Pursuit of Return

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Roblox - No, it's not just a video game





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Roblox - No, it's not just a video game
By Pursuit of Return • Issue #1 • View online
This newsletter is intended to provide investors with a certain amount of background knowledge when evaluating investments. It regularly discusses individual companies and occasionally deals with topics such as the structure of different industries and dominant competitive forces in those industries.

From an investor’s perspective, it has historically not been easy to invest in the video games industry. Listed video game companies are often centered around a few successful franchises or brands, which can create a high dependency on the hard to predict success of a few games and therefore limits the visibility of future cash flows. The company we are talking about today might have a different profile.
Roblox doesn’t create any games. It’s a platform for virtual experiences, which is characterized above all by the fact that the user is not only invited to enjoy the experiences on the platform, but also, thanks to the intuitive desktop application, can slip into the role of the developer, giving free rein to his creativity and imagination and, if successful, can even earn money from it. The developer community has already published tons of millions of games and at the end of 2020, there were 20 million different game-like worlds on the platform, which, in addition to reducing risk from an investor’s perspective, offer customers a wide range of shared experiences, such as organizing a fashion show, baking pizza together or more traditional games like shooters, with most of the experiences inviting you to hang out with friends. The platform is basically free of charge. However, if you want to individualize your identity (every user slips into the role of an avatar) or improve your gaming experience (for example by buying a cool motorcycle or a digital pet), you have to pay with the proprietary currency ‘Robux’, which has to be previously purchased with real money. Roblox collects a share of the Robux that has been used. But why would anybody pay to customize an avatar? The visual appearance of the character in the game is a status symbol. Users want to customize their avatars to differentiate from others and have the most appealing items. Walking around with a rare skin in the game is similar to uploading an admired post to Instagram and getting tons of likes, as we have seen with Fortnite as well.
As I said earlier, Roblox is a platform, so it makes sense that 79% of the employees are engineers (vs. ~31% at Google and 23% at Netflix), organized in 50 small teams to work relatively self-sufficiently on innovations that improve the tools for developers and the user experience, for example broadening the opportunities for avatar creation or improving the recommendation engine.
David Baszucki is the founder and CEO and therefore the most important person in the company when it comes to strategic decisions, as he owns 12% of the outstanding shares and 70% of voting rights. My impression agrees with the description of his person in the media: ‘unfailingly polite and enthusiastic, never claiming superior insight, and preferring to pass credit for his accomplishments on to others. In conversation, he shows interests both central and tangential to Roblox, like virtual environments, games, education, digital identity and the future of tech’ (source: Techcrunch). David certainly is a visionary and when he started Roblox in 2004 he wanted to create a platform for shared experiences and with that, connect the world. Despite temporary successes, failures and potential distractions, he has not deviated from this vision, so that his founder letter in the S-1 filing is reminiscent of old writings from 15 years ago. This is worth mentioning insofar as many companies, contrary to the original vision, throw themselves on trends and thus often dig their own grave. Baszucki developed a 2D platform for physical experiments back in 1989 and founded the Knowledge Revolution company. It was sold to MSC Software 10 years later for $ 20 million and Baszucki became general manager. After two years he left MSC Software and founded an investment company with which he invested in the social network Friendster. The feedback on the 2D platform combined with the later collaboration with Friendster gave Baszucki the idea of ​​developing Roblox: ‘Seeing how kids lit up when they were creating things using our physics software made me think of what would be the ultimate platform for our imagination. Also I like construction toys and I saw the direction 3-D rendering was going. It became clear to me that there was an opportunity to create an immersive, 3-D, multi-player platform in the cloud where people could imagine, create and share their experiences together.’ With the $20 million check he wouldn’t have had to work anymore, so I classify the anecdote as a sign of intrinsic motivation. As of today, his salary will be set to zero and he will receive shares when certain price markers are exceeded, which he plans to donate for philanthropic purposes.
Earnings power and moat
The accounting obliges Roblox to create significant Deferred Revenues, which currently obscure the true profitability of the company, at least on a GAAP basis. Free cash flow and bookings (see section ‘Financials’), the quotient of which results in an FCF margin of 22% for 2020, are suitable for classifying the operational development. This high profitability is due to two network effects that reinforce each other:
1. Roblox thrives on user-generated content that creates a two-sided platform network effect. More and better user-generated experiences attract more users, which leads to more revenues, which leads to more money paid out to developers. That again attracts more and better developers, some of whom even come together in teams. This increases the number and quality of the games and consequently the quality of the platform, which in turn attracts more users and allows the cycle to start all over again. This network effect is supported by the fact that Roblox is free for both the developer and the user. In addition, Roblox is not only available on most kinds of hardware such as PC, iOS devices, Android devices and Microsoft’s Xbox console, the platform even enables users to play together regardless of the gaming device they choose. At the same time, the games developed on Roblox cannot be used outside of Roblox, which means that the developer will incur switching costs.
