🌊 NYSE:SE - Shopee: The King of S&M (sales & marketing exp)
Evaluating ASEAN e-commerce marketplace Shopee's performance - using GAAP accounting metrics (e.g. revenue), rather than non-GAAP metrics (e.g. adjusted EBITDA/GMV)
Click here to read this stock report in your browser - emails may not reflect any subsequent editing! Also, paid subscribers can join our Telegram group chat by clicking here.
In this report, we shall attempt to evaluate the historical performance of SEA Ltd’s e-commerce marketplace Shopee - using GAAP accounting metrics, considering how unreliable non-GAAP metrics have been in the recent past.
Evaluating the business performance of startups (e.g. Shopee) can be performed via two measures, by asking: 1) Is There Product Market Fit? and 2) Does Operating Leverage Exist?
We can answer these two questions by observing SE’s historical GAAP accounting metrics rather than management’s promises - and from there, draw reliable conclusions with regards to their future outlook and potential valuation.
Paid subscribers gain access to a one-pager of SE’s key statistics and a comprehensive 500-row Excel financial model of SE’s three statements - get a 10% discount if you subscribe today!
Note: All share prices listed in this report are based on the closing share price at 16 May 2022 of USD 70.33. Please adjust as necessary.
EDIT (29.05.22): One thing that I previously forgot to include in this report is that by giving out excessive free shipping promotions, SE could have shifted their normalized shipping fee expenses from COGS to S&M (i.e. below the Gross Profit line). Hence, Gross Profit is not the best profit trend to observe in terms of estimating their normalized cash-on-cash return. With investors now demanding profitability and free shipping promotions expected to fall in frequency, investors should pay attention to how their Gross Profit trend improves going forward.
Chapters:
For ease of navigation, please click on the links below to jump to the respective chapters of this article:
Evaluating SE’s performance using standard GAAP accounting metrics - rather than non-GAAP metrics
The Underlying Economic Framework For Evaluating Startup Performance
(The above links which jump to the relevant chapters will only work in the desktop version of Google Chrome. If you’re using a different browser, please scroll to the relevant chapters below.)
Evaluating SE’s performance using standard GAAP accounting metrics - rather than non-GAAP metrics
SEA Ltd (NYSE:SE) probably needs no introduction to the mainstream investor - it was the darling of the stock market for quite awhile, after climbing +300% since the pandemic began, and +2,000% since its listing on the NYSE in Oct 2017. While you’d still be up +25% CAGR today if you had invested immediately before the pandemic began (or +33% CAGR from its listing), it’s still a far cry from the 250% CAGR you would have gotten if you had sold at the peak in Oct 2021 at $367.
The reason why SEA Ltd and its unicorn-like South East Asian (i.e. “SEA”) e-commerce business Shopee probably needs no introduction is because there are already thousands of similar reports like this one covering SE, amidst its meteoric share price rise over the past two years. Some of them go into extreme detail about their respective business segments - and if this is your first time stumbling across SE, these can probably do a better job of getting you up to speed with SE and Shopee than I can. Here’s an example of one such blog who I think has done a fantastic job of covering the bases of SE’s respective businesses:
Fortunately, my goal for this report isn’t to rehash the same business narrative of SE - which many of you have probably read 100x over already.
WHAT I WILL BE DOING DIFFERENTLY IN THIS REPORT will be to evaluate SE’s and Shopee’s historical performance via an accounting lens - by analyzing their GAAP accounting figures (e.g. revenues) from their three statements (i.e. P&L, B/S, CFS), rather than their pro forma or non-GAAP figures (e.g. GMV).
One nitpick that I’ve always had with all the previous SE reports that I’ve read thus far, is that most of them derive their valuation based on non-GAAP figures (e.g. GMV, EBITDA, QPU, etc) - rather than the more familiar GAAP-based line items extracted from their three statments (e.g. Revenue, Net Profit). To be fair, SE hasn’t attained profitability yet despite having been listed for nearly 5 years - hence more traditional valuation metrics like the PE ratio (or even EV/EBITDA) might be inadequate for valuation purposes.
