The stock market got extremely excited about the announcement earlier this month that DraftKings (DKNG -3.49%) would enter New York's online gambling market, the largest single market to open up for online gambling in the U.S. This is an opportunity DraftKings has eyed for a long time.
But there are also reasons to be cautious of DraftKings expanding further. The company has been losing money at an unsustainable rate, and will now have to spend millions to entice New York customers to make deposits to its mobile app. Investors may want to wait and see how this growth strategy plays out.
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DraftKings' cash burn business
The challenge with online gambling is that it's a marketing-intensive business. If you've watched any football in the last week, visited sports websites, or listened to sports-related podcasts you've probably been inundated with ads for gambling sites. These ads are expensive, and have consequences for DraftKings' operations.
You can see below that DraftKings is burning cash and spending hundreds of millions of dollars every quarter on sales and marketing. Entering a state like New York likely means that marketing spend and cash burn will go up.
DKNG Free Cash Flow (Quarterly) data by YCharts
Remember that DraftKings will be competing against Flutter's FanDuel, Caesars (NASDAQ: CZR), and Rush Street Interactive (NYSE: RSI) from day one in New York, and we should expect Bally's, MGM's (NYSE: MGM) joint venture BetMGM, Wynn Resorts' (NASDAQ: WYNN) Wynn Interactive, Resorts World, and PointsBet to follow soon. All of these companies are fighting over the same customers.
Is there a durable competitive advantage in online gambling?
A lot of investors and analysts are looking at online gambling stocks like software as a service (SaaS) stocks based on the thesis that their business models are similar. SaaS stocks are generally valued based on the following assumptions.
- Companies spend heavily upfront on software development and sales and marketing to build features and attract customers.
- Any new onboarded customer has high lifetime value because they generate revenue for years -- or decades -- and create high incremental gross margin for the business.
- SaaS businesses are usually subscription-based, which are sticky, recurring sources of predictable revenue.
If you're a SaaS company, you can justify spending $100 to attract a customer if they're going to generate $1,000 of value for your company over a decade or more. And SaaS businesses are generally very sticky. But is that the case in gambling?
The same stickiness doesn't exist in gambling. Better odds on a game or a betting incentive may only be a click away on a mobile device, and we know that there are nearly a dozen companies vying for customers in New York alone. Customers also aren't bound by long-term contracts or have auto-renewal features that are common in SaaS. To continue generating revenue, DraftKings will also continually have to ask customers to deposit (and lose) more and more money.
Even from a regular betting standpoint I have to wonder how durable margins are long-term. As customers search for game odds or bet options at home, why wouldn't they do that on multiple apps while watching a game?
As evidence that pricing power isn't particularly strong, DraftKings doesn't have the same level of high margins as SaaS companies, which could be a problem. The SaaS model is built on the idea that the upfront investment to attract customers is high but the long-term margin from customer revenue is also extremely high. DraftKings has the high upfront cost without the high ongoing margin.
DKNG Gross Profit Margin (Quarterly) data by YCharts
Competition will be fierce in online gambling
DraftKings has a war chest of $2.4 billion in cash on the balance sheet, and that gives it a long runway to outlast the competition as everyone tries to grab customers in online gambling. But I worry that this is the kind of business that will burn cash indefinitely on a never-ending quest to find more customers.
There are also competitors in this space with profitable physical casinos that can operate money-losing online businesses indefinitely to weed out competitors.
When moving to a different gambling operator only requires a few clicks, it makes the business less sticky than an SaaS businesses or a casino, where walking across town takes time and effort. That may make DraftKings less profitable than investors think, and makes me cautious about this stock long-term.
