Imagine a virtual world where people live, work, shop, and interact with others – all from the comfort of their devices in the physical world. This is known as the metaverse.
If you haven’t heard of Roblox, then I’m almost certain that some of your younger relatives have. Roblox is an early implementer of the metaverse. It operates an online video game platform that lets young gamers create, develop, and monetize games (or “experiences”) for other players.
The firm effectively offers its developers a hybrid of a game engine, publishing platform, online hosting and services, marketplace with payment processing, and social network. The platform is a closed garden that Roblox controls, earning revenue in multiple places while benefiting from outsourced game development. Unlike traditional video game publishers, Roblox is more focused on the creation of new tools and monetization techniques for its developers than creating new games or franchises. Roblox is increasingly focused on creating a metaverse that moves beyond games toward experiences like concerts, education, and even business management.
There is no cost to try Roblox or the vast majority of its user-developed games. To drive booking growth and keep the model churning, new Roblox users must purchase and spend the platform’s currency: Robux.
Roblox heavily benefited from the stay-at-home restrictions at the start of the pandemic with very impressive revenue growth (55% per year), even more so than its video game peers. It expanded its user base from 19.1 million daily active users, or DAUs, in the fourth quarter of 2019 to 58.8 million in the third quarter of 2022. Analysts project that the combination of popular games and a large user base will attract more users. Additionally, they expect that the firm will be able to further increase its penetration in non-U.S. markets.
According to Roblox data, Philippine users were the fourth highest in the world in spending time connecting and creating on the platform in 2021. This reflects Roblox’s status as a major social hub in the country and in certain other markets. A presence on the top 10 list indicates that at least hundreds of millions of hours were spent on the platform, with the top seven countries surpassing one billion hours.
Analysts expect that, going forward, growth will be slower than during the pandemic, but that DAUs will exceed 72 million in 2025.
Over the next five years and more, analysts assume the firm will continue to invest in adding new features to help keep both developers and older teenage gamers engaged with the Roblox platform. While an all-encompassing metaverse may be very far from realization, they think that Roblox’s steps toward a metaverse will help the platform hold on to users and developers as they grow older.
What is Roblox’s competitive advantage?
Roblox’s competitive advantage comes from its network effect. A network effect is a phenomenon where the value of a product or service increases as the number of its users grows, and this helps a company grow its advantage over competitors.
The Roblox platform consists of three separate pieces that work together. The first is the Roblox Client, which players use on PCs, Android, iOS, and Xbox One to play games, connect and chat with friends, and make purchases. Roblox Studio, the second piece, is the development environment for users to create, publish, and operate their games. The final piece is Roblox Cloud, the infrastructure for both online games and development.
Roblox doesn’t generate revenue from the sale of the Roblox client, games, or server space, but through in-game transactions, avatar cosmetics, private servers, subscriptions, premium development plugins, and advertising for developers. All of these transactions are done in Robux currency that can be purchased at multiple price points. Roughly 90% of Robux currency is spent within three days of being purchased.
Robux currency spent in games is split among three groups – app stores and payment processors, developers, and Roblox. Developers receive payment in Robux currency, not local government currency. The developer can either use the Robux currency to buy development plugins, bid for advertising for their game within other games, or use the Robux currency to buy other games.
Roblox’s network effect advantage comes from its unique business model. By providing a game engine, tools, and servers along with monetization opportunities, Roblox offers a tempting starting point for young gamers who are interested in creating games with a relatively simple to use game engine along with a robust set of tools and tutorials. The library of user-developed games attracts more young players who spend money in-game. The growing user base along with the ability to monetize games entices more developers from not only the current player base but also experienced developers, brands, and celebrities looking to market to younger users. Examples of the brands and entertainers using the Roblox metaverse include Netflix, which launched games around its Stranger Things franchise, and Lil Nas X, who hosted three concerts in November 2020 on the platform.
More recently, on November 3, 2022, Filipino-American fashion designer Josie Natori and the House of Blueberry (HoB) announced the design and launch of a digital fashion collection that combines Natori’s iconic designs with the magic of the virtual world for all avatars in Roblox.
The collection features printed robes, matching sets, earrings, sunglasses and four new hairstyles, all brought to life with Natori’s East meets West ideals. The Natori showroom has also been reinvented on Roblox in “Blueberry World,” filled with avatars decked out in signature Natori patterns and silhouettes.
Additionally, the social aspect of the Roblox Client helps to reinforce the networks as the relatively young players entice their friends to join Roblox and play the games together. Players can use Robux currency to create a private server to ensure that their friends and themselves can play an instance of a specific game.
Roblox’s ability to grow bookings per DAU, while massively expanding the user base in a highly competitive video game landscape, reveals the strength and advantage of the network effect.
What is Roblox’s estimated fair value?
According to the top fundamental investors over the ages, the fair or intrinsic value of a business is the present value of the future free cash flows it can generate. Free cash flow is the amount of cash generated that is free and clear of all internal or external obligations. The higher the future free cash flows, the higher the fair value, and vice versa.
At the heart of my industry-standard valuation model is a detailed projection of a firm’s future free cash flows, resulting from independent and fundamental research. This is used by analysts from the most reputable brokers, institutions, and research firms around the world.
The data sources and inputs below were used to determine Roblox’s estimated fair value.
The calculations below show how Roblox’s estimated fair value was arrived at by discounting its future free cash flows to their present values using the two-stage method. I use analysts’ estimates of free cash flows over the next 10 years for the first stage.
