RBLX - Roblox: Valuing Customer Engagement

2023-10-17 12:16:40 ET

Summary

• Roblox Corporation's EPS missed profitability estimates during the second quarter and saw fewer users accessing its platform on a sequential basis, causing its stock to decline.
• However, the company saw positive growth in revenue and bookings, indicating potential for long-term success.
• Roblox's focus on customer engagement, including collaborations with Meta, could drive further growth and revenue.
• Also, there should be a lot of benefits as a result of using Generative AI.
• However, it remains richly valued and is not a buy currently.

With investors focusing on profitability and GAAP EPS of -$0.46 missing estimates by $0.02 during the second quarter of fiscal year 2023, Roblox Corporation’s ( RBLX ) stock took a beating since around August 9 and is now trading at around $30.5. There was other bad news concerning users accessing its gaming platform.

Still, there were some positives with the revenue of $680.8 million, up by 15% year-over-year on a constant currency basis while bookings of $780.7 million , rose by 22%. Also, with the business generating cash, things are not necessarily so bad.

By focusing on customer engagement, the aim of this thesis is to show that Roblox deserves to be on investors' watchlist and is a long-term hold for those already invested in the stock.

Looking at Engagement

This can be the number of social media followers or fans for a movie star. It could also be the number of likes or retweets on X, formerly Twitter. Now, whether it's face-to-face interaction, social media dialogues, or the number of people accessing its platform for Roblox, any business would be delighted if its customer engagement strategy could boost its revenue. Now, this is precisely what has been happening for Roblox as it increased sales based on engagement. On top, the 15% sales growth in Q2 came more than two years after the COVID peak when it was primarily kids not going to school and spending time on its platform which accounted for the 108% YoY growth for the year ending in December 2021. Therefore, this suggests that it is able to sustain traction for its products, especially at a time when there is economic uncertainty.

Moreover, Roblox is a platform where in addition to playing games for entertainment purposes, developers can equally earn money by creating experiences or 3D immersive places where people can enjoy together with their friends. Talking figures, the company should be paying content creators around $800 million in fiscal year 2023 with the ten highest earners obtaining an average of $27 million each during the last trailing ten months. There is also an army of more than 1,000 creators earning tens of thousands of dollars a year individually. This is a lot of money representing around 24% of the company's forecasted revenues of $3.42 billion for this fiscal year which ends in December.

Now, these fees have gradually increased as shown in the chart below showing the importance Roblox attaches to its developer ecosystem for creating games and experiences, which is similar to content creators uploading videos on YouTube and getting paid in return.

Thinking aloud, in addition to this being an operating expense, this can also be considered an investment that has resulted in an increased market share of the gaming space. This is evidenced by the increasing number of customers who access the platform.

Increasing engagement

For the purpose of measuring the popularity of its platform, the company has the Average Daily Active Users (“DAUs”) metric, which, at 65.5 million in Q2, represented a 25% YoY increase. Also, as charted below, DAU has been increasing steadily since 2020.

Now, the management wants this figure to become 1 billion people daily over time. Well, many would express skepticism at such a high figure, but it is achievable because of the following reasons:

First, the company has been making progress in advancing the usage of Roblox throughout the world including 25% YoY growth in Germany, Korea with 34%, Brazil with 38%, India with 40%, and Japan with 107% in addition to its core market which is America.

Second, but more importantly, Roblox recently launched on Meta Platforms' (NASDAQ: META ) Quest Store. Meta Quest was in beta version on September 27 and witnessed 1 million downloads within the first five days on that platform.

Now, this event has not been well publicized, possibly as it is related to the metaverse theme, which, after creating hype in 2021-2022 following Facebook's rebranding itself as Meta has now subsided. However, if you take some more time to think about it, it is highly abnormal for Roblox as a major in social gaming play to be listed officially on Quest Store given that only about one year back, Meta and Roblox were fierce competitors since Mark Zuckerberg’s company had launched its own social VR (virtual reality) Horizon Worlds platform.

Thus, I believe Meta's action in some way represents a victory for the provider of user-generated experiences. It enables the company's 66.5 million daily active players which are already spread across Android, Xbox, iOS, and Windows desktop to further grow using the Meta route. At the same time, Roblox's creator community can now look to build experiences for a much larger audience.

Third, according to a discussion between CEO David Baszucki and Jonathan Lai of Andreessen Horowitz (a16z), a venture capital firm last month, Roblox intends to leverage Generative AI for generating everything from software code, avatar generation, and 3D object generation to game generation.

