Skillz (SKLZ -0.31%) has been a volatile stock since it merged with a SPAC and went public last December. The stock opened at $17.89 on its first trading day and skyrocketed to an all-time high of $46.30 in February, but tumbled back below $17 over the following four months.

I reviewed Skillz's near-term outlook last month and concluded that the online gaming platform company's customer concentration issues, high user acquisition costs, and widening losses could all prevent the bulls from returning this year. But looking ahead into the next five years, could Skillz eventually silence the bears and generate multibagger returns?

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Image source: Getty Images.

Understanding Skillz's business

Skillz's cloud-based online matchmaking arena enables mobile game developers to easily host multiplayer games, award cash prizes, process in-app payments, and monitor the performance of their games.

Outsourcing those features to Skillz is generally cheaper, simpler, and easier to scale than creating those features from scratch. That's a popular alternative for smaller developers, but larger video game publishers generally prefer to build and control their own multiplayer platforms.

Skillz served 2.7 million monthly active users (MAUs) across all its hosted games in the first quarter of 2021, but only about 467,000 of those MAUs made in-game payments. Skillz often tells investors there are about 2.7 billion mobile gamers worldwide, according to Newzoo's estimates, and that it's still in the "early phases of addressing our significant market opportunity."

Skillz plans to continue growing by boosting its user engagement rates with fresh content, broadening its reach into more gaming genres, expanding overseas, recruiting more esports influencers to promote its platform, increasing its ratio of paid users, and acquiring smaller companies.

But can Skillz keep growing?

Skillz's revenue rose 92% to $230 million in 2020, and it expects that figure to grow another 63% to $375 million this year. Analysts expect its revenue to rise 46% to $551 million in fiscal 2022.

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Image source: Getty Images.

But Skillz remains unprofitable, and Wall Street doesn't expect it to turn a profit anytime soon. Its user acquisition marketing costs more than doubled year over year in the first quarter and consumed nearly two-thirds of its revenue -- and those costs will remain elevated as it tries to attract more developers and gamers.

Skillz's ratio of paying users, take rate, and average revenue per paying user are all improving, but its total MAUs grew less than 4% year over year last quarter, so it will need to aggressively monetize its existing users to maintain its double-digit sales growth.

Another issue is its overwhelming dependence on a few publishers. Three games from two studios (Tether and Big Run) accounted for 79% of its revenue in 2020. In the first quarter of 2021, it admitted that games from its "top developers" accounted for 42% of its revenue.

These small publishers mainly develop simple card, bingo, puzzle, and pool games instead of more bandwidth-intensive first-person shooters or real-time strategy games. Skillz claims it can eventually expand into those higher-end markets, but we haven't seen much progress yet.

What will the next five years be like?

At $17 per share, Skillz has a market cap of $6.74 billion, which values it at 18 times this year's sales. That high price-to-sales ratio might seem reasonable relative to its near-term revenue growth, but its stock could underperform the market over the next five years, for three reasons.

First, Skillz's MAU growth is peaking, and it relies heavily on a niche market of smaller games that encourage players to enter cash-based tournaments. Skillz insists these tournaments are not a form of gambling, but that's still a grey area that could impede its expansion into new gaming genres and overseas markets. As a result, Skillz's growth in paying users could eventually peak.

Second, Skillz keeps a whopping 50% cut of all revenue from its hosted games. That's significantly higher than the 30% cut that Alphabet's Google and Apple typically retain from apps hosted in their mobile app stores.

Skillz desperately needs more developers to join its platform and diversify its customer base, but its high fees could keep new developers away and cause its top clients (such as Tether and Big Run) to consider other options. That pressure could make it even tougher for Skillz to narrow its losses.

Lastly, Skillz will likely keep diluting its shares with big stock bonuses and new secondary offerings. That behavior isn't surprising for an unprofitable tech company that needs to conserve cash, but its rising share count could also prevent its valuations from cooling off.

The key takeaways

On the surface, Skillz seems to be generating impressive growth with a disruptive platform. But if we dig a bit deeper, we'll notice its foundations are shaky and it still has a lot to prove.

I believe Skillz will need to acquire its smaller competitors or launch its own first-party mobile games to improve its scale and stabilize its business. Those moves might eventually make Skillz a more compelling investment, but I doubt it will deliver multibagger returns over the next five years.