Betting on DraftKings Shares Now Is, Yes, a Gamble

The market’s recent dips underscore the possibility of retreat and that investing carries with it some risk. One indicator of potential risk is found in filings with federal regulators, as shown by DraftKings (NASDAQ:DKNG) and its disclosure regarding DraftKings stock.

DraftKings (DKNG) logo on a phone
Source: Lori Butcher / Shutterstock.com

The disclosure was part of the company’s annual 10-K filing. These are required disclosures by the Securites and Exchange Commission so investors can understand the risks in a stock.

Disclosures like this can help investors evaluate a stock.

The risk factors in DraftKings’ 10-K take up a whopping 30 pages in a filing that is only 140 pages long.  In this article, we’ll highlight a few of them:

Competition for DraftKings Stock

What brick-and-mortar casinos will look like post pandemic in terms of return visitation is still unknown. But we can safely assume it will return in a big way. This means competition for DraftKings stock.

Gaming is a social activity most of the time and will continue to attract in-person visitation. Bachelor parties and weekend getaways with friends will never go out of style. And logging on to your favorite gaming app alone in your room won’t serve those needs.

In terms of online gambling in specific markets such as New Jersey, there are now 22 online casino apps and 18 sports betting apps in operation, according to NJ Online Gaming. We can expect that competitive environment in every state that legalizes online sports betting.

App development is a relatively easy task compared to building a large brick-and-mortar casino.

Discretionary Spending

Sports betting and gambling is a perfect definition of consumer discretionary spending.

After required living expenses, putting money in your 401(k) account and paying off credit card debt, many people choose to spend on gambling.

However, DraftKings stock will likely be affected when consumer spending drops. Consumers pull back after a terrorist attack such as 9/11, a global pandemic or even a normal economic recession. To treat DKNG as a defensive stock like soap and breakfast cereal is simply wrong.

Regulatory

I can’t imagine how big the legal and regulatory departments are at DraftKings, but it’s possible it’s larger than their technology department.

The company has to operate under a myriad of regulatory frameworks. These include state laws, local jurisdictions, tribal rules, federal regulations, plus international laws. In addition, there area technology regulatory issues such a GDPR, ADD Act and consumer privacy issues.

Do any of the DraftKings stock day traders know what a skin is? Gaming is probably one of the most highly regulated industries in the U.S. behind financial services and utilities.

Large Intangibles

As of the end of 2020, intangible assets (primarily goodwill, customer relationships, software and licenses) stood at $1.1 billion. This amounts to 40% of stockholders equity.

Most of this is primarily related to the company’s recent SPAC merger and acquisition in 2020.

Only time will tell if the deal was a fairly valued transaction, but I would expect massive write-downs in coming years if DKNG shares decline substantially.

Valuation Is Hard to Calculate

So what is DraftKings stock worth? There is of course no EV/EBITDA or P/E ratio we can quote as there is no positive EBITDA or earnings for quite some time into the future. Investors could perhaps be waiting even out to 2024 for positive EBITDA to show up.

And don’t let the Wall Street analysts fool you, most of them add back stock compensation to their EBITDA calculation to provide a much higher number (or lower losses). But stock compensation is a real expense. As Warren Buffett once said: “If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”

So to get a fair valuation, I can utilize a discounted cash-flow calculation. This is the last refuge of money-losing growth companies. If we assume that DraftKings can grow revenues at a 20% annualized rate over the next 10 years, and reaches an EBITDA margin of 10% by 2025, then the value of the company is perhaps $10-$15. If we lower the discount rate to todays average risk-free rates, then maybe the value of DKNG is much higher, but there’s no possible way that interest rates over the next 10 years will stay this low.

What Matters for DKNG Shares

However, none of that matters today because the company is growing rapidly and will continue to do so. That’s what “investors” love today. This is despite no profits to be had in the near future.

But it actually does matter, because all businesses require a return on capital in order to survive, whether it’s your local dry cleaner or the largest publicly traded company on earth. It is investors, or shareholders that require that return. Day trading and technical analysis may prop the stock up to unreasonable levels, but eventually, owners of a business need to see a return on capital.

In this classic and fascinating period of stock market history where holding periods on shares like DraftKings stock are often measured in minutes, hours or days, maybe it won’t matter for a long-time. But you don’t want to be caught holding the bag when mathematics comes back into style.

On the date of publication Tom Kerr did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tom Kerr, CFA is an experienced investment manager and business writer who has worked in the investment and securities business since 1994.


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