DraftKings: Massive Profits Await Someone, But How Will The Spoils Be Divided?

Summary:

• The sports betting market is consolidating around two major players, which produce more profit than expected, but high tax rates in states like New York are counterbalancing the profit growth.
• As I predicted, the industry standard is moving closer and closer to New York’s 51% rate. Over half of gross profits will be taxed away in the long run.
• The key question now is whether the remaining gross profits go to the bottom line of operators or leagues. So far, there have been no major league fees imposed.
• That could very easily change, however. The operators remain, as always, on the wrong end of a three-way asymmetrical power dynamic.
• Despite considerable growth and the potential for more, I am avoiding DraftKings.

Two years ago, I wrote an article that DraftKings (NASDAQ:DKNG) was a questionable investment because it was caught in a uniquely unfavorable market structure which almost guaranteed that while its activities would generate profits, most of them would be arbitraged away by its key partners, leaving relatively little for shareholders. I also thought the low barriers to entry would see the market splinter among many operators and fail to consolidate, spurring an almost permanent state of intense competition.

DraftKings bulls argued just the opposite, that the market would consolidate around a few key players and that such absurdly high tax rates as the ones imposed by New York would not last long in the system, and even if they did they certainly would not spread.

Two years later, where do we stand?

Consolidation And Taxation

The picture is mixed. On the one hand, I was clearly wrong about the consolidation question; the market is increasingly consolidating around just two major players. As of end of 2023, DraftKings and industry leader FanDuel have grown to 66% of the market, flip flopping back and forth for the number one spot. I would argue that even now this consolidation remains somewhat halting, and it is unclear exactly how far forward it will go, but clearly there has been more consolidation than I expected.

On the other hand, however, I would still argue that my arguments about the dangers of taxes, and the structural factors that make taxes more debilitating for DraftKings stock than the general effect of taxation upon all businesses, appear to be coming true. First, there was some argument that New York would be compelled to roll back its tax hikes on sports betting by the lower rates in other states; that hasn’t happened, with New York state still charging the same 51% it was charging two years ago – and pulling in by far the most tax revenue of any state from the sports betting sector.

Of course, New York is one of the largest states in the United States, and California and Texas have yet to get their operations really up and running. But New York state is also far and away the biggest money maker on a per-capita basis. At over $55 per head, New Hampshire’s $32 is the only one to make even half as much per person as the Empire State.

What’s more, there does not appear to have been any serious impact on sports betting activity in the state from these taxes. New Hampshire, as well as Rhode Island the number three per-capita state, both now have the same 51% tax rate that New York has. But New York continues to outpace the two smaller fellow Northeast states not only in total numbers, but even in per-capita numbers.

What’s more, there does not appear to be any major operator exodus on the horizon. Quite the contrary. Interest is growing. Two year ago, PENN Entertainment (PENN) disclaimed any interest in the New York market, citing, of course, those high tax rates. Now, it is paying $25 million for one of New York’s coveted nine online gambling licenses – the same price that the original nine operators were required to pay to get the licenses from the state. In other words, PENN is paying the same amount for the remaining 7.5 years of a 10-year license that the seller paid for the whole 10 in January 2022 – licenses in New York State are worth one-third more now, despite its higher taxes, than they were in ’22.

Coming Tax Wave Is Just Beginning

Now, just as I predicted, other states are starting to take notice. Last year, Ohio moved to no less than double their tax rate only seven months after the legal market went live, from the more or less industry standard 10% at the time to 20%. So far, there doesn’t appear to have been any major backlash there either.

This might almost be acceptable if the consolidation in the industry was helping to also reduce costs and competitive pressures. Operators could still see their profit increase if they could take more per person from more people even after paying the state its cut. But even as states are increasing their tax rates, they are also getting smarter about how much they take from each operator.

