Once a darling among investors, Sea Limited (SE -2.63%) has fallen out of favor over the last 12 months. Investors were concerned about two issues:

1. Can the Garena gaming operation turn around its business?

2. Is the Shopee e-commerce platform a viable business?

Sea's latest earnings report shows us how the company has dealt with these challenges and the early results.

Gamer plays game on computer.

Image source: Getty Images.

Challenge 1: Can Garena turn around its declining business?

Asked about Sea, informed investors will usually point out that it's a leading e-commerce company in Southeast Asia. While e-commerce is currently its most significant revenue contributor, Sea started mainly as a gaming company.

As recently as 2021, Garena had more than $1 billion in bookings every quarter. That year, the digital entertainment business generated $2.8 billion in adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA). By comparison, the e-commerce business generated a negative adjusted EBITDA of $2.5 billion.

But the good times did not last long for Garena. As the pandemic lockdown propelled its business to the sky, the reopening of global economies pulled it back to earth. Bookings -- a metric that tracks in-game purchases by Garena's gamers -- peaked at $1.2 billion per quarter in the second and third quarters of 2021, and have declined since then.

In the fourth quarter of 2022, bookings fell to just $544 million, not even half of their recent peak. A lower active user base -- down from 729 million at its peak in the third quarter of 2021 to 486 million -- and a lower-paying user ratio contributed to the fall in bookings.

To address the recent challenges, management has reduced its development pipeline to contain costs while improving user engagement on its core offering, Free Fire. The team hopes the gaming business will see better times when the macro environment improves.

Overall, Garena is still in deep trouble. Investors should track this segment closely in the coming quarters.

Challenge 2: Is Shopee a viable business model?

Shopee was a huge benefiter of the surge in e-commerce penetration in Southeast Asia and Brazil during the pandemic -- revenue surged by 160% and 136%, respectively, in 2020 and 2021.

While consumer demand naturally spiked during that time, Shopee also invested heavily in subsidies and promotions to further solidify its leadership. It could do so thanks to the enormous cash flow from its sister company, Garena.

Shopee's aggressive expansion wasn't cheap, with adjusted EBITDA coming in at negative $1.3 billion in 2020 and $2.6 billion in 2021. But as Garena's cash flow dwindled over the last few quarters, Shopee's had to pivot to a new strategy emphasizing profitability and self-sufficiency. The company had to cut marketing expenses, reduce staff, and exit unprofitable markets (Europe, India, and some Latin American countries).

So far, Shopee's strategy pivot has been positive. It reported a surprise positive adjusted EBITDA of $196 million in the fourth quarter of 2022. A year ago, it had a negative adjusted EBITDA of $878 million. Investors were pleasantly surprised by how quickly the turnaround occurred since the strategic shift only happened in the second quarter of 2022.

Still, there were some negative impacts on the strategic pivot, and one of the major ones was the massive growth slowdown. For example, revenue grew by 32% in the latest quarter compared to 89% in the previous period. Worse, gross orders and gross merchandise value (GMV) were lower year over year.

While investors will need a few more quarters to judge whether Shopee can resume its growth, they are probably more confident with the long-term sustainability of Shopee's business model after its recent profitable quarter.

So are Sea's woes finally behind it?

The short answer is not just yet.

On the one hand, there is a hugely positive signal from the recent earnings with Shopee posting a surprise profit.

Still, investors need to monitor the sustainability of Shopee's profitability over the next few quarters. Besides, we do not know whether Shopee can sustain its market share over time since it slashed marketing expenses and raised merchant fees.

And while Shopee has shown signs of development, Garena's headwinds remain after it reported weaker user engagements and financials. The battle is not over for the gaming business until these trends reverse themselves.

Overall, I think it's still too early to declare victory.