In this episode of Industry Focus: Consumer Goods, Emily Flippen and Motley Fool contributor Asit Sharma take another look at DraftKings (NASDAQ:DKNG). They talk about the company's business model and various revenue streams from different products, its financials, its first-mover advantage, what gives it a competitive and regulatory edge, international growth opportunities, and much more.

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This video was recorded on November 24, 2020.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, November 23rd, and I'm your host, Emily Flippen. [Editor's note: Emily misspoke. This was recorded on Tuesday, Nov. 24.] Today, I am joined by The Motley Fool's Asit Sharma to take a look at DraftKings. This is a company that I know we've talked about before, maybe not you and I, Asit, but I definitely talked about DraftKings on Industry Focus before. But I think this is a company worth revisiting in the wake of this month's election, as well as some recent earnings news from this company.

So, thank you for joining today, and I'm excited to chat.

Asit Sharma: Yeah, me too. I'm excited to chat about DraftKings. As you said, it's really interesting, a lot of potential here in the story, has had a few bumps. But now, since its IPO, a really viable company. And we're also going to talk about the earnings, I understand, after getting through some introductory looks at this company, which I know you're excited to do.

Flippen: [laughs] I am. And calling it bumpy is being pretty generous here. For anybody who's not familiar with DraftKings, they actually made a splashy IPO earlier this year, and despite being a really well-known sports entertainment company, it actually had a lot of, what I would call, yellow flags in its filings. They had issues like going concern, a ton of related party transactions, stiff competition and obviously evolving regulations for sports betting, were just a few of the issues that investors pointed out when sifting through this S-1, but at the same time, and I can't speak for everyone, but I can speak for myself, I know I found myself pleasantly surprised when actually reading through the document itself, because I had known from financial media just what a disaster it had been made out to be, when in reality, when I got to the documents, I was like, well, this isn't terrible, they have leading brands and leading market position in an industry that's really has inept competitors, right? The casinos really have just haven't been that aggressive in getting into things like daily fantasy sports or sports betting, which has left an opportunity for DraftKings in the market.

So, this is all just to say that DraftKings is a really interesting business, in my opinion, albeit one that's only had two quarters of public market experience behind it, but that's part of the reason why I'm really excited to dig into it deeper with you today, Asit.

Sharma: Yeah, awesome. Well, let's describe what this company does and then we'll hit those financials. So, Emily, let me ask you, have you ever played daily fantasy sports? [laughs]

Flippen: [laughs] I have not, and it's hilarious that you ask me that. So, if anybody is unaware, I'm not a sports fan. It's been very little, unless it's the bachelor brackets, that's probably the extent of my sports knowledge. The amount of research I had to do for DraftKings just to get an understanding of what daily fantasy sports was, was honestly absurd. [laughs]

Sharma: [laughs] Well, if it makes you feel better, I'm a sports fan, but I've never played Daily Fantasy Sports or DFS as it's also commonly known. Even though I have friends who play this and have asked me from time-to-time, hey, I've got this DFS team, why don't you join up, you know, it'll be really great, this is something we can do together. It's sort of a social thing as much it is a way to hone your impulses about sports and maybe make a little money [laughs] on the side; which we'll get into. But I had never taken that leap. I have so many hobbies that I get into and then they just -- you know, I end up not achieving anything. So, I've had to pass.

But daily fantasy sports was DraftKings' sole product offering until just a couple of years ago, until 2018, they don't break down how this major portion of revenue affects the topline versus others, but we are safe to assume that it's the majority or lion's share of the revenue. The company also has two other more recent revenue streams that it's added, its Sportsbook, which is basically mobile sports betting, its app is now in 10 states; and we're going to discuss that later on in this podcast. It's also added iGaming, or casino games, these are also apps, they're like black jack, roulette, slot machines, and other virtual casino games that you can play, if you're so inclined.

So, for those of you who aren't initiated into this world of DFS, what's the difference between this and sports betting? Well, Emily, you had some really good notes you shared beforehand, so I'm going to work through these, I think they're great and make it really easy to understand. DraftKings isn't just a sports betting play. So, they started, as we mentioned, in this DFS business, Daily Fantasy Sports. While it seems like it's sports betting, it's really about creating a team in a sort of a virtual world that's based on real-world players. So, this can be in a number of sports, it could be NFL, it could be Major League Baseball. When you bet on sports, that's pure chance, because you are working with fixed odds. So, you have on one side your idea of what will happen within a game or a game's result and you've got oddsmakers on the other side [laughs] who're setting odds as the house to beat you despite your skill level, and it's sort of hard to win when you are just betting on events.

