DraftKings: Coverage That Skims Surface Is No Service To Investors (NASDAQ:DKNG)

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There’s a hierarchy of media coverage on stocks that runs from the really relevant, such as earnings releases, or news of a new breakthrough product, an industry head or tailwind, an announcement of someone taking a run at the company, etc. Then there’s the mid-range coverage as it were that largely consists of mostly well thought out opinions of various stocks by analysts with proven chops in the sector. Then, alas, we have this mind-blowing tsunami of quick take media coverage all over the web flowing from financial sites that cater to the short attention spans of naïve retail investors who deserve better.

No problem with blah blah stuff per se. I’m a free enterprise guy. The web has no real filtration mechanism – it is what it is. But then too often these days I do come upon articles which bear no context and reveal stale truisms peddled by some sites and some corporate PR people. I believe it’s worth a challenge, no matter how big an audience that site gathers, or how many subscribers pay for its gospel. Again track records vary. This is only a plea for context, not a critique on bad judgments we all make from time to time.

Such is the case with a piece I read from a major financial website which, like the rest of us, has had its share of notably good and notably bad calls. That’s not my point here. What I found worth comment here, was a short piece on DraftKings (NASDAQ:DKNG) published on March 24. The surface facts were fine, but it’s the implications in the headline and lead paragraphs that to me could only misguide the already misguided. It’s an article that skims, but doesn’t contextualize.

The article echoes three management mantras, all of which are presented without context leaving the impression that while there are some little flaws to the DraftKings picture, overall one conclusion can be drawn: This is a company on the move.

The piece simply begins by stating that DKNG is in the online gaming business. Clearly that’s aimed at an investor segment that has been living under a rock for the last three years.

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The piece cites the company has made “steady progress” as the total addressable market reaches 36% of US population but fails to specify what that percentage is. Does it mean 90m potential gamblers? Or simply the adult population above 21 years of age? And what do sheer population numbers really mean? The answer in practical terms: Very little.

As in all things, Pareto’s principle prevails: You get 80% of your business from 20% of your customers. It has been challenged but proven beyond dispute that since propounded by the Italian scientist Vilfredo Pareto in 1895, it has never been wrong. The gambling business is among those that’s a precise example of that law at work. And that’s why massive numbers like addressable populations are interesting, but meaningless.

The piece then quotes DKNG management as predicting that sports betting eventually will be an $80b market. It’s an absurd number totally out of context. Firstly, we don’t know if $80b is handle, i.e., the amount wagered. Or is it “win” – that’s actual revenue retained by the active platforms? We aren’t told. All we’re told is that DKNG’s assessment of the total market is up from $67b indicated exponential growth.

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But let’s take $80b. If it represents handle, then the historical hold percentage of sports betting wagers is ~7% of handle. So the $80b becomes $5.6b in revenue. Even that number in a win would probably have to be shared by at least five to six major platforms that we see surviving. We do see DKNG among the leaders, probably No. 2 or No. 3 in share of market. The EBITDA forecast of $2.1b is very aggressive in our view. Why? Not because DKNG won’t perform per se, but because the company persists in what the article characterizes as “aggressive investments in growth.” Let’s look at what that means in real world terms:

In 4Q21, DKNG spent $278m in advertising and promotion aimed at harvesting as many new users as possible as new state after new state legalized. That spend was up from $192m y/y. For the entire 2021 year, DKNG spent $982m to generate $1.3b in revenue continuing to bleed cash. That is the principal reason analysts who had been singing the praises of the company virtually since its SPAC debut, urged holders to run for their lives. So from a high of $71, we now have a stock trading at $18.20. None of this hard truth appears in this article.

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Nor is the 600lb gorilla in the room facing all sports betting platform operators given at least a sentence to cogitate over: Having set the business model based on giveaways, excessive deals, will they be able to hold onto business once they are withdrawn? Caesars Entertainment Inc. (CZR) is among the strong sports betting contenders, has already announced sharp cutbacks in its media and promotional spend. At some point these companies need to begin showing a profit. Some analysts now suggest that it is entirely possible that DKNG, and some of its competitors, may never make a dime given that business model we now run by.

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(Churchill Downs Inc. (CHDN), long involved in online betting with its legacy TwinSpires site for horse racing that was morphed into a full scale sports betting app has officially abandoned the sector altogether.)

The hard truth is that there’s no real product differentiation among the top competitors now in the race. By in large they all offer player friendly, well-designed platforms with no distinctive elements that could command unswerving, long range loyalty once the heavy promotions end. Their overall tech stacks operate smoothly. Glitches are rare.

All that being said, we continue to believe that DKNG is a candidate for either a merger with a land-based casino operator, or an e-commerce giant. At its current trading range it can be attractive enough to bear a nice premium in a takeover situation. Long term, shorn of its excessive marketing spend, the company can still do very well in a sports betting market we believe can reach ~$25 to $30b in annual win by 2025/2026. We believe that DKNG’s strong geographic revenue footprint deleveraged in terms of promotional spend, could produce a sustainable 15% to 22% market share—among sector leaders.

Coming down the pike are these reality checks for DKNG that should have merited at least a few sentences or a paragraph to bring some balance to the article:

At some point over the next 18 months we believe market leader Fan Duel will be spun off by its UK parent into an IPO that will join DKNG as the best pure plays in the space. That would move lots of investor sentiment to that prospect.

The single wallet leaders, i.e. brick and mortar casino operators, will begin to see sports betting as a nice, adjunctive business kept viable by controlling promotional expense. It has already been proven that there’s indeed valuable spill-over business from live sports books to the blackjack tables. As they withdraw promotional dollars, and begin making money, it will signal a sector wide shrinking of such deals that could slow the growth arc of the business. Igaming i.e., platforms with casino games remain relatively small but have viable potential long term.

The states not yet in the legal column, especially the big kahuna ones like Texas and California will eventually join the party. What’s not clear yet is the industry design they have in mind. In particular, we’re seeing many signs of the stepped up aggressiveness among tribal casino properties to make exclusive deals with the states. Florida already has essentially done the sports betting deal with the Seminole tribe—cutting out any real prospects of major platforms entering the fray.

Conclusion

The discounted cash flow valuation widely noted for DKNG runs ~$30 a share. This means it’s undervalued to those who believe it. I dispute this number only because I think forecasting ahead as to what this still evolving business model will become is a fool’s errand. DKNG will be a solid participant in the sector’s future. But the business is tricky, and elusive, so over-dependent on marketing spend, that at present the only clear eyed question investors need to ask is this: One: Are you guys ever going to make money? And two, how do you propose to achieve profitability in a business crowded with 14 companies offering the same product giving away the store every day?

There’s an answer. It’s called consolidation. When the sector shrinks down to five or six platforms or perhaps even less, the marketing pressure for aggressive attack on buying new business will materially ease. Margins will be excellent, revenue growth will enter a normal range in single digits y/y and valuations for stocks in the sector will be based on far better real world metrics than what is now all over the web with skim the surface articles that do little to help investors make smart decisions on ideas for the various stocks.

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