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Gambling stock could face more headwinds than investors expect.

Shares of online betting provider DraftKings (NASDAQ:DKNG) have fallen 30% since peaking in March, as brick-and-mortar casinos make a comeback and short sellers target the stock. The latest setback was a report from Hindenburg Research that accused the company of links to illegal gambling around the world, but that’s not the only reason investors are selling.

Is the market’s negative sentiment justified or an overreaction to a company with a great long-term opportunity? It is now worth taking a step back and looking at the company’s long-term prospects.

 

Short-seller allegations

The recent Hindenburg Research report made numerous allegations, including allegations of illegal gambling activities and business in Iran, which are prohibited.

Ultimately, any report from short sellers should be taken with a grain of salt, as they have a vested interest in making a big deal out of any bad news. The most serious allegations were against SBTech, a company that DraftKings merged with in its IPO, but Credit Suisse pointed out that the DraftKings acquisition was about technology, not revenue. Even if SBTech’s revenue went away, it wouldn’t be the end of the world.

But even though a report of short sellers is not in itself a reason to sell, there are reasons to take a dim view of DraftKings’ stock.

Competition is a challenge

When DraftKings went public, it had tremendous tailwinds from the pandemic (which temporarily shut down most casinos across the country) and from more states opening up to online sports betting or iGaming

But the trends have changed in recent months. In-person casinos are almost fully open, and the pandemic and associated restrictions are easing. This could hurt online gambling.

So far, the news from the states with online gambling is mixed. Below you can see how revenue and sales (a measure of gambling volume) are trending in New Jersey, Pennsylvania and Iowa. The three-month period I chose shows mixed results and there is no clear trend in which direction each state’s online gambling is going. Depending, which month we use for comparison in the last six months, revenues may have fallen or only risen slightly. In other words, the days of explosive growth are over.

It is also clear that competition in online gaming is increasing in most states. In Iowa, for example, the number of casino/online brands reporting revenue rose to 18 in May 2021, up from just 13 a year ago. If states open up online gambling, they will likely have fewer restrictions on owning a physical casino or being able to take deposits in real life in the state. And that will only increase competition.

Evaluation is a challenge

It is this revenue pressure and the cost of marketing to new customers in a competitive market that concerns me most about DraftKings’ valuation being far too high. The company has a market cap of $21 billion, but also reports a higher loss from operations than it reports in revenue.

There’s a lot of revenue growth potential, but unless margins are high, I don’t see how the company can live up to its current valuation. And in the online gaming business, I think there will always be a lot of competition that squeezes margins for everyone.

We have yet to see that online gambling can actually be a highly profitable business, at least in the US. And that’s a problem if investors expect DraftKings to be a growth stock.

Source: (fool.com)