However, that still didn’t quite scratch away the itch that these are still non-GAAP figures - which I’ve never been comfortable relying wholly and exclusively on for estimating a company’s valuation (e.g. Valeant Pharmaceutical’s infamous ‘cash earnings’). Non-GAAP figures simply haven’t withstood the test of time as robustly as the GAAP accounting line items in the three statements have - where accounting standards lay out extremely well-defined definitions for their recognition criteria. While I’m not suggesting that there has been any hanky panky going on with SE’s numbers, it still makes me uncomfortable when two non-GAAP figures are combined to justify an investment thesis - e.g. improving Adjusted EBITDA losses/GMV over time.
What I find a bit unsettling is that, up to today, I have not come across a single investment thesis for SE based exclusively on traditional GAAP accounting line items - most of them incorporate non-GAAP figures to a significant extent in order to justify the investment thesis. This is what this report aims to cure - as I will be approaching SE’s valuation from a standard GAAP accounting perspective rather than using non-GAAP figures (the way an actual PE investor analyzing SE like Tencent might).
Scope
As most of SE’s Group performance and valuation is contingent on their e-commerce business Shopee, we shall be focusing exclusively on evaluating Shopee’s performance in this report, in the interest of brevity. We will also be focusing mainly on their ASEAN operations (63% of revenues) - since most of their other regions have either been declining in revenue share (e.g. Taiwan: 14%) or still remain fledgling operations (Latin America: 19%). And with Shopee’s recent exit from both India and France, I think we should conservatively not expect too much from their non-ASEAN operations.
Most investors would also agree that it is safe to assume that the status quo maintains for the rest of their other businesses, such as their Gaming segment. While the news of India banning its hit game Free Fire is bound to impact their valuations, it should not materially affect the Gaming segment’s pre-Free Fire role of basically being an internal reinvestment channel for their E-commerce segment. Given Shopee’s outsized contribution towards SE’s valuations and in the interest of brevity, we will be assuming the status quo remains for their Gaming segment.
SEA Ltd (NYSE:SE) Links:
Check out our related articles: What The Early Amazon Investors Saw & Big Tech is Officially in Value Investing Territory
We also have a sister news blog for daily market news, Value Investing Substack NEWS. Click the box above to check it out!
The Underlying Economic Framework For Evaluating Startup Performance
Since SE’s nominal profits are getting further and further away from breakeven levels over time, we can’t use traditional earnings-based valuation metrics like the PE ratio to inform SE’s valuations. This has resulted in most sellside analysts understandably relying on arcane non-GAAP figures like Adjusted EBITDA losses/GMV or Bookings/QPU in order to arrive at their valuation estimates - with accompanying disastrous results.
However, by understanding the underlying economic framework for evaluating startup performance, we can identify SE’s key success factors from a business perspective (i.e. what a businessman would look for) - and then reverse-engineer from there to determine what kind of GAAP accounting metrics we want to use to monitor their historical performance. In this way, we avoid having to jump through hoops in order to justify an investment thesis with arbitrary non-GAAP numbers. And to be fair, these are exactly the kind of standard GAAP accounting metrics that venture capitalists (VCs) would be demanding from SE’s management if they were raising funds from PE/VC (private equity/venture capital).
