We reiterate our Buy recommendation on Sea Limited with a target price of US$467, implying a 133% upside.
Sea Ltd has lost 45% of its value since 19 October 2021 (when it was trading at all-time highs) – by comparison, the Nasdaq has been flat in this period and the MSCI Emerging Markets Information Technology Index is up 8%.
The reason for Sea's extreme underperformance are threefold:
Tencent Holdings Ltd, one of the early investors of Sea Ltd, sold a portion of its stake (shares in Sea fell more than 11% following the divestment news last week). Tencent raised US$3bn (in absolute terms) by selling 14.5 million shares at a price of US$208, reducing the holding from 21.3% to 18.7%. The block sale was at a c7% discount to the previous closing price.
Tencent's sell-off is in response to Beijing's increasing regulatory crackdown, with most Chinese tech majors now reevaluating their holdings/investments. The divestment will expand Tencent's cash pile to US$30bn and fund its overseas expansion.
There have been concerns about weakening growth for the Garena Free Fire game, which is the mainstay of Sea Ltd's Digital Entertainment (gaming) segment. The revenue from the digital entertainment segment quadrupled between FY 18 and FY 20, but there now seems to have been misgivings about the sustainability of this pace.
The market seems to be pricing in Sea's poor earnings report, with consensus now bracing for a net loss of US$1.9bn (GAAP).
Nevertheless, we remain positive on Sea's prospects. Our response to the misgivings about the stock are as follows:
Tencent is barred from selling further shares in Sea for the next six months. Tencent has also stated that it intends to hold on to the majority of its stake.
We expect Free Fire Max (a new version of the game) to generate growth from new markets like Russia and Central America – Free Fire is already the leading game in ASEAN, Latam and India. We expect the digital entertainment segment to record 67% yoy growth in FY 22.
We expect Sea to generate net losses till FY 22 – as with other EM tech stocks, it will trade on the topline growth. We then expect revenue growth of 70% in FY 22 compared to 48% in FY 23. Widening losses can anyway be absorbed as Sea has accumulated a net cash pile of US$5.4bn – the company has the wherewithal to fund a cash burn for several years.
In our view, the next catalyst will be the Q4 FY 21 results announcement, scheduled for 3 February 2022 – we expect yoy revenue growth of 109% and robust growth from the digital entertainment segment.
We reiterate our Buy recommendation driven by our FCFF-derived target price of US$467; the target price derived by SOTP is equivalent to US$357.