Roblox: The Market Could Prove Challenging Long-Term

seekingalpha03-26

Roblox is a successful interactive experience platform with high growth ambitions, but concerns remain about long-term profitability and stock-based compensation risks.The company generates revenue ...

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Ian Tuttle Roblox (NYSE:RBLX) is one of the next-generation gaming platforms that has high growth ambitions and has already proven itself to be successful operationally and based on revenues. However, it is still early days, and there is some cause for concern surrounding long-term profitability, as well as risks pertaining to its SBC. Operational Analysis & Updates Roblox, while often considered a gaming enterprise, can more accurately be defined as an interactive experience platform, as its online ecosystem allows users to create and share digital experiences. Roblox's target audience is generally children and teenagers, and it appeals to a broad demographic among this age group. Harnessing the Lua programming language, it's accessible to young developers and hobbyists while also allowing depth for those who want to take the craft more seriously. Interestingly, central to Roblox's revenue model is its virtual currency, which it calls Robux. Users can buy Robux to spend on experiences, virtual items, and other content created by users. The clever part of this business model is that developers and creators also earn Robux, which can be exchanged for real money through the company's Developer Exchange Program ('DevEx'). What I like about this is that it creates an ecosystem of financial dependency for serious creators, which should reinforce both the quality of the content on the platform and, taken to the limit, provide full-time jobs for developers who want to work for the company freelance for periods of time. It remains to be seen how effectively the company can develop this over the long term, but the initiative is particularly noteworthy, in my opinion. Additionally, the firm has a subscription service called Roblox Premium, which provides a monthly Robux allowance alongside other benefits like advanced access to exclusive items and experiences. It also generates some revenue from advertising partnerships and licensing deals. Most of Roblox's revenue comes from the United States (64.4%), but also from Europe (18.1%), Asia-Pacific (10.3%) and other parts of the world (7.2%). Recently, the company has announced AI integrations with the intention of enhancing 3D content creation and improving user interaction. At the Game Developers Conference in San Francisco on March 18, 2024, it unveiled its Avatar Auto Setup and Texture Generator, which should help to increase the efficiency of 3D content creation. Our new AI technologies help anyone from an indie developer to a professional game studio quickly create rich, compelling content on the Roblox platform – getting them from idea to shared reality, faster than ever. With these tools, creators can focus on creative ideation and less on implementation, enhancing their experiences to grow engagement—and ultimately, their businesses. - Nick Tornow, Vice President of Creator Engineering at Roblox What I like about Roblox's strategic direction is that it focuses on democratizing the art of video game design and development, something that previously was only accessible to those with advanced skills. Roblox creates a user-friendly alternative to digital experience and game creation, and as such, it frees up a whole new range of creators who may not be interested in the significant coding skills that come with more typical, elite development tools. Additionally, its focus on a younger audience also primes the youth who may be interested in careers in gaming to get an easy start to what becomes a more challenging career at advanced studios. AI, thankfully, enhances this direction even further, and I can see the effects not only being beneficial to Roblox shareholders but also to the creative and career development of many young people. Competition & Market Considerations Craft outlines significant competitors to Roblox as follows:   FlowPlay: With only 72 employees, it is developing browser-based virtual worlds and multiplayer games.  Epic Games: Famous for its game Fortnite and the Unreal Engine, it has 8,667 employees, significantly more than Roblox's 2,457.  Unity Software (U): This company develops a platform for the creation and operation of interactive and real-time 3D ('RT3D') content. It has 7,703 employees.  Mojang: This is a subsidiary of Microsoft with 1,049 employees, and it is primarily a games development studio. It is most famous for its creation of Minecraft.  We can see from this list that Roblox has significant threats from both smaller upstarts and established niche enterprises, but also from dominant-conglomerate-backed firms like Mojang. Roblox has a lot to contend with here, not least the fact that video game technology is relatively capital intensive when you factor into the equation patents for technology that take many years and large funds to develop, which Roblox, at its $23 billion market cap, may not be able to withstand against Microsoft's $3.13 trillion market cap. My thoughts on Roblox, from looking at the product offerings, make me skeptical about the long-term outsized success the firm will see from what it is providing. I am not trying to knock the good quality of its platform, as there is evidently much to be excited about, but realistically, when compared against the offerings from other elite game designers, even toward Roblox's niche, games like Fortnite and Minecraft seem to have far more durable quality to me. However, there is significant growth to be had for Roblox; look at the trend in how younger generations are finding immense social value from online interactions over typical physical occasions: Deloitte Additionally, the video game market is expected to grow at the following CAGRs based on different research firms:   Grand View Research: Expected global video game market CAGR of 13.4% from 2023 to 2030.  Precedence Research: Expected global video game market CAGR of 10.5% from 2023 to 2032.  Fortune Business Insights: Expected global video game market CAGR of 13.1% from 2023 to 2030.  