On and off I have been loosely following the online sports betting market in recent years. Lately I finally had a chance to do a deeper dive into the sector and particularly the company, DraftKings. People are often excited about gambling stocks and related investment opportunities. Personally I am not a big fan of gambling because I hate losing in things that I don’t have an edge on. So let’s see if the DraftKings stock gives us any noticeable edge. Spoiler alert: not really. Nonetheless it’s always great to learn about a new company, a new sector, break them down and arrive at a conclusion on a stock, its valuation and what to do. So let’s take a look.
Company History
DraftKings was founded in 2011. Initially it offers only online daily fantasy sports (DFS) products, where users curate their own roster teams in various sports leagues and compete each other for prize money. Within a few years, it rose from a small start-up in Boston to become a major player in the space, forming a duopoly with another early mover FanDuel (now owned by Flutter Entertainment). In 2015, it raised a $300mm financing round valuing the company at $1.2bn.
By the end of the year, however, legal question emerged that would threaten the existence of the entire DFS business. It was premised on whether DFS is a game of skill or luck. If it’s a game of luck, then DraftKings and FanDuel would have been running gambling operations without proper licenses. After much lobbying effort over next 2 years, the duo were able to get around 20 states formally legalizing DFS and another 20 states allowing it without formal legalization. Quite a magnificent feat. Yet the biggest piece of regulatory victory came in 2018.
In May 2018, US Supreme Court struck down on constitutional grounds the Professional and Amateur Sports Protection Act of 1992 (“PASPA”), effectively allowing states to decide whether to authorize and how they would regulate sports betting on their own. Since the Court’s decision, many states have legalized sports betting. Capitalizing on its DFS platform, DraftKings has expanded aggressively into online sports betting (OSB) and online casino (iGaming) markets. In late 2019, the company announced to become public through a SPAC and a merger with SBTech, giving it a market cap of $3.3bn. As online betting continues to gain steam across the US, it has propelled the company’s valuation to today’s roughly $21bn enterprise value.
2021 Investor Day Presentation
The best way to understand the future of the company probably is to look at its 2021 Investor Day presentation. At this point DFS is a somewhat matured market. Massive growth will come from OSB and iGaming. The following page from the investor day presentation lays out what they think the revenue opportunity lies ahead. And taking the low end of this revenue range of $5bn, they think they can do $1.7bn EBITDA, or ~30% margin, over the long term.
Online Sports Betting (OSB) Market
As of earlier this year, there are 15 states that have legalized OSB, amounting to ~27% of US population. DraftKings operates in 12 of them. Market share wise, FanDuel has 40%, DraftKings 30%. Most other operators operate in only 1 or just a handful of states. From the page laid out above, the company first estimates the total US market assuming full legalization, then percentage of US population (i.e. number of states) that would get legalized and finally market share of DraftKings to derive its revenue potential in respective markets. We’ll follow the same sequence.
The company estimates total US OSB market to be $22bn. That is extrapolated from current states and markets that have legalized OSB, e.g. NJ and UK, adjusting for population and GDP, based on 2020 numbers. Prior to 2020, market research pointed to more like a $15bn market. The increase may be attributable to pull-forward demand in a year like 2020 when most people were forced to stay home. However, like many other online activities, this pull-forward demand may as well stay as people realize the convenience of online betting and now that it’s legal. FanDuel arrived at a similar estimate of $20bn.
OSB Market Penetration
Now let’s think about penetration, i.e. percentage of US population to get legalized. The company is assuming 65%. There are so far 23 states that have legalized sports betting (i.e. in physical locations), or 41% of US population. This includes the 15 states that have also legalized OSB, as mentioned earlier. This group as a whole is most likely to move forward with OSB in the near term. In the entire country, only 3 states have no activity on sports betting front, amounting to ~5% of population. On the other hand, in order to get to 65%, you would need at least one or two of the biggest 4 states, which constitute ~30% of US population.
