📍 TL;DR

• 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.

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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:

source: YCharts

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%

Steve Brubaker @SteveBrubaker

@FocusGamingNews @DraftKings This business is dumb. "For fully-year 2022, the company’s net loss stood at $1.4bn, an improvement on the 2021 net loss of $1.5bn."

1:16 PM ∙ Feb 21, 2023

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.

Underwriting Upside

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

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

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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