Is DraftKings Stock a Buy After a Big Drop?

Shares of online betting company DraftKings (DKNG 2.08%) have dropped 30% from their March highs as brick-and-mortar casinos make a comeback and short-sellers have begun targeting the stock. The latest setback was a report by Hindenburg Research that accused the company of ties to illegal gambling around the world, but that's not the only reason investors are selling. 

Is the market's negative sentiment warranted or an overreaction to a company with a huge long-term opportunity? Taking a step back and looking at the company's long-term prospects is worthwhile right now. 

Image source: Getty Images.

Short-seller accusations

The recent report by Hindenburg Research made numerous accusations, including allegations of illegal gambling activity and doing business in Iran, which is banned. My fellow Motley Fool contributor Rich Duprey gave a good overview of the report and what investors should think here. 

At the end of the day, any report from short-sellers should be taken with a grain of salt because they have a vested interest in making a big deal of any bad news. But I also don't think any of the accusations would sink DraftKings' business in the long term. The most damning accusations were against SBTech, a company that DraftKings merged with when it went public, but Credit Suisse pointed out that it was technology, not revenue, that DraftKings was acquiring. Even if SBTech's revenue went away, it wouldn't be the end of the world.

But even if a short-seller report isn't a reason to sell in and of itself, there are reasons to be down on DraftKings' stock. 

Competition is a challenge

When DraftKings went public, it had huge tailwinds from the pandemic (which periodically closed most casinos across the country) and from the opening of more states to online sports betting or iGaming. 

But trends have changed in recent months. In-person casinos are almost fully open, and the pandemic and related restrictions are subsiding. That could hurt online gambling.

So far, news is mixed from states with online gambling. Below you can see how revenue and handle (a measure of gambling volume) are trending in New Jersey, Pennsylvania, and Iowa. The three-month period I chose shows mixed results, and there's no clear trend to the direction each state's online gambling is headed. Depending on what month we pick to compare in the last six months, revenue could be down or only up slightly. In other words, the days of explosive growth are over. 

Source: states' gaming control boards.

It's also clear that competition is increasing within the online gambling space in most states. For example, in Iowa, the number of casino/online brands reporting revenue increased to 18 in May 2021 from just 13 a year ago. As states open up online gambling, they're likely to have fewer restrictions about owning a physical casino or being able to take deposits in real life in the state. And that'll only increase competition. 

Valuation is a challenge

It's this revenue pressure and the cost of marketing to new customers in a competitive market that has me most worried that DraftKings' valuation has gone way too high. The company has a market cap of $21 billion but also reports a higher loss from operations than it reports in revenue. 

DKNG revenue (TTM) data by YCharts. TTM = trailing 12 months.

There's a lot of revenue growth potential, but if it's not high margin, I don't see how the company lives up to the current valuation. And in the online gambling business, I think there will always be a lot of competition, squeezing margins for everyone involved. 

We have yet to see that online gambling can actually be a highly profitable business, at least in the U.S. And that's a problem if investors are expecting DraftKings to be a growth stock. 

Given the high valuation and big losses, I'm worried that DraftKings stock has further to fall. This was a hot stock until early this year, but it's a stock I wouldn't be betting on right now.