Daily fantasy sports is a skill-based game. So, you're taking your knowledge about players, about teams, and you're constructing your own fantasy team, you work with the same economics a real-world team does, so you've got salary caps on major players, you've got a budget to work with, and then you go up against other players who are doing the same thing. So, it's your skill versus someone else's skill, or your team, [laughs] your friends and the team you construct versus other people. It becomes more of a skill-based game.

And basically what happens is, you pay in to a pot, and winning teams take a portion of that, the house, which in this case, although it's not betting, I'll call them that, because in some states it's still an open question is this actual betting or not, but let's call DraftKings the house here. They take a rake or a percentage of all the money [laughs] that's coming in. So, it is a different phenomenon. And Emily, you liken this to stock investing, because when you're investing in stocks, you're taking your skills and your knowledge against, sort of, an equally uncertain outcome. And I say an uncertain outcome, because daily fantasy sports, while you create it based on your acumen, it follows real-world players and real-world results, so you just don't know what's going to happen, and that's how everything gets tabulated. But the idea is the more you know, you've got a theoretical way to offset the odds and make some money.

And as you point out, that's the argument [laughs] anyway. I haven't, as I said, taken the time to see how well or poorly I would do in that context, but that's basically the overview of how DraftKings makes money.

What about that quarter that we want to talk about?

Flippen: Yeah, it was an outstanding quarter for DraftKings. And again, you made a great point about how people liken DraftKings to sports betting, when in reality, the majority of the revenue is made up from daily fantasy sports. That being said, it's fair to say that the excitement for DraftKings is because of the opportunity that sports betting poses for increases in their revenue, and we saw that in the most recent quarter. The reason why this quarter is so exciting for DraftKings is because it's coming on the heels of the most recent elections here in the United States, in which we saw a handful of states, my home state Maryland included in that, and states that legalized some form of sports betting, which opens up opportunities for DraftKings.

So, when you looked at this most recent quarter, I'm not sure what stood out to you the most, Asit, but what stood out to me was just the high end of guidance that they met, even without factoring in expectations for what these new states could be like. They had a 44% year-over-year increase in revenue. Revenue is still small, it's just over $130 million for the quarter, so this is a small business, but it's a growing business. And it's clearly serving consumers in a way that they've been unable to be met by their competitors. So, despite the fact that it's not the most [laughs] lucrative business right now in terms of cash generation, it still is a business that's clearly serving a strong need.

Sharma: Yeah, I'm laughing, Emily, because I've heard so much about DraftKings, read their S-1, and sort of forgot that they are this small, you hear so much about them, you almost expect them to be bigger, but I guess that could be good in the long run in terms of revenue growth potential.

Flippen: I completely agree. And one thing that you noted was that sports betting, their app is only rolled out in 10 states right now, and a lot of the growth opportunity is related to sports betting. They have a strong lucrative daily fantasy sports business that is, for the most part, legal everywhere, under the same laws, actually, that make investing legal, is because there's a perception that it's based on skill, not luck. We can debate that to-and-fro, but we won't, we'll just say that's how the law is interpreted. So, daily fantasy sports betting is perfectly legal, but as more and more states legalize sports betting, I would expect them to continue to roll out their app into these new states.

And I like the way they talked about their expectations for what the future could hold in states like Maryland, like Illinois, which just legalized sports betting; Tennessee, where they got started there. They talk about rolling out slowly, working with regulators, getting an understanding for the market in those places, and then pushing advertising. That's how they make the most use of the money that they devote to getting and expanding into these states.

Now, that does mean that they probably won't be fully developed in states like Maryland, South Dakota, and the majority of Louisiana, which legalized in this last election cycle, until what management says is, probably 2022. So, that's like the downfall for me in this quarter is, and I understand it, I respect management for being conservative with their expectations for sports betting in the future, because they don't want to make a mistake when rolling out their app in these locations, but at the same time, are investors patient enough to wait until 2022 to see the lucrative -- and it's not even that lucrative, we're talking about Maryland, South Dakota, and Louisiana here, so it's a very, very small portion of the U.S.'s population.

