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Source: DraftKings Analyst Day – March 2020

Investment Thesis

Over the past few months, sporting events have resumed and sports fans can feel some sense of normalcy as the NBA, MLB, and now NFL are back. Now fans are flocking to check out the action as well as get in on the action themselves, as sports gambling is surging. DraftKings is the leader in daily fantasy sports games and offers an integrated online sportsbook that features its proprietary technology platform that administers payments and uses data analytics to offer a player-friendly service.

DraftKings is well-positioned to capture new customers who enter the gambling market, which will result in strong revenue growth. I will demonstrate that DraftKings offers one of the best online platforms for online gambling and is spending significantly on Sales and Marketing to develop a strong book of business. Because DraftKings offers an integrated service that will build on iGaming, Daily Fantasy Games, and its Sportsbook, DraftKings will generate significant free cash flows, as the online software should result in strong gross margins for DraftKings in the long term. I am bullish on DraftKings and will illustrate its potential to profit from the legalization of gambling. Today, I label it as a buy under $40.

Market Leader

Source: DraftKings Analyst Day – March 2020

DraftKings was founded in 2012 and has seen strong growth in its total registered accounts over the past eight years. During this time DraftKings evolved as the #1 daily fantasy sports platform and is beginning to offer a full sportsbook, which is already offered in seven states. DraftKings merged with Diamond Eagle Acquisition Group (the public acquisition vehicle) and SBTech, which is a world-leading online bookmaker, to form a fully integrated sports betting and online gaming company.

The Foundation

Source: DraftKings Analyst Day – March 2020

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As can be seen above, DraftKings offers a full platform that optimizes and connects its three products for Daily Fantasy Sports, Sportsbook, and iGaming. Between these three products, DraftKings will offer a full online and mobile casino in states where gambling is legalized.

Source: DraftKings Analyst Day – March 2020

This cohesive strategy allows for DraftKings to offer a user-friendly service and is creating synergies by offering different types of gambling on the platform. DraftKings is improving its payment solution and offers multiple secure payment methods, while its acquisition of SBTech will allow DraftKings to use an innovative betting platform and benefit from its investment in data analytics.

Source: DraftKings Analyst Day – March 2020

By DraftKings offering an innovative payment solution, it will make it easier for its customers to bet from different states and easier to receive payments. DraftKings also uses data analytics to create a personalized interface for its users within its products. DraftKings is creating the optimal platform and is well-equipped to continue to grow its registered accounts, which is already over 12 million.

Massive Opportunity

The global online sports gambling market is expected to be worth $127 billion by 2027. As sports betting and gambling legalizations have ramped up across the United States, 75% of all U.S. states have introduced some sort of legalized sports betting or legislation.

Source: Legal US Sports Betting – Bill And Law Tracker 2020

There is a huge opportunity in the United States and I expect these trends to continue over the next 10 years.

Source: DraftKings Analyst Day – March 2020

Clearly, there is a huge market opportunity and DraftKings is well-positioned to capture customers through its user-friendly service.

Financial Analysis

Based on YCharts estimates, DraftKings will generate over $1 billion in revenue and achieve 44% annual growth through 2022.

Source: YCharts.com

DraftKings is spending significantly on SG&A, as it costs $68 to acquire a customer who will then generate $100 for the company per season. DraftKings is consistently spending on promotions and offering deals to draw in new customers who convert to returning customers.

Source: YCharts.com

DraftKings only released its annual results for Q2 of 2019 for its first actual earnings report in 2020. DraftKings showed strong revenue growth (25.4% growth year-over-year, especially great considering the shutdown in sports), but SG&A expenses are high. This makes sense as the company is in unchartered waters navigating through the pandemic and must spend significantly to develop its customer base. The company has $1.2 billion in cash and equivalents, which means the company is in a solid cash position.

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This past quarter DraftKings reported a 33% gross profit margin, which is significantly lower than that of a year ago, 68%. In the company’s earnings call, CEO Jason Robins acknowledged that the decrease in gross profit margin is attributed to the coronavirus and the lack of Daily Fantasy Sports, which is the company’s highest-margin product offered. Therefore, I expect the company to return to generating higher gross profit margins, as the products offered are computer-based, which results in margin growth similar to that of a software-based company such as Facebook (FB), Microsoft (MSFT), and Salesforce (CRM).

This will result in free cash flow growth in the long term as DraftKings won’t have to continually spend on Sales and Marketing. This will take time as DraftKings is reinvesting free cash into account growth as it looks to be the market leader for online gambling.

Now we can estimate what DraftKings is worth and estimate an ROI.

DraftKings’ Valuation

To estimate if DraftKings is a good investment today, we will use the L.A. Stevens Valuation Model. The model consists of, first, a discounted cash flow model to assist in identifying the fair value of DraftKings. Additionally, the model uses the growth of free cash flow per share to determine DraftKings’ 10-year price target, and thereby, project an annual return if we were to invest at today’s share price.

**I used annual revenue estimates for 2020 of $520.47 million (YCharts.com) because the company has no TTM revenue

Based on the DCF model, DraftKings is slightly undervalued with an intrinsic value of $46.91.

Expected Return

Based on conservative estimates, we can expect about a 14% annual return if we were to invest in DraftKings today which is solid returns, hence why I label it a buy at $40.

Margin of Safety

For this evaluation, I used conservative growth estimates and free cash flow estimates. For DraftKings’ TTM free cash flow per share, I used YCharts revenue estimate for 2020 as DraftKings hasn’t reported its TTM revenue and has only released Q2 revenues for 2020, which were negatively affected by the pandemic.

For free cash flow, I used a 25% free cash flow margin as the company reported 33% gross profit margins, but I anticipate it will return to normal levels around 60%, as the company sported 67% gross profit margins for the same quarter in 2019. For revenue growth, I used 30% as the online sports gambling market is expected to rise steadily and DraftKings is expecting over 40% annual revenue growth through 2022.

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Key Components of This Investment

  • DraftKings is betting on gambling becoming legal and as it becomes legal, more and more people will be drawn to it who then become annual DraftKings customers. If gambling weren’t to legalize across the U.S. or gambling doesn’t popularize, this would stifle DraftKings’ growth.

  • We are assuming DraftKings will lower COGS and increase gross margins to normal levels, as this quarter’s poor gross margins were a result of the pandemic. DraftKings’ margins are a strength, especially over the long term as it operates its platform through software. If DraftKings doesn’t lower its COGS to what it was before the pandemic, it would make it hard for the company to generate free cash flows and this would be less rewarding for shareholders.

  • Jason Robins, the CEO, has 90% control of the company’s shares outstanding which means that he will control almost all decisions going forward, as he has 90% voting rights. Robins, who founded DraftKings, has implemented his vision to create an integrated betting platform and believes in him as CEO. If Robins were to change his vision or the company’s operations, I would have to re-evaluate the investment, but I am confident in Robins and his vision for the company. I will attach a clip if you’re interested in more details regarding Robins’ vision for DraftKings.

Conclusion

I am bullish on DraftKings and view it as a strong opportunity to gain exposure to the growing trends in online, mobile, and casino gambling. The company has established itself as a leader in online gaming and its online strategy should generate strong returns for shareholders over the next 10 years.

Thanks for reading!

Disclosure: I am/we are long DKNG, CRM, FB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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