SEA: Efficiency Comes First Regardless of Scale (Phone Meeting Summary)

Minutes of SEA Donghai Group's 2Q22 Performance Conference Call, see Financial Analysis for this Quarter in "No Growth but Still Losing Money, How Will Sea Save Its Valuation"

I. Management Report

Driven by a turbulent and unpredictable macro environment, we have suspended our guidance on Shopee's annual revenue. However, our focus this year is still very clear, that is to continue to increase efficiency by deepening monetization and optimizing cost structures. We will manage our operating expenses more strictly, such as marketing and logistics costs, while gradually increasing the monetization of various revenue streams.

II. Analyst Q&A

Q: Can you explain why the e-commerce business guidance has been suspended? What challenges has management seen that have made the outlook so uncertain? Could you share more information on Shopee's performance this quarter?

A: This is a positive decision by management and we hope to communicate with the market in a very candid manner. This does not mean that we believe the market will deteriorate immediately, rather the company will focus on tightening operations.

Q: Is there any update on the breakeven target for Shopee's Asian markets? The breakeven point in the Asian markets is within reach now, but HQ costs are still rising on a sequential basis. What has caused the increase in HQ costs? When will we see such improvement in the income and expenses?

A: Regarding the breakeven target for the Asian markets, i.e. post-HQ costs, we have shared before that we expect to achieve it next year. Our expectations have not changed. Considering that the loss per Asian order is less than $0.01, we have almost achieved our target.

While headquarters costs are still growing on a sequential basis, the growth rate has slowed down. This is mainly related to R&D and service costs, which are also in line with the overall growth of our business.

Q: Regarding the e-commerce business, from a consumer perspective, is it the decrease in consumption frequency or the prudence in ASP for large items that has caused uncertainty in predicting Shopee's revenue?

A: The reason why we have suspended guidance now is mainly because revenue growth is more of a result at this stage rather than a target. Our current goal is to increase platform efficiency and maintain the long-term health, strength and profitability of the platform. Even if we don't set it as a target, we will naturally continue to see growth. Overall, market conditions are somewhat headwinds, considering inflation and resumption of work, which is difficult compared to last year, especially considering the high base.

Q: If there are no new games released, what are our expectations for the development trend of the "Free Fire" series? Will it be more stable? Or will it potentially increase the payment ratio using the existing user base to support future subscription growth?

A: Considering the scale of Free Fire, our performance in the digital entertainment sector in the second quarter was also largely driven by Free Fire. In terms of active users, we see some stability compared to the previous quarter. We don't make any predictions about user trends, paid user trends, or booking volumes.

In Southeast Asia and Latin America, the two major markets, "Free Fire" has consistently maintained the top position in terms of downloads. Therefore, the decline in FF revenue seems more like the impact of industry factors and macro factors on the game.

On the other hand, other games in our current game portfolio are also performing well. For example, the performance of "Arena Valor" is very stable. So considering the adverse factors, even considering the life cycle of the game, we may not necessarily see a continued downward trend.

In the past quarter, we have done different common sense in electronic sports events, participation, new content, new game modes, etc., trying to retain our users and better interact with them. However, intense competition and macro-environmental factors unfavorable to us are real.

Q: Talk about the GMV growth prospects of the core market in the e-commerce industry in 2022 and 2023? Which markets have proven to be more resilient, and which markets are showing signs of early weakness?

A: I think the overall GMV growth of the industry will obviously slow down, but this also depends on how different industry players manage this growth. In different markets, such as Malaysia and Singapore, there have been amazing growth in recent years, so they will face higher year-on-year bases in the future. At the same time, markets such as Indonesia, the Philippines, and Vietnam continue to grow at a relatively fast pace.

Overall, the situation will slow down compared to last year. How much it will slow down remains to be seen. We believe that a better approach is discipline and prudence, managing macro uncertainty, and preparing for any negative events and situations, rather than relying on resilience and positive market expectations.

