[toc]The daily fantasy sports industry is on a roll.
FanDuel – the established industry leader, claiming 80% market share for Q4 2014 thanks to its dominance in football – saw revenues jump over 300% to $57.3 million in 2014, up from just $14.3 million in 2013.
Meanwhile, DraftKings – the clear No. 2 player at present (and perhaps No. 1) – has closed the gap (or rather, has taken the lead) on FanDuel at least for the early part of this summer, thanks to both its edge in baseball as well as its golf, NASCAR, and MMA offerings, which FanDuel currently lacks.
Investment in the industry is also hot. FanDuel has raised $87.5 million in (publicly known) funding to date, in addition to securing a multi-year partnership with the NBA last November in a deal that gave the NBA a stake in the company.
DraftKings has raised $76.4 million in (publicly known) funding. On Wednesday, we learned that a $250 million investment deal with Disney was called off, although an exclusive advertising deal between DraftKings and ESPN was cemented. DraftKings has partnerships with both Major League Baseball and the NHL.
Not just DraftKings and FanDuel
Even Beckett Media – the ubiquitous sports card price guide company whose baseball card price guide once (about two decades ago) had monthly circulation of about a million copies – acquired a fantasy sports platform last year, and announced to existing customers via e-mail last week that it is looking to launch Beckett Fantasy Sports shortly.
Depending on whom you ask, DFS has seemingly unlimited upside. Adam Krejcik of Eilers Research has projected that the DFS industry will clock in somewhere in a range of $500 million and $2.5 billion in revenues by 2020, up from likely under $100 million in 2014. Jason Ader of SpringOwl Asset Management is far more bullish, suggesting that DFS may be “as big as Macau over time.”
That’s quite a lofty statement, considering that the Macau gaming market is still projected to be in the $30 billion to $35 billion range in 2015 (down from $43.9 billion in 2014 and $45.1 billion in 2013) as the market strives for mostly political stability; moreover, I suspect the Macau gaming market is more likely than not to grow again in the not-so-distant future, thus providing the DFS industry a moving target.
Thus, at first glance, DFS has the appearance of a huge money grab. But is it really? And for whom?
Could DFS suffer the fate of online poker?
A few years ago, we had a very similar discussion to the one we are about to have, only about the online poker industry (see Sorry Mr. Online Poker. Nobody Cares About You).
At the time, the U.S. was on the cusp of legalized, regulated online poker with similarly lofty expectations, and a similarly endless supply of companies looking to get in on the action. I argued that the online poker opportunity in America was not nearly as attractive as it might have appeared; that it would likely benefit only a few operators; and that poker itself was (is) a self-defeating game facing an increasing skill gap problem.
As we know, the early returns on legal online poker in the U.S. have not panned out thus far, while expectations going forward have been cut dramatically.
The short version of this discussion is that DFS has all of the hallmarks of the online poker business, chiefly:
- Effectively zero barriers to entry, with high marketing expenditures which will ultimately grind out smaller industry competitors, and
- An underlying game with a projectable skill gap problem which will likely grind out first the fish, and then ultimately the high-volume players when they can no longer beat the rake.
Except the underlying game structure of DFS is far worse than poker.
Now I have little doubt that DFS is on the upswing, and perhaps still in the very early stages of one. But as a consequence of the skill gap problem, I suspect the DFS industry is likely to run into a buzzsaw, and far faster and harder than online poker did.
We’ll talk more about that last idea in a minute. But first, let’s talk a bit about the structure of the DFS market.
Market structure: This is good for whom?
As I see it, there are three key sources of potentially sustainable competitive advantages for DFS companies:
- Network effects (liquidity)/scale
- Key partnerships (FanDuel/NBA, DraftKings/ESPN, etc.)
The most important one of these is the first one, which is network effects, where DFS players will continually gravitate to the largest sites, eventually leaving smaller DFS operators in the dust. We’ve seen this in the online auction business, where buyers breed sellers, breeding more buyers, breeding more sellers, to the point where eBay is essentially the only company left to dominate this space.
We’ve also seen this in the online poker space, if you view this market share chart from bwin.party’s 2012 first half investor presentation:
In online poker, players breed players, and liquidity breeds liquidity. The largest sites (PokerStars) can offer the biggest prize pools and the greatest variety of game options, resulting in real product differentiation, which also helps drive brand value.
And ultimately, one company (PokerStars) ran away with the dotcom poker market, while the remaining players have been (and are being) ground out.
Now the above chart is slightly misleading, as the number two player – Full Tilt, the red line in the chart – was run by crooks and shut down following Black Friday in April 2011; its assets were ultimately acquired by PokerStars in a deal made with the U.S. Department of Justice.
As such, there is very conceivably room for two meaningful players in this type of game, particularly if they are going to divvy up partnerships with the major professional sports leagues as FanDuel and DraftKings are doing.
But the other problem hurting the smaller online poker operators in the (unregulated) dotcom space was the complete lack of barriers to entry.
When the online poker market was on the upswing, there was tremendous incentive for any number of players to come in and blow the market up with unsustainable marketing spend in a bid for market share. And this marketing spend was not just in ad expenditures, but also in player incentives in the form of deposit bonuses, rakeback, and player reward programs.
