$SKLZ | Skillz : Analysis and Insights - Septum Insights

Skillz offers one of the most compelling business models we have seen in over 20 years of equity research, with a substantial technological advantage over its better capitalized competitors forming a competitive moat that should allow it to grow rapidly for the balance of this decade.” - Wedbush Analyst on Skillz, Jan 2020

Introduction

To fully comprehend the power of the Skillz platform, we need to look at the core of what drives the continued growth of the platform. At the core of it lies two acquisition funnels and a userbase that can be thought of as a pyramid with varying skill levels with the apex layer representing the most skilled gamers who are also most engaged. The selection efficiency of the funnels and the not so easy task of keeping users in all layers of the pyramid engaged dynamically is ensured by Skillz’s patented AI algorithms using billions of data-points generated by the games on the platform.

Out of the two acquisition funnels, one is the classic user acquisition funnel for the Skillz games driven by their sales and marketing spend. However the second acquisition funnel makes Skillz unique as a mobile gaming company versus other game development companies. The second funnel is for adding mobile competitive games from qualified third party developer on the Skillz platform and then progressively nurturing the growth of the high potential ones. This funnel can be operated by Skillz at a low variable cost because the cost of development of games and the burden of creativity in making the games engaging lies with the game developer and not Skillz. Also, as we will see later in the article, this funnel offers some unique advantages to Skillz where they can identify a potential hit game in the early stages of its adoption cycle by gamers and then invest selectively in those specific games, thereby creating a funnel progression effect where the better performing games come out of the funnel as the Top Skillz Games like Solitaire Cube, Blackout Bingo, Pool PayDay etc. By this process of nurture and evolution, the top games become large enough to drive majority of Skillz revenues while the games that are yet to show the early promise continue to operate with a much smaller userbase while trying to innovate and experiment till they reach their potential and demonstrate above average metrics like Customer LTV ( Life Time Value) , low customer acquisition cost and high level of user engagement. The two funnels ( user acquisition and game evolution) work in tandem with each other fostering a environment where Skillz can achieve a industry leading high Customer Life Time Value greater than 4 for its games enabling it to continue increasing its spend on user acquisition and ultimately driving high revenue growth at 95% gross margins.

Lastly the pyramid shaped user ecosystem is created with super users who have achieved a high game skill level at the top of the pyramid and the newer players at the bottom layer of the pyramid. The middle layer of the pyramid are engaged paying users that are trying to move upwards in their skill levels and trying to improve the win rates. Skillz uses patented player matching algorithms for gameplay and along with player fraud prevention, both are critical to ensure the userbase at all layers of the pyramid remain engaged in the games and find the system fair and acceptable for them to make cash bets for their competitive games. The algorithms ( fine tuned over years of machine learning from game data) are key to maintain this balance across various layers of the pyramid, because players will churn fast if they keep losing due to wrong matching with another more skilled player. The dynamics of keeping all layers of the pyramid engaged, avoiding unfair and fraudulent play and not letting super skilled users win all the money from other lesser skilled players is key here for user retention and driving the frequency of games per user . Skillz has perfected these algorithms over time with usage of more and more gaming data from competitions on their platform. This is one reason why Skillz has been so hard to beat over longer periods of time by any company that has tried to emulate their model till now.

But before we dive into core competitive aspects of the model let us understand Skillz as a company better

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A. What is Skillz?

Skillz was founded with the belief that everyone loves to compete. The broad vision of Skillz is to build the competition layer of the internet by re-inventing competitive mobile gaming. To achieve that vision, Skillz has built a proprietary patent protected skill based mobile gaming platform that enables third party mobile game developers to integrate their respective games with the Skillz platform features that enables competitive gaming that is fair, fun and rewarding. Skillz has developed this eSports platform connecting game developers with game users through multiplayer competition that enables monetization for the developers while letting users win monetary rewards based on competition outcome.

Developing Skillz Games

Skillz provides a Software Development Kit (SDK) that game developers can integrate with their games to enable the features provided by Skillz platform. This software integration is fairly simple and based on some reports, it can be accomplished in a day or two. These games that are developed using Skillz begin as “Free to Play” games but once they meet certain well defined criteria, the games can provide “Prize” competitions to the users where each user can wager a certain amount of money for each competitive game and win a certain reward ( monetary or otherwise) based on outcome of the competition. These competitive tournaments can be one to one or may involve several players competing for a reward.

