DraftKings: Taxes Are Yesterday’s News, This Is Tomorrow’s

Summary:

• Growth in sports betting will prove to be very strong again in 2024.
• State taxation rates will almost certainly continue to rise, but that seems largely priced in at this point.
• My belief that the leagues will demand a greater share of gambling revenue is now even stronger. They appear to be gearing up for another major push soon.
• Gambling’s negative spillover effects on the leagues are even higher than I was expecting. If they are denied, I believe the danger of a major counter-regulation push is growing.

It has been about four months since I last looked in on DraftKings (NASDAQ:DKNG) and the company has seen some significant events, to say the least. It’s time to take a fresh look. Broadly speaking, my concerns have grown, not been assuaged, in the intervening period. And with my predictions on state taxation now more or less born out, it’s looking more and more like a sports league cash grab may be next.

Industry Growth Continues

Some good news first. The industry itself remains healthy. Sports gambling revenue came to $11 billion in 2023, almost 50% more than the slightly over $7 billion of 2022 and nearly three times the $4 billion and change of 2021. The best projection right now is that 2024 will come in close to $14 billion.

These numbers are being fueled by both growing consumer interest and also by the ongoing spread of legalization. Once there are no more states to bring into the fold the growth rate should slow significantly. But even so, the projections of $30 billion by 2030 still seem well within reach.

DraftKings in particular, however, is trying to navigate slightly more stormy seas.

Trial Balloon Popped Quickly

I have been rather amused by the sudden outpouring of articles warning investors that rising state taxes on gambling operators may pose a risk to fellow market leader Flutter (FLUT) and DraftKings. That, of course, was my argument two-and-a-half years ago, when the argument was not nearly so popular to make. I got a lot of pushback for “speculating” that New York’s tax rate success – from the state’s perspective – would produce similar tax hikes in other jurisdictions and “overlooking” the ability of DraftKings to “punish” high tax jurisdictions by passing on the tax to consumers. Presumably certain readers thought DraftKings could thereby ignite some sort of voter backlash and defeat the state.

I won’t explain again all the reasons I thought that was wrong, I’ve included links to my previous work above. For now, let’s just say my opinion hasn’t changed. What’s more, DraftKings just tried this strategy, and we can all see the results.

The only difference between my prediction and how events unfolded was that DraftKings switched its proposal from a handle tax to a winnings tax. Originally, I had spoken of the development of technology for DraftKings to start charging different odds to bettors in different states. Operators generate revenue by giving slightly less than even odds to the average bet, that is they pay the winner less than the loser pays them.

Widening the spread between the two in high-tax jurisdictions was supposed to boost the “take” or “hold” enough to cover the extra high taxes. As it turned out, DraftKings decided that was too complicated and opted for a simpler surtax on winnings. This was announced in the Q2 earnings conference call and was scheduled to be rolled out in all states with rates over 20% on January 1^st.

It lasted all of two weeks. Flutter reported its own earnings 11 days after DraftKings. Flutter wasn’t happy about the tax, and is still threatening to throttle back promotional spending in Illinois and other high tax jurisdictions, but it has made it clear it won’t be taking up the DraftKings option. After which, DraftKings clearly felt it had no choice but to fall back as well. The day after Flutter’s announcement, the plan was officially dropped.

DraftKings’s Ugly Asymmetry

So far, as I predicted. But the Flutter refusal has led, in my opinion, some people to misapprehend the nature of the fundamental flaw in DraftKings approach. Because Flutter shares market leadership with DraftKings, the demise of the short-lived winnings surcharge has been painted by many as a Flutter job; the winnings handle, so goes the common story, died because Flutter wouldn’t go along.

The unspoken implication of that statement is that if Flutter had gone along, the charge would have worked better. That is incorrect, in my view. The key point is not that Flutter wouldn’t go along; the key point is that there will always be someone who won’t go along because the very states that the surcharge is meant to punish will make sure of it.

You need a license to operate a legal gambling operation in a state. If a state doesn’t like the way you’re operating, it can always refuse to renew your license, or it can increase the number of licenses at any time and increase competition in the market, compressing your profit margin. It can even make agreeing not to levy a winnings surcharge or discriminate vis a vis other states in any way a condition of giving you a license, or giving your competitors one.

There is simply no getting around the basic asymmetrical nature of the relationship here: there are many operators and even more potential operators, there is only one state government that can authorize legal gambling operations in that state. The leverage will always lie with the latter.

Since I’ve already covered this in depth I will end this point here, my previous work is available for more information on this point.

Tomorrow’s News, Not Yesterday’s

While I absolutely agree that taxes will be an increasing drag on betting stocks over the coming years – I was taking that position long before it was popular – it is precisely the fact that it is now so popular that is causing me to start to look past it. Frankly, I think just about everyone is incorporating higher state taxes into their assumptions and projections at this point; that offers no meaningful advantage to investors seeking alpha in their stock investments.

I argued three months ago that the key point now was whether, and to what extent, sports leagues themselves started cracking down to obtain more of the cash flow that gambling generates. As the official league entities who are creating the entertainment that is being bet on, the leagues have a near-monopoly position, little less than the state governments. While state governments may generate as much as $9 billion or more in taxes by the end of the decade, leagues are still taking home almost nothing at this point.

I still feel that way about it, but my feelings have if anything intensified. I no longer believe it is just a question of getting a share of the profits. Furthermore, I think the negative spillover effects of gambling are becoming so large that they risk making an enemy of the sports leagues if the operators aren’t careful. To assuage their concerns, substantial cash outflows are almost certainly going to be required. This stands as an underappreciated bearish factor, in my view.

