2 Wrinkles in Sea Limited’s Great Earnings Report -- and Why You Should Probably Ignore Them

Shares of Sea Limited (SE -0.69%) shot up by 8.7% on Tuesday after the Southeast Asian internet company delivered a sparkling second-quarter earnings report. Sea handily beat even optimistic analysts forecasts for adjusted revenue growth, which came in at 93.4% and reached $1.29 billion -- a whopping $230 million ahead of expectations.

Yet for all of the well-deserved enthusiasm around Sea's growth, there are two caveats that may be reasons for caution. Investors should be aware of these potential pitfalls going forward, especially since Sea is unprofitable and trades at a high price-to-sales ratio of 23.

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Sterling Q2 results

The company witnessed strong growth in its core Garena mobile games division, anchored by Free Fire -- a free-to-play game that reached over 100 million daily active users. The number of paying players grew by more than 100%, which resulted in July being a record month for revenue. Overall, Sea Limited's digital entertainment division -- its only profitable division -- saw 62% adjusted revenue growth and 65.3% adjusted EBITDA growth. Free Fire even revealed it will run a new in-game crossover promotion event with the Netflix (NFLX 1.74%) show Money Heist in September.

While digital entertainment was strong, Sea's burgeoning Shopee e-commerce segment was even more impressive. Adjusted revenue was up a staggering 187.7% as gross orders grew by 150%, and gross merchandise volume (GMV) rose 109.9%, accelerating from 74.3% growth in the first quarter. All in all, Sea Limited grew its revenue even faster than it increased GMV due to an increased take rate of 6.4%.

With eye-popping numbers like that, what could be the problem?

Beware of revenue adjustments

The first thing investors should be aware of is that Sea Limited highlights -- and is usually judged on -- "adjusted revenue." That includes not only the revenue earned during the quarter, but also the changes in deferred revenue within the digital entertainment segment, and also adds back "sales incentives net-offs" in its e-commerce business. Deferred revenue accounts for subscriptions and other payments made up front that are usually amortized over the length of the subscription term.

When subtracting those two factors, the picture looks quite different.

 Data source: Sea Limited Q2 earnings presentation. Chart by author.

The above chart can be interpreted in one of two ways. On the one hand, actual GAAP revenue, which is more comparable to how other companies report, is about 31% lower than Sea's headline number.

However, that's not a reason for shareholders to panic. Many subscription-based software companies are judged on the equivalent of Sea's adjusted revenue number, commonly referred to as "bookings." That's because due to upfront payments, investors and analysts tend to look at bookings as more of a true measure of the overall business accomplished in a given time period. In fact, as part of the release, Sea disclosed that after speaking with the Securities and Exchange Commission, it would no longer cite adjusted revenue, but instead substitute its digital entertainment adjusted revenue with "bookings." 

The change in deferred revenue was 55.5% in the quarter, which means adjusted revenue was a tad lower than GAAP revenue. However, Sea's deferred revenue mostly occurs in its digital entertainment segment, which grew 62% -- relatively close to the change in deferred revenue. All in all, it's not much reason for concern.

On the other hand, I think that adding back rebates and coupons to e-commerce customers may be a bit disingenuous. Obviously, Sea is in the early stages of capitalizing on its opportunities in Southeast Asian e-commerce, and is making a bid to grab up market share as quickly as possible. Yet it's unclear exactly when the fierce competition against the likes of Lazada might ease, meaning these aren't likely to be "one-off" types of expenses. In fact, the company announced it would be also changing how it recognizes those expenses going forward to just reflect GAAP revenue, per the request of the SEC. Even though the company's e-commerce growth is booming, incentives and coupons grew by double that amount of sales growth last quarter. It's not a grave concern, but certainly something to keep an eye on.

Overall losses increased

On that note, the other reason investors may be concerned is Sea's bottom line, which is sinking further into the red -- the company's net loss deepened by 41.7% from the year-ago quarter's $0.48 per share to $0.68 per share in the most recent one.

While growing losses are never a great sign, it appears that Q2's deeper loss can be traced to management's increased spending on those aforementioned sales incentives, along with big investments in research and development. In fact, on an overall basis, Sea Limited slightly expanded its gross margins, and expenses from sales and marketing as well as the general and administrative category grew at a slower pace than gross profits.

The big expense that eclipsed revenue growth was R&D -- it was up by a whopping 114.9% in the quarter, topping revenue growth of 101.1% and gross profits growth of 106.1%. However, since R&D in tech companies can often be thought of as an investment in future products and capabilities, this also shouldn't be taken as a negative by shareholders.

Sea's bright picture looks unchanged after earnings

All in all, despite those two caveats, Sea looks to be outgrowing its competitors and seizing its large market opportunity in Southeast Asian e-commerce, digital payments, and mobile games. The company's adjustments to revenue figures and growing losses are definitely worth noting, but they seem like rather small details in light of Sea's otherwise excellent execution and the massive long-term market opportunities it appears well-positioned to capitalize on.