The criteria that a Skillz game needs to meet before it can host Prize based tournaments featuring player entry fees on the Skillz platform are as follows -

  1. Competition must be skill based and this is determined by Skillz patented algorithm. ( US Patent Number : US9446315B2). The use of patented algorithm reduces the randomness in the Skillz games and ensures that the game is compliant with the regulations that allow skill based cash tournaments.
  2. Game should be free of glitches.
  3. Game should have at least 4-Star and above average rating in the relevant App Store
  4. Game should have at least a 100 or more Daily Active Users

Once the game meets all the above criteria, it can host the tournaments that allow players to compete after paying a fee for each game and then win rewards based on the outcome of the competition. This then allows both Skillz and the game developer to share a part of cash raised from player fees and thus monetize the game.

Is it Gambling?

Skillz offers only skill-based games in its paid entry fee games and do not provide games whose outcome (win or lose) depends on chance ( like a Slot Machine). The broad definition of whether a game constitutes gambling involves three criteria:

  1. a Prize
  2. Paid-in consideration
  3. An outcome determined by chance

If ALL of the above three criteria are not met, then it is usually not considered gambling. For Skillz, the third criteria is not met as Skillz game focuses on making the outcome skill based and the patented algorithm is used to minimize the randomness in the game.

In US, each State decides whether to allow skill based cash reward games and also decide what types of games require a gambling license. Skillz offers the skill based cash tournaments only in states that allow these games to be played. 41 U.S. states and the District of Columbia allow such types of skill based cash reward games, which account for roughly 90% of the U.S. population on a combined basis.The states in which Skillz does not offer cash prizes are Arizona, Arkansas, Connecticut, Delaware, Louisiana, Montana, South Carolina, South Dakota, and Tennessee.

Skillz uses geofencing through the applicable user’s smartphone to restrict access to its paid entry fee contests to only those jurisdictions where such contests are permitted.As a result, device location settings within that smartphone have to be enabled. In addition, all Skillz gamers who enter into a paid contest must be at least 18 years old, although players of all ages can play it's free-to-play experiences.

Components of Skillz Platform

The Skillz platform consists of Live Operations, the Gamer Competition Engine, the Developer Console, the Payment Infrastructure, and Data Science.

  1. Live Operations :
  2. It is a highly-automated proprietary solution centered on driving user retention and engagement throughout the lifecycles of the platform’s games with significantly-reduced burdens around human capital and technological expertise from the perspective of developers. It assists with the introduction, presentation, and timing of events (including brand and influencer-sponsored events) and tournaments, as well as the merchandising of the in-game Ticketz store, which allows players to redeem prizes with the Ticketz currency earned through entry fees. Within LiveOps, the segment manager tool administers systems settings for users, determining items such as the achievements, deposit offers, incentives, and promotions that are presented at various times, as well as tournament availability for each player.

  3. Gamer Competition Engine :
  4. The Gamer Competition Engine is an end-to-end technology platform that is used to improve engagement, gameplay experiences, retention, and revenue, with a particular focus on the fair and timely matching of players in order to keep them within Skillz games. Developers access the Gamer Competition Engine, among other items, through Skillz’s software development kit (“SDK”), which plugs into the games and includes over two hundred features in a compact sub-15-megabyte package.It can be implemented by an average game developer in roughly one day. The content receives over-the-air updates on a continuous basis thereafter, and allows Skillz and its developer partners to update games on the fly. The social features within the SDK include in-game chat, friends leagues and tournaments, and the ability to highlight Skillz to the player’s social network.

  5. Developer Console :
  6. The Developer Console allows developers to quickly integrate content and monitor game performance through analytics centered on monetization and user behavior.

  7. Payment Infrastructure :
  8. Skillz’s Payment Infrastructure allow users to put money into and take money out of the platform in a reliable and timely manner. The importance of the Payment Infrastructure has led Skillz’s CEO to describe the company as “building a financial payment system that video games are sitting on top of.” In total, the company analyzes seventy payment transactions per second.