The latest big mover is the state of Illinois, which is upping a 15% flat tax rate on sports betting to a progressive 20% to 40% rate depending on gross revenues. FanDuel and DraftKings will both pay the highest rate – their smaller competitors will pay the low end.

Almost certainly, this doesn’t represent some redistribution of wealth philosophy so much as it represents a determination to preserve the current structural dynamics of the sports betting market, which so favor the state tax bodies over the operators. As the bulls have been saying, the big cats could conceivably push back against high tax rates if they saw a lot of their smaller competitors close up shop.

These progressive tax rates, however, all but ensure that smaller operators will not go out of business completely, and the digital nature of online betting almost guarantees that they could scale up quickly to replace some bigger player if they actually threatened to pick up stakes and leave the state.

Thus, while it is not clear how much further consolidation can go, even if it continues to progress the very act of getting bigger would increase the states’ tax rates. Altogether, consolidation seems likely to buttress the state Treasuries far, far more than the operators shareholders.

Bulls Push Back

It nevertheless continues to be argued that New York’s success is only temporary. Bulls argue that after having to take a few punches from the Empire State while they were getting themselves established in the market, DraftKings and its fellows are now prepared to fight back. Specifically, sports betting companies are preparing en masse for the completion of certain upgrades to their technology which will allow them to granulize odds and pricing at the state level.

Odds are more than just a reflection of how many people are on each side of a bet. They also reflect a book’s take. When we speak of operators, we need to always be careful to distinguish between their “revenue” and their “handle.” The latter is the total amount being bet on their site, the former is the cut of that money that they are taking for themselves. Generally speaking, two bettors with equal odds will need to bet about $105 each to earn a $200 victory pot. The other $10 or so goes to the book operator, who needs to pay taxes and earn profits out of that sum.

Right now, every American sees the same odds across the country when they go to place a bet, regardless of the tax rate of the state they reside in. Soon, that will change. The theory is that any state which imposes a higher levy than its sister states will simply see its residents offered worse odds, creating a bigger take for the operator to pay the taxes with and getting its shareholders off the hook.

Asymmetrical Relationships

I question whether this theory will pan out, for exactly the same reason I questioned whether the “New York will cave” theory two years ago would pan out; in a three-way betting ecosystem where there are one league of each sport, one state that each bettor lives in, and a whole bunch of operators in each league and sport, the state always has the upper hand because only each individual state government can grant access to the bettors, and the profits they offer, within their state borders.

That power comes with another, concurrent power; the power to set conditions, as well as tax rates, for market access to that state. I would think the rather obvious response any state would have to an attempt to vary odds would be to simply tell the operator that they would be fined if they discriminated against in-state customers. Of course, the operator could always just leave the state…but that is basically just the tax rate empty threat discussion again.

As long as paying taxes or offering equal odds does not completely eliminate the profits from the state, leaving would make no sense, since it would take some reduced profit level in that state all the way down to zero. Because there is no other state government you can go to authorize access to New York bettors besides the New York state government, New York state is in the driver’s seat, and likely to remain so regardless of what new capabilities are added to operators tech stack.

Running The Numbers

Putting precise numbers on this is hard, I’ll be the first to admit. Fellow SA Analyst Michael Wiggins De Oliveira has a Strong Buy rating on DraftKings, and puts its 2025 free cash flow projection at $500 million. I’m willing to take that as a starting point.

The first point to consider is that even that number is a 37 P/E assuming FCF correlates perfectly with net income. That is an aggressive multiple for a company, though not completely outside the realm of reasonable if the path to high profit growth is reasonably clear. Essentially the company is already penciling in $1 billion in net income just at the current price, which of course does those buying in now no good at all. Profit growth over and above that is needed to make DraftKings a good buy here.

As I said two years ago, I think the path to high revenue growth is very clear; profit growth is another matter.

How much will tax hikes take out of it? New York State generated $260 million in taxes in Q4 2023, and roughly $863 million for the whole year. That’s on top of a prorated $22.5 million in licensing fees which are apparently worth 33% more than they were two years ago and may continue to rise. Call it a $900 million run rate.

