Conclusion. Skillz is among the highest upside stocks in the market and is a buy but only for long-term aggressive growth investors. People that choose to invest in Skillz should monitor the balance sheet closely. Risk averse investors should avoid the stock as there is still significant potential downside in the stock ...
Skillz (NASDAQ: NYSE:SKLZ) was and still is a long-term speculation on the digitization of competition. According to the CEO Andrew Paradise, the company is currently 9 years into a 15-year plan of building the competition layer of the internet. Management believes that the business is currently tracking ahead of where they thought they would be when the business first started. I believe that if the current market was in a "Risk-On" environment, where inflation was low and the Fed wasn't threatening to raise interest rates, Skillz would likely be one of the hottest stocks in the market.
Unfortunately for Skillz and its shareholders, it is viewed as a company that could potentially get in trouble because of high cash burn and a balance sheet that might not have enough cash to carry the company through the current difficult macroeconomic conditions, especially if the bad environment persists for too long. Skillz was recently forced to build up a cash cushion by raising $300M of senior debt at unattractive 10.25% rates. Even before that capital raise, investors were already nervous about Skillz possibly never gaining operating leverage because of high marketing costs and the debt raise only exacerbated investor worries about the company which have led to a major stock downtrend.
Investors that buy into Skillz today are betting that the company can get through this current rough patch in the economy and reach the point where revenue growth sustainably exceeds marketing spend. While I do believe Skillz has the capability of achieving operating leverage, I have concerns about the company potentially either getting into trouble with the debt they have taken on or simply running out of money, which is why I view the company as a very high-risk, high-reward speculative play. There is enormous upside in Skillz but also enormous potential downside. The stock is a buy but only for aggressive growth investors that have the ability to see beyond the short-term.
The Bad: The Balance Sheet
The following shows various metrics in Skillz balance sheet since the beginning of January 2021 to the end of the third quarter of 2021.
Data by YCharts
Skillz came public as a SPAC at the end of December and gained $250 million in cash as a result of the transaction. In March, the company had a secondary offering which raised the company's cash to $613 million at the end of the second quarter. In July, did a warrant redemption for cash and the cash on the balance sheet rose to $693 million. This was not a whole lot of cash considering that the company has negative cash flows that have only gotten worse each quarter. If this was a bull market then this would not be an issue because the company would simply issue stock at a high valuation but in a bear market for profitless growth stocks, Skillz was not really able to issue more stock but instead issued debt
The terms under which Skillz received the debt were unfavorable, with the credit facilities basket having been limited to only revolving credit facilities. Moody's rated these bonds at B3, which is firmly in junk bond status and is only two grades above a level where default is imminent. The rating agencies expects that Skillz's EBITDA and free operating cash flow will remain negative for at least the next two years due to high customer acquisition costs. Moody's (NYSE: MCO) estimates that Skillz will be able to fund its free cash flow shortfalls through year-end 2025 with available cash balances. The company's increasing negative cash flows, the lack of a big safety cushion of cash, and the presence of unfavorable long-term debt on the balance sheet are the biggest reasons that the stock has continued to sink.
Data by YCharts
Marketing Costs
Among the biggest investor complaints about Skillz is that up until Q3. the growth of S&M was exceeding revenue growth, which is obviously unsustainable. The market has taken the view that Skillz is unable to grow without heavily spending on S&M and believe that as soon as the company cuts back on marketing, then revenues will fall off. Currently, many investors take the view that Skillz will never be able to develop operating leverage.
Data by YCharts
When the Skillz CEO Andrew Paradise was asked at the Wells Fargo 5th Annual TMT Summit about whether marketing spend growth would continue to remain even with or surpass revenue growth, he said that he expects Skillz's marketing spend to become more and more efficient over time, meaning that the same marketing dollars will bring in more and more users. More importantly, he believes that more of those users once brought on the platform, will have higher flow through to become paying users, with the end result being more revenues. Skillz's management believes that moving forward, the marketing spend will grow more slowly than revenue growth. Marketing spend won't necessarily go down but the expectation is that marketing spend will grow revenues far faster
Skillz expects to accomplish this in several ways. First, one of the primary reasons that the Aarki acquisition was made was because of its advanced advertising capabilities in the mobile gaming market. Aarki has the ability to reach more than 465 million monthly users which will vastly extend Skillz's player acquisition capabilities. Aarki is a Demand Side Ad Platform ("DSP") that participates in five trillion advertising auctions every month, which allows Skillz to capture a very large amount of data from the ad impression level, to on system habits, to end user purchase behavior. This allows Skillz to identify the most promising games early on through data and they then will promote the games that produce the highest ROI. Additionally, when developers soft launch games on the Skillz platform, Aarki gives Skillz the ability to learn how different iterations of the game during the soft launch can improve user engagement as well as retention. Aarki can then give their developers those insights. Aarki also has very advanced Machine Learning algorithms that can be used on Skillz's existing first party data to help convert MAUs to paying MAUs (PMAUs).
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The second way that Skillz expects to make marketing costs more efficient is through partnerships with brands that either already have an existing user-base or could potentially attract a huge gaming user base. If Skillz were able to gain an already successful mobile game like Candy Crush or Grand Theft Auto V, then most of the issues concerning marketing spend would likely quickly vanish. Unfortunately, up until now, the developers of already successful games are currently reluctant to build on the Skillz platform because they don't want to interfere with what is already working. Already successful mobile game developers often feel that joining the Skillz platform might cannibalize their game's existing business, even though, Skillz's data actually shows that every game that has joined the Skillz platform has shown accretive results.
