E-commerce has changed the way we live, shop, and do business. A growing proportion of consumer spending has moved online over the past decades, supported by the convenience of digital payments, improved internet connectivity, smartphone development, and upgraded delivery infrastructure. E-commerce can connect consumers to online businesses globally, potentially increasing the range of choice of products or providers. Omnichannel retail, where businesses operate both online websites and retail stores, can offer flexibility in delivery and returns and may provide a better shopping experience. Mobile commerce has also become more mainstream, powered by social media influencers and platforms, fueling the growth of e-commerce among younger consumers.
Sea Limited (NYSE:SE) operates Southeast Asia’s largest e-commerce platform, Shopee, in terms of gross merchandise value (GMV) and number of transactions. Sea started as a gaming business, Garena, but in 2015 expanded into e-commerce, which is now the main growth driver. Shopee is a hybrid consumer to consumer (C2C) and business to consumer (B2C) marketplace platform operating in eight core markets. Indonesia accounts for 35% of GMV, with the rest split mainly among Taiwan, Vietnam, Thailand, Malaysia, and the Philippines (9%). For Garena, Free Fire was the most downloaded game in January 2022 and accounted for 74% of gaming revenue in 2021. Sea’s third business, SeaMoney, facilitates e-wallet payments on Shopee and offline, and provides other digital financial services, such as credit lending.
What is Sea’s estimated fair value?
According to the top value investing minds over the ages, which I share, there is an absolute way to value a business. The fair or intrinsic value of a business is the present value of the future free cash flows it can generate. Free cash flow is the amount of cash generated that is free and clear of all internal or external obligations. Cash is a fact. The higher the future free cash flows, the higher the fair value, and vice versa.
At the heart of my valuation model is a detailed projection of a business’ future free cash flows, resulting from independent and fundamental research. This is industry-standard and used by analysts from the most reputable brokers, institutions, and research firms around the world.
The data sources and inputs below were used to determine Sea’s estimated fair value.
The calculations below show how Sea’s estimated fair value was arrived at by discounting its future free cash flows to their present values using the two-stage method. I use analysts’ estimates of free cash flows over the next 10 years for the first stage.
The second stage assumes that Sea grows at a stable rate into perpetuity.
The calculations show that Sea’s estimated fair value is about US$29.1 billion or US$51.77 per share.
What is driving Sea’s future free cash flows and estimated fair value?
Analysts’ estimates of Sea’s future free cash flows factor in a series of negative events over the past few weeks that have caused them to be less optimistic about Sea’s medium-term gross merchandise value (GMV) growth, and the outlook for its gaming business.
According to Bloomberg, CEO Forrest Li sent an internal memo to Sea’s employees on September 15, stating that “negative conditions will likely persist into the medium term” and that it is focused on profitability over the next 12 to 18 months.
As a result of the company’s negative expectations, analysts have lowered their e-commerce growth and gaming revenue forecasts over the next five years. They now expect Sea’s 2022 GMV to increase only 17% over the previous year, from a previously projected 21%, and revenue growth of 16% a year, over the next three years.
Li’s memo follows the shuttering or downsizing of parts of its operations that are likely to affect Sea’s near-term revenue and long-term potential. The estimated fair value reflects the business’ structural change where previous long-term expectations may no longer be sustainable.
Analysts forecast that Sea can still be breakeven in 2025, but the business may find it challenging to achieve profitability without sacrificing its expansion vision. As a result, analysts have lowered long term outlooks on market size by lowering GMV growth rates.
Sea also recently laid off hundreds of employees from its Shanghai Garena office, which is a major development center for its gaming business. The layoffs, compounded with cancellations of multiple games in its pipeline, could signify a muted outlook for gaming revenues indefinitely.
Free Fire game bookings are expected to decline over the near term, with no signs of reversal. The potential of the game’s long-term viability is now in question. The bookings in analysts’ projections assume a decline every year, over the next five years, which could possibly linger if there is no pipeline visibility.
