Electronic betting platform DraftKings (DKNG 4.96%) has seen a bit of a revival, with shares up more than 110% since January. While that's a cause for celebration, the stock is still down more than 60% from its former highs, so there's a ways to go for investors who bought at higher prices.
So are DraftKings shares on the rise or is the stock's run bound to run out of steam? Management is pushing to bring the company to positive non-GAAP EBITDA by next year, and the prime betting season -- when football resumes in the early fall -- is months away.
That could bode well for the business, but survival doesn't guarantee investment returns. Investors would be wise to consider some red flags in DraftKings that remain, despite the stock's recent rally.
Here is what you need to know.
Marketing expenses remain high
DraftKings is a leading sports betting and online gaming platform in the United States. Users can place bets (where legal) on various games and sporting events. But the space is very competitive, with similar companies like Fan Duel and casinos jumping into the business to protect what's historically taken place within their buildings.
To win customers, DraftKings spends a lot of money on sales and marketing, running commercials and ads, and offering incentives like free bets to get users onto the platform and keep them active. Ideally, users begin wagering their own money once their free bets run out.
In the first quarter of last year, DraftKings spent 75% of its revenue on sales and marketing -- spending $313 million to generate $417 million in revenue. In Q1 of 2023, that ratio improved slightly to 68%, or $521 million, to generate $769 million in revenue. It's good that sales and marketing expenses are declining as a percentage of revenue, but it remains concerningly high.
DraftKings still must prove to investors that it can reduce sales and marketing spending to a much smaller percentage of revenue and maintain its user base. Otherwise, it's arguable that the business model has no competitive advantage over others.
Reading the fine print in the balance sheet
Management recently updated investors on the company's balance sheet, disclosing $1.1 billion in cash and believing it will only burn $300 million between now and the end of the year. That's encouraging and a great sign for the company's financial stability.
However, some devilish details in DraftKings financials warrant close attention moving forward. For example, DraftKings uses stock-based compensation to conserve cash (employees get paid in stock instead of cash salaries) -- standard practice for many growing, unprofitable companies. But excessive compensation could increase outstanding shares enough to hurt shareholders, because more shares mean that each represents a smaller piece of the business. It's like cutting a pie into more slices; the pie doesn't grow, and you get less of it.
Image source: Getty Images.
DraftKings doled out $117 million in stock-based compensation in Q1, roughly 15% of its revenue.
Additionally, DraftKings has a $1.2 billion convertible loan. This debt can be paid back or converted to equity (shares of stock) by the creditor if certain conditions are met. Don't worry yet. The bond doesn't mature until 2028. Still, it could become a big problem if DraftKings doesn't generate enough profits to pay it back by then.
Should investors put their money in this stock?
If DraftKings can truly slow its cash burn to $300 million over the next three quarters, the remaining $800 million could give the company the chops to stick around as a viable business. But there are still questions about whether DraftKings can grow without throwing hundreds of millions of dollars at marketing. The convertible debt is a potential red flag when stock-based compensation is already aggressive.
Business success doesn't always translate to excellent investment outcomes, so while the jury is still out on DraftKings, investors should consider using some caution here. If you believe in management, buy slowly with a dollar-cost averaging strategy, or stay away until the company delivers more results that back up its goals.
Don't let the fear of missing out tempt you into taking a bad beat in your portfolio. DraftKings' story is still nowhere near done, so you have time to wait it out.
