DFS: The beginning of the end?

 As the industry fights for its life in courts and legislatures across America, Brad Allen takes a closer look at what the future holds for daily fantasy sports

What a difference a year makes. Twelve months ago, the only question for the daily fantasy sports (DFS) industry was how rapid its growth would be. For 2016, the outlook is considerably more uncertain. A new report from Eilers & Krejcik Gaming has aggressively revised down projections for industry growth, citing “significant changes” to the regulatory and funding environment.

The report says it is “easy to imagine a number of wildly divergent trajectories for DFS,” based on political, legal, economic, business model, consumer, and market pressures. However, of the three trajectories envisaged by the report, all are lower than previous projections, thanks in no small part to an “explosion of regulatory interest”.

As of February 2016 there were 29 states considering 36 unique pieces of DFS-related legislation, up from ‘just a handful’ in September 2015 – the date which heralded the start of the NFL season and massive advertising campaigns for industry leaders FanDuel and DraftKings.

An uncertain future

According to Eilers & Krejcik, the majority of the legislation aims to define fantasy sports, exempt the activity from state gambling law, and put into place some very basic regulatory framework with minimal licensing and generally no taxation. Other approaches treat DFS more like gambling adding enforcement mechanisms, and opening avenues for potential taxation. Many of those bills have advanced in the legislature, but none have yet become law, leaving the outlook uncertain.

The outcomes of these cases are clearly vital to the future of the industry. In Eilers & Krejcik’s opinion the worst-case scenario, which essentially sees the market stagnate for the next five years, is that DFS operators are forced to withdraw from a number of top-10 states including New York, Illinois, Texas and various smaller markets.

By contrast, the best-case scenario assumes DFS operators operate freely in all top-10 states and mostly pro DFS legislation prevails with minimal impact to overall liquidity. The base case assumes the loss of at least one top-10 state – likely New York – while key states such as California, Florida, and Illinois enact legislation that reduces, but doesn’t cripple player liquidity.

Stephen Murphy, CEO of in-play DFS operator Boom Fantasy, says he is “very optimistic” about the ongoing legal wranglings.

“There has been a tremendous amount of positive momentum in various states, including Virginia, California, Indiana, Massachusetts, West Virginia, Rhode Island, and so on. A few states will go the other direction, but the industry will continue to have a very large total addressable market once the dust settles,” he adds.

A piecemeal approach

However, this kind of piecemeal approach may not be conducive to a stable long-term regulatory base, according to Seth Young, COO of Stars Fantasy Leagues.

“Barring a solution that is translatable to each state – that is to say, a regulatory solution that has some symmetry across state lines – we’re opening up Pandora’s box,” Young warns. “We may very well see law pass in a number of states, but that may end up raising more questions than answers.

“We are in a position as an industry that we have the attention of policy makers around the country; instead of creating stopgap measures as quickly as possible in an effort to avoid unfavourable legal opinions, we should be working to introduce effective policy the first time around that is in the best interests of the industry’s ongoing viability.

“Some say stopgap measures are the best first step for this, but we are all quick to forget that a poorly written piece of legislation that became law is the reason that there are so many questions about the business of DFS.”

While the legal argument plays out however, the industry is suffering. The Eilers & Krejcik report states: “The funding environment is understood to now be significantly – arguably brutally – more challenging, and both DraftKings and FanDuel have likely lost their unicorn status.”

DraftKings reportedly raised $200m in August 2015, giving it a valuation of around $2bn. However a more recent funding round ending in February raised only $70m, prompting 21st Century Fox Inc. to cut the value of its $160m investment in DraftKings by about 60%.

Murphy explains: “Any kind of uncertainty scares investors and with more timid investors, FanDuel and DraftKings can’t raise as much money and therefore they can’t spend as much as they were anticipating. When ad spend is down, overall revenue projections need to go down accordingly.”

Cost control

As the venture capital cash hose gets turned off, Eilers & Krejcik expects the major operators to switch their 2016 focus from scaling at any expense towards cost-control and reaching breakeven or profitability.

“The ramifications of shifting to a cost management approach remains to be seen, but it will likely entail substantially lower ad budgets, reduction in sponsorships, and a far more frugal approach to all business operations,” the report says.

Importantly, the change in approach from the two dominant firms could have ramifications for the rest of the industry, as smaller operators get the chance to have their voice heard.

“I think the current environment forces FanDuel and DraftKings to spend a large portion of their time on the legal battle and lobbying efforts” says Murphy. “Beyond their core offering, they won’t be able to devote as many resources to innovation and new gameplay. So in that sense, I think it does provide a very valuable opportunity for smaller strong operators who have a unique and differentiated product.”

Not everyone agrees though. Young argues that the legal uncertainty in the US market is making it equally difficult for small groups to raise capital.

“Most of the businesses are not self-sustaining as the market is very young. We’re more likely to see more operations go out of business than we are to see FanDuel and DraftKings lose their market share with the existing structure of DFS.

“Depending on how the legal landscape shakes out, though, we may see the DFS model change significantly, which would leave certain companies in a position to rapidly expand their market share. Any group that is competing with the FanDuel and DraftKings model, though? It’s going to be a losing battle, with one or two exceptions.”

The disagreement between the two is symptomatic of the state of the industry. The only certain thing is uncertainty, and what will happen next appears to be anybody’s guess.

“We are witnessing a monumental shift from the status quo, which will impact the underlying market dynamics and competitive landscape,” Eilers & Krejcik says.

“It appears more likely than not that we will see some type of widely disruptive event this year, be it a major new market entrant, M&A, and/or a dying unicorn. It’s hard to envision a scenario whereby user growth doesn’t decelerate considerably.

Light at the end of the tunnel

Despite the widespread pessimism however, the industry is starting to show some signs of longevity.  FanDuel and DraftKings are gradually diversifying their revenue sources through the growth of golf, Mixed Martial Arts, and eSports, along with a more robust focus on Major League Baseball and the NBA, meaning NFL action dropped from over two-thirds of the total revenue for the major operators to around half in 2015.

Likewise, relationships with the pro sports leagues are becoming ever more ingrained. Both the NBA and MLB are equity partners in FanDuel and DraftKings, respectively, and nearly every pro team – including 28 NFL teams – has a sponsorship agreement with one of the companies. The NFL Players Association also has licensing deals with DraftKings and FanDuel.

“I expect the industry to be healthy and growing in five years,” says Murphy. “In one year, there may still be some residual state-by-state battles that FanDuel and DraftKings find themselves in, but I think there will be a lot more clarity even in 12 months. This industry is not going away. The demand is there, the business model is there, and the allies in the leagues and media partners are there.”