In the second half of 2020, online gambling stocks were some of the hottest growth stocks on the market. DraftKings (DKNG -0.89%) started a trend when it went public via SPAC merger, but Penn National (PENN 2.78%), Rush Street Interactive (RSI 3.46%), Golden Nugget Online Gaming (GNOG), and Gan Ltd (GAN -4.12%) all joined the party by hitting public markets or making deals to expand in online gambling.
The euphoria that drove those gains is quickly being unwound in 2021, partly due to the sell-off in growth stocks and partly because expectations may have gotten too high for online gambling. Here's how you should be looking at the market and the leading stocks in the space.
Casinos are open again
One of the reasons online gambling stocks did so well in 2020 was because physical casinos were closed. People who wanted to gamble needed to do so online and revenue jumped as a result.
We haven't seen a decline in online gambling revenue yet, but we are starting to see very bullish signs from physical casino operators. Caesars Entertainment (CZR 1.24%) said this week that weekends are essentially sold out and they are expecting a big rebound in revenue in the second half of the year.
If there are limited discretionary entertainment and gambling dollars to be spent, a rise in spending at the casino could translate to less spending online. That's at least one reason online casino stocks have been down recently.
Online gambling is far from profitable
Investors are also starting to see that online gambling companies are far from profitable and likely won't make money for years. It's very expensive to reach new customers, resulting in hundreds of millions of dollars being spent on sales and marketing, and it's far from clear when these companies will report net income.
Let's take DraftKings as a proxy for the industry because it's the biggest publicly traded pure-play company in the U.S. You can see below that revenue is growing quickly, but sales, general, and administrative expenses exceed revenue and losses are accelerating.
This could reverse course as the company gets larger and customer acquisition costs fall, but that could be years from now. And with sky-high valuations, investors have soured on the long runway these companies may have to profitability.
Waiting in the wings
What I'll be watching in 2021 is how established casino operators react to the online gambling market. Companies like Caesars, MGM Resorts (MGM 2.13%), and Wynn Resorts (WYNN 2.04%) have their own online gambling operations and established brands. They will be able to use cash flow from their existing businesses to fund online gambling growth and if they take market share from digital players who are burning cash it could be bad for stocks like DraftKings, Rush Street Interactive, and Golden Nugget Online.
If stocks continue to fall, we could even see these companies poach online gambling stocks to bolt onto their own operations. Las Vegas Sands (LVS 1.48%) has indicated its interest in buying online gambling assets in some form and that could be a possibility if stock prices fall.
Until online gambling companies prove they're sustainable long term, I'm going to have a hard time betting on the industry. For now, my money is on MGM Resorts translating its industry-leading brands and growing online gambling business into a juggernaut in the industry. And it can wait years for the online gambling market to mature, something online-only companies may not have the financial flexibility to do.