  9. Data Science :
  10. Data Science includes algorithms and machine learning technologies with anti-cheat, anti-fraud, and player matching, rating, and segmentation features, with the first two features particularly important to the company given its focus on fair competition and trust. The company’s Data Science technologies allow it predict the user’s probable next outcome and flag outliers. This technique has dramatically increased the difficulty of successfully cheating among bad actors, which has boosted the appeal of Skillz among the broader, largely well- intentioned gaming community. Skillz has identified 65 behavior sets among its player base, which it leverages to accentuate personalization. The company views its technological capabilities as industry-leading, as a key point of differentiation, and as an important driver of growth. At present, the company analyzes over three hundred data points from each game play session, which translates to over 1.5 billion data points each day from an implied over five million game play sessions.

Skillz Tournaments

Skillz offers a variety of tournament formats and hundreds of games on its free-to-play platform.Tournaments can be as small as one-on-one (head-to-head) competitions involving two players and can be as large as 32 players in a “bracket”-style tournament. The most popular tournaments are head-to-head and offer entry fees as low as $0.60; several other formats offer entry fees of $3, $6 and $12 and typically involve four or more players with prizes of $34 – 65.

Making Money

Skillz generates revenue through the receipt of a portion of the player entry fees generated in the paid contests that it hosts, net of the profit paid to game developers, end-user prize money, and certain end-user incentives.The economics of a generic transaction on the platform in 2019 are as follows. Gamer 1 (the winner) and Gamer 2 (the loser) wager $0.60 apiece to compete in a game against each other, creating a gross cash value $1.20 for that one competitive game. Of that amount, $1 goes towards the prize for the winner. Skillz typically retains the other $0.20 and sends about $0.04 to the developer. The remaining funds – about $0.16 per tournament – is booked by Skillz as revenue.

Popular Games

Skillz has over 9000 Game Developers who had launched a game integration on Skillz Platform and have 34 games so far that had $1 Million+ in Gross Market Place Volume (GMV). Skillz’s gross marketplace value (GMV) is the total amount contributed by players. Top grossing games as of Sep 2020, are Solitaire Cube, Blackout Bingo and 21 Blitz. Other popular games are Pool Payday, Dominoes Gold, Chip Ganassi Racing Blitz, Bubble Shooter Tournaments, Bubble Shooter Arena, Strike by Bowlero, Big Run Solitaire etc. These are mostly mobile games in Hyper Casual Category. Genres of Skillz games mostly are : Board,Card, Sports, Puzzle,Word etc.

B. Business Model

The underlying business model for interactive entertainment is audience x monetization. And while Skillz’s end market is mobile gaming, its model differs vs. traditional mobile game publishers. To start, Skillz operates a competition-based, multiplayer platform, that drives engagement through competition, whereas most mobile game publishers attract/retain players with additional content and events, relying on what management has described as the, “content treadmill”.

Skillz players submit to tournament entry fees,while mobile game publishers generate the majority of their bookings through in-app purchases and typically monetize less than 5% of the playing population, in addition to advertising. Skillz has characterized these business models as “static”, creating friction across the user experience.

Skillz does not develop the games it hosts on its platform, nor does it pay platform fees (to Apple, Google, et al.), which yields a gross margin of 95%. In contrast, while most mobile game publishers develop their games (and thus own the IP), they also pay digital platform holders a 30% fee, and thus the gross margin is below 70%.

Because Skillz’s monetization is unique, typical mobile game metrics like MAUs and ARPU are, perhaps, less important. What is, perhaps, more important are:

  1. converting new players to paying players,
  2. growing the number of tournaments per player, and
  3. increasing the revenue per tournament.

About 95% of Skillz’s revenue flows to gross profit (with about 5% paid for payment processing and customer support). Contribution profits exclude user acquisition costs and run about 35% (but can expand further as fixed costs are amortized over a larger pool of revenues).

Skillz has about 2.6 million MAUs on the platform. If we look at the last seven quarters – from 1Q19 to 3Q20 – MAUs, GMV, revenue and contribution profits have more than doubled. In 3Q20, MAUs reached 2.69 million,GMV exceeded $410 million, revenue hit $60 million, and contribution profit approached $20 million.

