The metaverse is coming.
That seems to be the growing consensus as big technology companies like Meta Platforms, Apple, and Microsoft are all prominently talking about their place in it. This strongly suggests that investors need to be paying attention to what the developing metaverse economy could mean for their investment portfolios. The hype is justified.
Smaller public entities are talking about metaverse potential too. For instance, online gaming and game creation platform company Roblox (RBLX -3.66%) came public last year amid metaverse hype (although its share price has suffered along with many other tech growth stocks over the past several months due to a market-wide sell-off).
There are at least three reasons you need to think about adding Roblox to your portfolio and one red flag to consider before doing so.
Image source: Getty Images.
Why buy: Huge advertising potential in the metaverse
The Roblox platform is a digital world with metaverse characteristics where more than 47 million daily active users can interact and play games made by developers. Roblox has a digital currency called Robux, which users purchase with cash or credit card. Robux sales are the primary revenue driver for the company.
When someone spends Robux, the transaction splits among a few parties; Roblox takes just under 24% on average, with the rest going to a combination of the developer, app store (like Apple's app store or Alphabet's Google Play), payment processors, and infrastructures like server hosting and support.
The metaverse could grow to become an entire digital economy. Its estimated size in 2020 was $478 billion and it could grow to $783 billion by 2024, according to GDA Capital, an advisory firm specializing in digital asset investments.
Roblox has begun to get some traction with advertisers, which could be a powerful revenue driver over the long term. Roblox states that its revenue contributions from licensing, advertising, and royalties are immaterial, but this could change.
Large brands are starting to invest in creating experiences on the platform. Nike has built NIKELAND, Music star Lil Nas X had a concert experience on Roblox, and Chipotle Mexican Grill had a promotion where it gave out free burritos in a digital restaurant on Halloween. The more Roblox grows, the stronger its platform can be as an advertising business. Its 47 million daily active users already make it comparable to the Roku Channel, the largest advertising-based video-on-demand platform in the U.S.
Why buy: Strong cash flows
Roblox invests a lot of money into its platform for servers and infrastructure as well as research and development. Still, overall, the company can be very profitable as it continues growing revenue and users.
Net income is currently negative because Roblox is aggressively spending to fuel growth but is already generating a lot of free cash flow (FCF), meaning it has cash available after it invests in its business.
RBLX Free Cash Flow data by YCharts
It's generated $599 million in free cash flow from $1.66 billion in revenue over the past 12 months. In other words, it gets $0.36 of FCF from every revenue dollar, which is strong for a company that's still in growth mode. This could mean that as revenue grows over time, its bottom line could grow quickly once it starts turning a profit.
Why buy: The stock's valuation
The company's initial public offering was in March 2021, shortly after many tech stock prices peaked. Roblox's strong growth, financials, and hype in a hot market created a pretty expensive valuation for investors to swallow. Shares debuted at just under $70 per share and hit as high as $141, a price-to-sales ratio of more than 24.
The stock price has fallen under $60 at some points, an almost 60% drop from its 52-week high. Analysts are calling for 21% revenue growth for 2022, expecting $3.3 billion in revenue, creating a forward P/S ratio of just over 10.
I don't think the stock is a "can't-miss" bargain at this valuation, considering its non-explosive growth and a market cap that's already more than $30 billion. However, I think the company's growth runway is very long, meaning growth may not be explosive, but it could grow at a healthy double-digit percentage pace for years to come. Investors should welcome the stock continuing to fall, but shares seem buyable here.
Why sell: User growth slowing down
Roblox seemed to benefit from the pandemic lockdowns; quarterly user growth was between 40% and 50% year over year in 2019, and it accelerated to as high as 97% year over year in 2020. It began to cool in 2021 -- user growth was 79% year over year in the first quarter, followed by 29% in the second quarter and 31% in the third.
User growth is a critical metric for Roblox because it will impact the company's revenue growth and its appeal to advertisers over the long term. Investors will want to see that this picks back up in future quarters. One possible way it can do this is to attract older users to its platform. If user growth remains slow, it could spell trouble for investors.