Let’s be clear about one thing - SE is still effectively a startup, with startup economics to boot. While it’s true that they have a mature Gaming business segment, SE’s valuations are to this day still very much contingent on their immature E-commerce business (i.e. Shopee) - resulting in their horrendously cratering Net Losses. This is largely due to the startup mentality which has perpetuated the Big Tech sector for the past half-decade - grow market share at the expense of profits today, and then switch to monetization after you’ve commanded a monopolistic position (i.e. the Facebook model). This is why Shopee’s sales & marketing expenses (S&M) as a % of revenue has consistently hovered at legitimately mindblowing levels, and is also why I referred to Shopee as the “King of S&M” in the title - for FY21, this metric stood at 57% (a healthy level for most industries is <20%):
One of the consequences of this gargantuan S&M spend was to invoke accusations of Shopee “renting market share”, where their explosive revenue growth was simply a function of their outsized advertising & promotion budget, rather than organic customer acquisition growth - the parallel here is if the coffee place next to you gave out perpetual 50% sales discounts. If true, the implication of this allegation is that Shopee’s explosive revenue growth has not been sustainable - and that once they turn off the marketing spigot, their revenue growth will normalize to much lower levels. We shall attempt to determine if this is true or not by evaluating their historical performance in this context using standard GAAP accounting metrics below.
Consequently, the question begs: how do we attempt to derive a valuation for SE, considering that Shopee (and the group as a whole) is still enormously loss-making? This is where “startup economics” comes into play - we want to figure out whether Shopee can eventually become profitable on a sustainable basis, how long it might take to achieve that, and what those future profits might look like. In other words, we want to analyze SE’s historical performance through the lens of a VC investor - without relying on potentially distorted non-GAAP figures as supplied by management.
The first thing to understand about evaluating startup performance is that only one GAAP accounting line item on their P&L really matters - Revenue. This is because at the startup stage, whether you have sufficient Revenue growth outweighs all other cost factors - in the context of deciding whether you want to pour more good money after bad into the business. If you have enough revenue growth, it could justify being unprofitable at the beginning for awhile - while if you don’t have enough revenue growth, no amount of cost-cutting is going to be enough.
In this context of revenue growth, there are two main considerations you want answered when evaluating a startup’s historical performance:
Is There Product Market Fit?
Does Operating Leverage Exist?
1) Is There Product Market Fit? This question basically asks whether there are enough customers in the world who actually want to buy the startup’s product - i.e. does it add value to society? There are too many aspiring entrepreneurs who adopt a “build it and they will come” approach to business - without stopping to question if anyone (besides themselves and their mom) actually wants the product badly enough to pony up actual money for it. This is clearly unsustainable, as you’re going to very quickly run into a brick wall if you can’t find enough customers. We can use VC metrics like the Efficiency Score to determine this, which we’ll explore further below.
2) Does Operating Leverage Exist? Of course, it’s not enough just to have product market fit and show revenue - you need to eventually be able to earn profits as well. While being profitable at the outset is always preferable, a business can still justify being unprofitable at the outset if it can prove that it will eventually become profitable. Typically, the way that happens is via an increase in operating leverage.
Here’s an illustration: suppose that a startup has large fixed costs (e.g. depreciation of upfront CAPEX), which might result in it being unprofitable at x amount of revenue. However, since those costs are fixed in nature, there should be a theoretical breakeven point represented by a multiple of x revenue - above which the business will become profitable (e.g. if the breakeven level is 10x revenue, then any incremental revenue above 10x would represent profit).
However, the bulk of a startup’s cost tends to be represented by variable costs (e.g. COGS or staff costs) rather than fixed costs - since it rarely makes sense to commit large amounts of upfront capital into a yet unproven venture. As such, it typically doesn’t make sense to invest into a business which is unprofitable at the outset - except in those cases where most of those variable costs can somehow be transformed into fixed costs over time. This transformation is referred to in the industry as Operating Leverage - which is usually engendered via Economies of scale. The reason why Economies of scale works is because at some point, there will be enough customers to justify the large upfront CAPEX investments required to make the unit economics self-sustainable - e.g. buying a home rather than renting, since on average your monthly obligations will be lower from buying vs renting (at the expense of the large upfront purchase commitment).
This is the basic formula which all “venture” startups of the past half-decade have been following in the pursuit of future profitability - scale the loss-making business up to a level where unit economics start to become profitable; or at least be able to show investors that your unit economics are improving. This is operating leverage at work - and one of the ways we shall be evaluating SE’s historical performance.
In light of ASEAN e-commerce price wars… here’s a 10% off discount for a paid subcription!
