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With its stock now trading down 70% over the past year, DraftKings (NASDAQ:DKNG) is now out of the “no way would I ever” territory and at least approaching a level where I would consider buying in. As part of my due diligence, I felt the need to update some research I did last year on online sports betting and its potential addressable market and profit. After doing so, I’ve concluded that my initial estimate of DraftKings addressable market probably was far too low…but I still have too many concerns to buy in.
Prior Research
My sports betting research was originally done in regards to fuboTV (FUBO) but it applies equally well to DraftKings. By the same token, today’s DraftKings research is equally useful to those who are considering a fubo investment or indeed an investment in any major sports television stock, such as Comcast (CMCSA) or AT&T (T) today. Disney (DIS) is reportedly reconsidering its prior decision to keep ESPN away from sports betting as well.
But the question of the day is DraftKings. As always, we are more interested in profit than we are revenue, except as revenue relates to profit. But what makes analysis of sports betting a little complicated is that revenue, in turn, is merely a subset of “handle.”
For those new to the subject, the handle of a sportsbook is the gross amount of money bet on its platform, while the actual revenue is the “take” of the platform of that revenue, with the rest of handle paid out to bettors as winnings. Needless to say, the biggest outlay of handle by far is payment to winners, with revenue for a sportsbook coming in well under 10% of handle.
Prior Estimate
In my research last year, I postulated that the US sports handle would come to about $150 billion, with roughly a 5% take rate, ie., for every $20 two people bet with each other, the operator would keep $1 for itself. This penciled out to $7.5 billion in actual revenue for operators, which I believed would be more like $1.8 billion in final profit for the operators after paying not only state and federal taxes, but also fees to the sports leagues who make these wagers possible – who have made it very clear they intend to be cut in on the resulting spoils.
At that level, DraftKings’ 70% decline over the past year still isn’t enough to make it a good buy. With a roughly 25% market share in the US, DraftKings would generate about $450 million in profit, while trading with a near $8 billion market cap. At a 19 P/E, with interest rate hikes probably about to finally end the days of the 25 P/E S&P, that wouldn’t leave much room for further upside.
But there are growing indications that my numbers may have been too conservative.
A Growing Pie
One of the single biggest and most important variables in the calculation is simply the size of the overall market. Goldman Sachs now projects a $39 billion mature market revenue run rate in 2033, a quintupling of my projections that absolutely blow my numbers out of the water. Other projections are not coming in at quite that level, but there is a growing consensus across the field that the final number is going to be well in excess of what I postulated.
I am slowly coming round to this conclusion as well: I probably did undershoot the revenue number. But my profit projections, which again are what investors should really care about, might not need nearly as much adjusting.
The sports betting industry, which is undoubtedly currently undergoing something that qualifies for the word “revolution,” suffers from three major weaknesses which impair its ability to extract additional profit from additional revenue.
First, Competition
The first is simply competition, or more precisely low barriers to entry. As the revenue pie grows, other companies who want in on the action find it easy to carve out a piece of the pie for themselves.
Disney is already moving ESPN towards gambling, perhaps with a partner, and Yahoo will probably do the same. Fubo, of course, is already hard at work getting its own sportsbook up and running.
This competition means that margins will likely be pressed further as revenue grows, shrinking market share and perhaps leaving DraftKings with a smaller margin on a smaller share of this larger pie.
Second, Asymmetry
That isn’t the only problem. For now, let’s assume that somehow, the industry does get to a $39 billion revenue run rate – a frankly mind-boggling number. Remember that it’s not just our minds being boggled; sports leagues and state legislature tax committees see that gold mine as well.
This brings me to the second big weakness that I see in betting companies – they have an extremely large dependency on external parties to produce their value. And the relationship between these external parties and the betting companies is asymmetrical, with DraftKings and its peers almost always in the weaker position. When profits do get boosted higher, DraftKings partners can see that and increase their own takes in response.
DraftKings has only limited power to stop this because of the asymmetrical nature of the relationship. There are several digital sports betting companies, and a couple dozen more companies who would like to get into the business. But there is only one NFL, NBA, March Madness, etc. So when it comes down to a showdown over profit, it is much easier for the NFL to get a new partner than for DraftKings to get a new sport.
Sports Leagues
In my prior research, I estimated league take at 1% of handle, equating to roughly 20% of revenue. For now, I am going to assume the share stays constant, meaning the leagues get their share of that higher revenue base but don’t actively try to increase their percentage. If anything, that’s probably a little too optimistic, but let’s leave it there because DraftKings’ other external partner is already gunning for it.
State Taxation
The whole key to this new industry is the legalization of sports betting. The Supreme Court ruling that kicked this all off did not say that states had to legalize gambling – just that they could if they wanted to. That means that DraftKings remains dependent on state legislatures to actually make their legal betting business – attractive to consumers only because it is more convenient than illegal betting – possible. And state legislatures know it.