The second stage assumes that Roblox grows at a stable rate into perpetuity. The calculations below show how Roblox’s perpetual growth, or terminal value, was arrived at by discounting its estimated tenth year free cash flow to its present value. This is then added to the present value of the 10-year free cash flows to arrive at an estimated total equity value and equity value per share.
The calculations show that Roblox’s estimated fair value is about US$36.6 billion or US$61 per share.
What are driving Roblox’s free cash flows and fair value?
Despite not posting positive earnings, the firm has been generating positive operating and free cash flows.
Analysts project that bookings will grow 16% annually over the 10-year free cash flow forecast. The growth in bookings will be driven by continued expansion of the user base, with annual growth increasing daily average users to about 140 million in 2031. This growth will be propelled by the firm’s network effect, as the current user base continues to attract more developers who create new games that attract more users. The social aspects of playing with friends will also help to expand the base. Analysts also expect continued growth in monetization. They project that average bookings per DAU will, however, drop over time as the new user mix shifts towards emerging markets that have lower purchasing capacity. Growth will also be driven by a slight increase in the age profile of users and by more diverse and complex games. They expect growth in the latter to also come from advertising and branding.
What are the risks?
Roblox operates in a highly competitive marketplace, against firms with more financial and development resources. While Roblox’s platform is a unique offering, the firm still competes with video game publishers both to attract new users and to hold on to their current players as they grow older. A key driver to the firm’s long-term growth will be keeping younger users as they age into and out of their teen years. Over two-thirds of users are under the age of 17 and around half are under 13 years old.
The young user base could also bring increasing regulatory enquiries as parents and authorities have historically been very concerned and vocal about games with very young users, particularly ones that allow chat, user-created content, and randomized in-game purchases. This additional scrutiny could force the firm to invest further in both algorithmic and human moderation, limiting the margin expansion.
Further moderation costs may be required to police the user content that infringes on intellectual property (IP) from multinational companies like Disney, WarnerMedia, and others. Many popular games on Roblox use copyrights from Marvel, DC Comics, Star Wars, and other major franchises without seeming to be licensed. If the firm would like to work with these IP holders to create unique games or spaces, Roblox will likely need to crack down on these games, which could cause players to leave the platform.
Is Roblox financially healthy?
Roblox’s balance sheet is sound. The firm has over US$3 billion of cash and equivalents, which is more than enough to cover its debt of US$989 million as of September 2022. The firm also generated US$56.9 million in free cash flow in the latest 12 months ending September 2022. Given the cash position and the cash flow generation, analysts believe that Roblox can issue a significant amount of debt in order to fund any potential acquisitions, though they don’t believe management is currently looking to make any large-scale purchases.
What optimistic analysts say
- Roblox is uniquely positioned to take advantage of the trend toward increased screen time among younger consumers.
- Roblox’s business model allows the firm to self-finance from its large pile of available cash and growing positive free cash flows (35.4% per year), while it focuses on expanding its subscriber base and monetization.
- Roblox will benefit as its user base grows older and has more disposable income.
What pessimistic analysts say
- Roblox’s tremendous subscriber growth was highly stimulated by the pandemic. A return to less restrictive lockdown guidelines globally will cause a major decline in user growth and monetization.
- Roblox’s model will invite regulatory scrutiny and force the firm to spend more money on moderation, limiting margin expansion.
- Roblox’s competitors have more development resources and offer games with better graphics and deeper gameplay. As Roblox users grow up, they will leave the Roblox metaverse for other gaming experiences.
Is Roblox trading at a discount to its estimated fair value?
The calculations below show how Roblox’s current discount to its estimated fair value and downside margin of safety were arrived at by comparing its estimated fair value and its downside margin of safety value, to the current market price. The downside margin of safety considers any uncertainty and miscalculation in estimating fair value, and aims to minimize potential losses.
As of November 11, 2022, Roblox’s share price of US$36.74 is trading at a 39.7% discount to its estimated fair value and a 24.7% discount to its estimated downside margin of safety value. These indicate that the market may be significantly undervaluing and underestimating analysts’ expectations about Roblox’s future growth.
The insight
In my opinion, Roblox’s upside potential is attractive, based on its current share price’s significant discounts to its estimated fair and downside margin of safety values.
The fundamental driver of a business’ future free cash flows and, ultimately, its fair value is the rate at which it is growing its revenue, earnings, capital base, and returns on capital. A business that increases its future free cash flows and earns higher returns on capital will be worth more.
Business decision makers and investors who use the discounted cash flow approach to valuation, focusing on increasing long term, future free cash flows, will ultimately be rewarded with higher share prices.
About the Author
US-based Eric Jurado is a contributor to The Independent Investor. He is an international investor, investment fund manager, and author. Eric’s news blog, The International Investor provides investment intelligence across businesses, industries and continents.
Disclaimers:
The author has no position in Roblox. The content is sourced, excerpted, and edited from analysts’ notes and S&P Global Market Intelligence. It is for informational purposes only and is not investment advice.
The information contained in the said content represents the views and opinions of the author and do not necessarily represent the views or opinions of The Independent Investor or its affiliates.
The Independent Investor hereby disclaims any and all liability to any party for any direct, indirect, implied, punitive, special, incidental or other consequential damages arising directly or indirectly from the content, which is provided as is, and without warranties.