RBLX - Roblox: The Kids Are Here To Replace Us

2023-11-29 09:35:20 ET

Summary

• The negative Roblox Corporation trends of 2022 have reversed.
• The company intentionally sandbags its GAAP reporting, but if we cut off those sandbags, they will likely be operationally profitable in 2024.
• User metrics show solid growth and increased stickiness, but user growth outside of North America is higher and less lucrative.
• My interest in Roblox is long-term. I think they have the best conception of the metaverse, and where that is all headed.

Bouncing Off The Post-Pandemic Lull

Roblox Corporation (RBLX) saw furious triple-digit growth during the pandemic, and paid for it with a slow 2022, but are now back to around 20% growth. User and revenue conversion metrics remain strong. Their big surge of R&D and CapEx is ending, and they are getting operating leverage on growth again. When we adjust for their odd revenue recognition, more on that below, they should become profitable again in 2024. After 3 quarters of dipping into negative free cash flow, it is positive again and should be going forward.

But my interest here is long-term. I think Roblox has the best concept of what they would like the metaverse to be, and the Roblox kids are jumping in with both feet. While Meta Platforms ( META ) burns billions on Reality Labs and damages adults' perceptions, two "gaming" companies, Roblox and Epic, already have metaverse experiences used by millions of (mostly) kids. Those Roblox kids will one day be the adults in the room.

Make no mistake about why these babies are here - they're here to replace us.

- Jerry Seinfeld.

Adjusted Financials and Roblox's Odd Accounting

Among companies I follow, Roblox is one of the most unique. One of the ways that is true is that they intentionally sandbag their GAAP reporting by recognizing about 90% of their revenue over 25 months. This is seen on their balance sheet in their now comically large and growing deferred gross profit, $2.7 billion, 16 months of TTM GAAP gross profits. That is just sitting around, waiting to be counted.

I make my own adjusted numbers for them to cut off those sandbags. These are my adjustments to Roblox's financials:

• Bookings is one of the non-GAAP numbers they report. It is the gross value of revenue in the quarter, almost entirely from the iOS App Store ( AAPL ), Google Play ( GOOGL ), and some on their website. I treat this as their real gross revenue top line, not what they report, which is more reflective of the previous 7 quarters than the one they are reporting.
• Adjusted gross profit subtracts from bookings GAAP cost-of-revenue and the deferred cost-of-revenue incurred during the quarter, which is money they have already paid Apple and Google.
• Adjusted operating income subtracts their operating expenses from adjusted gross profit.

So, the first thing is that Roblox used to be a profitable company in this view, just barely so until the pandemic, when they peaked at an adjusted TTM operating margin of 24% in March 2021. Their GAAP operating margin was -24% that quarter. That's how badly they sandbag their GAAP numbers.

But you see that changed in 2022 and continues into 2023, with a -18% adjusted operating margin in the TTM. What happened in that period was pandemic bookings growth, peaking at 229% YoY in June 2020, crept down, settling in now in the low 20s. But at the same time, R&D and other expenses were continuing to grow at astoundingly high rates:

I like what they are buying with all that R&D, but the huge gap between the blue bookings growth line and the green R&D growth line is unsustainable, and last quarter's earnings review focused on that . But note the September 2023 quarter, just reported. Bookings are growing faster than expenses, just by a bit. If they can keep that up, they will be back to getting leverage on bookings growth, and eventually positive adjusted operating income.

They are also at the end of their big CapEx surge that was happening at the same time. The combination had sent their free cash flow negative for 3 quarters, but that has ended.

The CapEx and reduction of costs are related because they built new data centers that are now reducing infrastructure costs:

They are almost done with the last of their new data centers, and their CapEx should be much lower for a while.

Summing up:

• Roblox sandbags their GAAP numbers, making them more reflective of the previous 7 quarters than the one being reported.
• After triple-digit pandemic growth and then a weak 2022, Roblox is back to ~20% growth.
• They had an R&D and Capex surge that is finally done.
• When we adjust for their odd revenue recognition, they should see operating profits again in 2024.

