This article is excerpted from a letter by MOI Global instructor Mark Walker, Managing Partner at Tollymore Investment Partners, based in London.

In March 2019 we acquired shares of Sea Limited at a price of $24 per share. SE is substantially owned by insiders: Forrest Li, the founder CEO, owns 31% of the business[1] and Tencent owns 33%. All directors as a group own 44% of the company. Management has shown a preference to direct efforts and capital to projects that they believe will create long term value. SE operates three platform businesses in gaming, ecommerce and digital payments, primarily in seven Southeast Asian markets.

Garena distributes mobile and PC online games in its markets. Most games that Garena distributes are done so exclusively. Garena also recently had significant success with its first internally developed game, Free Fire, which was the fourth most downloaded game in the world in 2018 and was available outside of SE’s core SE Asian markets, including Europe, LatAm and Africa.

Shopee is an ecommerce marketplace which has adopted a mobile-first approach since its inception in 2015. Shopee is a platform for connecting buyers and sellers of long tail products across fashion, health and beauty, home and living, and baby products. Shopee provides tools such as payment, logistics and fulfilment.

AirPay is a digital payments provider launched in 2014. Consumers can use the AirPay app as an e-wallet to pay for products and services. AirPay is integrated into the Garena and Shopee platforms.

All three business models are platforms which require investment to drive scale and barriers to entry but have potential winner-take-most economic outcomes.

Garena’s network effects emanate from the social, multi-player nature of the games distributed. Each new gamer increases the value of the platform for existing users. This dynamic might suppress the cost of acquiring new users as the network grows in scale, as current users will tend to invite new users to the platform. Strong and long-tenured developer relationships turn the flywheel: Garena’s success in distributing games for local game players has facilitated relationships with international game developers such as Tencent, Riot Games, Electronic Arts and PUBG Corporation. This has allowed Garena to source high quality games from world class developers, many of whom work as exclusive partners in SE Asia. Management is focused on the virtuous cycle dynamics of attracting more users with high quality games, which attracts more high-quality developers. The more users they have and the more games they distribute the better they become at localising games, increasing their appeal to gamers and developers.

Shopee also has platform dynamics: as the number of buyers increases, Shopee attracts an increasing number of sellers, resulting in increases in SKU variety available on the platform, which increases the purchasing opportunities, and therefore monetisation potential, or value, for each of those buyers. Shopee was the largest ecommerce platform in SE’s region in 2018 by GMV and total orders. Shopee was also the most downloaded app in the shopping category in Southeast Asia in 2018.

The long tail products that are the focus of Shopee’s marketplace support margins due to lighter price competition vs. top-selling products. Ecommerce lends itself to long tail selling due to the capacity for predictive analytics and personalised recommendations to stimulate liquidity in niche markets. Sellers are supported through a network of payment providers and logistics partners, integrated into the platform, as well as local teams to help sellers make use of Shopee’s business management tools. Shopee provides a one stop shop allowing sellers to streamline store setup, inventory and revenue management, delivery and payment collection.

The capacity for platform businesses to create substantial barriers to profitable participation may be quite broadly understood. As is the economic characteristic that additional users in a platform business model add more value for existing users. However, in addition, platform scale strengthens the ability of the platform to offer white labelled goods and original content. Netflix uses customer preference data collected over time to deliver not just a marketplace of products, but original shows. Like Netflix, Garena intends to develop more original content while distributing third party content. Based on customer intelligence, Amazon has c. 70 private label brands, which were started in niche categories like batteries. Amazon’s marketplace dominance allows it to scrape the content of user reviews and return feedback of third-party products and use that information to create superior products that are more valuable to consumers.

Garena’s user base growth and engagement are driven by the launch of new games, the expansion of existing games into new markets, and the improvement and launch of new content in existing games. Southeast Asia is the fastest growing games market in the world; despite >60% internet penetration, the region has the most engaged mobile internet users on the planet.

Garena organises hundreds of esports events annually and operates the largest professional league in the region[2]. In 2019, the global esports economy will grow to $900 mn, a yoy growth of 38%. Three quarters of this will come from sponsorships and advertising. Media rights, tickets and merchandise make up the remainder. Global esports audiences, currently c. 380mn people, or 5% of the planet, have been growing in the mid-teens. 20% of the global population is now aware of esports. This growth has been driven by streaming platforms such as Amazon-owned Twitch, which attracts 15mn viewers per day each spending 100 mins per day watching live gaming.

