2 Major Risks Smart Investors Should Know About Sea Limited

The Motley Fool
The Motley Fool

Sea Limited (NYSE: SE) is one of the more interesting investing stories in recent years. It not only runs a profitable video gaming franchise but also owns a fast-growing e-commerce business and an emerging fintech company. Then add in the fact that the company operates in some of the fastest-growing e-commerce regions -- Southeast Asia and Latin America -- and recently has entered Indian and European markets.

Investors, understandably, have shown a lot of interest in Sea, sending its stock up by more than tenfold in the last five years. That's even after its recent stock correction of more than 50% from all-time highs set in October!

While it's agreed that Sea has solid prospects , smart investors should not overlook the possible downsides of investing in this tech company. Here are two key risks that investors should know.

Image source: Getty Images.

1. Sea is overly dependent on a single revenue source

Investors have high hopes for Sea to replicate Alibaba Group Holding 's (NYSE: BABA) success in e-commerce in Southeast Asia. But Sea's biggest (and currently only) profitable business is the company's gaming subsidiary, Garena. What's more, Garena generates the bulk of its revenue from one single game -- Free Fire. While Sea does not break out Free Fire's income separately, the revenue contribution from its other games would likely be small compared to Free Fire.

The success of Free Fire cannot be overstated. Between March 31, 2016, and Sept. 30, 2017, Garena reported that quarterly active users (QAU) grew by 22 million to 69 million. After launching Free Fire, its first self-developed game, in December 2017, QAU surged to 88 million by the end of that quarter. Fast forward to the third quarter of 2021; Garena's QAU reached 729  million as Free Fire became the top-grossing game across Southeast Asia, Latin America, and India.

Free Fire 's success propels Sea's gaming revenue from $355 million for the whole of 2017 to $1.1 billion in just a single quarter. It also provides Sea with the necessary capital to invest in its other business segments, Shopee (e-commerce) and SeaMoney (fintech).

While investors are delighted with the opportunity to reallocate capital, it does open up other risks. As a start, there is no guarantee that Free Fire can continue to deliver revenue growth in the foreseeable future. After all, users may eventually get tired of the game, or other new games may become more popular. This will not occur overnight, but it is just a matter of time before Free Fire popularity plateaus and starts falling -- just like all its predecessors. Its QAU grew by just 4 million to 729 million in the latest quarter, an early sign of flattening growth. Even if Free Fire manages to sustain its popularity, other hiccups may come along that cause the game to become less profitable. For example, PUBG producer Krafton has recently filed a lawsuit against Free Fire . W hile still in its early stage, the legal action may lead to significant financial and operational penalties in the future.

In short, it is dangerous for Sea to be overly dependent on a single title. To this end, it is trying to diversify such risks by developing new games. It acquired a gaming studio in Canada to facilitate this process. But until Garena proves that it can deliver new hit games, investors should remain highly vigilant to this risk.

2. Shopee and Sea Money are gobbling up cash

With Garena's QAU user growth tapering, investors hope Shopee and SeaMoney can become the new money spinners. While both segments have good prospects, success is not assured.

Take Shopee, for example. Though it is a leader in Southeast Asia's e-commerce market, its rival Lazada is not sitting still. Alibaba has shifted its focus toward the international market -- Lazada is the key to this strategy shift -- as the Chinese government continues to crack down on its dominance in China. As Lazada exerts its muscle to gain share, competition will intensify in the Southeast Asia region.

If that is not enough, Shopee faces equally formidable competitors in its newer markets. In Latin America, it has to compete against top dog Mercadolibre . Similarly, Shopee will inevitably confront incumbents like Amazon as the newcomer ventures into India and Europe. While there is no guarantee that these initiatives will create value for shareholders over the long term, Shopee will need to fork out a lot of cash to participate in the race. For perspective, Shopee more than doubled its operating loss year over year to $741 million in the latest quarter, and the number could rise further in the coming quarters.

Similarly, SeaMoney is consuming a massive amount of cash. It reported an operating loss of $166 million in the latest quarter as it tried to scale in Southeast Asia. While the fintech is well-positioned to leverage Garena and Shopee's users and grow, it is too early to declare victory as it has to battle incumbents. Take Malaysia as an example. Grabpay and Touch & Go, backed by Ant Group, have been operating in this market for many years. It will take enormous effort, resources, and time for ShopeePay (Sea's e-wallet) to catch up with them.

In other words, Sea will need to invest heavily in both its e-commerce and fintech businesses. Historically, Sea bankrolled this with the cash flow from Garena. If Garena fails to sustain and grow its cash flow over time, there is a danger that Sea might need to scale down its investments in these newer areas. If that happens, Sea may have to scale back its ambitions for these young businesses, impacting its future growth.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Lawrence Nga owns Alibaba Group Holding Ltd. The Motley Fool owns and recommends Amazon, MercadoLibre, and Sea Limited. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy .

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