Research Notes: The Problem With DraftKings Stock
The big YTD rally in DKNG makes some sense — but raises the same long-term questions we've seen before. And it applies to the market as well.
Since going public, DraftKings stock has been a bellwether for the market as a whole. 2023 looks no different.
The year-to-date gains, and the rally after Q4 earnings last week, make some sense. This is a better business than headline fundamentals suggest.
But that rally creates a valuation problem — a problem which echoes similar concerns that have permeated the market going back to the mid-2010s.
An investor can tell a stylized, imperfect, yet somewhat accurate story of the entire equity market from 2019-2023 through DraftKings DKNG 0.00 stock.
DraftKings anticipated the boom in SPAC mergers, announcing its plans to go public via that route at the end of 2019. In an interesting post-mortem on the merger, SPACInsider argued that the boom in SPACs (126 closed mergers in nearly a decade before DraftKings and Diamond Eagle tied up, and 324 over the ensuing 32 months) was full of “direct attempts at capturing the DraftKings lightning in a bottle”.
After the merger closed in April 2020, DKNG was one of the clearest beneficiaries of what Matt Levine has called the “boredom markets hypothesis”. That hypothesis (correctly, in our opinion) posits that inexperienced retail traders piled into stocks in large part because the pandemic removed so many alternative options for entertainment.
By March 2021, DKNG had roared from its $10 merger price to all-time highs above $70. Around that time the mania for speculative, high-growth names peaked. DKNG tumbled and in the 2022 bear market threatened its $10 merger price on multiple occasions. Each time the stock held.
Here in 2023 (amidst a more modest form of speculative mania) DraftKings stock has gained 71%. The only stock with a higher market cap and better year-to-date performance is Coinbase Global COIN 0.00.
We expect DKNG may continue to be a bellwether, certainly for the rest of 2023. The interesting question is what that means for the stock, and perhaps for the market as a whole.
Stocks Are (Still) Too Expensive
After the insane trading of 2020 and 2021, it’s easy to forget that some observers thought equity market valuations were stretched long before the pandemic arrived. Remember that in December of 2018, the S&P 500 technically met the requirement for a bear market, dropping 20% (almost exactly) from an intraday high in what was a remarkably swift plunge:
There’s little doubt that valuations were a major factor in that fall. After all, even following that sell-off Amazon AMZN 0.00 closed the year at roughly 80x earnings. Netflix NFLX 0.00 had a price-to-earnings ratio around 100x (and a ~$130 billion market cap on the back of negative free cash flow). The rest of the tech market, in particular, was littered with barely profitable (and unprofitable) companies valued in the billions of dollars.
Many argued it was simply the dot-com bubble all over again, a criticism that grew louder when, despite massive red ink, Lyft LYFT 0.00 and Uber UBER 0.00 both went public in 2019.
But even a more nuanced look at valuations raised concerns. There was a large number of good, fast-growing businesses that were difficult to underwrite reasonable, (let alone compelling) annualized returns going forward. A lot of the math boiled down to “if they hit their five-year targets and trade at 55x earnings in 2024, the stock should do all right.”
Of course, during the 2010s, those growth stocks not only beat value, but gave value a wedgie and took its lunch money. As we noted back in November, investors that focused on silly things like profits and cash flow models were absolutely crushed during that decade:
Negative 20x EV/EBITDA Sounds Bad
As the joke goes “Do you want to run DCF models, or do you want to make money?” After a stretch in which valuation again seemed to matter, and a 2022 in which value handily outperformed growth, 2023 feels a bit like 2019 (itself a lower-grade version of 2021). And DKNG represents a shining example.
After all, DKNG rose 15% last Friday, following a fourth quarter report in which it raised full-year 2023 guidance for Adjusted EBITDA…to a loss of $350 million to $450 million. That range of course excludes stock-based compensation. DraftKings didn’t disclose the expected figure for 2023, but share-based comp averaged ~$630 million the last two years. A slide in the Q4 earnings presentation projects average dilution of ~3.8% over the next three years, which in turn suggests an annual impact at the current market cap of $300 million or so.
Even at that latter, lower, estimate, this remains a business nowhere close to actual profitability, with EBIT margins in the range of negative 30%including the impact of dilution. That sharply unprofitable business now trades at almost 3x revenue and, as the header of this section suggests, roughly negative 20x times EBITDA.
The Case For DKNG Stock
We’re being tongue-in-cheek in citing a negative EBITDA multiple, of course. And while negative EBITDA (with so many adjustments) seems like a shorthand description of a simply terrible business, there is in fact some reason for optimism both toward DraftKings as a business and toward the company’s fourth quarter report.
Most notably, DraftKings continues to take market share, as detailed in a recent report from respected industry consultancy Eilers & Krejcik:
And where DKNG gets interesting is that, at this point, there’s little way to actually lose that share, at least in a hurry. The ridiculous level of promotions that we discussed in depth last year has been reduced significantly. After offering a $5,000 “risk-free bet” to new customers, Caesars Entertainment CZR 0.00 is focusing on profitability going forward. So is BetMGM, a joint venture of MGM Resorts International MGM 0.00 and Entain (ENT.LON).
That reduced promotional activity should benefit DraftKings’ margins going forward as well. There’s already been some help: promotions as a percentage of gross revenue (promotional spend is not booked as an expense, but a reduction of revenue) declined ~600 bps in 2022.
That’s a key reason why the company raised 2023 guidance with the Q4 release. With the Q3 report in November, it had initially projected an EBITDA loss of $475 million to $575 million. It’s easy to be skeptical about the market being optimistic toward a still-massive loss, but a $125 million improvement is material (not least because it represents roughly four percentage points’ worth of margin).