There is evidence to support the assertion that esports is becoming increasingly mainstream:

  • Personnel have been recruited from mainstream sports media. A few years ago, Activision announced that it was forming a dedicated esports division, and it hired Steve Bornstein, former CEO of ESPN and the NFL Network, to lead it.
  • Broadcasting rights deals are being struck with Twitch as well as mainstream broadcasters such as Disney and ESPN.
  • Sponsorship is becoming more mainstream. Esports teams have traditionally been able to pull in sponsors that are already closely associated with gaming e.g. from PC gaming companies like Razer, computer-makers HP and Intel, to Toyota and T-Mobile.
  • Employment conditions of players are formalising. Guaranteed contracts with minimum salaries are becoming more common, and teams are investing in state of the art training facilities, including coaches, chefs, dieticians, and sports psychologists.
  • Esports is big enough to fill an Olympic stadium. The finals of the League of Legends World Championship were held at the Beijing National Stadium. Esports are increasingly included in the thoughts of Olympic Games organisers around the world. Esports were featured at the 2018 Asian Games as a demonstration sport and will be a medal event at the 2022 Asian Games. Paris 2024 Olympic organisers were “deep in talks” about including esports as a demonstration sport at the games.

Shopee’s capital allocation priority is to build marketplace scale and liquidity, and increasingly on monetisation as GMV and market share continue to rise. It is this higher scale and liquidity that increases the rate at which the business can monetise its assets. In management’s words in the 2018 10K:

“We have made a strategic decision to invest in the growth of our Shopee marketplace by incurring sales and marketing expenses in advance of our monetisation efforts. We believe that taking a thoughtful approach to monetisation by building our user base and increasing engagement first will allow us to maximise our monetisation in the future.”

And on the FY17 conference call:

“It’s very clear in our mind, and it becomes clearer with every passing day, that almost all of our markets are consolidating very quickly and more quickly than we would have anticipated that even six or nine months ago. Secondly, as a matter of principle, when given the choice to ease our spend and maintain our share or invest more heavily to expand our share, we’ve chosen the latter strategy. Reason being, we believe that investment is going to help us achieve dominance in the categories that are so important to us, female long-tail categories. That kind of dominance and the ability to be the go-to platform for these important and very profitable categories as we’ve talked about in the past should bring us to higher monetisation levels going forward. So really, just to conclude, at the end of the day, winning a merchant or a customer today in our mind is much better than having to spend more to win them in the future.” The emphasis is ours; it seems consistent with a capital allocation objective to maximise total long-term value for owners and reflects a capacity to suffer that is a desirable quality for such long-term owners.

Ecommerce penetration is materially below global averages in almost all Shopee’s markets, but ecommerce and m-commerce engagement in Indonesia, Shopee’s largest market representing almost half of GMV, is the highest in the world. The GMV of the internet economy is 2.8% of SE Asia’s GDP in 2018, up from 1.3% in 2015 — and is projected to exceed 8% by 2025. SE Asia is almost 10 years behind the U.S., in which the GMV of the internet economy was 6.5% in 2016.

The monetisation of Shopee’s customer is improving, driven by (1) higher take rates increasing the gross profitability of transactions on the platform, and (2) falling shipping subsidies driving sales and marketing leverage. Shopee’s take rate (revenues/GMV) is currently suppressed by efforts to build scale and market leadership, entrenching the network effects’ barriers to entry of the business. But the take rate has been increasing and management expects this to continue through a combination of commissions, advertising fees and value-added services. Outside of Taiwan, Shopee charges zero commissions. In Shopee’s most competitive market, Singapore, peers are charging between 3% and 30% commissions. Qoo10 charges 8-12% seller commissions in Singapore. 11street charges between 3% and 12% commissions rates to sellers in Thailand and Malaysia. In fashion, Shopee’s largest category, sellers are charged 12%. Lazada charges on average 6.5% commissions plus a 2% payment fee in its markets. In fashion, sellers are charged 12% including the payment fee. Naturally the direct profitability of Shopee’s business is driven by the take rate that Shopee can command on the GMV passing through its platform. In 2017 Shopee’s take rate was practically zero and its gross margin was -125%. In 2018 the take rate was 2.8% and the gross margin was -65%. In 4Q18 Shopee’s take rate was 3.7% and its gross margin was-52%. Even if we can expect diminishing marginal returns to higher take rates, the capacity to increase the take rate bodes well for the potential gross profitability of future transactions.

