Enthusiast Gaming (NASDAQ:EGLX) recently reported first quarter 2022 results. To say that the numbers were impressive would be an understatement: They were phenomenal, even surprising management. My intent with this article is to highlight and then go into some detail regarding the headline numbers. Bottom line up front: EGLX continues to improve margins every quarter. On top of phenomenal revenue growth, this puts them on the cusp of being EBITDA positive. Q1 posted an all-time high for gross profit in spite of it being the seasonally weakest period of the year while operating expenses have finally flattened. 2022 may be the turnaround point for the stock.
For those unfamiliar with the EGLX business model, they make money primarily through selling ad space on their digital properties, all of which are related to video gaming. Smaller portions of revenue come from subscriptions to their webpages, monies made from hosting video game conferences, or small transactions for in-game use. Revenue growth has been sensational since they went public in 2018 as they have acquired more and more revenue-generating assets. Here are quarterly top-line numbers for the past two years, with comparable quarters shown side-by-side:
|(millions)||Q1 22||Q1 21||Q4 21||Q4 20||Q3 21||Q3 20||Q2 21||Q2 20|
*Data compiled by author
Gross profit has been even more impressive on the back of consistent margin expansion:
|(millions)||Q1 22||Q1 21||Q4 21||Q4 20||Q3 21||Q3 20||Q2 21||Q2 20|
*Data compiled by author
Gross profit outpacing revenue growth is a result of more and more of their revenue coming from higher-margin compartments, that of direct sales and subscriptions. Those jointly made up $8.5 million or 18% of revenue in Q1 2022 vs. $4 million or 13% of revenue in the comparable quarter of 2021.
The most encouraging part of their financial report, in my opinion, was that operating expense has finally leveled out, even decreasingly slightly from the sequential prior quarter. It would appear as though the company has hit a critical mass and can sustain operations from ~$25 million worth of expenses per quarter. Management has highlighted this as a baseline looking forward, saying:
...we have entered a period of stability and operating expenses. OpEx is very stable.
It was on that matter that the CFO gave a resounding "yes" to the question of if they would be cash positive next year. They're on track to quickly hit the milestones of EBITDA positive, then cash positive, then earnings positive.
Other matters worth a few paragraphs:
1) Glaringly absent from the commentary during the conference call was anything to do with their gaming social network under development, "project GG," or their "pan-enthusiast" subscription offering. Both were focal points in prior calls. I assume that they have steered away from a focus on either, as perhaps they're realizing that the juice isn't worth the squeeze. I wish they were being more transparent on the status of those initiatives. Clarity either way would bolster the investment thesis. I for one appreciate when management candidly explains when they're shrugging off agendas they were previously excited about. Hopefully, it means that associated expenses will fall off. I'm fine with management throwing things at the wall to see what sticks, proverbially. But if it doesn't stick, I want them to explain as much.
2) Of note was the percentage of revenue that was attributable to repeat customers. Analysts have routinely asked about the stickiness of the business model and if customers are just "trying out" the EGLX platform. In Q1 of this year, 65% of the direct sales revenue was from renewals with existing customers vs. 42% last quarter. This speaks to the value that clients find by partnering with Enthusiast. Elaborating on this point, CEO Adrian Montgomery said:
...deal size among our renewals on average is larger than deal size for new customers. Again, this is a very important metric for us to watch, as it continues to demonstrate to us the value that our flywheel of services we offer brands is helping them convert their spend with us into new customers for them.
The company also announced an exciting line-up of new customers brought on in the quarter to include Hut 8, the FDA, Coca-Cola, Toyota, Puma, Wendy's, Fidelity, Lionsgate, and Red Bull. I find this list of new customers more compelling than the list of repeat customers, which consisted of the United States Navy, HBO Max, the Truth Initiative, DoorDash, e.l.f Cosmetics, and H&R Block. The new customers are larger and more established, on average, with very deep pockets. As these transform into renewal customers, considerable profits to EGLX will result.
3) EGLX also announced a new channel through which they will present content and therefore be able to utilize as advertising, that of TikTok. Though still in the early stages, this is a huge opportunity given how massive TikTok is. With 1 billion monthly active users and No. 1 on engagement among all social media (among a host of other impressive stats), tapping into TikTok could put lots more money on the topline.
4) I was on the conference call and had the chance to ask two questions that I want to briefly mention. First is the issue of return-on-ad spend (ROAS), or how much revenue companies are generating per $1 they spend on advertising when they advertise within the circle of EGLX properties. A commonly accepted benchmark for "worth it" in terms of return-on-ad spend is 4:1, or $4 in sales from every $1 spent on ads.
This can be a tricky metric to measure since it's extremely difficult to determine how many and to what extent each dollar in sales is a result of a particular advertising campaign.
