Emerging E-commerce Franchises / Sea Limited

Today, Alibaba and Amazon are likely household names and for good reason. Both of them are giants straddling a number of industries and likely touch close to 2 billion consumers annually. Both of them also tend to be trendsetters that determine the evolution of markets / industries (or at least in thought).

While Alibaba and Amazon get most of the attention, there are other giants in the making that I think get less attention than they rightfully deserve. In particular, Sea Ltd. and Mercadolibre are two such regional champions that are likely to become significantly more dominant over time. Mercadolibre has actually been operating since the early days of the Internet with almost 20 years of history, but Sea is a relative newcomer. Given the company’s short history and limited time in public markets (IPO’d in late 2017), I believe Sea to be a misunderstood and underestimated company with significant value-creation potential.

A Company With Potential to Become Both Tencent and Alibaba in South East Asia?

Sea was originally founded a decade ago as Garena in South East Asia (I will refer to the region using the shorthand SEA below) with a focus on games. Today, Garena remains one of Sea’s key operating segments (essentially generating all EBITDA and cash flow at the consolidated level) and is one of the largest game distributors / developers in the region. Tencent has been a key investor in Sea pre-IPO, and as a result Sea enjoys preferred access to Tencent’s game library in SEA with Sea’s value-add being game content localization. Essentially, Sea has closely mirrored Tencent’s path of development within the Chinese gaming industry since Tencent’s early days were also focused on localizing foreign games for Chinese consumption.

Historically, game developers seem to have had fairly average business models. Except for truly celebrated franchises, many game developers essentially have boom / bust business models with some games working and some games failing. And even for the games that work, many fail to develop into franchises with long term fan bases. By acting as a localizer / distributor, Sea has minimized the risk of game development (i.e. most of the development risk is borne by the original IP creator), but at the same time face potential risk of losing key titles since they do not own the IP of distributed games. This was the state of Garena at IPO, which I think made it a fairly average story. While Tencent is certainly the single most successful gaming company globally (gaming division is likely valued by investors north of $150-200 billion), there aren’t many other large successful gaming companies out there. The most successful publicly listed ones would be Activision Blizzard (ATVI) and Electronic Arts (EA) and both have market caps just around $30 billion (for apple’s-to-oranges comparison consider that EBay, an also-ran e-commerce company, has an equivalent market cap and many young SaaS software companies carry similar market caps).

However, Garena’s business seems to have dramatically improved since IPO. The company launched its first self-developed game called Free Fire, which, very surprisingly, became a top 5 mobile game globally across iOS and Android. Free Fire registered users total almost half a billion across 130 countries.

From afar, this seems almost destined to be an instance of the boom / bust cycle I cautioned above just given the incredible level of success, but the process of development of Free Fire seems unique enough to warrant attention.

First, Free Fire, while self-developed, is modeled after already successful franchises within the battleground genre such as Playerunknown’s Battlegrounds. Garena did not take material risk in terms of concept or gameplay, but rather focused on a very important blind spot of global game developers – producing a fun, playable game that caters to smartphone players that have low quality phones with limited storage and limited data plans. Similar to how Tencent eclipsed leading developed market game companies by focusing on mobile whereas ATVI and EA are largely PC and console game developers, Sea has taken it even further by focusing on mobile and accessibility from a data and storage perspective. This seems like a highly repeatable process, which I think has drastically improved the business model. At Garena’s current scale, the number of players that can challenge them with a similar model is low. The most capable would be Tencent but Tencent is one of Sea’s largest shareholders with, likely, limited interest in eroding the value of their equity stake (and potentially jeopardizing the fruitful distribution relationship that they have in SEA for Tencent games).

Secondly, games have evolved to become much more stickier than in the past. Many modern games are highly repeatable since gameplay is no longer particularly story-driven. Successful games are much more likely to be multiplayer and competitive in nature. In addition, huge esports ecosystems are developing around competitive gaming with strong parallels to physical sports like soccer and basketball. Many people do not get tired of repetition in physical sports. The same dynamic is developing within games with the potential to significantly lengthen game lifespans. This insight is not novel for industry watchers, but what I think has gone unstated is how these shifting dynamics have created more of a network effect for games.

