Last week, the Morgan Stanley analyst team issued a note on DraftKings where they said they believed the company would be “one of the winners” in what over time is sure to be a very large betting and iGaming market in the U.S.
“Though there is a lot of negative written about the levels of marketing and promotional spending, this has driven a very concentrated market that only players of scale can really compete in,” said the Morgan Stanley team on February 26.
Though their price target remained at $31 – compared to the price last week of around $20 – they did upgrade the stock to Overweight.
This week, the team says it is “not surprising” that investors got in touch to express their own views about that verdict.
Online sports betting and the tax issue
The main areas of investor concern were the potential for tax increases, marketing spend levels and cost leverage.
On the tax issue, there are understandably some investors who believe there is the potential for tax rates to rise. But the Morgan Stanley team points out that as it stands there have only been seven instances in the last 20 years where gaming tax rates have been changed; Colorado in 2016, Iowa in 2003, Illinois (three times, once in 2002 and then twice in 2020), Michigan in 2004 and in New York back in 2001.
Of these, three were actually decreases while only four were tax increases.
“Remember that the gaming industry is typically a very high tax contributor for states, so it generally has political clout,” the Morgan Stanley team noted.
“While recent proposals in Virginia (removing promotion deductions) and Hawaii (55% tax rate) highlight increased risk, these are only proposals right now.”
They also point out that fears over New York’s high rate of 51% gaming tax for online sports betting might set an example for other states to look to emulate might be overstated.
The analysts note that of the 10 states that legalized sports betting in the past year, all except New York have had tax rates of 20% or less.
Tax rates among the 10 states of have legalized in the last 12 months
Arizona – 10%
Connecticut – 13.75%
Florida – 10%-15.75%
Louisiana – 15%
Maryland – 15%
Nebraska – 20%
Ohio – 10%
South Dakota – 9%
Wyoming – 10%
New York – 51%
Notably, though, Morgan Stanley added that regardless, they are now modeling average tax rates of 25% in 2025 vs. 20% in 2021 “to bake in potential risk.”
The issue of marketing spend
Looking down the line as more states begin to mature, the analysts suggest that marketing spend should “decrease significantly” as customer retention becomes more important to the sportsbooks than acquisition.
Modeling this for DraftKings, they have built a “waterfall” of state-by-state revenues, marketing and promotional spend to reflect the dynamic market situation. From this, they point out that while this envisages DraftKings spending ~$1.3bn on marketing in each of the next three years, this should drop off to ~$900m by 2025.
“We see this as fair given there will be fewer new states to be acquiring customers,” analysts point out before saying that promotional spend would stay at ~$1.25bn in 2025.
This implies that the combination of marketing and promotional spend will come in at around 37% of gross revenues in 2025.
This is “a very healthy reinvestment rate, in our view,” they add.
The cost leverage question
The last area of concern is cost leverage where Morgan Stanley say they model gross profit margins dropping to 41% from 46% in 2022 before improving back to 54% in 2025.
This, they say, is due to the shock to the system brought about by the New York tax rate.
“Then going forward, the biggest driver of the improvement should be dissipating promotional spending,” the team added.
Moreover, the team also note that the shift to the DraftKings-owned SBTech platform from Kambi will drive lower fees. They suggest, therefore, that product and tech spend should stabilize at around 10% CAGR growth for the period 2021-25.
Answering the question; why now?
The near-term “catalyst path” for online sports betting remains risky, suggest the analysts, and having spoken to investors, the team admit that the consensus remains bearish.
But they suggest this means that any positive surprises at this point, particularly in terms of the upcoming earnings statement, could be a “value driver.” Indeed, they point out that what might initially be viewed as bad news could actually turn out to be the opposite.
“We see a chance that when DraftKings reports on Feb 18, if it guides the Street EBITDA expectations down from (a negative) $550m to our (negative) $800-900m, the stock may actually trade up as it removes the overhang and is likely the trough,” they add.
The relative positioning of DraftKings vs. the sector
They conclude by suggesting that the thinking behind some of the other investor preferences for other stocks with which to play the online sports betting and iGaming theme are flawed.
They note, for instance, that they are also Overweight on Entain, Flutter Entertainment and Caesars Entertainment themselves and hence some of this is “fair feedback.”
But on two other crucial players they are less than convinced.
“We are concerned BetMGM loses market share, and Penn’s Canada (Ontario launches in April) share doesn’t live up to expectations,” they add.
As they conclude: “We view DraftKings as the pure play on US sports betting / iGaming, with the most negative sentiment, and hence see a greater opportunity to be a contrarian with it.”
