent.

What sets them apart?

Started being asset-light and non-CCC, focusing on categories with long tail SKUs, higher GPM and frequent orders - essentially copying Alibaba while Lazada had the JD.com model (ironically it's owned by Alibaba)
Rigorous attention on what a seller needs to run their business like shipping and logistics
Viral effect - many of their consumers become sellers and vice versa
Social features, live streaming and in-app games (Compared to my earlier conversations with the company where they simply said they want to emulate Alibaba, in June they mentioned the founder is also studying the best practices of PDD's social networks)

Potential lock-in-loops - 3 virtuous cycles that help user retention (feel free to point out if any doesn't make sense to you!)

Engagement lock-in-loop (Hierarchy of engagement) - According to Tavel, there are 3 levels of engagement

Level 1 is to grow engaged users, this means focus on growing the number of users that actually completed a purchase on Shopee after visiting the site or downloading the app
Level 2 is to retain users, for eg the product selection should get better the more the customer uses Shopee
Level 3 is self-perpetuating where the more users engage with Shopee, the more value and benefit they get from it. An example could be the cross pollination where sellers become buyers and vice versa

AI lock-in-loop is essentially more usage > more data for Shopee > better machine learning > better products > more usages and the cycle repeats
Marketplace lock-in-loop where higher sales > greater investment by sellers > selection and product offering increases > higher buyer engagement and mind-share > higher sales once again

Finally, as the proof is in the pudding, I believe that if Shopee's flywheel is working, it should be getting better without a proportional increase in S&M expenses. As shown below, Shopee has been steadily decreasing S&M expenses as % of GMV from the peak of 10% in 3Q17 to ~4% in 2Q21. On the other hand, sales as % of GMV has been increasing and finally crossed S&M expenses since 2Q19 and the differential is widening.

However, I do not expect Shopee to be profitable anytime soon. Management has mentioned no timeline to breakeven, but given their access to capital and a very profitable gaming business compared to single-country platforms like Tokopedia, Bukalapak and Tiki, I can understand if they opt to go for market share over profitability as long as the e-commerce market is growing over 30%.

Finally, they are launching Shopee in LATAM, for now it's only cross border e-commerce but the company does see a potential in that market. For now I do not like the idea, but I also didn't like the idea of Shopee in 2018 and they have proved me wrong in ASEAN region.

D. Culture and management style

Hiring:

They look for 5 values

We serve - need a mindset of serving customers every way they can
We run - want people that move swiftly
We adapt - run but with your eyes open
We commit - want people who we don't need to remind what's in their job description and are proactive
We stay humble - most important trait, intellectual honesty and authenticity begins with humility. In this video from 20:45 min, Nick Nash does not draw any attention to himself, saying his main goal is to be a mentor and teacher, love to be a guide

For their interview process, almost everyone they hire will be put through a rigorous case study that is based on practical examples that gives them a taste of the work they will go through like a coding exam or a written business proposal

Retention:

Try to avoid misunderstandings and turnover through a lot of coaching
They also offer rotation programs throughout their business which make them more appealing to bright talent in the region. For eg if you're a high performer in Garena, you can always try out in Shopee or SeaMoney if you want a change of environment

How do you maintain the culture of a small start up?

Have to think like a start up, the moment you stop being paranoid you die - https://www.youtube.com/watch?v=XSBvsPDvMBI (17 min)
Need the right balance between decentralization and centralization. They create broad based frameworks to decide what is decided in the HQ vs regional office, want to empower each region to make their own decisions with local judgement
Brought back some of the California style where they play hard and work hard
Since the beginning, SEA has shunned VC money as they think about the business in 10-15 year cycles while a typical VC would look to exit in 5-7 years

What does Forrest Li (founder with 9.7% of CSO) do?

Spends most of his time on the culture. No other big player has paved the way in ASEAN so SEA has to build and nurture talent
Forrest encourages people to take risk, and if they can prove themselves early, they get more responsibilities. Many of their successful managers are very young and grateful for the opportunity
Besides culture, Forrest and the management team spends a lot of time learning best practices and understand why each business made a decision to enter each category. Recently they started studying LATAM businesses as they are starting cross border e-commerce business to LATAM

E. Valuation - Blue sky or bear case?

This was very tough for me as this is probably the first undeniably "growth" / loss-making stock I've posted, so I'm very open to feedback. I approach this from two angles, first would be more bottom-up SOTP and second is how management describes the business from top-down relative benchmark to China.

Gaming assumptions for 2020-2024:

QAU grows 19% CAGR, QPU grows 21% as monetisation ratio gradually increases from 12.7% in 2Q2021 to 13% in 2024 (I believe Tencent has 15%+ monetisation ratio)
Rev per paying user increases at 3% CAGR from $36 in 2020 to $41 in 2024 (Tencent mobile games get $110 per paying user) with EBIT margin gradually remains at 55%

E-commerce assumptions 2020-2024:

Shopee GMV to have 34% CAGR for the next 5 years vs 107% for the last 3 years. For sense check, Goldman expects ASEAN to grow 31-32% CAGR till 2024, so with some consolidation between players I believe 34% for Shopee to be reasonable.
Take rate gradually increased from 7.7% in 2Q2021 to 10% by 2024

Multiples and dilution

For gaming I based the valuation metrics of the top studios in China, US and Europe for bear, base and bull cases which look acceptable to me
E-commerce is where I found more trouble where I couldn't bring myself to use the peer ranges, especially if I refer to MercadoLibre which has $51bn valuation against a $14bn GMV (sell side is putting ~60% value to e-commerce and 40% to payments). The main peers I used were PDD, BABA, MELI and EBAY

For the second valuation method, during presentations, the company would do back of the envelope calculations where ASEAN's GDP is 1/4 that of China. As SEA is Tencent + Alibaba in ASEAN, they think the value of the company should be 1/4 of the combined market cap of those 2 companies :)

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1. Shopee's success in LATAM (or maybe even Europe / India if we are to believe the reports that they're doing small trials in those regions)

2. Food delivery in Vietnam (Shopee Food is now #1 in the country) gets rolled out across ASEAN

3. New game launch that becomes a hit (doesn't even have to be self-developed as they have right of first refusal for Tencent's games in ASEAN, and they've already launched Moonlight Blade in Taiwan which is Tencent's third or fourth highest grossing game in China)

4. Continued market share gains in e-commerce and fintech

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			2021	2022
Price:	341.00	EPS	0	0
Shares Out. (in M):	552	P/E	0	0
Market Cap (in $M):	189,000	P/FCF	0	0
Net Debt (in $M):	-4,000	EBIT	0	0
TEV (in $M):	185,000	TEV/EBIT	0	0