While Garena is becoming a more attractive asset, Sea’s e-commerce arm, Shopee, is likely the crown jewel in the long run. Shopee was established just about 5 years ago and fought an uphill battle against long-established players in SEA. However, Shopee quickly overtook peers with a 3P platform with key social e-commerce features and is now vying for the top spot across the region against Lazada, Alibaba’s subsidiary in the region. Going up against Alibaba is likely a challenging consideration for many investors, and hence Shopee seems to have received very limited credit from investors. Until recently, Shopee was possibly even assigned a negative value by investors due the large cash losses. However, despite all the good things I have to say about Alibaba, Lazada is not doing particularly well. Alibaba recently disclosed the Lazada revs declined YoY during their earnings call. Perhaps a topic relevant for future debate, I currently do not see Lazada successfully turning around in a way that would jeopardize Shopee’s success.

Globally, there are many e-commerce examples that we can look to to see just how hard it is to dislodge an incumbent. Even for weak players, leading players generally only take away growth rather than existing customers. Example – Ebay. Shopee likely have solidified their position in the region and now it just comes down to a question of how much growth they can accomplish and what the unit economics will be. As hinted above, Shopee is losing quite a bit of money at the moment, which is a risk worth monitoring. But at the end of the day, e-commerce business models are generally negative working capital on the 3P side and have strong network effects.

While Garena and Shopee are the two core assets, the company does have a fintech play (Airpay). It doesn’t appear to be all that strong (at least not in the same way that Alipay or WeChat Pay are in China). They have also reduced disclosures around this business. Hence I don’t think Airpay should get much credit at the moment but it is a free option if it works out.

So when you put that all together, Sea in some ways brings together some of the more attractive attributes of both Tencent and Alibaba and faces manageable competition in SEA. Overtime, Sea can further develop the platform to encompass newer areas such as those that are currently being pioneered by Tencent, Alibaba, and Amazon in their core markets.

Large Opportunity in SEA with Potential to Go Global

SEA as a region does not get the attention it deserves likely because it is overshadowed by its larger neighbors to the north – China and India. I’d wager that the vast majority of people are not aware that Indonesia is the 4th most populous country in the world just behind China, India, and the USA.

Source: United Nations Population Division via Worldometers.info

In fact 4 of the top 20 countries by population are located in SEA. SEA contains a total population that is ~700 million and hence one of the largest addressable markets in the world.

SEA (and Sea, the company) is also benefiting heavily from the rapid adoption of smartphones. This is a key reason for the fast adoption of games as an entertainment form as well as for e-commerce. Similar to China a decade ago, many of these countries lack strong offline entertainment and retail options, making the digital alternatives much more competitive. As great as Amazon is, US offline retail is an acceptable experience (and better on the luxury end). This is a vastly different story for the emerging markets where e-commerce platforms are not competing with branded stores but mom and pop corner stores and where games are not competing against movie theaters or live sports but perhaps a much more simple outdoor experience.

The SEA region alone makes Sea an attractive story if they are able to dominate in the long run. What is incredible is how Garena appears to have a good shot of expanding beyond SEA into other emerging markets. As mentioned above, Free Fire is a global top 5 game in 2018 and found strong traction in Latin America (a region with another ~half billion population) as well as growing traction in countries like Russia, Turkey, and India. The reason is simple – Garena solved an emerging market issue when they focused on creating a game that works with low end hardware and limited data plans. What they solved is not specific to SEA and given the repeatability of the development process as they have carried it out with respect to Free Fire, the prospects look pretty good.

Mis-Priced

The stock has done very well year-to-date (+210%). Yet, despite the strong performance, Sea still looks quite undervalued relative to the long term potential of the business. If the business model were weaker, the strong performance would certainly warrant increased caution. A meaningful portion of the performance is also likely just a function of the significant sell-off the stock experienced for the ~1 year post IPO.

Currently the company has a market cap of ~$16 billion with a net cash position of ~$1.5 billion. As of the most recent quarter, Garena had a revenue run rate of $1.6 billion annualized and an EBITDA run rate of $1 billion. Revenues grew 170% YoY while EBITDA grew 310% YoY. In comparison, ATVI has a market cap of $37 billion with ~$7.5 billion of revenues and $3 billion of EBITDA. EA has a market cap of $27 billion with $5 billion of revenues and ~$1.5 billion in EBITDA. Both of these companies are growing drastically slower than Garena. There are many factors that may suggest SE deserves a lower value (e.g. Shopee cash flow dynamics), but Garena alone looks undervalued enough relative to the whole market cap of the company. Investors will likely be quite happy with the outcome even if Shopee turns out to be worthless.

Disclosure: I own shares in SE, BABA, and Tencent as of publication date.