User and Revenue Conversion Metrics

User metrics growth remains very solid, though like bookings, well below 2019-2021.

Combining those metrics in a ratio, we get a sense that the platform has gotten stickier.

In the past year, users have spent an average of 17 more minutes per day on the platform versus 2019.

Revenue conversion remains above pre-pandemic levels:

The one thing that does worry me, and came up in the call, is that user growth is much higher outside North America. This is why that worries me:

North American daily average users [DAUs] are still growing at 11% YoY, but everywhere else is 22% combined. That's a geographic shift to a less lucrative user base.

But there's a beneficial demographic trend in age groups:

Roblox was long a platform for kids, but it is a sticky platform, and those kids are aging up. Roblox doesn't break out bookings by age (probably because that under-14 number would be a bad look), but here's one of the more interesting charts: the difference between over-13s and under-14s in the average number of minutes per DAU:

On average, the over-13 group spends an extra 13 minutes per day on the platform, and that delta has been growing quickly since year 2 of the pandemic. My interpretation of that chart is that the platform is stickiest with superusers who spend more time on the platform as they age. They also probably spend more money as well, but we don't know that for sure.

Also, Roblox developers are launching 17+ games for older teens and adults now. That's the next step in the aging up of the Roblox generation.

The Upshot

This was a nice quarter that reversed many of the bad trends of the previous 4 quarters. Investors were very encouraged by the reduced growth in operating expenses and reduction of CapEx.

Roblox is a company that moves very slowly, often too slowly for Wall Street. In-game ads are a great example. Other gaming companies rush to throw ads everywhere, cluttering up the experience, and raising ire among players. Roblox launched a very new kind of in-game ad experience a year ago and is still being very circumspect about putting it in games. Ad revenue is still very small, an unpulled lever.

Another unpulled lever is that Roblox's growth is almost entirely via word of mouth. They spend a small amount on iOS App Store and Google Play Store ads, but that's about it. When you search for Epic's banned Fortnite on iOS, this happens:

Their marketing expenses rose this quarter, but still only 4% of bookings in the TTM. They move slowly and deliberately with their eyes on the horizon.

All that R&D expense is making its way into the Roblox experience: voice chat, better avatars, better tools for developers, more monetization options for developers, AI for moderation and developers, launching on PlayStation and Meta Quest. All that happened in the past 18 months.

Roblox Corporation has the right strategy for the metaverse in my opinion:

• Build a giant sandbox.
• Hand out pails and shovels for free. Keep making those tools better and easier to use.
• Aside from trust & safety, do not interfere with what the kids do in the sandbox.
• Move slowly, especially since they have a young user base.

It sounds simple, but it is very hard to get right. But when you do that, strange and sort of wonderful things start happening .

Of all the things parents might suspect their little darlings of doing on game creation platform Roblox, replicating Ryanair flights likely isn't one.

And yet here they are , checking in luggage, queuing at security, wading through duty free, and grabbing a dirty burger before making the arduous trek to the gate, where there is, lo and behold, more queuing.

A bunch of teens who enjoy budget air travel much more than I do built an entire virtual version of Ryanair ( RYAAY ) inside Roblox, one of several virtual airlines. They have built 505 virtual 737 and A320 aircraft, and 11 airports. 160 users from 16 countries work at the virtual airline, and there are 150k paying customers a year. They have "ambitious growth goals for 2025," and you can learn about it on their investor relations site and annual report. These kids love virtual budget travel. Wild.

Something like Roblox RyanAir could never come out of a top-down development model. If you want to understand what the metaverse is, this is it . My long-term thesis on Roblox is right there in a virtual budget airline that no adult would have ever thought to build, but that has now carried over a million virtual passengers.

Those Roblox kids will one day be the adults of the world.

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