Sell Down in Sea Group and What's next?

Sea Group has been sold down from US$370 on 20 October 2021 to US$87.62 on 22 April 2022. This is a 76% decline in share price.

Is this the end of the Sell Down?

The sell down in the past 6 months has been due to 2 reasons: (i) risk off behavior by investors due to interest rate hikes and quantitative tightening and (ii) companies failing to meet their own guidance or have growing losses.

The effects of (i) should be almost done, barring any surprises from the Federal Reserve such as a 75 basis point hike in May 2022. However what I am worried is Sea Group will report another set of poor results for 1Q2022 in June 2022.

Why a Poor Q1?

The growth of Sea's gaming arm has slowed as the popularity of Free Fire has plateau. In addition, while Shopee and Sea Money are growing, their losses are growing as well because these 2 segments are operating at negative margins. Hence, if Sea Group reports a loss that is of the same magnitude as Q1 2021, I expect another wave of sell down in June 2022.

Unless Sea Group provides an optimistic guidance that it is able to breakeven on an accounting basis in 2023, i doubt there is any other catalyst to move share prices up to its old highs. Given the current climate where investors are brutally selling off shares due to poor results and guidance, I expect Sea Group to suffer the same fate with its large losses. Investors will remember Sea has a few billion in bonds maturing in 2025/2026 and given its low share prices, bondholders will likely be redeeming in cash. This means Sea Group has to start putting in profitable quarters soon, otherwise a severe cash crunch is due in 4 years time if it continues burning billions in cash annually.

All in all, I expect another 25% fall in share prices, similar to what paypal experienced when it did not meet expectations. Sea Group is a prospect to look at after all the negatives are priced in. As mentioned in my previous post on Sea Group, my expectation is it has a valuation of US$95 (US$55 billion valuation). However, it is not a good time to buy now with prices offering too small a margin at US$87.62.

How much is Shopify Worth?

Shopify is a well known name in the e-commerce space for Canada and USA markets. It holds the number 2 spot in market share behind Amazon. Unlike Amazon, Shopify allows for its merchants to have customizable layouts for their e-commerce shops. Shopify earns from the subscription plans a merchant signs up to join its platform and the transaction fees for sales.

Verified Profitable Model

Unlike most start ups which promise growth and a large market share that can be monetized, Shopify has achieved this with an e commerce market share that is number 2, behind Amazon and is profitable in monetizing its user base. It achieved profitability in 2020, registering a core earning of US$90 million.

For 2021, its core profits tripled to US$268 million.

Shopify's FY 2021 results

How High can Profits Go?

I do not have a crystal ball but I will guess. With the post COVID-19 world, it is unlikely companies in the digital space will continue its blistering growth. I doubt Shopify can repeat a tripling of its core earnings this year; profits will grow by US$150 million to about US$400 million (55% growth).

Thereafter we will see a decade of 20-30% annual growth from growing revenue which will help profits, before an eventual plateau. This is because there is a limit to how much Shopify can take from Amazon in the growing e-commerce pie of the Western World and the inability to penetrate into China's market. 

Risk to its Business

The entire Western World is now in an interest hike tightening environment due to inflation. The first order effect is that consumers are going to tighten their belt and spend less. This  affects e-commerce spending growth.

The second order effect is a raising interest environment means it is more expensive for western countries to service their debts. Budget cuts may be inevitable which spurs less growth for the economy and in turn consumer spending.

In the short term, it is likely Shopify will announce US$2 billion in losses for its equity investments in other companies which it has marked up over the past 2 years due to the US market rally. The fear of interest rate hikes has wiped out most of the US companies equity gains.

Valuation of Shopify

Looking at FY 2022, I would expect US$400 million in profits. Followed by a decade of double digit growth of 20-30% with some downside in a changing monetary environment; a 90 times P/E to its core business earnings for FY 2022 is where I would invest. This is because I have to stomach a decade of risk that either the growth story does not materialize or a new entrant disrupts Shopify.

This values the company at a US$36 billion valuation. At current valuations of US$58 billion ($460 share price) or 145 times P/E, I think the market is baking too much optimism that Shopify will execute perfectly for the next decade. There is no margin of error. Hence, a further 40% of reduction of share price (US$276 to US$280) is warranted.

No doubt it is a company with a good growth story, but its current valuation is too high to justify it.