Since going public last year, mobile-gaming platform Skillz (SKLZ 2.93%) has been targeted by multiple short-sellers who publish their bearish opinions in short reports. And I love reading them! Even though I personally own Skillz stock, I believe in approaching these reports with an open mind so they can challenge any of my assumptions that may be wrong.

Eagle Eye Research is one of the latest short-sellers to release a report, which makes it sound as if Skillz is using funny money to game the stock market. And unsettlingly, the short-seller's conclusion is supported with some valid points I overlooked.

A person examines a one hundred dollar bill using a magnifying glass.

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The uncomfortable reality of bonus cash

Skillz had a net loss of $122 million in 2020, and this unprofitability is one of the biggest problems some investors have with the company. Its largest drag on earnings is sales and marketing (S&M). Last year, the company spent more on S&M than it generated in revenue -- $252 million vs. $230 million.

However, much of this massive S&M spend goes toward user incentives, including something called bonus cash. Skillz incentivizes users with free money to sign up, play, and refer their friends to the platform. And this bonus cash can be used to play games for real payouts.

Eagle Eye asserts the bonus cash artificially inflates revenue, and there's certainly some truth to this. Think of it this way: Two companies each sell a $10 product. One company incentivizes a sale by offering a 20% discount, selling it for $8. The other company keeps the price at $10 but gives the buyer $2 toward the purchase. Both companies bring in $8 in new money, but the second company's revenue looks 25% higher. 

Skillz users pay entry fees to play games for a chance at winning cash, and Skillz generates revenue by taking a cut. But it's possible for Skillz users to pay entry fees exclusively with bonus cash. In those instances, Skillz generates revenue solely from its S&M spend, which is just an unprofitable merry-go-round.

For the record, Skillz doesn't treat all bonus cash the same. Game developers expect the company to incentivize users. In cases of reasonable expectations from game developers, Skillz counts user incentives as a reduction of revenue. This is similar to how DraftKings recognizes revenue for its daily fantasy sports (DFS). Revenue from DFS is net of user incentives, per the company's filings.

For 2020, user incentives reduced Skillz's revenue by $51.3 million. But there were also more discretionary user incentives that didn't get recorded as revenue reductions. These counted as expenses, accounting for a whopping $91.5 million of its S&M spend last year.

Therefore, you could say Skillz is giving users money from its own pockets to grow its revenue. And this reality admittedly puts a huge asterisk on its top-line numbers.

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Image source: Getty Images.

What it means for investors

Here's why bonus cash could be a problem for long-term investors: It's possible for users who never deposit cash to pay entry fees with bonus cash, win money, and then withdraw their cash winnings. If this happens, Skillz's revenue might actually appear fine for a time, but it would be disastrous for the long-term financial health of the company.

Furthermore, it's possible to envision a scenario in which management achieves its revenue guidance by quietly increasing user incentives in hopes of seeing that trickle back up to the top line. Indeed, this is what Eagle Eye is suggesting.

We can't predict the future with certainty, but we can look back at the company's track record so far. The majority of entry fees right now -- 82% -- are paid with past winnings. In fact, most cash has historically stayed inside the ecosystem. Consider that in 2018 and 2019, there were combined cash deposits of $134 million but only $20 million in withdrawals. In other words, over $100 million entered the Skillz ecosystem and didn't leave. Therefore, withdrawals aren't a problem for now.

While past winnings provided 82% of entry fees in 2019 and 2020, 11% came from new cash deposits. Only 7% of entry fees came from bonus cash provided by Skillz. We don't know how much of the past winnings came from bonus cash, but we can say over 60% of new money is coming from users' wallets, not Skillz's coffers.

I believe it's unfair to say Skillz's management is gaming the system with these user incentives. However, investors should be aware of the issues bonus cash creates. In the past, I've been tempted to value this unprofitable stock based on its price-to-sales (P/S) ratio. However, as we've seen, the revenue figure doesn't tell the whole story. Therefore, it may be better to judge this company's performance based on user deposits and withdrawals going forward.