This type of activity was devastating to industry profitability – and particularly to the smaller operators – as poker players went site-to-site chasing deposit bonuses.
This is where we are with the completely unregulated DFS industry with effectively zero barriers to entry. Right now, as long as the DFS industry looks to be on the upswing, any number of DFS operators can and will enter the market, driving up marketing spend in the form of both ad expenditure and player incentives.
Such marketing spend will dampen overall industry profitability, and ultimately grind the smaller players into the ground.
Consequently, if DFS is going to be a money grab for somebody, it is probably going to be one or two players who can build sustainable network effects – most likely FanDuel and/or DraftKings at this stage, though it’s not inconceivable that other players (such as Yahoo!, PokerStars or some other player) could make a dent.
That said, the industry as a whole faces an even bigger problem fundamental to the DFS game itself as currently constructed.
The Achilles heel: Attrition rates and the skill gap problem
Here’s the truth about poker:
- It is not reasonable to expect that bad players (fish) will continue to enjoy losing large sums of money into perpetuity.
- The money is not so much earned by good players making expert plays as it is given away by bad players making mistakes.
- In order for a professional player to continue playing in significant volume – this includes players who multi-table cash games and play tournaments in volume, thus producing both rake-generating events and liquidity for the poker room operator – the player must have an edge over the opposition that is greater than the size of the rake.
- Over time, the skill level of the regular players rises, as do the number of players with professional-level skills.
- As fish get wiped out and exit the game, games become tougher; the threshold for a professional player rises, and the marginal pros also exit the game as they can no longer beat the rake.
- As the games get tougher, more fish get wiped out, thus further raising the threshold for a professional player.
- As players get wiped out, rake (revenue) drops and liquidity suffers.
This is not really conjecture.
Though the article I wrote back in October 2012 initiated the discussion of the skill gap problem (see the follow up pieces by Chris Grove and Steve Ruddock), the reality is that PartyGaming observed new player attrition rates rising from the very start of the poker boom in 2003 (as I wrote here) all the way through the end of its existence (PartyGaming merged with Bwin in 2011 to become bwin.party), thus highlighting the increasing skill gap between new players and the existing player pool.
For DFS, the same, but different
DFS, unfortunately, has all of the problems of poker but without any of its intricacies.
DFS is almost a purely data-driven game. There’s no check-raising, or continuation betting, floating, or 3-bet pre-flop frequencies as there are in poker; even with tracking software in poker, you still have to figure out how to play the game.
Not so in DFS, where lineup optimizers are widely available, and a player can take a single optimal lineup and plug it into a zillion different contests on any given site on any given day.
The thing is, DFS simultaneously requires too much skill and not enough:
- DFS requires too much skill in that if you are a casual player not playing optimal lineups where everybody else is putting in volume entries with optimal lineups, you are going to get wiped out in short order.
- But at the same time, DFS requires not enough skill; once the fish playing sub-optimal lineups quit the game, the only people left will be people playing optimal lineups in volume.
And when there are not enough fish making mistakes and contests are dominated by people playing optimal lineups in volume, the edge in playing an optimal lineup in volume will eventually be less than the rake, which at FanDuel has generally aggregated in the 8%-10% range (spreadsheet courtesy of Chris Grove) at least through the end of 2014. And when that happens, eventually either the rake rate will have to be reduced – pinching revenue projections – or the volume players will quit playing, leading to both reduced entries and thus revenue, and also reduced liquidity.
So how bright is the outlook for DFS?
I’m of two minds on this. On the one hand, I see a lot of potential upside in DFS, particularly from the standpoint that DFS offers an (apparently) non-illegal set of sports betting products in many markets in the U.S. where traditional sports betting remains illegal. On the other hand, I find myself skeptical about how big that upside really is.
And in any case, I am almost certain that the existing player pool is being wildly overvalued.
As I noted earlier, PartyGaming observed attrition rates rising from the very start of the poker boom in 2003, and all the way through the end of its existence as a stand-alone company in 2011.
However, the rise in attrition rates was masked by the explosive growth of new players throughout the mid-2000s, which is likely why it took until 2012 for the serious discussion of the skill gap problem to take place.
This is likely where we are with DFS, where explosive growth has and may continue to mask skill gap concerns in the near term. The key difference is that DFS is barely off the ground, and questions already abound out of the gate (see Ed Miller here, Adam Krejcik here, and this discussion here).
The simple fact is that we live in a time in which more people are more knowledgeable about gambling than ever before; we have more computing power than ever before; and games are solved faster than ever before.
Moreover, we have a game that I suspect is largely solved such that edges will continue to get slimmer and slimmer, particularly as contests are being dominated by players making volume entries with effectively optimal lineups.
At some point – barring some drastic change in the product – I find it likely that DFS is going to run into a buzzsaw, where attrition rates are too high and the influx of new players will not be enough to mask the skill gap.
When this happens, something is going to have to give – when the fish quit and/or the number of volume players with optimal lineups is too high and the edges become too small, either the rake must be cut, or the volume players who no longer have an edge will also abandon the game, with projected revenue from both the existing and future player base declining in either case.
And in contrast to poker, I don’t see this taking a decade to occur.