The biggest one is CA. However, it will likely be years away for them to legalize. One of the biggest arguments for states to legalize sports betting, gambling, cannabis and the like is the state budget deficit. CA is truly an outlier, with a staggering $75bn budget surplus last year. Second is TX, which will be even harder under the more conservative political climate. TX at one point deemed DFS illegal.
Third is FL. They are the more likely one among the top 3, with a bill passed on the legalization front, but subject to legal challenges. Fourth is NY, which has basically approved and is part of the 41% from earlier. The fifth and sixth states are IL and PA, both of which have already legalized OSB. So the 65% is actually reasonable. FanDuel also increased its estimate from 50% in last year’s annual report to a similar 65% this year.
DraftKings’ Market Share in OSB
Key question really is if DraftKings can maintain its market share with competitors flooding in, offering seemingly the same products. There are couple positives going for them (and frankly FanDuel as well). First, it has established itself as a trusted and well-recognized brand in the space. New users most likely opt for brand name operators. Second, their dominance in DFS has created significant first mover and cross selling opportunities. In most states, they are converting 60+% of DFS users to OSB. Third, benefits from economies of scale are real. Once they attain certain size, they can opt for national marketing (as opposed to local). They have the clout to make partnership deals with sports leagues, teams, and media distributions, e.g. for streaming sports content on its platform while allowing betting in real time.
In addition, customers are remarkably sticky. Once you acquire a customer, customers tend to stay in the same platform as they are already comfortable with the particular product, brand and user interface. This is why we still have not seen much migration of bettors on offshore accounts to legalized platforms. Both DraftKings and FanDuel also launched shared wallets across their various products and apps, solving a major pain point for customers to start a new account elsewhere.
That said, there are some legitimate competitors coming in, from PointsBet, MGMBet, Barstool / Penn National, Bally Sports, FoxBet (also owned by Flutter) to William Hill. They all provide some twists to their product offerings. For example, Bally Sports is a regional sports network that partners with Bally casino to offer betting while watching sports content. Barstool has a huge sports fan following, though most of which may already have accounts at DraftKings and FanDuel. In my opinion, it will most likely end up with 4-5 companies dominating the space. And DraftKings should be one of them.
Online Casino (iGaming) Market
I am going to keep the iGaming discussion short as lots of the factors above apply here. As of earlier this year, there are so far 6 states that have legalized iGaming, or 11% of US population. In general iGaming is a tougher nut to crack than OSB and will take longer time due to the lack of sports as a political cover. In fact majority of lobbying efforts are still focused on OSB and not iGaming yet. FanDuel actually had a more benign estimate on iGaming market in the US: $30bn total US market with 16% penetration in 5 years.
Market share wise, both DraftKings and FanDuel have ~20% currently. However, there will be more competition on the way as every land casino is incentivized to participate, leveraging its own local or national brand recognition. Nonetheless, as said before, cross selling opportunities are real for OSB operators like DraftKings. According to the company, nearly all of its iGaming customers (98%) have been cross-sold from other DraftKings products.
Summary and Valuation
The above table shows a more conservative view on DraftKings revenue potential and implied EBITDA at a matured state. The “low” case can be thought of as a 5 year out projection and “high” case as 10 year out. It reflects potential timeline of new states legalizing OSB and iGaming, and time to reach maturity in new markets. Case in point, in LTM 1Q 2021 period, DraftKings did ~$840mm of revenue but negative $500mm of EBITDA, largely due to big marketing spend to acquire customers in new states and markets. All in all, I do see the company do $5-7bn in revenue and $1-2bn of EBITDA in 5-10 year timeframe.
At current valuation of ~$21bn, it implies 10-20x of the future EBITDA range. I can’t say I am all that excited at the current price. However, I admire the company’s continued transformation and expansion into adjacent business lines. Just last week, it announced to launch an NFT platform and marketplace, for buying, selling and trading digital collectibles across sports, entertainment and culture using existing DraftKings accounts. Time will tell but it makes business sense for the expansion. Until next time..