New York represents approximately 6% and change of the US population, though it may represent more than that of the long-run gambling population because, for historical reasons that aren’t entirely clear, gambling has always been more popular on the East Coast than the West Coast or middle America. If we optimistically assume that nationwide taxes will be only 10x New York’s take, that’s $9 billion in taxes.

Assuming the $39 billion optimistic revenue projection from Goldman I reported two years ago still holds, and assuming that operating costs remain below 50%, the gross profits probably comes to about, again optimistically, about $20 billion. Taking the taxes out leaves $11 billion.

With DraftKings holding roughly 1/3 of the market, that corresponds to roughly $3.5 billion for the company. That seems to leave a lot of margin for error for investors to buy in here. That number, however, has to be divided amongst the operators….and the leagues.

The Key Question

This, to me, is the key point now. In my prior article two years ago, I argued that the same asymmetrical power dynamics between the operators and the states also applied to the leagues. If your an operator, and you need league buy-in on your product to make it work, there is precisely one NFL, one NBA, etc. They can hold you to ransom, I argued, just like the state can. Even if we assume the states have already taken their cut, what share might the leagues take out of that $11 billion as well?

I’m honestly not sure. So far, this has been one of the surprises in DraftKings favor for me; while the state has done exactly what I thought they would, the leagues are not collecting from the operators as I expected. If that remains the case, it leaves considerably more money for the operators than I predicted and almost certainly DraftKings will move further up from here.

I am still not entirely persuaded, however. If there’s one thing we’ve learned, it’s that the NFL and any other league worth its salt doesn’t like to leave money on the table, especially when the money is coming from something which is causing them as much trouble as gambling is. For all the negative headlines they’re getting, they probably expect to be compensated for their trouble.

Original proposals were for leagues to collect roughly 20% of the operators take, in what they called an ‘Integrity Fee.’ After the Ohtani debacle they’ll probably need a new name. Assuming the leagues held to that number, they’d collect 20% x $39 billion = $7.8 billion, leaving barely $3.2 billion for the operators and leaving DraftKings right around the $1 billion mark its current stock price already prices in, with no upside.

What To Watch

League integrity fees may be what to watch now. True, taxes could still go even higher, but even though New York’s rate seems likely to gradually become the new normal, even I question how much higher from here rates can go. The key point now is what the leagues take. The suggestion that they would take nothing, I don’t really take seriously. The suggestion that perhaps they will take less than I thought, however, is starting to look very possible. Suggestions have been made that perhaps the league fees will only be 5% of the revenue, which would be a massive swing that would put real appreciation for DraftKings back on the table.

Another factor to consider, however, is that we haven’t factored in any federal taxes yet. There is a 0.25% of “handle” federal excise tax which corresponds roughly to another 5-6% of revenue. That one, of course, applies regardless of profitability, so it could knock another $260 million off of DraftKings FCF and push us below the $1 billion mark if the leagues came back strong.

And then there’s always the slim chance that state taxes could go even higher, or that revenue maybe won’t quite reach Goldman’s aggressive forecast.

Investment Summary

Altogether, the picture remains mixed. Between a possible revenue shortfall, possible league challenges, what I consider to be almost certain ongoing tax hikes, and the growing likelihood that online gambling is becoming largely a two-company duopoly, I can see an argument for a very wide range of possible outcomes, both above and below the current share price. FCF projections of anywhere from a couple hundred million to a couple of billion are all plausible for DraftKings. My best guess would be somewhere around $1 billion to $1.5 billion, but that is a guess in which I have very low confidence.

Altogether, while the increasing consolidation of the industry is definitely a point in DraftKings favor that I underappreciated, the fact that the tax issue seems to be playing out as I expected and the ongoing threat of further revenue leakage to the leagues just doesn’t leave me confident. I rate DraftKings a Hold only.

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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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