But if it takes two years to roll out in new states, when big states, representing larger portions of the United States population, start to legalize sports betting, man! It could just be years and years until they're fully built out in these locations, which is kind of a "bummer," [laughs] for lack of a better word.

Sharma: Yeah, I think you're right. And one of the really interesting advantages that we're seeing out of DraftKings is that they've spent a lot of time -- at least the predecessor companies -- in developing their technology. They're sort of like agile software developers; they talk about that in their S-1. And they also have a lot of experience with the regulatory environment. So, this is something, if you can be a first-mover when a state opens up, then you can grab market share, and that's what DraftKings has been really good at doing. I think that potential, definitely you can see it if you are a patient type of shareholder, give them a chance to, sort of, follow along with the legislation that's opening up state by state as more states legalize sports betting and allow some of these activities that are future revenue growth opportunities, like, the virtual casino games, those types of apps to flourish.

So, I think there's, you know, a nice potential here. And also, like, big picture, Emily. I like the fact that the balance sheet is pretty strong. I read those going concerns issues too, and for those of you who aren't accountants, that simply means that the auditor [laughs] looked at the books of the company and said, hmm... we're not sure if this company is going to make it over the long term if they don't get some cash confused [laughs] soon. Basically, when you're an auditor, you look at a one-year period. So, it's sort of, you're right, a yellow, yellowish, red, reddish flag, [laughs] but the good thing about an IPO, and like a reverse merger, which this was, is that you can sort of capitalize assets of one company, then common stockholders come in.

And I took a quick look at the balance sheet, it's pretty strong. I mean, they don't have any appreciable long-term debt, they've got a lot of working capital. The company, as you said, is running some losses and still isn't cash flow positive, but now they've got some buffer for those longer-term penetrations into gambling markets that you're talking about, to play out.

Flippen: And let's talk about those markets, because despite a strong financial position, we haven't even mentioned maybe one of the biggest issues facing this business right now, which is a lack of sports. [laughs] It's a little bit hard to play daily fantasy sports or, you know, bet on sports when sports aren't happening. COVID has impacted this business, and when I looked at the most recent quarter, I expected it to be worse than it was, if I'm honest with you, they still had more than one million unique monthly active users, which was an year-over-year increase of 20%; that was really interesting to me.

The red flag for me was the fact that the average revenue per user did fall to $34/user, which was a 6% decrease year-over-year. So, they weren't monetizing those users at the same level. But they also believe that their revenue and their earnings would have been a lot higher if they had full seasons of the NFL games, for instance, that could have dramatically impacted the way average revenue per user shook out this quarter.

All in all, though, I was just shocked that there were still one million unique monthly active users even during these trying times.

Sharma: Yeah, that also spoke to me, because we're not going to be in this, sort of, COVID languishing around without sports and activities forever. So, if you can keep those users, and they probably are going to be pretty sticky, then most shareholders can look forward and look ahead to see the benefit of that. Hopefully, over time, that average revenue per user is going to increase, the bigger thing during the pandemic, maybe it's just to get new users in.

So, you know, like you, I wasn't too phased. You know, I wish that the ARPU would have been higher this quarter, it had been on a really nice increase over the past couple of years, but all in all, you know, I'm not a shareholder, but I would take it.

Wanted to mention one other thing. Well, you know, you're going to talk about margins, and then I'll jump in with one other thing that I've noticed on this most recent report.

Flippen: Yeah, I think margins are worth noting here. I find this really interesting, and maybe some sports bettors can email us, or if you're listening live put it in the comments, to maybe explain some of this to me, the technical aspects of it, but generally when you look at how the business for DraftKings breaks down right now between sports betting and daily fantasy sports is that, daily fantasy sports is a really high-margin lucrative business for them. They're operating a platform to connect two people who are essentially taking opposite sides of a bet. You can relate that to the way, say, the stock market works.