C. Financials and Estimates

Revenue

Skillz generates revenue through paid contests offered on its platform. It keeps a percentage of the entry fees for these paid contests after deducting the applicable developer’s profit share, end-user prize money, and certain end-user incentives. For the period ended September 30, 2020 and in 2019, cash deposits represented roughly 11% of total entry fees, with prior cash winnings that had not been withdrawn at roughly 82%, and end-user incentives at roughly 7%. The developer’s profit share is based upon entry fees paid by net cash deposits adjusted for certain costs that are incurred by Skillz for its monetization services. End-user incentives are recorded as a reduction of revenue if Skillz believes that the applicable game developer had a valid expectation that certain incentives would be offered to end-users. If Skillz believes that there was not a valid expectation of the incentives being offered, they are booked to sales and marketing expense instead.

The company typically withholds 16 – 20% of the total entry fee as a commission, and gets around 14% of the proceeds. The delta between those ranges reflects the actual payment to the developer, which is a single-digit percentage of the proceeds, although developer agreements can impact total compensation. Skillz handles payments to developers and players as well. Revenue is recognized upon the completion of a game. At present, advertising represents an immaterial portion of total revenue.

Expenses

  • Cost of revenue Cost of revenue includes amortization of internal use software, customer support costs, direct software costs, payment processing fees, and server costs. Skillz’s cost of revenue represents a much lower percentage of revenue than the standard mobile industry platform fee of 30% as the distribution platform partners do not receive any share of end-user deposits. Instead, they receive a fee for end-user deposits made through their own payment systems, if applicable.
  • Research and development Research and development expense includes software development costs (mainly for product and platform development), personnel-related expenses (benefits, salaries, and stock-based compensation), and the allocation of maintenance, rent, and utilities costs based upon headcount.
  • Sales and marketing expense Sales and marketing expense includes direct advertising costs, discretionary end-user incentives, personnel-related expenses (benefits, salaries, and stock-based compensation), and the allocation of maintenance, rent, and utilities costs based upon headcount.
  • General and administrative General and administrative expense includes personnel-related expenses (benefits, salaries, and stock-based compensation for the administrative, corporate, executive, and finance teams), outside professional services expenses, and the allocation of maintenance, rent, and utilities based upon headcount. General and administrative expense is expected to increase for the foreseeable future due in part to the costs associated with being a publicly-traded company.

Key Metrics

  • EBITDA EBITDA reflects net income or loss before depreciation and amortization, other non- operating income or expense, and income taxes.
  • Adjusted EBITDA Adjusted EBITDA reflects EBITDA adjusted for stock-based compensation and other special items, including fair value adjustments for certain financial liabilities and impairment charges.
  • Monthly active users (“MAUs”) Monthly active users reflects the number of end-users who entered into a free or paid contest on Skillz’s platform at least once in a month averaged over each month in the period (typically a quarter). In 2019, 10% of the company’s monthly active users participated in paid contests, meaning that the vast majority of the player base opts for a more traditional free- to-play experience.
  • Paying monthly active users (“paying MAUs”) Paying monthly active users reflects the number of end-users who entered into a paid contest on Skillz’s platform at least once in a month averaged over each month in the period (typically a quarter).
  • Average revenue per monthly active user (“ARPU”) Average revenue per monthly active user reflects the average revenue in a given month divided by monthly active users in that month, averaged over the applicable period.
  • Gross marketplace volume (“GMV”) Gross marketplace volume reflects the total entry fees paid for contests that are hosted on the Skillz platform. Total entry fees include cash deposits, prior cash winnings that have not been withdrawn, and end-user incentives.
  • Take rate Take rate reflects the percentage of the entry fees for paid contests that Skillz retains after deducting end-user prize money, end-user incentives accounted for as a reduction of revenue, and the profit share that is paid to developers.

D. Potential Upside

Skillz financial forecasts do not include potential upside from a number of incremental opportunities. However there are several potential upsides that has a good chance of getting realized resulting in incremental revenue to Skillz.

  1. Brand Sponsorships
  2. Users pay cash to play tournaments and win prize money based on outcome of competition. Skillz returns a major share of the fees collected per tournament back to the winner while keeping a smaller share as its take rate after deduction of payment processing fees and developer share. Skillz wants to provide more opportunities to Brands to sponsor some of these tournaments facilitating increased level of engagement with existing and potential customers. When brands sponsors the prize money, Skillz will be able to keep a much larger share of the fees collected from the users in the tournaments. This will result in a direct positive impact to Skillz revenue and margins. Because Brand Sponsorships bring new customers to the platform, customer acquisition costs also get reduced.

