Investors apparently didn’t like second-quarter earnings from DraftKings (NASDAQ:DKNG) on Friday morning. DraftKings stock faded nearly 6%. But to be honest, I’m not entirely sure what drove the selloff.
The headline numbers were mixed, admittedly. DraftKings posted a much larger loss than analysts expected. But the company is in uncharted waters in almost every single sense. Even ignoring strategic considerations that drove at least part of the shortfall, it’s asking too much of Wall Street to pin down profitability estimates right now.
A potential issue with the Internal Revenue Service too may have been a factor. But that also seems to be much ado about nothing — or, at least, not much.
From here, earnings don’t really change the story surrounding DraftKings stock. The problem is that I wasn’t completely sold on that story to begin with.
Revenue Growth and a Higher Loss
From a broad perspective, little in DraftKings’ second-quarter results looks surprising. Revenue increased 24% year-over-year, thanks to the acquisition of back-end provider SBTech. Revenue for the legacy business actually declined year-over-year. But with pro sports still shut down for most or all of the quarter, that weakness is far from surprising.
And DraftKings saw strength once those sports came back. Handle — the amount wagered — on many games in July reached multiples of past peaks. Clearly, there was a substantial amount of pent-up demand that should benefit revenue in the third and fourth quarters. Indeed, DraftKings guided for pro forma revenue growth of 22%-37% in the second half of the year.
Again, the loss was higher than anticipated. And it was significant. Operating loss in the quarter was a whopping $160 million, more than 5x the figure from the year prior. Sales and marketing spending alone was nearly double the company’s gross profit.
But DraftKings should be spending up at the moment. Some of the money went to fund free-to-play simulated games, for instance. Those games brought on new daily fantasy users who can be converted to profitable sportsbook customers down the line. Management in the past has floated the idea of keeping those simulated games even once normalcy returns, in a bid to attract football fans, among other users, year-round.
The bottom-line number missed Street expectations, but the story of Q2 isn’t much of a surprise. Amid a pandemic, revenue faltered. It roared back once games returned thanks to desperate customers. And DraftKings spent big to capture more users ahead of the expected rollout of sports betting products across the country. I’m honestly not sure what else analysts, and investors, were expecting.
The Tax Issue
There was another development on Friday that might have impacted DraftKings stock. An internal memo from the IRS suggests that DFS operators DraftKings and FanDuel, a unit of Flutter Entertainment (OTCMKTS:PDYPY), will have to pay excise taxes on tournament entry fees.
Some headlines suggested the tax issue was a factor in DKNG’s 6% decline on Friday. But, from here, the IRS memo looks to be much ado about nothing, for a few reasons.
First, it is just a memo. Both DraftKings and FanDuel will fight the interpretation, under the argument that fantasy sports is protected under federal law and in many states defined as a game of skill, not luck.
Second, the case for DraftKings stock doesn’t, and shouldn’t, center on the DFS business. DraftKings has never turned a profit from DFS. It hasn’t even really come close.
Rather, the point of DFS is to acquire users who will become iGaming and sportsbook customers. Those verticals are where the money is.
And, third, even if enforced, the new IRS policy doesn’t appear all that material. One estimate suggests the entire market would pay an incremental $8 million annually. Another sees a hit to DraftKings profits of $20 million to $30 million per year in a “worst-case scenario.” For a company planning to generate $1 billion in annual EBITDA (earnings before interest, taxes, depreciation and amortization), that’s a manageable hit.
Little Has Changed for DraftKings Stock
Overall, the Q2 release and the tax news change little for DraftKings stock. The intriguing bull case remains. So do the risks.
The bull case is self-evident. Sports betting will be a big business in the U.S. It should get a boost as state governments, desperate for cash after the current crisis, become more amenable to legalization.
And DraftKings has a key edge given its DFS user base, which provides a valuable head start.
The risks are myriad, however. I’ve long wondered whether the head start is as valuable as a $13 billion market capitalization suggests. To at least some extent, industry leadership is priced in. Yet there are a lot of strong rivals bidding for share.
FanDuel, for instance, leads in New Jersey. Churchill Downs (NASDAQ:CHDN) has been offering online betting on horse racing for years, and has been planning for sports betting legalization for almost as long. Caesars Holdings (NASDAQ:CZR), toward which I remain bullish, has a partnership with William Hill (OTCMKTS:WIMHY), one of the United Kingdom’s best operators. Those are just a handful of the online operators targeting the market.
Indeed, DraftKings’ own chief executive officer highlighted the case in the company’s Q2 release. “We believe that the best product will ultimately win with the American consumer,” said Jason Robins.
I believe Robins is right. But DraftKings has a long way to go before it proves it has the best product. Given the abnormal external environment, second-quarter results aren’t enough evidence.
It will take more time for the company to secure its leadership. In the meantime, I’d like to see a cheaper price before making my own bet on DKNG.
Matthew McCall left Wall Street to actually help investors — by getting them into the world’s biggest, most revolutionary trends BEFORE anyone else. Click here to see what Matt has up his sleeve now. As of this writing, Matt did not hold a position in any of the aforementioned securities.