Q: How is the progress of the new game, will it be released in the second half of this year or 2023? How to consider the EBITDA profit margin of the digital entertainment business in the next few quarters? By 2023, will you continue to invest in improving the retention and participation of Free Fire users?

A: We do have some games in the pipeline, whether they are self-developed or agent games, we will announce later this year.

I think in the long run, our goal is to continue to diversify our game portfolio, mix e-sports and casual games together, and cross more diverse markets, so the direction is consistent.

As far as the EBITDA profit margin of digital entertainment in the next few quarters is concerned, I think our EBITDA profit margin is still at the top of the industry, exceeding 45%. As we said before, there will be fluctuations every quarter, depending on e-sports events and other activities.

From a financial perspective, we don't think there will be anything in the near future that will have an immediate and significant impact on Free Fire.

Q: Have your expectations for monetization rates changed since the suspension of revenue guidance? Have your profit expectations changed? A: There may be many factors affecting the cash conversion rate, but we only want to say that it will gradually increase over time. We have not set specific conversion rate targets for any particular year. The increase in cash conversion rates is based on different revenue streams. As for transaction fees, the rates are prescribed by us. On the other hand, there are also commission rates. For example, we offer more services and products to sellers who join certain plans and charge higher commissions accordingly. However, this is not directly set by us, but more based on the adoption of sellers.

There are also advertisements, which are also based on customer adoption, as well as accounting-related changes that may affect fees.

Q: Has there been any change in the guidance for the gaming business? Secondly, can you provide more details on the growth rate of your advertising revenue?

A: There have been no changes in the guidance for the gaming business. As for advertising revenue, we have not broken it down, but there is also a gradual upward trend in this regard. This is due to the continuous increase in revenue based on transaction fees, and we see our high-profit margin revenue continue to grow, and Shopee's overall profit margin is also increasing.

Q: You mentioned a strategy of focusing more on improving efficiency. Will this be achieved by actively reducing or cutting expenses in certain strict areas?

A: Improving efficiency is more than just cutting costs. It is important to focus on the overall efficiency of the ecosystem.

For example, we work more closely with third-party logistics partners and other agents and service providers to better arrange delivery routes and increase delivery density. There are many ways to improve the overall efficiency of the ecosystem.

In terms of payments, for example, we continue to increase the usage of e-wallets and increase the usage of other online payment methods over time, which can also reduce payment costs and reduce transaction frictions. So there are many things we are focusing on in the ecosystem, and we want to ensure that they can be more efficient.

At the same time, we continue to review various components of costs in other cost management areas to see if we can save during this process.

Q: Regarding e-commerce, you said it was a strategic change. Will you restore guidance in the future? Do you intend to change the metrics tracked internally - revenue growth, or EBITDA, or any metric the company will focus on?

A: No decision has been made yet about future guidance.

Q: How is the digital bank plan being implemented in various countries? If the accounts receivable on the balance sheet is about $2 billion, how much actual loans have you provided?

A: As for the digital bank plan, as I shared before, we focus on the quality of the project, not growth. Banking business is a business oriented towards trust, reliability, and integrity, and it is very important to establish a sound system for this purpose. So we are not focused on driving growth in this area. Our credit business is the same, we continue to consolidate the business model, provide the services needed for consumers in different markets, and cooperate with third-party financial institutions.

We are looking more for how to establish a robust model that can withstand the test of the cycle and become our long-term sustainable business model. Q: What is the reason for impairment of goodwill, and which part of the investment does it involve - e-commerce, logistics or gaming?

A: As far as the impairment of goodwill is concerned, it is related to various past investments rather than any specific sector. However, as you know, considering the macro environment as well as market fluctuations in our company's valuation and stock price, we also believe that a prudent approach is to actively manage and review our investment portfolio on the books to evaluate the necessary goodwill impairment. We still have about US$400 million on our balance sheet. At this stage, we do not believe that all of them need to be written off. On the other hand, we will continue to evaluate during this period.