Also, comparing return-on-ad-spend across mediums (radio, tv, etc.) helps inform to which those ad dollars should be devoted, but that matter is complicated by the fact that different demographics favor different mediums, so the demographic you are trying to target matters a lot. In a word, return-on-ad spend is complicated. Perhaps that's the reason I have yet to get a straight answer from Enthusiast regarding the ROAS their partner companies are seeing when advertising with them. Instead, they pointed to a couple important indicators that are worth digging into.
The first is viewability. This is a measure of how often ads actually end up in viewable form in front of a human being. EGLX is boasting 90% viewability on their YouTube inventory. The second is completion rate, or a measure of how often a video ad gets played to the end. EGLX also is citing a 90% completion rate on YouTube. Both of these measures bode well for how effective EGLX is as an advertiser.
The second matter I brought up on the conference call is how EGLX might be able to avoid the seasonality typical to traditional advertisers, where Q1 is the slowest quarter of the year and things pick up steam to peak in the Q4 holiday spending season. The CFO, Alex McDonald, referenced generally how advertisers might see 15% of annual revenue in calendar Q1, 25% in each of Q2 and Q3, and then 35% of business in Q4. However, I believe EGLX sees themselves and is trying to show that they are not a traditional advertiser. One thing that may help them smooth out seasonality is the fact that major video gaming events happen at various points throughout the year, and companies may be eager to advertise around these events to get their products or services in front of lots of target eyeballs at that time. Two such events are championship-type competitions for various gaming titles and slates of industry expos. In fact, the return of "Pocket Gamer Connects London," a mobile gaming industry conference, in Q1 of this year was no doubt part of the reason they had such a fantastic quarter.
I want to approach valuation from a couple of different angles. First, I want to take what the CFO said about typical seasonality in the ad business and then extrapolate that onto what might happen this year if his generalization holds true (all numbers are in Canadian dollars).
Recall that he mentioned 15% of business falls in Q1 then 25% in each of Q3 and Q4 and the remaining 35% in Q4. With a gross margin that expands ~50 bps each quarter, the base line they have expressed for the remainder of the year, the results are shown in the following chart:
With ~$25 million in quarterly OPEX, that would put them within a spitting distance of profitability. However, a significant chunk of OPEX is owing to stock-based compensation and depreciation/amortization. Taking out non-cash expenses in Q1 would result in $18.7 million in expenses. Calling it $19 million per quarter for simplicities sake ($76 million total), the above results would yield $16.6 in adjusted EBITDA, or $0.11 per share for the full year. At current trading levels that would represent a forward price/adjusted EBITDA ratio of 21.
A more conservative approach would be to take revenue growth from Q1 of 57% and copy/paste the same results onto each quarter for the rest of the year with the same gradually expanding gross margin, shown below:
Under the same cash OPEX assumptions of $76 million for the full year, there would be $1,246,073 in adjusted EBITDA, about a penny a share.
Both of these approaches are short-term in nature. I'm a long-term investor. Putting together a model that paints a picture of business results five years down the road is more my style.
My required rate of return is 12%. To get that from EGLX at current trading levels, they would have to be trading at CAD$5.28 at this time in 2027 to bring me that. At a reasonable adjusted EBITDA multiple of 20, that would require them to generate adj. EBITDA of CAD$0.26 at that time. With gross margin that gradually expands up to 35% in the next five years and cash operating expenses of $85 million (growing by $1 million each year to support growth), revenue would only have to grow by ~14% annually from TTM revenue of $184.5 million to get to the $350 million in sales needed to get the CAD$0.26 in adj. EBITDA per share. Here is all that in a table:
I'm of the personal opinion that growing revenue by 14% annually for the next five years and expanding gross margins by 640 bps up to 35% over the same time frame is very achievable for EGLX. It might not look exactly like this. Maybe margins will be weaker but revenue growth will be stronger, or vice versa. The numbers aren't supposed to be exact. Rather, it becomes clear that EGLX doesn't necessarily have to knock it out of the park in order for investors who buy now to realize returns in excess of long-term stock market averages, which I peg in the ballpark of 7%-10%.
As always, a discussion of risks is necessary. The biggest threat I see to EGLX is the possibility that an economic slowdown will exhaust businesses' appetites to spend on advertising. Between the war in Ukraine, blistering inflation, and persistent supply chain issues from the COVID lockdowns, there are lots of things putting pressure on the economy. The stock market has been swooning under these pressures lately, and if a full-fledged recession emerges that may bode poorly for EGLX.
Every conference call management sounds increasingly confident about near-term profitability. The naysayers of the business model have put tremendous downward pressure on the stock price, at $2.34 currently, since it reached an all-time high in excess of $8.00 per share back in April 2021. But I believe that those naysayers are running out of any evidence supporting their pessimism. How many sequential quarters of improving gross margins need to stack up before admitting the strength of the business model? On top of year-over-year revenue growth that has never been less than 30%, the bull case is very robust.
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Disclosure: I/we have a beneficial long position in the shares of EGLX either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.