Valuing Engagement

Now, given the ease with which anyone can generate realistic images and even art using either OpenAI's Dall-E 2 or Stability AI's Stable Diffusion text-to-image generator, adding Generative AI tools could really revolutionize user-generated content on Roblox's platform and significantly enhance social experiences. In addition to the value-add that this could bring to engagement by empowering casual users to create the most artistic graphics to be embedded into games, there are also productivity gains. Thus, according to a study by research firm McKinsey , Generative AI through the use of chatbots could significantly improve customer experience while reducing costs for the company. These cost savings are explained by the use of natural language instead of complex computer codes for coding purposes, which should improve content creators' productivity, by 20% to 45% of current annual spending or a midpoint of 32.5%

In other words, it means that AI can improve engagement while at the same time improving productivity.

Next, to value the stock, I consider that in addition to being an operating expense, the developer exchange fees are an investment for generating additional revenues. Thus, for FY-2023, $800 million in fees should generate $3.42 billion . Making use of historical figures, I calculated $538.7 million and $623.8 million as developer fees for FY-2021 and FY-2022 respectively (from the quarterly figures in the above chart) before the jump to $800 million expected for 2023. Now, assuming expenses of $1 billion on fees for fiscal 2024, this should generate revenues of $3.94 billion according to estimates by analysts.

However, this figure does not include productivity gains obtained by applying generative AI and, just for software coding which is a key component of game production, productivity gains of 32.5% are possible as evoked earlier. Now, when adding 32.5% of productivity to $1 billion, this comes to $1.325 billion (1 billion x 1.325) as shown in the table below.

This is as if $1.325 billion is spent on fees instead of $1 billion, and translates into sales of $5.22 billion ((3.94/1000) x 1325)) instead of the $3.94 million expected. As a result, the price to sales is lowered to 3.6x (3.94/5.22 x 4.77) or by 24.5%. However, this is not sufficient to weigh on valuations as Roblox is already more than 600% overvalued to the sector. This explains my Hold position.

Risks and Key Takeaways

It is precisely because of this high degree of overvaluation that the stock is seen as a risky investment. Still, the above calculation does not factor in a potential increase in sales thanks to the Facebook collaboration. As such, any revenue increase will further reduce the P/S ratio which should in turn decrease the degree of overvaluation.

Furthermore, the company’s performance is also flagged as bearing high risk, especially in light of its profitability which is attributed to a score of F . Now, it is true that this is a loss-making company with operating losses of $923.8 million in fiscal 2022 compared to $390.6 million in fiscal 2021, but, its balance sheet boasts a cash balance of $3 billion implying that it is under no pressure to contract debt at the high prevailing interest rates. Also, the fact that it has been generating cash from operations which amounted to $369 million during the last quarter is another positive.

In this respect, the use of artificial intelligence for avatars could significantly increase engagement. Now, an avatar is a representation of someone on the platform, and through the use of AI-generated images , one can create his or her own custom avatar after uploading a picture. This also brings monetization opportunities and there are other scenarios where through the creation of artistic images or visuals, Generative AI could attract more people to the platform. Additionally, the company already leverages previous flavors of AI, namely machine learning, for example, to auto-translate creators' experiences.

In conclusion, by focusing on customer engagement and valuing it from the AI perspective, and also highlighting the collaboration with Meta, this thesis has shown that Roblox is on a path to growth with its focus on social experiences and user-generated content. In addition, there is also immersive advertising which is now live "in an early form" with over 200 brand activations with the first sales dollars planned for this year itself since advertisers include NARS Cosmetics, H&M, Spotify ( SPOT ), NASCAR, and iHeartRadio. An announcement as to expectations will be made during Investor Day on November 15 . Therefore, depending on the demand for advertising, the stock could see an upside.

As for profitability, operating loss will be contained only if bookings growth exceeds the rate infrastructure expenditure is growing and this is expected for the first quarter of 2024. Still, since the company "continues to hire a lot of people" as per the CEO, more value-focused investors may have to wait for margins to improve in a sustainable manner. Therefore, there may be further volatility in the stock when third-quarter results are announced around November 8. Thus, Roblox stock is not a buy currently.

Finally, for those with a longer-term focus, this is a cash-generating business and the balance sheet is healthy enough to continue funding the capital required for this engagement-led business model as it advances towards its objective of connecting 1 billion people daily.

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