Sea Limited Just Pulled Off a Minor Miracle: Time to Buy?

Southeast Asia's video game, e-commerce, and digital finance platform Sea Limited (SE -0.96%) was perhaps the poster child for the pandemic. With the underpenetration of e-commerce and digitization in the region heading into the pandemic, Sea's growth absolutely exploded in 2020 and 2021, sending shares as high as $372 in late 2021.

Yet a violent reversal of pandemic trends and high inflation decimated pandemic winners, and Sea's stock plummeted almost 90% to a low of $40.66 last year.

In response to the changing landscape, Sea's management also reversed strategies, from a focus on top-line growth to an extreme focus on profitability. On the company's recent fourth-quarter release, that change of strategy yielded remarkable results -- a highly encouraging development for shareholders.

Now profitable across all three segments

Prior to last year, Sea only had one profitable business: its Garena video game segment. In the pandemic and pre-pandemic years, Sea used those profits to fund the build-out of its Shopee e-commerce platform and its SeaMoney digital financial services platform. Both of those businesses took lots of capital to build, and each of those segments regularly inked eye-popping losses in the hundreds of millions of dollars per quarter.

However, in the company's recent fourth-quarter 2022 release, not only did the company report operating profits and free cash flow at the overall company level, but each of those three segments is now profitable in its own right.

Data source: Sea Limited Q4 earnings release.

As you can see, Sea managed to grow operating profit by $785 million relative to the year-ago quarter, even as it only increased revenue by $229.5 million. And the profit gains are even more shocking when one considers operating profit from the digital entertainment segment dropped by $458 million in that time. That means between Shopee and Sea Money, Sea was able to grow profits by over $1.2 billion -- more than revenue grew across those two segments.

At the beginning of 2022, Sea had promised Shopee would generate positive adjusted EBITDA before headquarters costs by the fourth quarter of this year, but fourth-quarter results far exceeded those goals, generating not just EBITDA, but also operating profit. That's why the stock surged more than 20% on Tuesday, defying the overall market's 1.5% drop that day.

But the story gets even better

Not only did operating profits flip to positive territory across each of Sea's main segments, but the company also appears to have been free-cash-flow-positive. While Sea hasn't released its annual report yet and didn't itemize its cash-flow statement in the release, the company did note it generated about $209.8 million in excess cash during the quarter.

Sea's cash and equivalents actually declined $401.6 million in the quarter, but that was due to another positive development: Management repurchased some of Sea's 0.25% convertible bonds due in 2026, buying back $817.2 million of bond principal for only $611.3 million -- a 25% discount.

That's like borrowing $100 and only paying back $75 -- essentially, getting paid to borrow.

Obviously, Sea had the benefit of some very fortunate timing, as it issued the convertible bonds in September 2021, near the very top of the market. In the fourth quarter, Sea bought some of the bonds back at the bottom -- a near-perfect bit of selling high and buying low.

While there was certainly some luck behind that, this episode shows that management not only has savvy operational expertise, but also financial markets insight -- an uncommon combination for a tech company.

Image source: Getty Images.

How the company did it

When asked about the remarkable turn to profitability on the earnings call, CEO Forrest Li said: "There's a lot of hard work, and we make sacrifices. We exited the markets, we downsized operations, we walked through all these initiatives to decide which is core, which is less core, what we need to prioritize and what we need to deprioritize."

Looking further under the hood, three main tactics stood out:

First, Sea raised prices to sellers on its Shopee marketplace, or its "take rate," and was also helped by increased high-margin advertising revenue. Revenue for Shopee surged 31.8%, with core marketplace revenue outside of first-party sales up an even higher 43.5%. That high revenue growth came even while gross merchandise volume (GMV) actually declined 1%, although GMV rose 7.7% in constant currency.

While some may scoff that last quarter's growth came mostly from raising prices, remember, the sign of a good business is that it can raise prices without meaningfully losing customers. Sea seems to fit that description.

And even that muted GMV growth was impressive in light of sales and marketing expenses declining a stunning 55% for Shopee and 61% at the overall company level. So, the fact that Shopee could still grow GMV on a constant currency basis while cutting marketing expenses by more than half says something about its brand presence across its core markets.

Finally, management also pointed to meaningful logistics cost savings, without going into too much detail. While the company doesn't break out gross profit growth specifically for Shopee, the company did grow overall gross profit 29.5%, much higher than overall revenue growth of 7.1%.

Not only did Sea improve logistics costs per package in the quarter, but Li added there is even more room to improve, saying: "[T]his will remain an important area of focus going forward. ... While we have already seen early results from these efforts, there is still greater room for improvement."

Growing revenue in spite of cost cuts is what this market wants to see

All in all, Sea was able to raise prices while cutting logistics and marketing costs, and still maintained GMV growth on a constant currency basis. Moreover, management paid off some debt at a big discount, further lowering risk.

This is awfully impressive, and bodes well for Sea's stock -- even after Tuesday's big jump.