Shares of DraftKings (NASDAQ:DKNG) went into a new up-leg after the sports betting company submitted its earnings sheet for the third fiscal quarter. DraftKings is seeing profound revenue momentum in its core business of online sports betting which has become an increasingly popular pastime for consumers in the U.S. With strong revenue and user growth trends in DraftKings’ business as well as lower acquisition costs, the betting firm is set for strong EBITDA and earnings growth over the next five years. While shares of DraftKings are not a bargain, the potential for multiplier expansion is there and I see a favorable risk profile that is skewed to the upside, even after a massive 242% rally this year!

Previous Rating

I recommended shares of DraftKings in October 2021 at $48.12 after the company acquired a gaming company called Golden Nugget which was set to fortify DraftKings’ market position in the online betting industry. Since then, shares are down 19%, but the business is moving in the right direction: DraftKings is growing its revenues and users at double-digit rates annually, customer acquisition costs are in a down-trend and DraftKings is expected to generate its first-ever positive adjusted EBITDA next year.

Strong user and revenue growth momentum

DraftKings is a sports betting and iGaming platform that is operating in 23 states. Online sports betting is big business and the (global) industry is set, according to Statista Market Insights, to turn over $42.5B in revenues this year. The projected annual revenue growth rate between FY 2023 and FY 2027 is approximately 10%.

Due to the growing popularity of online gaming/betting, DraftKings has seen significant growth in its user base in the last several years. At the end of the September quarter, DraftKings had 6.6M customers (+35% Y/Y) on its betting platform with growth exploding since the pandemic. However, as opposed to many other companies that saw pandemic-driven tailwinds, DraftKings is not seeing a slowdown in this growth.

One reason why DraftKings is doing well with users is that its betting platform is engaging, offering consumers entertainment and betting opportunities at the same time. As a result, DraftKings has seen an increasing market share for its product in the marketplace: the betting company had a 33% market share in its core markets, showing an 8 PP improvement over the year-earlier period.

The popularity of DraftKings’ betting platform as well as growing market share is translating to strong financial trends, although DraftKings is not yet making a profit. The company reported $790.0M in revenues in Q3’23, showing 57% year-over-year top line growth. Net losses and adjusted EBITDA losses narrowed significantly year-to-date: in the first nine months of the year DraftKings’ adjusted EBITDA losses declined by 55% compared to the year-earlier period to $302.1M.

Nearing an inflection point

DraftKings’ strong growth in its core markets as well as lower acquisition costs are expected to lead to a significant adjusted EBITDA gains in the next five years. DraftKings has submitted its long-term growth outlook recently which implies that the betting firm’s top line will grow at an average 14% rate annually between FY 2023 and FY 2028 while its adjusted EBITDA will soar to $2.1B. This year, DraftKings’ EBITDA is expected to be negative $100M which means the firm expects to see a $500M change in EBITDA next year. Therefore, DraftKings is set to near a crucial inflection point in FY 2024 which is when the company is expected for the first time to post positive adjusted EBITDA.

What drives EBITDA profitability besides top line and user growth is that DraftKings’ customer acquisition costs are falling. Customer acquisition costs tell gaming companies how much it costs to bring a paying customer to the platform. Customer acquisition costs have fallen significantly in recent years, in part due to increased brand recognition and the broader popular trend of online sports betting where DraftKings has become a household name. The platform’s customer acquisition costs declined 21% in FY 2022 and are set for a 20% drop in FY 2023 as well, all the while the customer base is expanding at a very healthy rate (as discussed above).

DraftKings’ valuation and fair value estimate

DraftKings is highly valued and the firm’s shares are priced at 3.7X FY 2024 revenues… which is not a small multiplier to pay for a company that is not yet profitable. Since DraftKings is not generating profits just yet, the company does not have a P/E ratio. However, analysts expect continual top line momentum which may justify the risk with DraftKings despite the fact that the company is losing money: the company is expected to generate 65% top line growth this year and 25% next year.

The company’s biggest rival is FanDuel which is not publicly traded and other gaming companies are largely focused on running actual casinos like MGM Resorts International (MGM) or Wynn Resorts (WYNN). Given the lack of comparable rivals and profitability, I believe the best approach to derive a fair value is to value DraftKings based off of consensus revenue estimates and the company’s past valuation history.

DraftKings trades at a 3.7X P/S ratio today, but has historically traded at an average of 6.0X… which is not cheap, but also not unusual for a start-up that sees high mid-digit top line growth annually.

I believe DraftKings can trade at its past average P/S ratio of 6.0X again, but only under the condition that the firm achieves positive EBITDA profitability next year and continues to expand its revenue base. Applying a 6.0X P/S ratio to FY 2024’s consensus revenue estimate of $4.6B implies a potential fair value of around $58 per share. The fair value estimate implies 62% upside valuation potential (based off of a share price of $36.44), but I expect this upside to only be fully realized if DraftKings manages to be profitable.

Risks with DraftKings

The biggest commercial risk that I see for DraftKings is that the company operates in a high-risk industry. Online betting is subject to regulation and new anti-gaming regulation headwinds in the states in which DraftKings operates in could negatively affect the company’s ability to grow its revenues and achieve its EBITDA targets.

Final thoughts

DraftKings is seeing strong growth in its core business with revenue and user growth soaring and the company is nearing an inflection point as well: adjusted EBITDA profitability. A significant positive development for DraftKings is that the betting platform has reached such a critical scale that its customer acquisition costs are falling, improving the firm’s economics and furthering the company’s goal to become EBITDA-positive in FY 2024. While shares are not exactly a bargain, I believe the multiplier factor has room for growth as the firm executes on its long-term plan of achieving double-digit top line growth and significant adjusted EBITDA gains over the next five years!