2. Social interaction: Users usually play with their friends or make new friends on the platform. Both the user and the friends invite further friends. The more friends each user has on the platform, the more valuable and entertaining the platform becomes for her and the non-monetary switching costs arise. This works particularly well thanks to the young target group, because children have to be part of the community. It is also essential that all participants can communicate with each other (in fact, Roblox announced voice chat lately) and that the players are brought back together with acquaintances from past interactions with the help of a social graph when they enter a game.
Number of users and experiences
Roblox has been attracting more monthly active users than Minecraft since 2019 and most recently officially reported MAUs of over 150 million in July. At the Roblox Developer Conference (RDC), CEO & Founder Dave Baszucki announced that ¾ of the 9-12 year old US kids and 50% of US kids under the age of 16 are hanging out on Roblox on a monthly basis, but even 1/3 of the 9-12 years old kids in South Korea are on the platform. Management is already preparing the platform to achieve the internal goal of 1 billion users worldwide. The number of daily active users was 37 million in the fourth quarter of 2020, which is +94% above the previous year. The hours of engagement rose by 128% over the same period to a run rate of 2.8 billion hours per month. The average DAU spends around 2.6 hours a day on the platform!! There are 55,000 games or experiences in which at least 1,000 hours have been spent in the last year, of which 272 achieved at least 10 million hours of engagement, with the user jumping into an average of 20 different experiences per month. However, roughly 90% of users’ in-experience engagement was distributed across the top 1,000 experiences. As there were 20 million experiences available, you could argue that that is pretty concentrated, but I think it’s a nice diversification compared to traditional video game companies, although we have to watch that over time. The payout to developers is also increasing sharply. When the company’s first IPO plans became known, more than $250 million in developer earnings where expected, which ended up being $329 million for 2020, +194% more than the year before. At the same time, there were over 1,250 developers and creators that earned $10,000 or more and over 300 developers and creators that earned $100,000 or more. Three developers have even earned over $10 million, although I would not expect those developers to be individuals, as professional developers have already come together to form teams and companies.
Source: Roblox
Source: Roblox
As mentioned above, accounting requires Roblox to create significant Deferred Revenues. Thus, the sales according to GAAP in 2020 differs significantly from the bookings (~Non-GAAP Sales). When the user buys Robux, the dollar equivalent is reflected in the cash flows and bookings. However, since the user does not necessarily spend the Robux immediately, the revenue is distributed over the average lifespan of a paying user, which is currently 23 months. In times of strong growth like 2020, this leads to a large gap between sales and bookings. Hence on the surface we see a company that is still deep in the red. On an adjusted basis, however, I calculate an EBIT margin of 26% and a free cash flow margin of 22%, as can be seen in the table below. Notably, the network effect described above enables organic growth and therefore low marketing expenses of only 3% of bookings in 2020, compared to ~15% of bookings at traditional video game companies of scale and other companies like Facebook. As the concentration on mobile devices continues to increase, the gross margin should move in the direction of 30%. The developer exchange fees should increase in the long term as a share of sales, because the management wants to use efficiencies gained elsewhere to increase the payouts to the developers. All other cost items are likely to continue to decrease as a proportion of sales with further scaling. Last week the management announced the guidance, which points to around 10% bookings growth and an engagement on 2020 levels.
Income Statement 2020 (Sources: Roblox; my own estimates)
Income Statement 2020 (Sources: Roblox; my own estimates)
Growth opportunities
Roblox should have a bright future, as we can hardly imagine what the platform will look like in 10 years. At this point we should focus on the visible growth opportunities: 1) Expanding internationally, 2) Attracting older Users, 3) Increasing platform use cases, 4) Improving monetization.
1) Expanding Internationally: While Roblox generates 68% of bookings from US & Canada (vs. 73% in 2018), DAUs and hours engaged outside of North America already account for 70% and 65% respectively. At the same time, DAUs and hours engaged in Europe, Asia and the rest of the world grew faster in 2019 and 2020 than in the US & Canada, which means that the international expansion seems to be working. According to CEO Baszucki, in China there are 3x as many potential Roblox players as in the United States and today there are actually zero players because the platform has not been launched yet in China, as the JV between Roblox and Tencent just recently got the approval.
2) Attracting older users: Due to the blocky nature of the platform-physics it’s difficult to judge but Roblox is seeing promising signs. The 13+ year old DAUs grew +107% in 2020, faster than the +72% for the 12- year old, so that the 13+ now make up 45% of total DAUs. The same is true for hours of engagement. More targeted content, improving graphics, personalized curating of messages and an improving recommendation engine should aid the shift to older players. However, the competition for older audiences is likely to be a bit tougher.
3) Increasing platform use cases: The vast majority of time spent on Roblox today is for video gaming or at least game-like experiences. However, Roblox will focus on broadening the use cases. For example, they will be more and more experimenting with concerts, like they have done quite successful with Lil Nas X last year. Those concerts become a cultural phenomenon that kids feel they have to be a part of. Longer term, the platform can be used for education, work and even e-commerce, which could drive engagement and monetization significantly.