  3. US Android Availability
  4. Skillz operates primarily on the Apple App Store due to Google Play’s terms of service, which treats prize games as gambling and do not allow such apps to be distributed through the Google PlayStore. Skillz has found alternative methods of distribution to Android devices (i.e., Samsung Galaxy Store) and also users can download on Android devices directly from Skillz website by changing a few settings. Despite Google’s restrictions, Android userbase of Skillz is growing faster than the larger Apple userbase. However a full approval to distribute on Google PlayStore will be a huge boost to Skillz adoption by the large Android userbase globally. This can make a big boost to Skillz current revenue targets.

    There is a good possibility that Google may approve and allow cash based gaming apps like Skillz, DraftKings, Fanduel etc. on Google Playstore in the near future and hopefully this year. Google recruited Head of US Betting Operations in August to focus on enabling such types of games. Here is a link to a news article

  5. International Expansion
  6. Last year less than 10% of the company’s revenue came from outside US even though mobile gaming is 4 times larger outside US. Skillz will pursue new markets through existing channels and with localized content. For 2021 the company intends to start in India, which ranks as the second most populous country in terms of active smartphone users with over 440 million (only 32% penetration rate) vs. 270 million for the U.S. (Newzoo), and is #1 globally in terms of downloads, projected to increase at a low double-digits CAGR and exceed 30 billion in 2024 (Sensor Tower).

  7. Genre Expansion
  8. Currently Skillz has most of its presence in five genres: Card, Sports, Word, Board and Puzzle. Skillz plans to extend beyond casual content, and introduce new categories like first person shooter (FPS), racing, and real-time strategy (RTS), among others. Such expansion into new genres actively pursued by Skillz will result in incremental upside to revenues.

  9. Introduce Ads
  10. Last year only 10% of Skillz Monthly Active Users (MAUs) were converted to paid users and participated in paid contents. The other 90% was not monetized and did not make contributions to Skillz revenue. Hence the company plans to target the other 90% with non-intrusive, low friction ads, virtual goods, or brand-sponsored prizes, creating new opportunities to monetize user engagement. ARPDAU ranges from $0.03-$0.15 (GameAnalytics), and the company believes it can introduce ads and experience similar levels of monetization. This will also have the advantage of generating a revenue stream where Apple gets a share of Skillz’s success as ad revenues will be shared with Apple and the respective Game Developer. Apple currently do not get any revenue share from Skillz apps and some investors see that as a risk in future for Apple to ask for a take rate ( see Risks and Concerns section). The sharing of ad revenue will mitigate this risk to some extent as mutual interests will get aligned better between Apple and Skillz. Sale of virtual goods to non paying users in future will also have similar effect on Skillz revenue and also add to Apple’s share.

  11. Synergies from Targeted Acquisitions
  12. M&A has not been a part of the company’s growth strategy currently but Skillz may consider acquisitions opportunistically like fast tracking Skillz adoption and expansion in international countries.

E. Septum Insights Commentary

A Pyramid User Ecosystem

All users playing Skillz games are not same. There are a large group of users who do not play the cash games and currently do not contribute to Skillz monetization. Among the remaining users ( around 10%) who do play the cash competition games, there are users at different skill levels. There are top players who actually make good profit despite Skillz take rates and the volume of profit depends on the total number of games they play per day or per week. These are the whales or super users who drive the maximum volume on the platform and they need opponents. Skillz has player matching algorithm that matches based on skill level and try to mitigate the effect of highly skilled players winning against weak opponents. However this can be only mitigated and not eliminated as winnings eventually flow upwards from the bottom of the pyramid towards the top. This is one reason I do not look only at churn of paying players but the LTV figures which factors monetary value besides the churn. The churned players are more likely to be the players in the bottom rung of the pyramid who are losing games more frequently than others and losing cash more than their expectations. They can be those who are not able to adapt themselves into the competitive ecosystem that requires someone to keep improving the skills of the game to win more frequently. Long term they will not be the profitable users for Skillz as they are not able to traverse the pyramid upwards where the most profitable players reside. Their cash deposits however, have served a useful purpose in feeding the upper rungs of the pyramid in the ecosystem. Every time user cohorts are acquired by Skillz, there will be different types of users that will eventually reside in the different layers of this power pyramid and the ones who are not able or willing to improve the skill levels required in the game churns out eventually. Since the profitable users playing frequent games remain in the ecosystem, the LTV stays high.

