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Like Sea Limited? Here Are 2 Risks to Be Aware of Before You Buy | The Motley Fool

Sea Limited (NYSE:SE) has been a hot stock — and for good reasons.

For one, the tech company has proven its mettle. In just five years, it has transformed from a pure-play gaming start-up into a rising force in e-commerce, food delivery, and fintech. Moreover, Sea has often outperformed expectations, thanks to its strong execution and an ever-growing total addressable market.

The result: Its shares have rallied nearly 2,000% since Sept. 2016. Shares of Amazon, for perspective, rose approximately 240% over the same period. But to sustain its momentum, Sea will need to overcome some risks that could derail its growth trajectory.

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Sea Limited is overly dependent on Garena

Many tech sector investors may be familiar with Shopee, Sea’s fast-growing online shopping platform. But ask them about Garena — its gaming business — and you might get questioning looks. 

Make no mistake, though: It was Garena’s success that paved the way for Sea to expand into what it is today. The game developer and distributor is the company’s main earnings engine, generating billions of dollars in profits every year that it can use to scale up its other businesses, such as Shopee and Sea Money. This dynamic was clear in the latest quarter with Garena generating $741 million in adjusted EBITDA, while the remaining businesses reported an EBITDA loss of $765 million.

Garena is one of the world’s largest game distributors with rights to distribute top titles like Call of Duty and League of Legends in Southeast Asia. But the core driver of its performance is Free Fire, a mobile game it developed in-house. Sea doesn’t break out user numbers for individual titles, but it’s likely the majority of Garena’s quarterly active users — 725 million as of the second quarter — are on the platform to play Free Fire. This means the bulk of Sea’s profits can probably be attributed to this single game.

On one hand, this is an impressive achievement. Garena started out in 2009 as a little-known game distributor. It only released Free Fire in 2017, and at the time, no one could have predicted the title would become so successful. On the flip side, one video game serves as the foundation of its digital entertainment business — that’s a concentration risk that just can’t be ignored.

So far, Free Fire has been firing on all cylinders. Its user base continues to expand, not just in Southeast Asia but also in the United States and worldwide. This is fueling Garena’s ever-rising profits, but investors are counting the days until Free Fire starts losing relevance. In the gaming world, that’s simply a matter of time.

The big question is: Can Garena can come up with another smash hit? The company seems hard at work trying to create one. In Jan. 2020, it acquired U.S.-based Phoenix Labs, the maker of Dauntless — a highly rated, cross-platform game. Sea recently said it has expanded the Phoenix Labs team, adding new offices in Montreal and Los Angeles. But game development is notoriously difficult and expensive. If Garena fails to craft a title that can replicate Free Fire’s success, its future performance (and ability to prop up the rest of the company) will be in question.

Stretching itself too thin?

While Garena is Sea’s core profit driver, investors are most excited about Shopee.

Building on its success in Southeast Asia and Taiwan, Shopee is now pushing into other, equally promising markets. For instance, it is growing quickly in Latin America, where it is already one of Brazil’s most popular shopping apps. And earlier this month, Reuters reported Shopee is planning to launch in India and Europe too.

But while Shopee has executed well in Southeast Asia, there’s no guarantee it will be able to translate that experience into wins across these new regions. For one, success in retail requires a deep understanding of local markets, which can differ greatly from one country to the next.

But even if Shopee overcomes that challenge, it may face a dearth of resources to power its expansion. On one hand, it will need to compete with e-commerce giants like Amazon in a race to scoop up talent. And on the other hand, there is still the need for Garena to cover the bills, which isn’t sustainable long term.

Keep in mind that Sea is expanding beyond e-commerce into adjacent markets such as food delivery and logistics too. These initiatives have the potential to become sizable sources of revenue. For example, the company’s ambitions appear to be to turn Sea Money — its fintech arm — into the Ant Group of Southeast Asia. But this business, like the others, will require heavy investments in order to get it scaled up into a profitable operation.

Thus far, the market has cheered Sea’s never-ending drive to expand, but there is a real risk the company is trying to do too much, too fast. This risk should be low at the moment as Sea still had approximately $6 billion incash and short-term investments as of the second quarter, but investors should be on the lookout for red flags on its balance sheet or in its cash flows.

Sea is not a cheap stock

Many investors believe Sea Limited could one day be the next Amazon or Tencent. And given its impressive track record so far, it has a real shot at achieving that level of success in Southeast Asia and beyond.

However, the scale of this opportunity also explains why the stock trades at a nosebleed valuation of 25 times sales. That is an incredibly high bar to live up to, and investors should carefully consider the risks the company faces before rushing into this growth stock.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.


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