But when you're looking at sports betting, in particular, you mentioned this earlier, Asit, they are oddsmakers, who essentially have to go through and set the rate to be fixed. So, it's more akin to gambling. And oddsmakers, whether it's somebody making a software platform or a physical person sitting behind a desk making odds, it requires a lot more time and energy to go through that process, which means that the margins for their sports betting business, which is the highest growing part of their business right now, in comparison to daily fantasy sports, it's much lower. This is already a lost business, right, this is already producing massive losses, not just in terms of accounting, but cash flow as well. So, they're shifting from a business model that had higher margins to a much lower margin business for the purposes of expanding and taking market share with the hopes that scale in the future will make it profitable.

But it is worth noting that, as this company succeeds in sports betting, if it does succeed in sports betting, as it does, you can expect over the short- to medium-term, for the margins just to get worse here.

Sharma: Yeah. And you've put, sort of, an astute point on it, that there's some components in this that's going to be fixed over time. You mentioned scale, so in terms of operating margin, you're adding on expenses to your payroll, other types of below the line costs, so below gross margin, but these are operating expenses, that's sort of a near-term, long-term investments, but the payoff should be, as sports betting flourishes, and they do enter into more states with software that's pretty much developed and templated, that you get a payoff with rising betters, more people coming to the platform, take a bigger handle, i.e., you know a sports betting bucket of revenue.

So, I think that, again, if you buy this proposition that they are a market leader in the DFS world and they're growing in these other instances of sports betting and the casino games, then you're willing to take that near-term margin hit, because some of it represents investment. As you're pointing out, Emily, that has a payoff in the future. Now, [laughs] how long? Some of this depends on how long it takes for states to gradually go one-by-one to allow sports betting, so it's a little hard to predict, you have to be patient in this game.

Flippen: And speaking of patience, sometimes patience pays off. And I talked about the three states -- it's really like two and five eighths [2.625] maybe. So, you know, South Dakota, Maryland, and then the majority of the parishes in Louisiana legalized in the most recent election cycle. Patience pays off there. But we're actually seeing international opportunities for DraftKings as well. One of the things that management talked about in the most recent call was the opportunity in Ontario, which is the largest province, I believe, in Canada. If there are Canadian Fools out there and that's wrong, I apologize greatly.

Sharma: My wife has family there; and I think you're right. [laughs]

Flippen: [laughs] Okay. Good. It would be a very American thing for me to get the Canadian province size wrong, but I believe Ontario is the largest Canadian province in terms of population. Oh, gosh! I hope that's accurate. [laughs] Either way, it's a great opportunity for them to expand into Canada. The Ontario government recently changed language around their sports betting laws, which could potentially allow DraftKings to launch sports betting there. That would be a big opportunity, and that, in my opinion, is in part of the conversation right now. We focus so much on the United States and the state-level legalization, that we forget about the international opportunity for DraftKings' business, both with daily fantasy sports, as well as, sports betting.

So, I like that. Patience is a good word to describe this business. This is not a business that's going to generate money anytime soon. If you're a shareholder, you can probably expect to continue to be diluted over the next few years if you're holding this company. But at the same time, sports betting is clearly coming. We saw it in the most recent election, we see the rise in revenue from the most recent quarter. There's demand for this business. And if you have the patience to sit around for five to seven years to wait for this business to really shake out, then it could be a really good bet.

Sharma: Sure. There can be some benefit in investing in one of the first-movers with the technological edge, with the regulatory edge and a really great franchise in their DFS books. So, why not? I have to add this to my watchlist going forward. [laughs]

Flippen: [laughs] It's been on my watchlist awhile. I personally have never taken the plunge into buying it, and I've talked about it on podcasts before. Part of the reason why is, is because, as somebody who follows the cannabis industry, I see what a burden regulations have had on highly regulated industries, it makes it a really, really challenging industry to predict what the long-term, say, margin profile could look like, because the regulatory burden is so hard to quantify for these businesses. And that's without even touching on the timeline and how regulations control the timeline for expansion. That adds a level of unpredictability.

And there's also the issue of competition. I mentioned casinos have largely been inept. And I think that's true, it doesn't mean they'll continue to not pay enough attention or research and development costs to getting into this industry, they could, but we actually see FanDuel, for instance, is a big competitor in terms of platform. I wonder if competition among sports betting platforms leads players to go to the lowest cost platform available, which then leads to a race to the bottom in terms of margins and how much they're taking as their take rate. I don't know if that's the case, I feel like DraftKings has a really great brand reputation behind it, maybe there is some loyalty for consumers there, or customers there. But those are, again, things that will take a long time, probably, to prove out.