4) Improving monetization: In 2020 Roblox generated an average of 6c of bookings per hour of engagement, up against 5c the year before. In Q4 2020, it reached a record level with 7,6c per hour, which is still low compared to other forms of entertainment (e.g. Netflix is viewed as one of the lowest on a cost per hour basis at ~25c) and other video game companies (e.g. Activision was ~50c per hour in 2015). In 2020, Roblox only had an average of 490,000 users spending money on a daily basis (1,5% of DAUs), up from 185,000 the previous year. The subscription offering ‘Roblox Premium’ is growing twice as fast as Roblox since introduction in September 2019 and should support ARPU growth over time, while subscription plans for individual experiences should further drive that. Another type of monetization is immersive brand advertising, which would be a high-margin addition and Roblox plans to incorporate features like branded worlds, like they did with DC Comics.
Roblox competes with any alternative leisure activity. Accordingly, in addition to obvious competitors like Minecraft and Fortnite, it also competes with a large number of powerful players from other sectors such as Facebook (Horizon?) and the like. Thanks to the network effect, I consider the risk emitted by new providers to be low. Roblox, Minecraft, Fortnite and Co. have a very high number of active users who spend many hours on the platforms. If all of your friends are hanging out on Roblox, it becomes a default place to spend time. This has been achieved by being cross-platform and free to play for everyone - much like a social network. This makes it more difficult for other platforms to come up and compete.
Risk factors
As a skeptic one can bring some risks to light. I would highlight the following:
Like every video game, the experiences on the platform offer a certain addictive potential, which is particularly critical with Roblox, because the platform is mostly used by children. Due to the young consumers, there are regulatory hurdles that restrict Roblox in areas such as data collection and thus make protective mechanisms more difficult. Occasionally criminals have abused the platform to seek contact with children in the physical world. Parents can use apps to monitor their smartphone behavior and restrict or deactivate online chat options on Roblox and restrict access to a list of age-appropriate games. Roblox designed the platform to comply with the United States’ COPPA and the European General Data Protection Regulation (GDPR). In addition, the company works both globally and regionally with regulatory authorities and security officers, to whom suspected exploitation or inappropriate material is reported directly. Roblox also works with other companies in the field of security assurance to leverage progress across the board and the S1-filing incorporates the word ‘safety’ 119x. In short, they do everything in their control to ensure the safety of the user.
For 2020, 35% and 19% of revenue were generated on Apple App Store and Google Play Store, respectively and 68% of engagement hours on Roblox were from users who signed up through these stores. This creates a certain dependency and thus a risk, as Roblox has to adhere to their rules and ultimately these companies are competitors. However, the CEO spoke of a very good relationship with Apple. Another risk factor is, that users might ‘outgrow’ Roblox and switch to other games/platforms as they grow older, but in my opinion, it is difficult to see kids ‘graduating’ from Roblox and moving on to traditional social media. A 2D scrollable feed of Instagram doesn’t sound so exciting after having grown up in a 3D virtual world.
While Roblox is said to collect 30% of the transaction value (or 70% for avatar creations), due to the exchange rate (a user pays 1c per Robux but if you want to pay out Robux as a developer you get 0.35c per Robux) the developer only gets 24.5% of what the user pays. There is already an early stage competitor promising a 50% share, but interviews with some developers indicate that they are very happy with the split, as for example in this podcast. However, management wants to increase that share over time.
Roblox will be listed today through a ‘direct listing’. Direct listings aren’t new but have gained attention of late. Roblox is the fifth company to go public using this method.
Twelve months ago, Roblox was valued at $4 billion in a financing round and at $29.5 billion in another round two months ago. The simplest valuation approach would be to apply the price/sales multiple from Unity on top of the bookings. Unity is one of the two largest gaming engines which could be used for comparison by some investors as there is no comparable company listed on the stock market. Unity is worth about $ 30 billion right now and is expected to generate about $1 billion this year. This 30x P/S multiple would value Roblox at ~$60 billion or $90 per share. You could also look at companies like Snap and the like for comparison. I have constructed a DCF model containing the following assumptions: Bookings CAGR of 18% over the next decade, an EBIT margin of 28% in 2030, a terminal growth rate of 1.5% and a discount rate of 7.2%, which leads to a fair value of $56 per share. As my assumptions seem very cautious to me, I am happy to pay a bit more on that one.
An article about Roblox that does not mention the word Metaverse seems incomplete, but I’ll leave the topic to others because it deserves its own newsletter.
How did you like this? I would appreciate any feedback as I want to make this great.
Thanks for Reading.
Please note that this article does not constitute investment advice in any form. This article is not a research report and is not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.
The author has no position but plans to open a position in Roblox. The author has no business relationship with any company mentioned in this article and the author is not receiving any form of compensation for this article.
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