I think it is not unreasonable for me to forecast a 15% market CAGR over the next decade, and my upper-end estimate is a result of what I believe could be significantly higher growth in digital entertainment as AI makes content faster to produce with higher quality and more immersion through technology such as VR and AR, more personalized, and, most importantly, cheaper to access. I believe the attraction toward digital social events and digital entertainment may increase exponentially, and as such, I consider my 15% market CAGR conservative. Key Financials The notable concern with Roblox at the time of this writing is that it is not yet profitable. Consider its net income margin of -41.15% and its EBIT margin of -44.73%. However, this is somewhat balanced by remarkably strong revenue growth, which makes an investment in Roblox more compelling. Consider its YoY revenue growth of 25.81%, which is a 963.92% difference from the sector median of 2.43%. We can see that it has a much higher CAPEX / Sales ('TTM') of 11.46% than the sector median of 3.99%, and this looks promising to me in determining that the firm is investing heavily in its future growth at this time to generate a significant long-term competitive advantage. Additionally, the company's last two earnings results have beaten expectations, which is promising, but consider also that over the next fiscal year, analysts are expecting consensus YoY growth of -10.37% for normalized EPS. This thankfully goes up in fiscal 2025 to 14.44% growth. It mentioned in its Q4 2023 results that it is expecting an EPS contraction in fiscal 2024 due to higher investments in platform growth, which is apt to me during a time when investments in AI should be paramount. The company also reiterated its long-term goal of 1 billion daily active users, which is high considering it reported 71.5 million average daily active users in this report. As the firm's top line is experiencing such high growth, I am not too concerned with the operating and net income loss at this time, as it is fair for a company at its stage of development to prioritize long-term cash flows to earnings. We may also want to consider, however, that the firm's balance sheet has an equity-to-asset ratio of just 0.01 and debt-to-equity of 23.11, where debt includes both current and long-term lease obligations. To my mind, this is slightly too weak, even though the company is at an early stage, and while I understand the need and the importance of growth, it adds an amount of risk for me as an investor that I am not sure I am comfortable tolerating. This is because I am unsure how scalable its platform really is. I believe it is more likely that the company commands a large but still niche corner of the gaming market, and I am unsure whether 1 billion daily active users is feasible with its current model. I could be wrong, but based on my analysis, the business would need to diversify and advance its offerings for broader scope to reach its long-term goals. It, therefore, needs to be careful about how it is allocating its debt and equity financing to support its scaling ambitions. Valuation For its valuation, I have considered its price-to-sales ratio of 8.03 against the sector median of 1.29 and also against RBLX's five-year median price-to-sales ratio of 12.34. The stock has lost value since its IPO, but I am not sure it is trading at what I would consider a fair multiple at this time: Seeking Alpha In fact, it is very difficult to ascertain what a fair value for Roblox would be, as it has not developed any lasting positive trend in reaching profitability or in free cash flow generation. As I expect revenue growth of around 15% over the next 10 years as a CAGR, I believe a price-to-sales ratio of roughly 9 could be tolerated over the long term by the market, and hence, I consider an undervaluation of roughly 11% at the time of this writing. Consider the following chart as a peer analysis that shows how high the premium is for Roblox and the associated market sentiment compared to Unity Software and Sea (Garena) (SE): Author, Using Seeking Alpha My fair price-to-sales ratio of around 9 for RBLX ignores the high sentiment period up until 2022 and takes a rough median from the ebb and flow of the price-to-sales ratio over the past two years. Further Risks As I mentioned, I believe Roblox will face scaling issues related to the niche of its gaming ecosystem. However, there are also financial concerns raised by Geoffrey Seiler related to stock-based compensation, which I believe are valid. He mentions that \"it [SBC] was 33% of revenue in the quarter [Q4, fiscal 2023], and the company is projecting stock comp to rise by 31% in 2024 to $1.14 billion.\" This outlines a significant detriment to the business, and it is something that I believe management should address. Wider shareholders could be considered as being overlooked both in terms of share dilution and also in terms of the income statement. Indeed, it is important to reward staff with equity in the business, as this generates deeper skin in the game in the work culture, but perhaps they should do it at a lesser amount while profitability is of such deep concern. Additionally, as discussed above, I would like to reiterate the substantial risk I see with the firm reaching its high growth goals. I believe it is favoring long-term growth to profitability at this time, and that is fine to some degree. However, I remain skeptical of how scalable the product is. I believe the product lacks total-market appeal, and not only that, but it caters to an age group that seems to me to be quite concentrated, being targeted to teenagers. As such, 1 billion daily active users seems like too high a goal, and I believe if the financial management is structured with this in mind, shareholders could suffer as investments are made for growth in markets where there is no associated demand. Conclusion  Overall, I do like Roblox as a business, but I can see some considerable downsides in its financial management at this time, and also, I think its ambitions may be too lofty. That being said, I could be wrong, and I would love to be proven so. Nonetheless, I consider the investment slightly too risky for my appetite at this time, and while I will be watching from the sidelines, the investment is a Hold rather than a Buy by my analysis.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":1,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2422569574"}