Pretty much everyone is planning on upping their take, but undoubtedly the most aggressive in this regard so far has been New York State. Under the legalization bill that went active January 8th, the state extracts a whopping 51% of total revenue – not profit, revenue – as well as an initial flat fee. Despite protests from the industry, New York feels comfortable doing this because with wagers in the state already at an $8 billion annual handle run rate, it is the third-largest market in the country, knows it, and doesn’t think operators can afford to ignore it.
They’re probably right. While it is certainly not inconceivable that the tax rate could go down, it would likely only do so if Goldman’s revenue projections proved too optimistic, which would just mean operators were hurting in a different way. Assuming that we really are about to quintuple the existing market size, New York has left more than enough for operators to turn an adequate profit, and probably won’t feel much pressure to lighten up. If anything, other states who see a New York market growing despite such rates will become more inclined to emulate them.
If I plug in Goldman’s revenue projection, but also increase my prior estimate of state taxes and fees from 12% to 51%, the increased tax rate accounts for a whopping 60% of the revenue increase, leaving only $11.3 billion of revenue for the operators after paying the leagues and the states. This revenue pool must cover not only payments to investors, but also payments to employees, vendors and other operating costs.
Operating Costs
In my original research, I had operating expenses at $3 billion per year industry-wide, but that was on a much lower sales figure. Granted, gambling will be digital, and that should reduce costs compared to taking cash and selling tickets in an old-fashioned casino. But between credit card fees, customer service, the odd blown-call gamble forgiveness, and maintaining the apps and websites, this number probably still needs to grow quite considerably.
For now, I am going to assume that costs grow only half as fast as revenues off of the original base. That is, if revenue quintuples, I will assume that costs “only” triple, to roughly $9 billion.
Final Profit Number
This leaves a final industry-wide profit number of $2.3 billion per year – compared to roughly $1.8 billion in my prior estimate a year ago. For this extra $30 billion in revenue, DraftKings and its industry peers reap another $500 million in profit.
Anticipating Objections
I recognize that these calculations are necessarily estimates and hypotheses. And doubtless, they will strike some as far too conservative. But consider which prong you think should be cut back to leave more for the operators.
Is it the states? Bear in mind that even these numbers show that operators are probably going to make more money than was anticipated just a few years ago, and states know that legalization is playing a vital role in this process.
So why exactly would they feel compelled to yield to calls for a lower tax rate? Any threat from DraftKings or others – “lower the rate or we’re walking out” – just doesn’t seem to be that credible, considering that everyone knows that a smaller share of something is preferable to a larger share of nothing. Any operator who does walk out of New York or anywhere else for that matter will probably quickly find themselves replaced by a competitor.
Much the same logic applies to the leagues, who know that all this gambling largesse is only possible because of their product. In fact, while the argument could perhaps be made that the state’s take is too large in my calculations, the argument could also be made that the leagues take is too low, considering that I did not increase their percentage at all.
This leaves costs, which I think is probably the most questionable piece of my numbers. Without prior history to guide us, we simply don’t know how digital gambling costs will shake out in the long-term compared to more traditional in-person competitors. If costs only doubled instead of tripled as revenue quintupled, profits industrywide would shoot above $5 billion.
Against that must be set the possibility that the increased competition I spoke about could simply leave less for everyone. That is, perhaps revenue won’t quintuple, but will exceed my prior projection by some lesser amount. As Jeff Bezos loves to say, “your margin is my opportunity,” and presumably the same digital nature that makes online betting cheaper to implement also makes it cheaper for imitators to copy.
Why Buy When You Can Build?
The one other potential path to profit for DraftKings investors might be that age-old standby, acquisition. As the second-largest market operator in the country, DraftKings represents a quick entry to the top of the industry for anyone who wants to get in quick.
But while I don’t rule out that possibility, I don’t think that the list of acquirers spans quite as wide as some think. And this brings me at last to the third hole in the business model, as I see it: I increasingly question whether it makes sense for sports betting and sports streaming to be in separate companies at all.
Fubo management has made it clear from the beginning that they see gamification and streaming as going hand in hand on the same platform, and the number of dissenting voices is getting slimmer and slimmer. It’s now almost a universal consensus that gamification boosts engagement. Even DraftKings itself has become the partner of DISH Network’s Sling TV, and its competitor FanDuel is already partially owned by Fox Corporation (FOX) (FOXA).
This means that any acquirer is likely to come from the ranks of media companies. And yet, most of them seem to agree with fuboTV that it is cheaper and better to copy DraftKings than to buy it. Not just fuboTV but Disney’s ESPN and pretty much everyone is looking to build a sportsbook, not buy one.
Investment Summary
It’s getting harder and harder to defend my $7.5 billion revenue projection, and I’ve tried not to waste time here by doing so. But I’m not so sure profit in the industry is going to shoot up nearly as fast as revenue. While I agree DraftKings has a large addressable market in front of it, the asymmetrical nature of its relationship with its key partners makes me question whether it can extract enough profit to be considered undervalued, even at this much lower price.
I’ve decided to hold off on any purchases for now.
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