2022 has not been kind to stocks so far, especially the high-growth parts of the market. The iShares Russell 1000 Growth ETF, which tracks large- and mid-cap growth stocks, is down around 10% in 2022. The popular Ark Innovation ETF run by Cathie Wood is down 26% in 2022, another example of the sharp decline in high-growth stocks right now.
Gaming platform Roblox (RBLX -1.07%) has been hit extremely hard by this growth stock sell-off and is now down over 40% in 2022. With shares down so much this year, is now the time to buy Roblox stock?
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What is Roblox?
Roblox is a gaming and entertainment platform focused on serving children and teens. What makes the platform unique is that Roblox itself doesn't publish gaming content, but builds the tools and services so outside publishers can easily produce and monetize games on its platform. The most similar business model is YouTube, but instead of video content, Roblox has games and 3-D experiences.
The company makes money by selling an in-game currency called Robux to users. Users pay for digital goods and services within the games on the Roblox platform with Robux, with Roblox itself taking a cut of the transaction. Since these are all digital experiences, Roblox has high gross margins, with its main cost of revenue coming from payments to mobile application stores, customer support, and some server costs. As of last quarter, its gross margins sat at 75%.
Solid growth and large market opportunity
During the pandemic, with many kids stuck inside, Roblox saw tremendous growth in both usage and spending on its platform. For example, in the heart of the pandemic in the third quarter of 2020, daily active users (DAUs) grew 97% year over year, and bookings (the revenue equivalent for Roblox) grew 200% year over year. Recently, that growth has moderated, with DAUs growing 31% and bookings growing 28% year over year in Q3 of 2021. This huge slowdown might seem concerning, but from my chair, 28% bookings growth is highly impressive considering it is coming off of 200% growth the year prior. Over the longer term, investors should expect bookings and user growth to moderate closer to the 20%-30% range.
What's most exciting about Roblox is the large market opportunity it is going after. With less than 50 million DAUs (estimated 47.3 million at the end of last quarter) and over 2 billion mobile game players worldwide, Roblox is only a small portion of the gaming market right now. If it can make its platform popular for users of all ages around the world, the company has a long runway of growth ahead.
This brings up the biggest hurdle Roblox needs to get over: increasing the average age of players on its platform. in Q3, 23.1 million of Roblox's DAUs were under 13, making up around half of its users. Management breaks out the over 13 age cohort in its earnings slides. That group hit 23.8 million DAUs in Q3, growing 48% year over year. This is more than double the 20% year-over-year growth rate in DAUs for the under-13 age cohort. If the older users can durably grow at a double-digit rate, then Roblox has a chance to become one of the dominant platform businesses in the world, similar to YouTube.
What about the valuation?
Just because a stock is down 40% does not mean it is cheap. All that matters is the price you are paying now versus what earnings you think the business will generate in the long run. Roblox's market cap is currently $35 billion. Over the last twelve months, it has generated $600 million in free cash flow, which is the best metric to measure profitability for a business like this. That gives the stock a trailing price-to-free-cash-flow (P/FCF) of 58. For reference, the average stock in the Nasdaq has a P/FCF slightly over 30.
This P/FCF multiple might seem expensive at first glance. But investors should remember that right now Roblox is investing heavily for growth, which is dampening its ability to generate free cash for shareholders. And if it can continue compounding bookings and DAUs, annual free cash flow will likely grow as well.
Taking these two factors into consideration, Roblox stock doesn't look overly expensive on a multi-year time horizon. If you are confident the company can continue growing users and bookings at a double-digit rate, now could be a great time to buy and hold Roblox for the long term.
