E-commerce, payments, and gaming company Sea Limited (SE 5.21%) is turning away from revenue growth and toward cash flow at all costs.
Investors grew accustomed to mind-numbing growth figures from Sea Limited. Consider that in 2017, the company generated revenue of $414 million. In 2021, it generated revenue of nearly $10 billion -- up 24 times in just four years. And revenue through the first half of 2022 is up another impressive 44% year over year.
According to Bloomberg, Sea Limited just sent a memo to employees, saying that its top goal is to become cash-flow positive as quickly as possible. And as we'll see, it's pulling out all the stops to accomplish this. Here's what investors need to know.
Why Sea Limited is pivoting toward profits
In 2017, Sea Limited primarily generated revenue from its video game platform Garena, much of that coming from Asia with a concentration in its home Singapore market. Since then, the company has expanded its revenue sources to include e-commerce (through its Shopee platform) and digital payments (through its fintech arm SeaMoney). It's expanded and grown substantially in markets like Europe and Latin America.
Sea Limited is now prioritizing profits over growth because of how quickly the global financing market changed. In his memo to employees, founder and CEO Forrest Li explained, "With investors fleeing for 'safe haven' investments, we do not anticipate being able to raise funds in the market."
In short, Sea Limited grew and expanded rapidly. But it did so by relying heavily on cash from financing activities, as the chart below shows. And it can't keep dipping into that honey pot now that the macroeconomic environment is different.
To Li's point, the cost of capital rose. The Federal Reserve raised interest rates at the fastest pace in decades, giving investors much better returns on relatively risk-free assets. They're now less willing to lend money to companies like Sea Limited without demanding a much higher rate of return. Basically, the terms for borrowing money aren't as compelling as they were.
Similarly, the Federal Reserve has taken liquidity out of the system by shrinking its balance sheet. This has a side effect of causing stock valuations to drop. Sea Limited could raise funds by diluting shares as it's done in the past, but the terms are far less attractive. Sea Limited stock had a price-to-sales (P/S) valuation of over 30 in early 2021. Its valuation has plummeted more than 90% to a P/S ratio under 3 as of this writing -- an all-time low for the company.
Sea Limited isn't the only company pivoting in light of market conditions. For example, the parent company of Snapchat, Snap (SNAP 2.09%), released a memo to employees earlier this month, and tech website The Verge got hold of it. Snap's CEO reportedly said: "Our business will be valued based on our ability to generate profits. We must adapt our strategy accordingly."
Snap is adapting to the market's preference for profitability, in part, by launching an enterprise division for its augmented-reality technology. But it's also cutting projects like its selfie drone. And as we'll see, Sea Limited is making cuts as well.
What Sea Limited is giving up
Sea Limited's video game segment, Garena, is its profitable venture. However, adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) for this segment fell 55% year over year in the second quarter of 2022 to $333.6 million, in part due to its hit Free Fire game being banned in India and also a general slowdown in the video game space.
However, Garena's struggles appear to be ongoing. According to a September Reuters report, about 15% of Garena's staff may have just been let go as Sea Limited pivots hard toward profits. Moreover, the same Reuters report says that Sea Limited is shutting down Shopee in Argentina altogether as well as shutting down local operations in Columbia, Chile, and Mexico -- cross-border shipments will still be allowed in those three countries. This follows Sea Limited pulling out of some European markets earlier this year.
Finally, back to the Bloomberg report, management is extremely serious about cash-flow positivity. It's reportedly forgoing paychecks for executives until Sea Limited reaches self-sufficiency. This, of course, implies that the company hasn't been self-sufficient to this point, emphasizing once more that its growth was funded by financing.
Lower top-line growth, lower valuation
Sea Limited investors should be encouraged that there's a viable path to self-sufficiency. Consider that in the first half of 2022, the company reported a negative $1.2 billion in cash from operations. But it spent $540 million on property and equipment alone, much of which is for e-commerce infrastructure. Simply curtailing spending to grow Shopee will substantially push the overall business toward breakeven.
That said, Sea Limited's e-commerce segment accounted for nearly 59% of overall revenue in Q2. And its 51% year-over-year growth for this segment far exceeded the overall revenue growth of 29%. In other words, the company is cutting back on its top-line growth driver, which typically merits a cheaper valuation.
Pivoting toward self-sufficiency is important and necessary for Sea Limited in the current economic environment. It also means the stock may be fairly valued in a low-growth, break-even scenario. That makes this a company I would watch from the sidelines for now. Wait and see if management can accomplish its self-sufficiency goal. And see what kind of profits it's capable of after the pivot is complete to get a better idea of the long-term opportunity.