Since, getting already extremely popular games on the platform has been a no-go so far, Skillz has been focusing on partnering with very popular brands that have a large potential user-base for competitive gaming and that is where the partnership with the NFL comes in. If the NFL partnership produces one or even several successful games that attracts a big user-base to compete on Skillz for prizes, then that would likely go a long way to improving user acquisition costs.
If the Aarki acquisition and the NFL partnership have a far more beneficial effect on increasing marketing efficiency than the market is currently pricing in, then it could lead to Skillz "beating expectations" down the road and a significant rise of the stock price. That is among the scenarios that investors in Skillz are speculating on when investing in this stock.
The Good: The NFL Partnership
The NFL Game Developer Challenge is currently at the semifinalist stage. In recent investing conferences held in December, Andrew Price indicated that originally the developer challenge was only designed to produce one winner but the submissions have been so good that now the plan is to release several winning NFL developer challenge games. These NFL games should be released in the fall of 2022 and if the games prove successful, it could change how Skillz is perceived among other brands, big name game developers, users and also investors. The primary purpose of the partnership with NFL is to help build and enhance the Skillz brand and any success of the games coming out of the NFL Game Developer Challenge could go a long way to help accomplish that goal. The stronger the Skillz brand, the more efficient the marketing spend should become.
The secondary reason the NFL partnership was made is because the NFL is the biggest competitive sports brand within the USA and Skillz management hopes that helps attract other competitive sports brands to Skillz, including other professional sporting leagues. So far, Skillz has not yet signed on any other big sporting brands like MLB or the NBA but it has attracted one smaller league called the Drone Racing League or DRL. This league recently released its first mobile game, Drone Racing Arcade, on the Skillz platform. The more of these branded partnerships that Skillz attracts, the more customer acquisition costs should go down relative to revenue generated.
The Good: Going International
There are currently 2.8 billion monthly active users in mobile gaming. Of that 2.8 billion, several studies show that approximately 40% would want to actually compete for prizes. So, the worldwide TAM for Skillz is approximately 1.1 billion people. The US market makes up approximately 20% of the worldwide TAM and Skillz is primarily in US markets. (Skillz is 90% US revenue). For Skillz to access approximately 900 million people in its TAM, it will be necessary for the company to go global.
Skillz has taken its first steps to begin a major worldwide push by launching in India with a live pilot on January 3, 2022. If this announcement was made in a bull market, the stock would have likely soared because India is a potential huge revenue opportunity. India is the world's largest mobile gaming market at 12% of the world's total app downloads, according to Sensor Tower data.
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Skillz can be considered a first mover in mobile esports. The first mover status is allowing Skillz to build up what eventually could become a data network effect moat that will make it difficult for any fast-follower companies attempting to use a similar business model to catch up to Skillz. One example of how powerful a data network effect can work is Google (NASDAQ: GOOGL), which has used its first mover advantage in search to build a data network effect that has maintained Google's dominance, despite Microsoft Bing (NASDAQ: MSFT) and others making furious attempts to catch up. As things stand now, Google still maintains a 92.47 percent market share in search.
Virtuous cycle of data CBInsights
CEO Andrew Price has recently made statements about Skillz currently having two data network effects:
Data network effects around cheating and fraud. Data network effects around personalization.
What this means in practical terms is that the more people that join and use Skillz platform, the more data Skillz collects that can be used to improve algorithms that makes it harder for people to cheat on the Skillz platform as well as allowing Skillz to personalize the platform better for each player. Both of these things can improve each player's competitive experience and make the platform as a whole an increasingly more attractive place for new users to join over other options. An example of personalization might be Skillz using its algorithms to more evenly match competitors in a game so that two opponents of equal skill levels are better matched.
Secondarily, first mover advantages have allowed Skillz to develop a significant amount of IP around its mobile esports platform. Currently, Skillz has 70+ patents on its platform's tech stack. Skillz is using these patents to build an intangible moat.
Analyst Price Targets
Skillz Analyst Price Targets Yahoo Finance
The above is based on 6 Wall Street analysts offering 12-month price targets for Skillz in the last 3 months. The average price target is $15.83 with a high forecast of $25.00 and a low forecast of $11.00. The average price target represents a 223% increase from the last price of $4.90.
Skillz Valuation
Data by YCharts
In its short time as a public company, Skillz is currently sitting at its lowest valuation. This valuation is currently reflecting both balance sheet risks and worries over marketing spend.
I think the worries over marketing spend are much less concerning than what many people think. I think that Skillz has the ability to grow marketing spend slower than revenue growth and over time develop operating leverage. The problem is time. Skillz has a ticking debt bomb on the balance sheet if the economy should get worse and I think some of the company's fate might be determined by exactly how bad macroeconomic conditions become. If Skillz survives, which at this point is still likely, then the current valuation will one day be looked upon as a once and a lifetime opportunity to buy Skillz.
Conclusion
Skillz is among the highest upside stocks in the market and is a buy but only for long-term aggressive growth investors. People that choose to invest in Skillz should monitor the balance sheet closely. Risk averse investors should avoid the stock as there is still significant potential downside in the stock.
Wager Mage
Photo: Emma Llamas
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