Online gambling is a fairly new concept and the market is dominated by a finite number of major players. It is easy to overlook sports gambling companies as serving a small, niche market. Moreover, some investors may believe that sports betting apps rose in popularity during the stay-at-home phase of the pandemic, and have since fallen out of popularity.
But a company called DraftKings (DKNG 4.96%) is quietly gaining momentum, thanks in large part to new product innovations that have jump-started revenue and transformed the mobile sportsbook into more than a pandemic fad.
DraftKings recently crossed a 52-week high; however, the stock is still heavily discounted from its historical levels. Despite its recent run-up, now may be a great opportunity to buy the stock.
Overview of the market
Investors should understand that the U.S. sports betting market has experienced some pretty significant changes in recent history. Prior to 2018, the Professional and Amateur Sports Protection Act (PASPA) of 1992 essentially made sports betting illegal with the exception of a handful of states. However, in 2018 the Supreme Court ruled this legislation as unconstitutional, granting individual states the right to determine their own regulations.
While this was a big step forward for sports betting companies, it is important for investors to realize that the U.S. market is still evolving. Per DraftKings' most recent 10-Q filing:
[A]s of March 31, 2023, 33 U.S. states, the District of Columbia and Puerto Rico have legalized some form of sports betting. Of those 35 legal jurisdictions, 28 have legalized online sports betting. Of those 28 jurisdictions, 24 are live, and DraftKings operates in 21 of them.
The above illustrates that while most of the U.S. has legalized sports gambling in some form or fashion, that does not necessarily make each location an active market for DraftKings. For example, there are 11 states that have legalized sports betting, but do not have DraftKings currently operating there.
Nonetheless, it's pretty telling that since the Supreme Court's decision in 2018, over 60% of U.S. states have swiftly passed regulation to allow sports betting. And while DraftKings still has a lot of open market opportunities, its unique product differentiation has really helped it acquire new users and increase engagement across the platform. It is this dynamic that has me excited about the company's future prospects.
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Innovation is leading the way
Generally speaking, there are two common ways to wager on an outcome in sports betting. One is to place a bet on a particular game or event. These usually carry lower odds because the outcome is binary -- either you guess correctly or not. These types of bets are generally viewed as mundane and the only real differentiator among sportsbook apps is the odds for a particular game.
A more exciting form of betting can come in the form of a parlay. A parlay is when you bet on a series of events happening, and in order to win you must guess correctly on each leg of the bet. Naturally, the more outcomes you add to a parlay, the worse the odds become, thereby making your bet more risky. Another popular wager is called prop betting. Props are very specific things such as betting on how many points a certain player may score, or how many touchdowns a team may have.
The advent of placing a bet on your phone through an app seemed pretty novel just a few years ago. However, DraftKings has some stiff competition, namely from FanDuel, Penn Entertainment, and even traditional casinos such as MGM Resorts International or Caesars Entertainment. Additionally, privately held sports entertainment company Fanatics recently outbid DraftKings for the acquisition of the Pointsbet's U.S. business as it looks to make a move into the gambling arena.
The increased competitive landscape has more or less forced DraftKings to develop some new and interesting ways to engage with its users. But the icing on top is that it has done so in a cost-efficient way. DraftKings has been rolling out new features such as in-game betting and same-game parlays. While the data is limited, early adoption signs are encouraging.
Should you buy the stock?
DraftKings' new features allow users to place bets while the game itself is currently live. Prior to this innovation, once you placed a bet before a game, you were locked in at those odds. However, DraftKings' algorithms change the odds of a game or prop as it plays out in real time. This is a big deal because, in a way, DraftKings has added an additional layer of gamification to its product suite, enticing users to place more bets as they watch the progress of a particular game. These enhanced features have led to increased engagement across the platform, which has helped the company expand margins and trim losses.
For the first quarter ended March 31, DraftKings reported total revenue of $770 million, which represented an eye-popping 84% growth year over year. Per the Q1 press release, the top-line increase was "driven primarily by efficient acquisition of new customers, product innovation driving higher hold percentage, decreased promotional intensity in more mature states, and continued healthy customer retention."
The staggering growth in revenue has helped DraftKings dramatically reduce its net losses. For the quarter, DraftKings posted a net loss of $397 million. By contrast, the company posted a loss of $468 million during Q1 2022. While the company is not yet profitable according to generally accepted accounting principles (GAAP), investors can see firsthand just how engaged DraftKings' user base is by looking at revenue growth and the underlying catalysts.
Should the company continue to keep users engaged, it is natural that DraftKings will not need to invest as heavily in customer acquisition over time. Subsequently, a growing top-line and capital efficient cost structure will lead to expanded margins and eventual consistent profitability.
DraftKings' shares trade at 5.4 times trailing-12-month sales. By contrast, FanDuel-owned Flutter Entertainment trades at a price-to-sales ratio of 3.7 while MGM and Caesars trade at 1.4 and 1, respectively. While DraftKings trades at a premium to its peers, it's also important to keep in mind that the stock is up 23% in just the past month. Clearly, there is some momentum propping up the stock as it heads into second-quarter earnings in August.
Long-term investors should be compelled by DraftKings' growth prospects, the most obvious of which is penetrating more markets in the U.S. If the company continues to keep users engaged, revenue should grow at a healthy rate, thereby leading to expanding margins and reduced cash burn. A prudent action is to dollar-cost average into the stock over time, and keep a close eye on quarterly results, particularly the path to profitability.