Analysts are now less optimistic on Sea, given their view of more risks, but recognize the potential rewards to their forecasts if Garena and Shopee can resolve key concerns.
What is the outlook for Sea?
Analysts expect the Shopee e-commerce platform to be Sea’s main growth driver over the long term. The business’ fair value will be dependent on this platform. According to Euromonitor, Shopee has a 30% market share in its main market, Indonesia, and analysts estimate about a 30% to 35% market share in the rest of Southeast Asia, including about a 9% market share in the Philippines.
Sea has built its leading market share quickly using subsidies, free shipping, and incentives that attracted consumers to its platform. But, in the process, it has burned a lot of cash and has not yet seen any profits.
While positive signs exist and Shopee currently enjoys a market-leading position, analysts believe that it is too early to tell who the ultimate long-term winners will be. E-commerce is still in the early stages in Southeast Asia, and outside of a slight lead in market share, they do not see obvious and distinct advantages for Shopee.
As user growth has been highly contingent on subsidies that heavily increased sales and marketing expenses, analysts are concerned that growth could decelerate sharply once these incentives stop and when Sea becomes more focused on profitability.
The massive potential for Sea is evident as e-commerce is 7% to 8% of overall retail sales in Southeast Asia, compared with 22% for China. Analysts forecast a 23% five-year annual growth rate for the digital economy in the region. China’s e-commerce is expected to grow 11% over the same period. Given the robust regional backdrop, analysts believe this should provide a conducive landscape for Shopee to succeed.
However, despite a massive opportunity, Shopee remains vulnerable to increased sales and marketing expenses, and consumers’ low cost to switch to other platforms. Other platforms can offer the same products with subsidies to consumers who are cost-conscious. This also implies the possibility of new competitors in e-commerce in the region that can replicate the same strategy.
Because of Shopee’s lack of differentiation as a sustainable competitive advantage, analysts can see further heavy subsidies in order to ward off threats and maintain market share, which could be impossible to continue over the long term in the pursuit of profitability. The company has indicated a goal for Shopee to be profitable by 2025, but analysts believe this could be a challenge without clear key advantages.
What optimistic analysts say
- Sea could maintain its leading market share as Southeast Asia e-commerce expands without having to sacrifice profitability through increased sales and marketing spending.
- Garena could find another hit game that increases bookings, in addition to Free Fire. Also, India could rescind its sanctions on Free Fire.
- SeaMoney could increase its market share above its current 3% level and become one of the preferred payment options in Southeast Asia.
What pessimistic analysts say
- Sea might be challenged to achieve profitability due to consumers’ low costs to switch to other platforms and lack of differentiation on its platform.
- Garena might not be able to come up with another hit game, and Free Fire might see a decline in bookings as the game ages.
- If SeaMoney is limited to the Shopee platform, consumers might opt to use other regional payment platforms amid ample competition.
Is Sea currently trading at a discount to its estimated fair value?
As of October 31, 2022, Sea’s share price of US$49.88 is currently trading at a small 3.7% discount to its estimated fair value. This means that the market’s sentiment is in line with analysts’ expectations about Sea’s future growth.
The insight
I believe the fundamental driver of a business’ future free cash flows and, ultimately, its fair value is the rate at which it is growing its revenue, earnings, capital base, and returns on capital. A business that increases its future free cash flows and earns higher returns on capital will be worth more.
Business decision makers and investors who use the discounted cash flow approach to valuation, focusing on increasing long term, future free cash flows, will ultimately be rewarded with higher share prices.
About the Author
US-based Eric Jurado is a contributor to The Independent Investor. He is an international investor, investment fund manager, and author. Eric’s news blog, The International Investor provides investment intelligence across businesses, industries and continents.
Disclaimers:
The author has no position in Sea. The content is sourced, excerpted, and edited from analysts’ notes and S&P Global Market Intelligence. It is for informational purposes only and is not investment advice.
The information contained in the said content represents the views and opinions of the author and do not necessarily represent the views or opinions of The Independent Investor or its affiliates.
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