Sea Limited (SE 7.74%) has generated massive returns since its IPO in Oct. 2017. The Singapore-based gaming and e-commerce company went public at $15 per share, and its stock hit an all-time high of $372.70 last October.
However, Sea's stock subsequently plunged nearly 50% to under $200 per share as five red flags appeared. Let's examine those challenges and see if they soften the bullish case for this high-growth stock.
1. Tencent's big divestment
On Jan. 4, Chinese tech giant Tencent (TCEHY 6.88%) sold 14.5 million shares of Sea at an average price of $208 to $212 per share. The $3 billion sale reduced Tencent's stake from 21.3% to 18.7%.
This wasn't the first time Tencent sold its shares of Sea. At the time of Sea's IPO, Tencent owned 39.7% of its outstanding shares. Tencent is reducing its stake in Sea for three reasons. First, it's prudent to lock in some profits following Sea's massive four-year gains. Second, reducing its stakes in other influential tech companies, as Tencent recently did with JD.com, might appease China's antitrust regulators and prevent it from being hit with new probes or fines.
Lastly, the divestment clarifies that Sea isn't controlled by a Chinese company -- which might have hampered Sea's expansion in India and other countries that are engaged in conflicts with China. Tencent's big sale doesn't indicate Sea's business is deteriorating, but it still spooked the bulls.
2. Voting power changes
Sea plans to propose a major change to the voting power of its Class B shares -- which are only held by Tencent and Sea's founder and CEO Forrest Li -- at its annual meeting on Feb. 14. Sea wants to increase the voting power of its Class B shares from three votes to 15 votes.
If 75% of voters approve of that special proposal, Tencent will convert all of its Class B shares to Class A shares, which only have one vote each. Li's total voting power would then increase from 52% to 57%, while Tencent's voting power would drop below 10%.
Li has always held a majority voting stake, but the plan would further weaken the bonds between Sea and Tencent, which had previously licensed many of its top mobile games to Sea's Garena gaming unit.
It also suggests that Sea and Tencent could be transitioning from allies into rivals in the mobile gaming market, where Garena's hit battle royale game Free Fire competes directly against Tencent's PUBG Mobile.
3. Free Fire's peaking popularity
In 2017, Garena's launch of Free Fire, its first self-developed game, significantly reduced its dependence on Tencent's licensed games. Free Fire "caught fire" across Southeast Asia and Latin America, and it was the most downloaded mobile game of 2019 and 2020, according to App Annie.
Free Fire also boosted Garena's margins, since it didn't need to pay any licensing fees, and enabled the segment to generate stable profits. That profitability partly offset Sea's ongoing losses at Shopee, its e-commerce marketplace, and Sea Money, its digital banking and payments platform.
In other words, Sea is spinning and balancing a lot of unprofitable plates on top of Free Fire. Unfortunately, Free Fire's popularity seems to have peaked. According to the tracking site Active Player, Free Fire hosted 325.9 million monthly active players over the past month, compared to a peak of 356.6 million monthly active players at the end of last April.
That's still a very large audience, but Garena clearly needs to launch new hit games to reduce its overall dependence on Free Fire.
4. Alibaba's potential comeback
Sea's Shopee overtook Alibaba's (BABA 3.43%) Lazada as the top e-commerce player in Southeast Asia in 2019.
As Lazada fumbled with cultural and technological clashes between its Chinese and Singaporean teams, Shopee claimed the lead with steep discounts and aggressive marketing campaigns.
But Lazada isn't down for the count yet. In December, Alibaba claimed that by 2030 Lazada could nearly double its customer base to 300 million and quintuple its annual gross merchandise volume (GMV) to $100 billion. By comparison, Shopee generated $35.4 billion in GMV in 2020.
Alibaba's potential comeback in Southeast Asia could cause headaches for Shopee, which is already racking up big losses by expanding into Latin America, Europe, and other overseas markets. If Sea focuses too much on that overseas expansion while growing complacent in its home market, it could unexpectedly lose shoppers to a resurgent Lazada.
5. Rising inflation and higher interest rates
Lastly, rising inflation and interest rates will likely cause investors to sell the tech sector's pricier, more speculative, and unprofitable growth stocks.
Sea's stock might not seem too expensive at eight times next year's sales right now. But it's still deeply unprofitable, and investors can currently invest in profitable tech giants like Salesforce at comparable price-to-sales ratios. Sea's widening losses, aggressive expansion plans, and recent stock and debt offering also make it a risky stock to own as interest rates rise.
I'm still bullish on Sea
All these headwinds will likely limit Sea's near-term returns. But over the long term, I believe it will still generate bigger gains as it profits from the expanding e-commerce and gaming markets in Southeast Asia and Latin America.