RBLX - Roblox: Battling Safety And Platform Costs

2023-10-17 11:23:34 ET

Summary

• Roblox continues to face modest growth and large operating losses, with little prospect of improvement in the near term.
• AI has the potential to reduce the burden of trust and safety costs, although this is likely to take time.
• Given Roblox's large losses and low growth, the stock could be vulnerable to a further pullback in the near term.
• Longer term, the stock should do well if Roblox can resolve its cost issues.

Roblox (RBLX) is likely to continue registering steady growth with poor margins in the near term, which may result in ongoing downward pressure on the stock. Longer term, AI has the potential to reduce the burden of trust and safety costs. There is also potential for platform fees to decline over time, if app side loading becomes a more serious alternative. Assuming current cost issues are resolved in time, Roblox could perform well if it achieves a Lego type of outcome, where the company matures with its user base and the company's IP can be extended into novel areas.

Roblox

Roblox is investing heavily in its business at the moment, which is weighing on margins but also has the potential to improve monetization over time and lower costs. An important part of improving monetization is increasing the willingness of developers to pay for tools, which will help to keep money in the ecosystem. Roblox recently introduced product analytics for Developers so that they can monitor things like user acquisition. In the last six months, use of analytics by the top 10,000 developers has increased from 22% to 40%. Roblox is also working on a solution so that developers can offer VIP subscriptions for their experiences. This should help to support growth and could provide a more stable source of revenue.

Roblox is already an important developer platform, with developers on track to earn 800 million USD in 2023. Over the last 12 months, the 10 highest earning creators on Roblox earned an average of 27 million USD each. The thousandth ranked developer on Roblox is now earning 64,000 USD per year. This indicates that to a large extent revenue is driven by a relatively small group of developers, and that some of these are relatively large businesses.

Advertising is another important avenue for improving monetization and margins. Roblox has now done over 200 brand activations on the platform. Management has stated that pricing is currently low, but the company expects to float prices at some point which is expected to result in higher pricing. It will take time for Roblox to build a competitive adtech stack and attract an advertising customer base, but this should eventually be a high margin source of revenue which is incremental to the current business.

Roblox was recently made available in open beta for Meta's ( META ) Quest VR headsets and achieved one million downloads in the first five days. Extending its software across hardware platforms should strengthen Roblox's competitive position and provide incremental growth, but in this case may not significantly improve margins. Meta plans on charging a 30% hardware platform fee on sales made through the Meta Quest Store.

AI

Roblox has a large team that is developing AI driven tools for developers and users. Use of AI within Roblox is relatively broad, with the company reportedly having 70 machine learning training stacks at the moment. An example of this is auto translation, which Roblox launched 1.5 years ago. Roblox has around 66 million daily active users globally who use a range of languages, making auto translation an important feature.

AI can also provide automatic moderation of 3D content, helping Roblox to reduce the burden of providing a safe platform for users. Moderation costs currently amount to roughly 17-18% of bookings , making this an extremely important line item. Management commentary points towards this being a focus area for the company, although it is unknown when this may begin to impact the company's bottom line.

Roblox initially launched Semantic Search in Japan, and has now rolled this out everywhere, helping to improve search results for things like pop culture terms. Roblox has seen a more than 3% increase in global click-through rates because of this.

Roblox hopes that these tools will:

• Accelerate creation
• Make users more willing to pay for content
• Lower moderation costs

AI could therefore drive revenue growth and improve Roblox's margins, although this is likely to take time.

Alternative App Stores

Mounting regulatory pressure could provide Roblox with a significant tailwind in the not-too-distant future, helping the company to resolve some of its cost issues. It appears likely that Apple ( AAPL ) and Google ( GOOG ) will be required to allow users to choose where they download apps from and the payment systems they use, although this is likely to vary from country to country.

The EU Digital Markets Act is targeting anti-competitive behavior by big tech companies through legislation. It covers a range of areas, like the interoperability of messaging apps, but also the distribution of apps. Platform owners will also no longer be able to require app developers to use certain services in order to be listed in app stores.

Meta is planning to let people in the EU directly download apps through Facebook ads, with a pilot set to start as soon as this year. Meta doesn’t initially plan on taking a cut of in-app revenue from participating apps, although this could change in the future.

This is important for Roblox as it is currently offering a platform built on the iOS/Google Play stores. By the time the app stores and developers take their cut of revenue, there is little left for Roblox to profitably operate its business. Absent the roughly 30% app store tax, Roblox’s financial performance would be vastly different. Even with alternative app stores becoming a viable option, it is not clear to what extent Roblox stands to benefit though. Users know and trust Google and Apple, and there is significant inertia in user behavior.

Financial Analysis

Roblox's business continues to register steady growth, with bookings up 22% YoY in the second quarter and revenue up approximately 15% YoY. This type of growth is reasonable given the difficult macro environment and Roblox's growth spurt through the pandemic, but may be falling short of the expectations of some investors.

Roblox had 65.5 million DAUs in the second quarter, up 25% YoY, and hours engaged was 14 billion, up 24% YoY. Roblox has struggled to increase revenue per DAU and revenue per engagement hour in recent years, but it has also avoided these figures reverting to pre-COVID levels. This is somewhat surprising given that Roblox's user base is on average getting older. The percentage of paying users has generally been declining over the past 2-3 years though. Some of these trends may be due to varying user growth across geographies.

While Roblox's income statement generally shows a gross profit margin of around 75%, I believe including developer exchange fees and infrastructure and safety and trust costs as part of COGS better reflects the nature of the business. Doing this demonstrates that Roblox's margins are currently structurally low and that absent significant changes it will be difficult for the company to generate reasonable returns on its investments.

Despite Roblox's gross profit problem, the company has done a reasonable job of improving operating profit margins with scale. This is largely a function of the fact that the company has minimal sales and marketing expenses and is efficient in its use of general and administrative costs. The burden of R&D investments has risen substantially over the past two years, which is primarily related to personnel costs.

While Roblox's pace of hiring continues to moderate, the company hasn't been able to drive operating leverage in recent quarters due to low revenue growth.

Valuation

Despite the stock price being fairly flat over the past two years, Roblox's valuation is still relatively high. While some of this is a reflection of the strength of Roblox's competitive position and the size of the company's opportunity, it may limit upside in the near term. Growth is unlikely to return to pre-COVID levels and Roblox has a lot of work to do to achieve reasonable profit margins.

Roblox's free cash flow margins are highly correlated with the company's growth rate though, meaning that if/when growth improves, so will free cash flow. This situation could set the company up for a significant rerating at some point.

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