Two Acquisition Funnels : A Business Model Better than Venture Capital

As discussed earlier, Skillz has an additional acquisition funnel besides the classic user acquisition funnel that is needed by all gaming companies to bring new users to the targeted games. This second acquisition funnel is unique to Skillz as it is a gaming platform instead of a game development company. What is advantageous to Skillz here is that they can operate this funnel at minimal variable cost because the development cost of each game and integration with Skillz SDK is responsibility of the game developer company. With thousands of developers developing thousands of games, integrating with Skillz and working with Skillz to deploy on the platform and distribute to users, Skillz has the unique opportunity to collect user engagement and activity data throughout the lifecycle of each game passing through this unique funnel from early stages to maturity. This enables Skillz to then use their patented data science algorithms to identify the high potential games in the early stages and select those that are driving user engagement, better conversion to paid users and higher ARPU, lower user churn and hence higher overall user Life Time Value (LTV). Once identified, Skillz can unlock and deploy its user acquisition and user engagement budget on these selective games driving bigger success for these games. Thus Skillz can make their investments in these games more selective and productive. This is a better investment model than even a venture capital model because in case of venture capital investment the initial investment in multiple companies is made without any advance knowledge of how they will perform down the road and the ones that do perform later will become a costlier investment for subsequent funding rounds. This is not the case with Skillz as agreements with developers are done upfront and any subsequent investment in user acquisition for a selected game is usually done by Skillz in exchange for a higher take rate of revenue which benefits Skillz even further.

Understanding the CEO Factor

Skillz Founder and CEO is Andrew Paradise who will retain majority control of the company with majority of the voting rights by virtue of a dual class share structure. So understanding Andrew’s strengths and weakness is critical for the investment thesis. Because I have not directly interacted with Andrew, below commentary is mostly based on feedback in several third party reports that I had a chance to review.

Andrew is a strong visionary leader and seems to be also very demanding. He is very hands-on leader and knows every aspect of the business well. His leadership style has both pros and cons. It is suited for certain type of employees who are highly motivated while can create burnout for others who cannot keep up with high expectations. Often I came across feedback from people comparing his leadership style with that Elon Musk or Steve Jobs. It remains to be seen whether Andrew will be able to deliver similar to the visionary leaders that he is compared with. So far, he has delivered well despite the cons pointed out by his critics in his leadership style.

For investors, he seems to believe in underpromise and overdeliver. He seems to be committed toward hitting business goals including future revenue targets. He also believes in the long term success of the company which can be seen in the way the SPAC deal was structured where Founders committed to a 24 month lock up provision versus a regular 6-month duration.

Overall, I like Andrew leading the company as he seems to be smart with a consistent record of past success and seems to know every aspect of the business. There are risks of-course with demanding work environment like higher employee attrition but the overall feedback was that this is kept under control.

A Virtuous Flywheel

Skillz Platform creates a virtuous cycle with a flywheel effect driving success of games. Users acquired by Skillz are cross pollinated across other games and therefore the success of one game with a growing userbase can also influence success of other games as they gain some of the users organically from Skillz platform. A game driving higher user retention and conversion to paid users attract higher sales and marketing investment from Skillz which drives more user growth and engagement for these games resulting in higher revenue for the game developers. These game developers in turn reinvest some of these additional gains into making the game even better which in turn drives higher user engagement and growth creating a virtuous flywheel. This way a high potential game gets bigger and bigger on Skillz platform while also helping other games on the platform through cross pollination of users. Skillz benefits in every step of this virtuous cycle.

Data driving Experimentation

All mobile games integrated with Skillz is generating a constant stream of data regarding user activity and engagement. Skills owns all these data and it is able to understand user monetization, retention, conversion to paid and engagement levels at each given time per game. This then becomes a hotbed to run AB testing or various other types of experimentation to test different types of hypothesis. Skillz thus have the luxury to make data driven decision making based on what works and what does not ( whether hypothesis in the experiment was proven true or false). Andrew in Investor calls gave various examples of how such different experiments run on the platform led them to realize the potential of non-profit tournaments and brand sponsored tournaments. Such experiments can help them decide how to reduce user attrition , how to drive higher ARPU and what factors need attention in a game for it to succeed. Also they can bring the best practices learned over time from one successful Skillz game and apply to a new Skillz game in the early stages of user adoption and fast track the success of the newer games. As you can see, Skillz only gets better over time through this process.

