3 Reasons Investors Should Worry About Skillz's $9 Billion Valuation

Great potential doesn't always equal automatic success. Skillz (SKLZ -5.96%) is an esports company that offers mobile skill-based games, sometimes played for money. The company doesn't own or produce the games; instead, Skillz is the mobile landlord, handling the money and the process of matching players. The esports company reports earnings soon, and investors seem to be expecting big things. The shares are up significantly since their IPO, yet Skillz's business moat seems questionable. Competition in mobile gaming is fierce, and Skillz asks developers to pay a heavy price to try to rise above the noise. Investors may want to take some of their holdings off the table, instead of betting on this company's continued growth. 

Copies upon copies

The first challenge facing Skillz is its heavy reliance on just three games for most of its revenue. In the company's stock registration statement, Skillz said that in the nine months ended Sept. 30, 2020, 63% of its revenue came from Tether Studios, known for Solitare Cube and 21 Blitz games. Another quarter of Skillz's revenue came from Big Run Studios and its Blackout Bingo game. Without these three games, Skillz would be left with just 12% of its historical revenue.

Image source: Getty Images

The esports company plans to grow partly by bringing more diversity to its gaming lineup.

Imagine Skillz as a mall with multiple empty spaces for stores just waiting to be filled. Games like Solitare Cube, 21 Blitz, and Blackout Bingo are the anchor stores. Skillz collects rent in the form of a cut of all sales and wants to fill all available empty stores. However, unlike an actual mall, Skillz has no physical presence, property taxes, or upkeep costs. That's why the esports company carries a massive gross margin of more than 94%. On the other hand, Skillz doesn't own any proprietary games that it can leverage toward greater success in the future.

Without proprietary games of its own, Skillz relies on the developers of popular games it already carries. Licensing games from other companies works as long as the developers feel they need Skillz to continue their success. However, the video game industry seems poised to follow the same route as video streaming. Netflix (NFLX -2.52%) is a near perfect case study; the company spends billions annually developing originals to combat licensed content being moved to competing streaming services.

But while Netflix creates distinctive content to stand out from the crowd, every popular game Skillz currently relies on has many competing apps that are also highly rated. Skillz's top three games seem to have virtually no moat to protect their future growth. One of the esports company's most popular games is 21 Blitz, which is highly rated at 4.6 out 5  stars on the Apple (AAPL -2.19%) App Store. But there's little to differentiate this game from similar competitors.

(Data source: App Store Preview – Play 21 , 21 Jack , 21 Frenzy )

This list doesn't include apps like Pocket7Games,  which offers a variation on each of Skillz's top games in one app. Skillz's other two popular games, Solitare Cube and Blackout Bingo face similar challenges. In each case, there are a handful of other highly rated games that look and play similarly to the Skillz equivalent.

To avoid being considered gambling, all of Skillz's games must be skill-based. In order to meet this criteria, it's nearly impossible for the company to create a proprietary game. Skill-based games like Solitare or Bingo must be played in according to their traditional rules to protect the skill-related competition. If the company's offerings included items like power-ups or unique abilities that exist in proprietary games, the games might be considered gambling, which would change the economic and regulatory risks Skillz might face in the future.

The inability to prevent this type of competition suggests that Skillz's competitive moat may be a dry rock bed, and investors need to take note.

Breaking through the noise at what cost?

The second challenge Skillz faces is the company's significant cut of developer revenue. One of the biggest obstacles for a new game developer is to break through the noise of the millions of other apps users might consider. Skillz aims to solve part of this problem by connecting its skill-based betting system to an appropriate game.

According to its terms of service, "Skillz shall pay the Company fifty percent (50%) of Net Revenue as a monthly revenue share." By point of comparison, Apple normally pays 70% of revenue to developers, and it boosted that cut for developers earning less than $1 million late last year to 85%. If Skillz had a massive user base, paying 50% of revenue to join the dominant player might make sense. However, as of September 2020, Skillz reported monthly active users of about 2.7 million.

There are an estimated 2.7 billion mobile users , which means Skillz has less than 1% market share. Mobile gaming is a big opportunity, but with a relatively tiny Skillz base, is this enough to attract developers to give up 50% of their revenue? Paying Apple either 15% or 30% and then paying for merchant processing and betting development separately could potentially make more sense.

The issue cuts both ways. A small firm might feel like 50% being paid to Skillz is too expensive. Companies like Tether Studios and Big Run are already successful, and they might decide they no longer need the Skillz brand and services to keep their app's success intact. The fact that Skillz doesn't own any games seems to be a recurring theme to the risks the company faces.

Like the wild west

The third risk facing Skillz has to do with its own advertising. The mobile advertising business is much like the Wild West. Advertisers can promote their game in almost any way they want . There are many examples of mobile apps showing an ad that is nothing like the actual game. Skillz is spending money hand over fist to attempt to bring in new users. In the company's registration statement, it reported spending over 100% of its revenue on sales and marketing in multiple periods. If the company grows effectively, this expense may pay off.

However, Skillz runs the risk of confusing or even alienating its users and potential gamers through its own advertising. The fact that Skillz has 167 complaints through the Better Business Bureau as of this writing suggests the company's reputation isn't exactly stellar. Though questionable advertising might not result in a fine, legal consequences, or a complaint, Skillz's reputation could take damage.

In a recent advertisement for Archery Elite – Tournament, Skillz used a video ad they have repeatedly run for the more popular game 21 Blitz. The ad claims, "they award $2 million a week," followed by the download page for Archery Elite. This $2 million per week doesn't refer to Archery Elite; it actually refers to the game 21 Blitz. Users who download Archery Elite could feel misled or frustrated if their expectations aren't met.

A second issue is a recent advertisement for Blackout Bingo. One of the women in the ad says, "You just play games and win loads of cash!" She suggests that it's free to play and says, "You can win up to $2 million a week." The problem is the games that allow users to win money also charge users money to enter. In addition, the statement about winning $2 million a week includes all the company's winners combined. The word "you" suggests that a single individual could win $2 million, which is simply not the case.

Skillz carries a $9 billion-plus valuation, and its projected revenue for full-year 2020 is just under $225 million. This ratio of 40 times sales is a nosebleed valuation at best. The company also doesn't expect positive EBITDA until 2022 at the earliest. Given the multiple risks and the rich valuation, investors should tread very carefully.