Roblox: High Opex, Stagnant Revenue Point To Overvaluation

The immense growth of digital gaming technologies over recent years has led to significant controversies over the industry’s long-term potential. One notable example is the gaming company Roblox Corporation (NYSE:RBLX). Roblox is a game that allows users to create and develop games. The platform obtains around 59M daily active users, with over 4M game developers. Most Roblox users are children and teenagers, with a staggering 13.4B total gaming hours. The platform has grown tremendously over recent years, seeing its DAUs rise from 13.7M in 2018 to nearly 60M in Q3 of 2022. If around 28% of its users are in the US and Canada, then around 16.5M or ~27% of the combined 6-17-year-old population in the US and Canada use the platform daily.

In my view, it is evident that Roblox is reaching its upper limit for user growth. It is a wildly popular platform among children and seems unlikely to expand its North American user base much further, though it still has substantial user growth potential in Asia. The company has marketed itself to investors as a growth opportunity since it went public, though its stock has declined considerably since and is trading at less than half of its IPO price. A rapidly growing company that can never profit has no value (from a DCF standpoint). To stay afloat, I believe the firm must prove itself as a profitable enterprise quickly. Even then, RBLX appears very expensive compared to its potential profitability and will likely need a much better income source to maintain its current price.

Growing Customers, Falling Revenue

Roblox’s biggest positive factor is its tremendous market share and viral popularity among its target user base. While it has maintained decent growth since 2020, its booking revenue (from “Robux” sales) per DAU has declined by around 30% since its 2020 peak. More recently, this change has caused the firm’s total sales per quarter to fall. To make matters worse, its operating costs have skyrocketed to 133% of total revenue. See below:

Today, Roblox is an equity-destroying enterprise and has only maintained its cash reserve through a $1B junk-bond sale and relatively large share compensation. The company’s share compensation rate has risen to $161M per quarter, meaning equity holders will likely be diluted ~3.2% per year at its ~$20B market valuation today. While that figure may not be significant, it could snowball if the firm’s stock-based compensation rate continues to climb as its market value trends lower. Its cash flow per share has fallen dramatically and is nearly negative, meaning the company may need to see equity to offset losses this year. See below:

In my opinion, the most significant issue with Roblox’s stock-based compensation is not necessarily its dilutive impact but its disproportionate size to the firm’s sales. Though the pace of dilutions may become an issue if the stock continues to decline, nearly a third of its total quarterly revenue is going to stock-based compensation today. To me, that is a strong indication that the firm’s management is not necessarily in a share-holder-value stance. While it makes sense that Roblox should prioritize growth over profits, it seems it is not making the necessary steps to ensure increase eventually results in strong shareholder value.

Many analysts point to the Metaverse as an expansion avenue for the firm as it invests in space. I believe it remains unclear if gamer demand for metaverse technologies is as strong as many investors believe. More importantly, it remains unclear if Roblox can earn a profit in that segment, considering it has thus far failed to do so in the traditional computer segment. Additionally, it may pose a significant risk to RBLX’s value if it invests capital and managerial focus into the “Metaverse” instead of its core business, particularly considering the questionable profitability and growth potential of the Metaverse itself.

Roblox’s Valuation Remains Nonsensical

Roblox went public in 2021 at a very reasonable period when the valuation of many “digital-market” stocks was very high amid tremendous retail investor speculation. The company had strong 2020 growth, mainly due to the one-off bonus from COVID lockdowns that forced many children to stay home from school, causing gaming activity to surge. Since then, its revenue has stagnated while its profitability has collapsed. Roblox’s DAU growth is positive, but without profits, the stock is not likely to stay afloat.

The company may not be in a rush to turn a profit because its maximum EPS would likely be extremely low compared to its valuation today. Thus, selling equity at a high valuation may be better as investors hope for more growth to justify its extreme price. The company’s price-to-sales ratio is at a very high 8.86X. The firm’s sales per share have not risen over the past two years, so I would not necessarily expect it to over the long run. The lowest operating expense to sales it has had is ~88%, while the best gross margin it has had is ~76%. Since its operating costs-to-sales have always been higher than its gross margins, it is unclear if the company can turn a positive operating profit. See below:

Being very generous, let’s assume Roblox can maintain a 76% gross margin while lowering its operating costs-to-sales to 60%, meaning the firm generates a positive operating margin of 16%. At ~2.07B in annualized sales, that translates to ~$330M in hypothetical operating income. At an $18B enterprise value today, its “EV to operating income” (roughly the same as “EV/EBITDA) would be around 55X. To put that in perspective, the gaming giant Activision Blizzard (ATVI) has a 22X “EV/EBITDA,” I believe that stock is also wildly overvalued.

The bottom line is that Roblox’s valuation does not seem justifiable, even under the best assumptions. For the company to be fairly valued today, I believe it needs to double or triple its revenue-per-share (after dilutions) while halving its operating costs compared to sales and maintaining strong gross margins. Roblox would also need to accomplish this feat quickly enough to justify the risks of waiting for investors (or time-value of money). I believe this feat would be possible if Roblox were consistently expanding its DAUs while increasing its revenue per DAU. However, considering its sales have stagnated despite rising DAUs (and immense operating costs growth), I think it is improbable.

The Bottom Line

There is no doubt that Roblox is wildly popular among children today. There is also little doubt that it will continue to be popular and may become even more popular in certain parts of the world over the coming years. However, those facts alone do not justify the company’s valuation today. Indeed, it seems that in the digital consumer sector (be gaming, social media, or similar), it is tough for companies to maintain and grow profits without compromising user experience. In a world where hundreds of new games are being developed each day, an increasing number of which are free, I do not believe substantial profits are likely to be found in the sector, particularly compared to today’s extreme investor expectations of it (considering valuations). Indeed, for the sake of the children playing games, I do not necessarily believe profits should or can safely be prioritized in the online gaming industry.

Looking at Roblox’s valuation today, investors expect the company to grow tremendously and become far more profitable. While I believe Roblox will remain popular, it may only retain its DAUs by not compromising user experience to increase profits. It is certainly possible that Roblox can be profitable. Still, its maximum potential annual profits appear to be only 1-2% of its current market value, meaning the stock is likely overvalued by at least 50% today.

I believe RBLX is a short opportunity, and I am bearish on the stock due to excessive overvaluation. In recent months, Roblox’s stock has carved a support level at the $30-$40 range, and it may be sometime before it falls lower. Indeed, the stock could rebound in the short run if investor confidence returns. It is also very volatile and has growing short interest, so there are relatively high risks of betting against the firm. RBLX’s implied volatility is also well-below average today, so long-put options may be a suitable way to bet against the stock with defined risk.

In my view, if its Q4 earnings show sales stagnation again, then confidence in the company’s growth potential is likely to crash and catalyze a significant slide for RBLX. Of course, that is not guaranteed, so short-selling caution is advised. Overvalued stocks can remain overvalued for years. That said, with retail speculation in the digital stock space seemingly declining (see ARK invests’ downfall), I tend to believe that RBLX (and similar companies) are unlikely to rise substantially any time soon – though the possibility persists.