Sea Limited (NYSE:SE), an e-commerce and video game company based in Singapore, went public at $15 a share in late 2017. Its stock price subsequently surged to about $230 per share, boosting its market cap to over $120 billion and making it Singapore's most valuable company.

I was initially skeptical about Sea -- it was deeply unprofitable, faced intense competition from Alibaba's (NYSE:BABA) Lazada, and its valuations were frothy. But after tracking Sea's growth over the past several quarters, I finally started a position this January.

I turned bullish on Sea for two main reasons. First, its e-commerce platform Shopee more than doubled its orders year over year in the first nine months of 2020 and surpassed Lazada in total downloads. Second, Sea's adjusted EBITDA turned positive over the past two quarters as Shopee narrowed its losses per order while its gaming segment, Garena, raked in higher profits to offset its e-commerce losses.

Promotional art for Free Fire.

Image source: Garena.

However, Garena's growth spurt mainly comes from a single game, Free Fire. Let's look back at Free Fire's origins, how it became the core profit engine of Sea's sprawling business, and whether or not the company's dependence on a single hit game is sustainable.

The history of Free Fire

When Sea went public, most of its mobile games were licensed from other publishers. The licensing fees for those games, which include Tencent's (OTC:TCEHY) League of Legends and Arena of Valor, took a bite out of Garena's revenue.

To reduce its dependence on third-party games, Garena published Free Fire, a battle royale game developed by the Vietnamese company 111 Dots Studio, in late 2017. Similar to other popular battle royale games, Free Fire lets up to 50 players parachute into an island arena to fight each other.

Free Fire hit over 100 million daily players last August as people played more games throughout the pandemic, and it remained the highest-grossing mobile game in Southeast Asia and Latin America last quarter, according to App Annie. The firm also ranked Free Fire as the world's most downloaded mobile game last year.

Garena's Free Fire.

Image source: Garena.

Free Fire doesn't require much storage space and runs well on low- to mid-range devices, which makes it a popular choice for gamers who can't run higher-end battle royale games like PUBG Mobile, Fortnite, or Call of Duty: Mobile smoothly. It's also a popular game for online esports tournaments. Last quarter, Sea noted that Free Fire's esports tournaments had accumulated more than 150 million online views to date.

The economics of Free Fire

Free Fire generates a large portion of Sea's digital entertainment revenue, which rose 80% year over year in the first nine months of 2020 and accounted for 47% of the company's top line.

That revenue growth is impressive, but a closer look at the digital entertainment unit's adjusted EBITDA -- which offset Sea's e-commerce and fintech losses over the past two quarters -- reveals just how important Free Fire is to Sea's future:

Adjusted EBITDA (Million USD)

FY 2019

Q1 2020

Q2 2020

Q3 2020

Digital Entertainment

$1,021.9

$298.4

$436.2

$584.5

E-commerce

($1,043.3)

($260.0)

($305.5)

($301.6)

Digital Finance Services

($113.4)

($101.6)

($110.1)

($149.3)

Other Services

($28.0)

($2.6)

($6.4)

($9.1)

Total

($178.6)

($69.9)

$7.7

$120.4

Data source: Sea Limited.

In other words, Free Fire's growth buys Shopee and its payment platform SeaMoney more time to narrow their steep losses. 

The future of Free Fire

Keeping gamers engaged in Free Fire might seem challenging as the game enters its fourth year and the battle royale genre matures. To counter that slowdown, Garena is testing out Free Fire MAX, an enhanced version for higher-end devices, across several markets. It's also constantly refreshing the game with new features and rewards.

Looking ahead, Garena could still promote Free Fire in new markets -- such as North America, Europe, or Northeast Asia -- or even license it back to Tencent (which owns a significant stake in Sea) for Chinese gamers. In other words, there are still plenty of ways for Garena to keep Free Fire's flame alive.

The bottom line

Sea Limited is a promising growth stock, but it's deeply unprofitable by GAAP standards and its positive adjusted EBITDA is pinned to a single mobile game. Free Fire is still incredibly popular, but investors should keep tabs on its growth to see if it can continue to support Sea's unprofitable e-commerce and fintech divisions.

 
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.