Sea Limited Sets a Baffling New Goal for Shopee's Profits

Sea Limited's (SE -2.20%) first-quarter earnings report on May 17 allayed some concerns about the Singapore-based tech giant's future. Its revenue rose 64% year over year to $2.9 billion, which beat analysts' expectations by $40 million. Its adjusted net loss widened from $320 million to $445 million, or $0.80 per share, but still topped estimates by $0.60.

I reviewed Sea's earnings report last month and concluded that its stock would remain cheaply valued (at about three times this year's sales) until it meaningfully narrowed its net losses.

Image source: Getty Images.

But today I'd like to focus on a baffling new goal it set for Shopee, its unprofitable e-commerce unit. Starting in the fourth quarter of 2021, Sea started to claim that Shopee would soon generate positive adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) "before HQ costs" in Southeast Asia and Taiwan.

I'll explain why that statement is practically meaningless, and why Sea's emphasis on this new metric raises a few red flags for Shopee's future.

Reviewing Shopee's staggering losses

Over the past five years, Shopee has become the top e-commerce platform in Southeast Asia and Taiwan. However, it became the market leader by relying heavily on aggressive promotions.

Data source: Sea Limited.

Those loss-leading strategies prevented Shopee from ever turning a profit. But instead of stabilizing its core Southeast Asian and Taiwanese markets first, Shopee started expanding into Latin America with even more aggressive subsidies and promotions over the past two years. 

What are Shopee's "HQ costs"?

Shopee defines its "HQ costs" -- or "headquarters' common expenses" -- as its "staff cost" along with "general and administrative expenses such as building facilities and server hosting expenses." In other words, they're the direct operating costs it incurs from expanding Shopee's marketplace.

Those "HQ costs" should normally be categorized as operating expenses. However, Sea seems to believe that splitting certain "HQ" expenses from its other operating expenses (such as marketing costs) might give investors a clearer view of its underlying growth, since its HQ costs would presumably decline as it scales up its operations.

But in reality, Shopee's "adjusted EBITDA before HQ costs" is merely a proprietary measure of profitability that conveniently excludes some of its biggest operating expenses. That makes it even more difficult for investors to gauge Shopee's actual profits, since its adjusted EBITDA already excludes significant one-time and variable expenses.

Is Sea trying to muddy the waters?

In the first quarter, Sea said that Shopee's HQ costs increased by $162 million year over year, which accounted for nearly half of the $330 million increase in its adjusted EBITDA loss.

It also said Shopee's adjusted EBITDA loss per order, after excluding HQ costs, improved year over year from $0.12 to $0.04 in Southeast Asia and Taiwan. During the conference call, CEO Forrest Li said that narrower loss indicated Shopee was "well on track to achieve positive adjusted EBITDA before allocation of HQ costs in the region."

However, that "region" doesn't include Brazil, where it incurred an adjusted EBITDA loss of $1.52 per order during the quarter as it took on entrenched e-commerce leaders like MercadoLibre.

Sea also stopped disclosing Shopee's total adjusted EBITDA loss per order (including HQ costs) in the first quarter, which had previously widened by four cents year-over-year to $0.45 in the fourth quarter of 2021. That glaring omission -- along with its emphasis on achieving a positive adjusted EBITDA in Southeast Asia and Taiwan after excluding HQ costs -- suggests that Sea is trying to make Shopee's growth look more sustainable by cherry-picking its operating expenses and operating regions.

Should investors be concerned?

This isn't the first time Sea used proprietary growth metrics. When Sea went public in 2017, it initially used an "adjusted revenue" metric for its e-commerce and gaming units. It eventually stopped using that metric in 2020 after receiving inquiries from the Securities and Exchange Commission (SEC).

Sea might believe that excluding its HQ costs and Latin American business from Shopee's adjusted EBITDA will give investors a clearer view of its core business in Southeast Asia and Taiwan. However, it arguably muddies the waters and makes it much more difficult to evaluate Shopee's growth as a global e-commerce platform. Investors should pay close attention to how Sea uses the term "HQ costs" over the next few quarters to see if it's actually masking some more serious problems.