Sharma: You know, there have been a couple of whiffs in the past about FanDuel and DraftKings, sort of, sharing this market, and some have looked askance at that, so maybe there needs to be [laughs] some competition. But I think one thing that we do discount now, and we're right to, that most of the big casino properties have been caught off-guard by this whole move to online sports betting. But I think a few are waking up. I know MGM has invested some in this space, so that's something to keep an eye on as well if you are a shareholder, that the bigger companies that -- you know, they own property in Las Vegas and they have licenses in various states for subsidiary companies, they won't sit still forever, at some point they're going to have to react to this competition and that first-mover advantage might get dulled some. So, that's just another part of the risk equation that you're pointing out, Emily. I think it's a really important one to pay attention to.

You know, I know we're running close to time on this, but I wanted to just shout-out one more thing from the quarter, if I could; and I can make this quick. We talked about the company still losing money, Emily. They lost $348 million this quarter on $133 million in revenue. So, I just want to point out, if you are a shareholder, you might have looked at that and said, what in the world is going on? [laughs] The reason, or the biggest reason, is that they almost quadrupled their marketing spend to $203 million during the quarter. They did this because in the first quarter, or sorry, in the first part of this quarter, they were live in seven more states, including Illinois, which is a really big state for daily fantasy sports for the first week of the NFL season this year versus last year. So, they went ahead and plowed into that.

Now, they're probably going to have an ongoing, elevated marketing spend. So, some of this is the timing issue, you're not going to see a one-to-one return on the dollar for that marketing spend, don't get too caught up in one quarter, because that makes the losses look really bigger than they will be once you average them out over several quarters going forward.

Flippen: That's really good to note; I completely missed that when looking at their most recent quarter. But before we sign off here, Asit, I want to ask you, is there anything that DraftKings could do over the short-term, say the next few quarters, that would make you want to buy shares, you would be really interested as an investor, more interested than you are today?

Sharma: Well, something that, you know, I pointed out when we were prepping for this episode, Emily, DraftKings has spent this whole COVID pandemic just going after partnerships and trying to secure extensions of relationships it has and introduced new ones. Two that I'll mention, it expanded its relationship with the PGA Tour to become the first official betting operator for the Tour. And it also snagged an extension of its multiyear exclusive deal to remain the official daily fantasy sports partner of Major League Baseball.

So, I really like how much the management is emphasizing the partnerships with sports properties, because to me, that helps bring recurring revenue and it helps widen the user base, and it makes them more of a dominant player in the industry. This is one thing, if they continue to do partnerships with this, the analog for me is how PayPal in the payment space, went through so many partnerships in the first couple of years out of the gate after it was spun-off from eBay, and it is reaping the rewards of those partnerships now. I'd love to see that in a company. And if they continue to do this, you know, I might swallow that, sort of, regulatory risk that you just so well laid out and take a starter position and start watching this a little more closely.

What about yourself?

Flippen: I love that. And I think you have me sold there on the idea of partnerships with the PayPal example. So, I think for the same reasons you just mentioned, if they continue to show new partnerships, I would worry less about their bottom-line and more about the connections, the states that they're expanding to. I'd be willing to take a small bet here, right, [laughs] I'll put a little bit down here on DraftKings. I feel sold now. [laughs]

Well, Asit, thank you so much for joining, as always, it's been great.

Sharma: Thanks so much, Emily, I really enjoyed this one.

Flippen: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say "Hi!" you can always shoot us an email at IndustryFocus@Fool.com or tweet at us @MFIndustryFocus.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for his work behind the screen today. For Asit Sharma, I'm Emily Flippen, thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

Asit Sharma owns shares of PayPal Holdings. Emily Flippen owns shares of PayPal Holdings. The Motley Fool owns shares of and recommends PayPal Holdings. The Motley Fool recommends eBay and recommends the following options: long January 2021 $18 calls on eBay, short January 2021 $37 calls on eBay, and long January 2022 $75 calls on PayPal Holdings. The Motley Fool has a disclosure policy.