Shopee has heavily subsidised the cost of shipping for its sellers in order to build supply scale. The extent of these subsidies has been declining without any noticeable impact of GMV growth, resulting in sales and marketing expenses declining as a percentage of revenues. Shipping subsidies declined qoq in absolute dollar terms in 4Q18 as free shipping is now only available on baskets of a minimum size. This marketing efficiency improvement was achieved while GMV/orders grew 27%/31% quarter-on-quarter. Sales and marketing as a percentage of GMV for Indonesia, Shopee’s largest market, was lower than the ratio for Shopee as a whole, supporting the contention that scale drives operational leverage with respect to the cost of acquiring new customers. Management expects sales and marketing expenses to decline in absolute terms from here, signalling a potential inflection point in ecommerce profitability.

What are the counterarguments to our conclusion that this is a high-quality business with avenues for profitable redeployment of capital? Negative experiences spread quickly online, and SE’s business success is driven by customers’ trust in the platform. Customers must believe they will be protected in order to transact safely online. As the number of connections and transactions grows exponentially there is a risk that this additional complexity renders SE’s risk control measures inadequate. This might lead to negative network effects as one or both sides of the platform are driven away by unpleasant experiences. Shopee verifies sellers, screens listings and has teams dedicated to dispute resolution. Shopee also offers a ‘Shopee Guarantee’ under which buyer payment is held by Shopee until delivery of the goods, reducing settlement risks and encouraging buyers to purchase online. The huge increases in active user engagement across a variety of online services suggests consumer comfort with transacting online is increasing.

Ecommerce competition may inhibit user monetisation. Shopee may not be able to adequately monetise the transactions taking place on its platform. So far KPIs relating to the company’s monetisation progress are moving in the right direction. Take rates are increasing and subsidies are reducing without harming the company’s asset growth.

Changing gaming tastes. Garena has three- to seven-year agreements in place with multiple developers. It can use its experience as a distributor of games developed by others to improves the prospects for success in its own internal development ambitions. Free Fire is a short, but encouraging, piece of evidence that they may be able to do this successfully.

Assuming, for now, that AirPay is worth nothing, what is the implied valuation of Shopee for a range of sustainable growth hypotheses applied to Garena’s profits?

If we assume that Garena can never grow its EBITDA, an investor with a 10% opportunity cost of investing might be willing to pay 10x EBITDA, or c. $5.5bn to earn this opportunity cost. This would imply a valuation of Shoppe of $3.3bn, one third of SE’s current enterprise value of $8.8bn and 5x Shopee’s expected sales this year.

If we value Garena at 16x EBITDA, or less than 4% sustainable EBITDA growth, both Shopee and AirPay are priced by the market as worthless. The implied value of less than $9bn for Garena would seem conservative given the business’s demonstrated profit growth and potential.

If Shopee and AirPay burn through SE’s $2bn cash pile but fail to make progress in demonstrating the ultimate path to sustainable profitability, we might be willing to pay $9bn to own SE’s equity, c. 18% downside from today’s market cap of $10.8bn.

What assumptions does an owner of this business need to make to render his interest worthless? We could assume that Free Fire is a one hit wonder, and therefore Garena’s profitability shrinks by some 30%, and never grows again. We might also need to assume that the company’s cash balance of $2bn is used to fund investment in AirPay and Shopee which earns zero return, and that in addition SE continues to burn cash at the current rate of $750mn per year for the next five years (undiscounted). There is evidence to suggest that this is not an appropriate set of assumptions: Shopee’s take rates are improving; Shopee’s sales and marketing leverage is improving; and Shopee’s user, order and transaction growth remain strong.

If Garena can sustainably grow nominal EBITDA in line with real GDP growth in the region of c. 5%, AirPay is worth nothing and Shopee is valued at 5x 2019 revenues (making no adjustments to revenue to reflect the potentially supressed take rate), SE’s equity is worth c. $16bn, 50% higher than the current quoted market cap.

If Garena can sustainably grow nominal EBITDA modestly in excess of real GDP growth in the region of c. 5%, AirPay is worth nothing and Shopee is valued at 10x normal revenues, adjusting the estimated take rate from 4% to 10% in line with competitors in the region , SE’s equity is worth c. $37bn, 240% higher than the current quoted market cap.

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Disclaimer: The contents of this document are communicated by, and the property of, Tollymore Investment Partners LLP. Tollymore Investment Partners LLP is an appointed representative of Eschler Asset Management LLP which is authorised and regulated by the Financial Conduct Authority (“FCA”). The information and opinions contained in this document are subject to updating and verification and may be subject to amendment. No representation, warranty, or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this document by Tollymore Investment Partners LLP or its directors. No liability is accepted by such persons for the accuracy or completeness of any information or opinions. As such, no reliance may be placed for any purpose on the information and opinions contained in this document. The information contained in this document is strictly confidential. The value of investments and any income generated may go down as well as up and is not guaranteed. Past performance is not necessarily a guide to future performance.

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