Meanwhile, the company is still acquiring new customers — and paying up to do so, which hits near-term profitability. Launches in Maryland and Ohio alone had a $75 million negative impact on Q4 results. Over time, acquisition spend will slow, promotional activity will further moderate, and it seems exceptionally likely that some form of profitability — real profitability — will emerge. There is a quality business here underneath all the red ink.
But what is that business really worth? Once again, it seems like the market isn’t necessarily asking that all-important question.
At its Investor Day last year, DraftKings raised its long-term target for Adjusted EBITDA to $2.1 billion at maturity. Maturity in its model was defined as five years after a) 65% of the U.S. population gained access to legalized online sports betting (which, for investors unfamiliar, is authorized solely on a state-by-state basis) and b) 35% of the population resided in states with legalized iGaming (ie, online casino games).
At its Capital Markets Day in November, Flutter Entertainment (FLTR.LON) unit FanDuel gave its own projection for 2030: 80% of the U.S. population would have legalized sports betting, and 20% iGaming. Net/net, that 80/20 split probably maps roughly equally to DraftKings’ 65/35 model.
In other words, DraftKings’ biggest rival would suggest that maturity would arrive in 2035, 12 years from now. Intuitively, that makes some sense. iGaming growth continues to stall out: only six states have legalized the activity, with failures in many other states (including yet another loss in Indiana this week, a state with a long history in land-based gaming as well as one of the earlier entrants into online sports betting). Population coverage is now about 12%, well below the DraftKings target.
Efforts to legalize online sports betting in California have made no progress amid a highly contentious group of interests (most notably Native American tribes). Texas is probably a no-go for the time being. A launch in Florida has hit a legal roadblock, but likely would go through the dominant Seminole tribe, potentially freezing out the likes of DraftKings. That’s 20%-plus of the population right there.
The DraftKings maturity model suggests $2.1 billion in EBITDA. Assuming that does arrive in 2035, and dilution averages 3.8% annually (the projected rate over the next three years), DraftKings needs something like an 18x EV/EBITDA multiple in 2035 to support the current stock price at a 10% discount rate.
I mean…maybe? An 18x EV/EBITDA multiple for this business should in turn be a mid- to high-20s price to free cash flow multiple. Flutter, before the pandemic and before FanDuel became such an asset, received about those multiples. It was perhaps the best operator in Europe; peers generally saw low to mid-double-digit EV/EBITDA multiples. To be fair, iGaming businesses there faced a number of potential headwinds (additional taxes and advertising restrictions among them) that are less likely to arise in the U.S. any time soon. On the other hand, iGaming was a far bigger chunk of revenue than was online sports betting.
And one thing to keep in mind here (one thing that the market clearly forgot in 2020-2021) is that online sports betting really is not a very good business. Margins are probably in the range of 2.5% relative to money wagered. Sports don't run 24/7, and in the U.S. in particular wagering drops tremendously outside of football season. Particularly if the industry's revenue model looks like FanDuel's 80/20 sports betting/iGaming split, a high-teens EV/EBITDA multiple is a big ask.
So we’re probably looking at a stock where returns are not that great even if management targets are hit. It’s possible DraftKings finds some extra revenue. Chief executive officer Jason Robins floated the idea of international expansion on the Q4 call, but we are exceptionally dubious of that idea. Existing operators are entrenched, regulatory barriers to entry are not insignificant, and there’s no real brand equity for DraftKings in the U.K. and Europe (the most valuable regulated markets). The U.K.’s Bet365 has been one of the best operators in the business, and it’s made no headway during its initial (if modest) expansion across the ocean.
Again, we’ve seen this story before. Back in 2019, I called out Salesforce.com CRM 0.00 as the classic example of this trend. It was a great business, and so despite heavy stock-based compensation and a questionable valuation CRM stock kept rising.
But CRM has now underperformed the S&P 500 over the past five years, and is negative over the past three. The fundamentals always win out — eventually. We’re skeptical DKNG, or any other growth stock, will prove immune to that rule.
As of this writing, Vince Martin has no positions in any securities mentioned.
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To be sure, DKNG wasn't alone in driving the SPAC boom. For instance, Virgin Galactic SPCE 0.00 closed its SPAC merger first, in October 2019, and its stock performed roughly as well as DKNG in the early going.
Still, the fact that experienced de-SPAC analysts — and SPACInsider does do good work — are calling out DKNG means something.
I covered a good number of those dearly-valued tech names for a retail-focused site at the time, and wrote a version of that sentence more times than I care to admit.
Adjusted EBITDA loss of ~$400M at the midpoint plus ~$300M in SBC and ~$200M in D&A = ~$900M, on an expected 2023 revenue base of roughly $3 billion.
FanDuel projects total online revenue in 2030 of $40.5 billion, with roughly 45% of that coming from iGaming. DraftKings’ maturity model suggests 43% of its revenue would come from iGaming.
3.8% annual dilution gets shares outstanding to 700 million; stock price in 2035 of $61.29 gets market cap to ~$43 billion, or 20.5x the $2.1 billion target. We’ll give credit for a few billion in free cash flow in the last few years of the period that can reduce dilution; 18x seems a close enough estimate for our purposes here.
The astonishing trajectory of FanDuel’s value is shown by the deals in which the business was purchased. Flutter, then known as Paddy Power Betfair, acquired 58% of FanDuel in 2018 for $158 million. It bought an additional 37% in December 2020 for $4.2 billion.
Hold — the percentage of wagers won by the house — generally runs in the mid-7 percent range, and DraftKings itself is projecting EBITDA margins at maturity just above 30%.