Stickier than Gambling

For a user of skill based games, the mastery of the game is a critical factor in the user journey. For a Skillz paying user playing cash tournaments on skill-based games, the mastering of the skills is also tied to the ability of the user to win more competition against matching opponent. So there is an element of time investment by the user in acquiring the skill besides making a monetary investment. Even for a non-paying user who is only playing practice games, there is still a progression of skill level as the user spends more time playing the game over and over. For a non paying user, there is investment of time. For pure user playing games of chance, there is no such investment involved and there is no progression of skill mastery. As such a user can switch more easily from playing one gambling game to another without feeling the loss of time invested in acquiring a skill. This puts the Skillz game at an advantage and shows up as higher LTV ( LifeTimeValue) of a Skillz user than a gambling app.

Growth Tailwind of Mobile Games Industry

The article focuses mostly on Skillz as a company but it would not be complete without the mention of an extremely favorable industry outlook of mobile gaming in which Skillz operates. The global video games industry is projected to reach $175 billion in 2020 ( at 20%+ growth rate). It is estimated to grow at low double digits CAGR for next several years. Within this industry, mobile gaming is the fastest growing segment at 26%+ CAGR estimated for 2020 and also the largest segment (49%) of the global video gaming TAM. Out of this fast growing mobile gaming segment , one of the fastest growth categories are casual games where Skillz currently makes most of its revenue from. This is a tremendous tailwind for Skillz’ business and will help drive growth for the company besides all other company specific advantages that Skillz enjoys.

F. Risks and Investment Concerns

  1. MAUs did not grow much from Q1 2020 to Q3 2020 :
    1. Based on my research and inputs from sources, I could gather following two points that addressed this concern for me -

    2. As per sources who spoke to the company directly on this, they seem to plan for their sales and marketing spend on user acquisition in such a way where a big jump happens in Q1 compared to past year’s Q4. The ad rates seem to be lowest in Q1 and therefore this spend is most efficient in Q1. That is why a big jump in MAUs happen from Q4 to Q1. Post that MAUs increases only incrementally without the big jump seen in Q1. Bottomline, what I hear is that Skillz is not concerned about this and seems to happen as per plan. As we go through a few earnings report, I plan to monitor this accordingly.
    3. Second and perhaps more important for me is that MAU is not as important a metric for Skillz as Monthly Paying Users volume growth and also growth as a percentage of MAUs. This is because unlike other apps, all monthly active users are not monetized in the same manner and the paid users are more critical to Skillz’ success. When I look at the trend from Q4 2019 to Q3 of 2020, I see a steep increasing trend of monthly paying user growth , which is very encouraging and a solid indicator of future growth in revenue. As per the Stifel Analyst report, Monthly Paying users conversion from Monthly Active Users (MAUs) grew approximately from 10.4% in Q4 2019 to 11.6% in Q1 2020 to 12.2% in Q2 2020 to 12.9% in Q3 2020 with total paying user-base doubling in 4 quarters.
  2. User Churn:
  3. Skillz has not provided user churn and has provided LTV ( Life Time Value) which factors the user churn in the denominator besides accounting the monetization value of the user. Skillz LTV is the highest among the mobile app development companies. One analyst (Citi) estimated paid user churn to be around 2% which also seemed to be low compared to other gaming apps and also compared to daily fantasy gaming apps from the historical churn figures I was able to find mentioned in some public reports several years back regarding daily fantasy gaming apps like FanDuel and Draftkings. Skillz has a pyramid shaped user ecosystem ( covered earlier) which means the lowest rung of the paid userbase will always have some consistent losers who are not able to move upwards in the pyramid. Though I do not have access to Skillz churn data per user, I can make a reasonable assumption that most of the churn is happening in this layer and is a natural outcome of the way the pyramid ecosystem works.

    One encouraging sign I see is that Skillz user engagement spend is flattening as portion of revenue spend, showing that it is scalable. This is the amount Skillz spend every quarter driving engagement of users which helps reduce churn as less engaged users are provided incentives to play on the platform. This is a sign that the model can scale without a need for an increased rise in engagement spend as proportion of revenue.

