Gaming powerhouse Roblox released their S-1 last week, and in our minds this is the most anticipated IPO of the year. Roblox is an impressive story in its own right, but the impact of Work From Home (WFH) makes the numbers truly eye-popping, in ways both bad and good (but mostly good).

For those of you without pre-teens in the house, Roblox is the hottest game among the Under-12 Set. Using basic, block-like graphics (think Minecraft) Roblox is a gaming platform. Developers, with a very low bar to qualify for that designation, can build games that run inside the Roblox app. Players can then pick and choose which games to play. And the scale of games on the platform is somewhat staggering, there are 18 million games (“experiences in the company’s terminology) on the platform today.

Gameplay is often pretty simple, but with common design themes and UI mechanics across games. The company monetizes through sale of in-game currency which can be used to decorate players’ avatars and other items.

But wow, how does it monetize. According to the S-1, 36 million people play Roblox every day. The simple mechanics, and generally kid-friendly graphics make this very attractive to players not ready (or allowed) to play AAA games like Call of Duty or League of Legends. Put simply, in many households, Roblox has become the go-to destination for Screen Time, and we can attest to this personally.

This is one of the rare recent IPOs for which the financial statements match the excitement for the company. In 2019, the company generated $488 million in revenue, and in the first nine months of 2020 Roblox generated $588 million in revenue. They have seen an explosion of usage this year with the lockdown keeping students “studying” indoors.

But wait, aren’t they losing money? On a purely accounting basis, the company lost $91 million in 2019, and $206 million in the first nine months of 2020. However, this is an accounting artefact. When the company books revenue (i.e. someone buys in-game currency with real world dollars), the company has to account for that money over the “lifetime value” of the customer. This is purely an accounting fiction. We get that it makes sense to account for the cost of something over the life of the required service. That being said, this treatment really distorts the actual business. If we add back the amount of revenue that is being held to be accounted for over several years (i.e. deferred revenue) we arrive at a figure the company labels as “bookings”. Usually, we are skeptical about relying on non-GAAP metrics, but this one seems justified. And on this basis, the company generated $694 million in booking in 2019 and $$1.2 billion in the first nine months of 2020, and cash from operations of $99 million and $345 million, respectively.

In theory, we understand the argument as to why the company would need to use this deferred revenue. If you book a contract to provide telecom equipment and there are distinct milestones and deliverables over the life of that equipment (e.g. service and maintenance), deferring a portion of that revenue makes sense. When we are dealing with in-game currency that gets spent as soon as it is purchased, this theory falls apart.

We think following bookings numbers make a lot more sense.

Admittedly, the company does have some big expenses. First is the amount it pays its developers. These typically run in the range of 20% of revenue, but are up to 36% this year with all the added activity. The company also has to spend a lot hosting all those games, another ~30% goes to infrastructure and security (read moderating to keep content kid-friendly). Another major costs is payment processing fees, at about ~25% of revenue, this is the cut that Apple, Google and other payment processors take. This is an expensive business to run, but the vast majority of their costs are variable costs that grow with the business.

The company does face some challenges, especially given that it is likely going to come out at a premium valuation.

First is geography. The company generates just under 70% of revenue in the US and Canada. Intriguingly, they note that these only comprise 33% of users. This is one of those 50% glass of water things. We could argue that they are under-monetizing outside of the US, but we could also argue that this is just a big opportunity to really boost their numbers as they improve their monetization in other markets.

The user base is also, not surprisingly, young, with 54% of users under 12 and 67% under 16. So one could argue that the user base may age out and move on to big kid games. On the other hand, this is highly desirable demographic. So long as they can maintain safety and privacy standards (challenging, but so far so good), the company will have many years to maneuver and hold onto the audience. They note that expanding the age range of their users is a key strategic goal, leading to investments in improved graphics and gameplay. So there is a case to be made that they can continue to hold onto to many users for a long time.

And this leads to the Metaverse. A popular idea among gaming companies today is the idea that they are creating a new ‘place’ for people to spend time. The metaverse is more than a single game, it is a major leisure time destination. As a result, we see companies like Roblox and Fortnite hosting virtual concerts with musicians and other celebrities. We would argue that this was proving itself a viable proposition before the lockdown, and its popularity has only grown since.

A common criticism we have heard about investing in games in the past is that gaming is a hit driven business, and investors cannot judge which games will take off and which will not. The Metaverse is a powerful counter to that fear. If developers can build a big enough audience with a game, there are many ways to hold on to and monetize that audience, greatly dampening the perceived volatility of a hit game.

And Roblox goes one step further. Roblox is not a single game. It is 18 million experiences, a platform in its own right. It is already a powerful social tool. Kids who cannot meet friends in the real world can spend hours chatting on Zoom (or Discord) while they cycle through various games. Spend enough time with Roblox users and it quickly becomes clear that Roblox has immense operational leverage. Add a few social tools (e.g. built-in chat), keep rewarding developers, improve the gaming tools and graphics, maintain the pace of non-gaming content – and what they end up with is a major entertainment complex.