Wait for the Pullback in DraftKings Stock

DraftKings (NASDAQ:DKNG) has gone parabolic. Since April 1, DraftKings stock has more than doubled.

draftkings stock
Source: Lori Butcher/Shutterstock.com

The gains make some sense. As I wrote last week, the market in the last few weeks has seen almost a second wave of “pandemic plays.”

When the coronavirus first hammered U.S. stocks, some names rallied while markets plunged. Investors bought manufacturers of personal protective equipment, as the likes of Lakeland Industries (NASDAQ:LAKE) and Alpha Pro Tech (NYSEAMERICAN:APT) gained. “Stay at home” plays like Zoom Video Communications (NASDAQ:ZM) and Teladoc Health (NYSE:TDOC), a long-term favorite of mine, did the same.

As panic subsided, the rally broadened. Investors started looking for companies whose long-term prospects had improved, even if short-term earnings would take a hit. For example, we’ve seen software plays like Okta (NASDAQ:OKTA) and Twilio (NYSE:TWLO) break out to new highs after March sell-offs.

DraftKings stock has done the same. But after this rally, it does seem like the easy money has been made. At the highs, DraftKings is pricing in a significant amount of success despite some still-significant concerns.

The Long-Term Case for DraftKings Stock

Purely from a short-term perspective, the rally in DKNG doesn’t make much sense. U.S. professional sports are shut down with limited exceptions. DraftKings is actually running free-to-enter pools based on simulated football and basketball games simply to keep customer interest intact.

But investors have returned to taking the long view, as they should. And from that perspective, DraftKings stock should be rallying.

After all, DKNG is primarily a play on U.S. sports betting, though the company does offer an online casino product as well. Both markets may wind up expanding more quickly than believed.

U.S. states are seeing significant budget pressure as a result of coronavirus-driven shutdowns. To fill their coffers, some states may legalize sports betting and iGaming.

Even of the 17 states that have legalized sports betting, there may be larger opportunities ahead. Several — most notably New York — have authorized sports betting only on-premise.

Online availability in those states would dramatically increase the size of the market. It would also give DraftKings a competitive edge as it ports existing daily fantasy customers over to its sportsbook.

More states with legalized sports betting sooner means a larger market for DraftKings. It means more revenue and profits more quickly. Looking at that long-term case, the rally in DKNG certainly seems logical.

Valuation and Market Questions

That said, the rally has gone awfully far at this point. DraftKings now has a market capitalization in the range of $8 billion. (That figure is based on the pro forma share count from a recent filing with the U.S. Securities and Exchange Commission. Some public sources report larger numbers which appear to be incorrect.)

That’s an enormous number for the sports betting opportunity, in particular. Bear in mind that sports betting isn’t really that profitable of a business. In Nevada, for instance, in 2019, sportsbooks “held” just 6.2% of the money wagered. And unlike slot machines, sports betting, even in a global digital age, can’t and doesn’t run 24/7.

The American Gaming Association has estimated that each year about $150 billion is wagered on sports, mostly illegally. Nevada’s hold suggests, then, that a fully legalized nationwide market would only drive roughly $10 billion in revenue.

Again, DraftKings already is worth about $8 billion. And competition will be stiff. Fellow daily fantasy sports operator FanDuel, in which Flutter Entertainment (OTCMKTS:PDYPY) owns a sizable stake, actually has the market share lead in New Jersey and Pennsyvlania. Penn National Gaming (NASDAQ:PENN) owns a stake in Barstool Sports, which will underpin its online sports betting offerings.

European leader William Hill (OTCMKTS:WIMHY) already is a force in the U.S. market, and other overseas counterparts are angling for a piece of the proverbial pie.

It’s going to take time for the legalized market in the U.S. to mature. Competition is going to be stiff. An $8 billion market capitalization is getting to a point where investors are underestimating both of those risks.

A Buy on a Pullback

This is not to say that DraftKings stock is a short. It’s not to say it’s a bubble.

Rather, there are risks here, and valuation is one of those risks. Bear in mind that DraftKings only joined the public markets in December, via a reverse merger with a SPAC (special purpose acquisition company).

At that time, the owners of DraftKings, as well as back-end provider SBTech, which was acquired in the deal, were willing to execute that merger at just $10 per share. The stock now is at $24.

Again, the outlook probably is a bit brighter now, given the potential for accelerated legalization in both sports betting and iGaming. Still, one has to wonder if DKNG really is worth 140% more than its own management agreed to accept just five months ago.

Meanwhile, earnings loom on Friday, and they’re not likely to impress. The legacy DFS business runs losses. Revenue dried up in the last three weeks of the quarter.

It’s possible DKNG sees a short-term pullback. And it’s then that I’d get more interested. Again, the fact that DraftKings stock has rallied over the last six weeks makes some sense. I’m just not sure it should have run quite this far.

Matthew McCall left Wall Street to actually help investors — by getting them into the world’s biggest, most revolutionary trends BEFORE anyone else. The power of being “first” gave Matt’s readers the chance to bank +2,438% in Stamps.com (STMP), +1,523% in Ulta Beauty (ULTA) and +1,044% in Tesla (TSLA), just to name a few. Click here to see what Matt has up his sleeve now. Matt does not directly own the aforementioned securities.

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