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Why Is Everyone Talking About Skillz Stock?

By Jon Quast - Jan 21, 2021 at 7:15AM

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Its robust user engagement and stellar margins have drawn a growing following, but there are some red flags beyond the hype.

Cathie Wood is the founder and CEO of ARK Investment Management, and retail investors are tracking her moves like never before. Even Matthew Winkler, editor-in-chief emeritus at Bloomberg, recently called Wood the "best stock picker of 2020." Needless to say, when she speaks, people listen.

Investors were therefore intrigued when her fund purchased shares of little-known esports company Skillz (SKLZ -8.05%) in early January.

Skillz just went public via a special purpose acquisition company (SPAC), which is why many investors likely still haven't heard of it. But given Wood's vote of confidence, it's probably worth getting to know. Here's what Skillz does, what to like, and what to be worried about.

A woman plays a mobile game on her phone.

Image source: Getty Images.

What Skillz does

Skillz operates a mobile gaming platform, enabling creators to launch games and allowing gamers to compete for cash prizes. It's not a gambling platform since all games must be skills-based. Gamers pay an entry fee to play. From there, the developer takes a cut, Skillz takes a cut, and winners get paid as well.

Mobile gaming is a big deal. According to data cited by Skillz in its investor presentation, mobile gaming is currently a $68 billion market, which is bigger than movies and music. But while other entertainment industries were experiencing single-digit percentage compound annual growth rates from 2014-19, according to NewZoo, PWC, and Grandview Research reports, mobile gaming was growing at 20% annually. And Skillz believes its model aligns it with both gamers and developers, increasing its odds to take market share. 

A woman shrugs.

Image source: Getty Images.

What's to like

Skillz is a technology platform, and its profit potential is off the charts. It's not developing games, it's providing the space that brings gamers and developers together. In the third quarter of 2020, the company's gross margin was 94.8%, and it was 95.5% through the first three quarters of 2020. These flashy numbers suggest that Skillz can leverage revenue growth into substantial cash flow.

If you're impressed with Skillz's gross-profit margin, then you'll want to go ahead and sit down before reading about user engagement. Users spend 62 minutes per day on Skillz's platform, outperforming user engagement on many other apps. According to the company, Facebook users only spend 41 minutes per day on Facebook, and people only spend 40 minutes per day watching Alphabet's YouTube. Even ByteDance's TikTok falls short of Skillz's user engagement, with 52 minutes per day per user on average.

All that time spent on the platform means Skillz is generating a lot of revenue per user. Average revenue per user (ARPU) was an impressive $6.30 in 2019, dwarfing that of many other mobile game companies. And it's still improving. In the third quarter, ARPU was $7.49, up 23% year over year.

A growing industry, an engaged user base, and extreme profit potential are all reasons to like Skillz stock for the long term.

A large, red exclamation point sits on a wood floor and leans against a wall.

Image source: Getty Images.

Some red flags

According to Skillz, there are 2.7 billion mobile gamers in the world, and it only has 2.7 million monthly active users currently, meaning this company's growth shouldn't stall for the foreseeable future. Accordingly, it's aggressively spending on growth -- specifically on sales and marketing (where it spent 106% of revenue in 2020). In other words, more cash is going out to win customers than is coming in. 

On the surface, this is a savvy move by Skillz. Management says that users pay for themselves after just four months. However, the company has increased spending drastically in recent months with muted results. In the first quarter of 2020, Skillz had 2.6 million users, an increase of 102% year over year. But it still only had 2.6 million users in the second quarter. And in Q3, it only added 100,000 users despite spending over $73 million in sales and marketing. The payback period of these cohorts will be significantly longer, and the situation points to soon-to-be-slowing revenue growth unless user growth picks back up.

Despite the high profit potential demonstrated by its stellar gross-profit margin, Skillz is miles away from net profits because of all its spending to acquire new users. And the company doesn't plan to change that. Net income isn't even on the radar.

And the company isn't projecting to have earnings before income, taxes, depreciation, and amortization (EBITDA) until full-year 2022, when it expects to have a paltry $8 million in EBITDA.

SKLZ Chart

SKLZ data by YCharts.

What to do

The market capitalization for Skillz has soared to over $9 billion, meaning it trades at over 16 times revenue estimates for 2022. This pricey forward P/S implies extreme future growth. But we've seen some indications of slowing growth. For this reason, Skillz isn't a stock I'd buy today. Rather, I'd watch it from the sidelines for now.

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