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

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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 lớn direct efforts and capital to lớn projects that they believe will create long term value. SE operates three platkhung businesses in gaming, ecommerce & digital payments, primarily in seven Southeast Asian markets.

Garena distributes sản phẩm điện thoại và 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 & 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 năm ngoái. Shopee is a platkhung for connecting buyers & sellers of long tail products across fashion, health và beauty, trang chủ và living, và baby products. Shopee provides tools such as payment, logistics và fulfilment.

AirPay is a digital payments provider launched in 2014. Consumers can use the AirPay phầm mềm as an e-wallet lớn pay for products & services. AirPay is integrated inkhổng lồ the Garemãng cầu & Shopee platforms.

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

Garena’s network effects emanate from the social, multi-player nature of the games distributed. Each new bạn increases the value of the platkhung for existing users. This dynamic might suppress the cost of acquiring new users as the network grows in scale, as current users will tkết thúc to lớn invite new users lớn the platform. Svào & 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 và PUBG Corporation. This has allowed Garena lớn source high chất lượng games from world class developers, many of whom work as exclusive sầu 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 và the more games they distribute the better they become at localising games, increasing their appeal khổng lồ gamers và developers.

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

The long tail products that are the focus of Shopee’s marketplace tư vấn margins due lớn lighter price competition vs. top-selling products. Ecommerce lends itself lớn long tail selling due khổng lồ the capathành phố for predictive sầu analytics & personalised recommendations to lớn stimulate liquidity in nibít markets. Sellers are supported through a network of payment providers và logistics partners, integrated into lớn the platform, as well as local teams to lớn help sellers make use of Shopee’s business management tools. Shopee provides a one stop cửa hàng allowing sellers khổng lồ streamline store thiết đặt, inventory and revenue management, delivery và payment collection.

The capathành phố for platkhung businesses lớn create substantial barriers lớn profitable participation may be quite broadly understood. As is the economic characteristic that additional users in a platkhung business Model add more value for existing users. However, in addition, platkhung scale strengthens the ability of the platsize khổng lồ offer white labelled goods and original nội dung. Netflix uses customer preference data collected over time to lớn deliver not just a marketplace of products, but original shows. Like Netflix, Garena intends to lớn develop more original content while distributing third buổi tiệc ngọt content. Based on customer intelligence, Amazon has c. 70 private label brands, which were started in nibít categories lượt thích batteries. Amazon’s marketplace dominance allows it khổng lồ scrape the nội dung of user Reviews & return feedbachồng of third-tiệc ngọt products & use that information lớn create superior products that are more valuable to lớn consumers.

Garena’s user base growth & engagement are driven by the launch of new games, the expansion of existing games inkhổng lồ new markets, và the improvement and launch of new content in existing games. Southeast Asia is the faskiểm tra growing games market in the world; despite >60% internet penetration, the region has the most engaged sản phẩm điện thoại internet users on the planet.

Garemãng cầu organises hundreds of esports events annually and operates the largest professional league in the region<2>. In 2019, the global esports economy will grow khổng lồ $900 mn, a yoy growth of 38%. Three quarters of this will come from sponsorships và advertising. Media rights, tickets và merchandise ảo diệu the remainder. Global esports audiences, currently c. 380mn people, or 5% of the planet, have sầu 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 sầu gaming.

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

Personnel have been recruited from mainstream sports truyền thông media. A few years ago, Activision announced that it was forming a dedicated esports division, & it hired Steve sầu Bornstein, former CEO of ESPN và the NFL Network, to lớn lead it.Broadcasting rights đơn hàng are being struchồng with Twitch as well as mainstream broadcasters such as Disney và ESPN.Sponsorship is becoming more mainstream. Esports teams have traditionally been able lớn pull in sponsors that are already closely associated with gaming e.g. from PC gaming companies lượt thích Razer, computer-makers HPhường and Hãng sản xuất Intel, to lớn Toyota và T-di động.Employment conditions of players are formalising. Guaranteed contracts with minimum salaries are becoming more comtháng, & teams are investing in state of the art training facilities, including coaches, chefs, dieticians, & sports psychologists.Esports is big enough lớn 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 và 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 lớn build marketplace scale và liquidity, và increasingly on monetisation as GMV và market giới thiệu continue to lớn 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 & marketing expenses in advance of our monetisation efforts. We believe sầu that taking a thoughtful approach lớn monetisation by building our user base & increasing engagement first will allow us to lớn maximise our monetisation in the future.”