Renegotiating The Deal

Let me begin with the profit angle.

I take the point made by some that gambling is already benefiting sports league’s bottom line indirectly because it makes broadcasters perhaps willing to pony up more for rights, knowing that they can secure sponsorship from operators. The DraftKings payment to Amazon for exclusive sponsorship of Thursday Night Football betting alone is as high as $15 to $20 million.

And that is only for one weeknight in one sport. There is an argument to be made that sports leagues are already getting their money, just it’s being reported as a rights fee instead of a profit share.

Perhaps, but it isn’t clear that even Amazon knew how big sports gambling was going to become when it signed its NFL deal. Those deals were signed all the way back in 2021, when the COVID cloud was still lifting and the size of the revenue opportunity in legalized gambling remained somewhat indeterminate. When I wrote my original gambling revenue estimate article that year, I based my work on estimates that the industry would top out around $7.5 billion in revenue. A year later, the new estimate from Goldman Sachs was $39 billion by 2033. Needless to say, I had to write another article at that point. So the leagues probably already feel that a hike in their take is in order.

But I am beginning to think the clouds on the horizon are even darker than that.

Gambling On Gambling Is Backfiring

It’s not just a fight over profit share anymore. League reputation and brand risk from gambling is growing, and so is the cost to manage it. There have been a number of gambling scandals over the past few years, and the perception is that the growing ease of placing bets is making it all the more imperative for leagues to track and monitor players themselves, as well as gamblers, since players can be induced or coerced into throwing games.

It should not be underestimated how seriously the leagues take the threat of gambling corruption, not just to their reputation in the abstract but to fans confidence in the integrity of their game – which is, after all, the only thing that makes the product they sell of any value. Fay Vincent, a famous Commissioner of baseball, once warned that if baseball ever came to be seen as a pre-determined show, entertainment instead of competition, like wrestling, “it’s dead.” Other leagues feel the same.

On-field officials aren’t immune either; witness MLB’s ongoing investigation of one of their own umpires for placing bets. He insists that he only bet on other sports – but it’s not hard to imagine the progression. First will come betting on other sports, then betting on baseball games he’s not umpiring, then betting on things in the game he insists he can’t possibly influence, like the starting lineup or the number of pickoff moves.

The league doesn’t want to start down this slippery path, which means it needs to be monitoring for any kind of gambling by any of its officials, on-field or off, at any time. The same goes for the players, the equipment providers, the field staffs, perhaps even the families of all those people…this kind of monitoring gets expensive in a hurry. Even worse is the hit to the game’s integrity every time something slips past the monitoring, which it has several times this year alone.

Data Fees Are The New Integrity Fees

Evidence is building that the leagues are preparing another major push for a much bigger cut of the cash. They are not calling it an integrity fee any longer, although that proposal periodically reappears as well. The new idea is to require betting houses to use official league data as the final arbiter of betting outcomes – and to charge significantly for the access to that data.

Like the league’s previous proposals, this has been met with fierce backlash from the operators and the mobilization of their lobbying teams to fight it; so far, it hasn’t passed. But I’m increasingly concerned this is a penny-wise, pound-foolish approach. Alienating the people who provide the product that you’re selling – without games there is no gambling – is not generally a winning strategy.

There would, in any event, in this case appear to be an overlap of interests. The operators, as well as the leagues, need the games to be perceived as legitimate and competitive to remain in business, and the monitoring necessary to achieve that both imposes certain costs and requires league cooperation. Expecting the leagues to carry so much of the burden and get so little of the cash flow just doesn’t seem sustainable in the long run.

Potential Scenarios

At this point, the least bad scenario for DraftKings and Flutter is that leagues will want to tally up these additional costs, to say nothing of the brand damage, and start sending the operators a bill for at least some of it. I doubt the league will be swayed by arguments that they’ve already been paid in rights fees negotiated when gambling revenue was only 1/3 of what it is now, and is expected to triple again. This is especially true when the brand damage wasn’t even a fraction of that.

The real nightmare scenario is that the operators fail to assuage the league’s concerns, and entities with lobbying muscle little less than the operators’ begin to seek a whole new and far stricter regulatory system. As I said, the operators have a fundamental leverage problem with the states and the leagues. Such a push would be difficult to fight off if it ever began in earnest.

DraftKings’s Enduring Upside Potential

None of this is to say that there are no positives in the sports gambling space right now. There absolutely are. For one thing, legalization is continuing apace; North Carolina has now legalized gambling and there is no sign of the momentum slowing down nationwide. For another, revenue within each state is also still growing. In fact, North Carolina’s revenue was already 5x the annual estimate for its opening year after just 82 days.

Sports leagues have yet to have any more success with their data licensing fees than their integrity fees, and even if they’re successful, it could always be less than feared. I don’t consider these irrelevant considerations. I have spent less time on them in this article because they have been adequately covered in my colleagues’ Seeking Alpha articles in recent weeks and months.

Investment Summary

DraftKings is not operationally deficient; it is one of the top operators in its field. My concerns stem more from the field itself, and how its asymmetrical power balances and substantial negative spillover effects on a key partner affect its long-term profit trends. While it will take time for all of this to play out, I think the risks both to the leagues and from the leagues are being underestimated, just as taxation was in 2022, and I am staying with an Avoid rating despite DraftKings industry leadership position.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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