  4. Apple will eventually impose Fees:
  5. Currently Skillz do not have to pay a take rate of Apple on the fees collected from the users. This is because of Apple’s policy to let cash gaming apps be exempt from the take rate. Skillz also uses its own payment infrastructure and avoids any payment fees to Apple. Can Apple change their rules later? I don’t believe Apple would do so without attracting additional concerns from authorities on the control it exercises over third party companies. If Apple changes the rules, then not only Skillz but gaming apps like DraftKings, FanDuel, BetMGM and numerous other companies in the cash gaming space will be impacted. Hence I don’t foresee this happening. Skillz is also planning to use Ads to monetize the non paying user base and that can be a future revenue source for Apple as it will get a portion of the proceeds collected from Ad revenue generated by Skillz.

  6. Large Game Developers or Unity will build something similar:
  7. Skillz has been very active in patenting its multi-player tournament style games from third party game developers using its platform with 58 granted and pending patents. Every aspect of the platform has been patented by Skillz over last 6 years including the skill determination and normalization of chance, the architecture to host and play the games asynchronously, fraud detection, algorithmic player matching based on skill levels etc. For a large game developer or Unity to create a similar competitive third party gaming platform at scale will have to cross the barrier of building something that does not infringe Skillz patents. Few of them so far have created any platform that owns third party competitive gaming user data or own user engagement for third party competitive games. Currently every game developer owns user data of their own games that they developed or acquired. To create an alternative third party platform of gaming ecosystem, they will have to start from scratch . There is also the need for them to navigate the regulatory landscape state by state which Skillz has done over the years making their games accessible to users in states that allow skill based cash tournaments. Amazon and Sony besides various other venture back startups have tried to emulate this over the years and have failed. A few have tried to compete using games they own but so far have not been successful.

    So while it is not impossible for others to replicate Skillz model, it seems to be very difficult to compete with Skilz at scale Skillz operates in this space. Skillz has several years of head-start being singularly focused on competitive gaming while creating a formidable moat with patents.

  8. Game Quality and Genre Diversity :
  9. Skillz games are currently in the Casual games category and involves genres like card, board, puzzles etc. Gradually we are seeing Skillz gaining success in Sports category and also expanding into other genres like racing. While it remains to be proven if Skillz can really be successful with games from other categories and genres of mobile games and is a risk item for them to scale bigger, many analysts believe that as the platform grows several fold with millions more users playing the games on Skillz, the chances of success and attracting bigger game developers become much higher. The big game developers will get attracted to Skillz large engaged high lucrative user-base over time and would like to exploit their unique monetization model for their games. Also with Apple putting additional restriction due to app privacy disclosure rules, ads may get less effective than what it is today and might result in lower revenues.

  10. Regulatory Concerns:
  11. Currently Skillz is allowed in majority number of States in US and Skillz games currently cover about 80% of the global population. Regulatory landscape has been showing favorable trend so far for skill based gaming and gambling apps. However there is risk that in future based on how these apps are perceived , the regulatory landscape may change. So assessing this risk, I do not see much near term risk ( say next 2 years) but long term risk still exist and needs to be monitored.

Conclusion :

Skillz has a great business model and is a compelling investment long term. There are risks as with any investment but the upside potential seems to be much bigger compared to downside risk making it an attractive investment for me I invested majority of my position in SKLZ when the price was in teens and plan to hold it for long term unless any elements of investment thesis changes.

Note: There are several other aspects of Skillz that I wanted to cover including SPAC structure, stock valuation, detailed analysis of patents, game cohort performance etc. but the current format here limits how much content I can publish in one article. If you found the article useful, please help us spread the word about Septum Insights. Thank you.

References : Analyst Reports ( Wedbush, Wells, Canaccord, Citi, Stifel etc.), Skillz Investor Conferences, Skillz S-1 Prospectus, Public Articles and Interviews on Skillz & other sources. Sections A, B, C, D : Summarized and Adapted from Skillz Analyst Reports and Skillz SEC filing documents. Sections Intro, F,G,H : Septum Proprietary Research using references above.

Disclaimer : This is not investment advice and not advice to buy or sell any securities. Risk management is extremely important especially for growth stocks.