And on the FY17 conference call:

“It’s very clear in our mind, và it becomes clearer with every passing day, that almost all of our markets are consolidating very quickly and more quickly than we would have sầu anticipated that even six or nine months ago. Secondly, as a matter of principle, when given the choice khổng lồ ease our spkết thúc and maintain our share or invest more heavily lớn expand our mô tả, we’ve chosen the latter strategy. Reason being, we believe that investment is going lớn help us achieve sầu dominance in the categories that are so important to us, female long-tail categories. That kind of dominance & the ability lớn be the go-to platsize for these important and very profitable categories as we’ve talked about in the past should bring us lớn higher monetisation levels going forward. So really, just lớn conclude, at the over of the day, winning a merchant or a customer today in our mind is much better than having to lớn spover more to win them in the future.

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The emphasis is ours; it seems consistent with a capital allocation objective sầu khổng lồ maximise total long-term value for owners & reflects a capađô thị to lớn suffer that is a desirable unique 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 GDPhường. in 2018, up from 1.3% in 2015 — và is projected khổng lồ exceed 8% by 2025. SE Asia is almost 10 years behind the U.S., in which the GMV of the mạng internet economy was 6.5% in năm 2016.

The monetisation of Shopee’s customer is improving, driven by (1) higher take rates increasing the gross profitability of transactions on the platkhung, & (2) falling shipping subsidies driving sales and marketing leverage. Shopee’s take rate (revenues/GMV) is currently suppressed by efforts to lớn build scale and market leadership, entrenching the network effects’ barriers to entry of the business. But the take rate has been increasing & management expects this to continue through a combination of commissions, advertising fees và value-added services. Outside of Taiwan, Shopee charges zero commissions. In Shopee’s most competitive market, Singapore, peers are charging between 3% và 30% commissions. Qoo10 charges 8-12% seller commissions in Singapore. 11street charges between 3% and 12% commissions rates khổng lồ sellers in Đất nước xinh đẹp Thái Lan & 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 platkhung. In 2017 Shopee’s take rate was practically zero and its gross margin was -125%. In 2018 the take rate was 2.8% & 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 lớn higher take rates, the capacity to lớn 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 khổng lồ 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 form size. This marketing efficiency improvement was achieved while GMV/orders grew 27%/31% quarter-on-quarter. Sales and sale 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 khổng lồ the cost of acquiring new customers. Management expects sales và kinh doanh expenses to lớn 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-unique business with avenues for profitable redeployment of capital? Negative experiences spread quickly online, & SE’s business success is driven by customers’ trust in the platform. Customers must believe sầu they will be protected in order lớn transact safely online. As the number of connections & transactions grows exponentially there is a risk that this additional complexity renders SE’s risk control measures inadequate. This might lead lớn negative sầu network effects as one or both sides of the platkhung are driven away by unpleasant experiences. Shopee verifies sellers, screens listings & has teams dedicated lớn dispute resolution. Shopee also offers a ‘Shopee Guarantee’ under which buyer payment is held by Shopee until delivery of the goods, reducing settlement risks & encouraging buyers to purchase online. The huge increases in active sầu 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 lớn adequately monetise the transactions taking place on its platkhung. So far KPIs relating to the company’s monetisation progress are moving in the right direction. Take rates are increasing & subsidies are reducing without harming the company’s asphối growth.

Changing gaming tastes. Garemãng cầu has three- to lớn seven-year agreements in place with multiple developers. It can use its experience as a distributor of games developed by others khổng lồ 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 lớn vì chưng 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 lớn 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 lớn pay 10x EBITDA, or c. $5.5bn khổng lồ 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 và potential.

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

What assumptions does an owner of this business need khổng lồ make lớn render his interest worthless? We could assume that Free Fire is a one hit wonder, & therefore Garena’s profitability shrinks by some 30%, & never grows again. We might also need khổng lồ assume that the company’s cash balance of $2bn is used khổng lồ 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 sầu years (undiscounted). There is evidence khổng lồ suggest that this is not an appropriate phối of assumptions: Shopee’s take rates are improving; Shopee’s sales and sale leverage is improving; and Shopee’s user, order & transaction growth remain svào.

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

If Garemãng cầu can sustainably grow nominal EBITDA modestly in excess of real GDP growth in the region of c. 5%, AirPay is worth nothing và 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.