Note from Daily Trade Alert: The following article first appeared in The Growth Stock Advisor, a premium newsletter offered by Investors Alley.

Anyone with children under the age of 16 is probably well aware of the wildly popular gaming platform, Roblox (RBLX).

Yet, this recent stock market entry is largely being ignored by Wall Street. After an initial opening day pop, Roblox stock has done almost nothing. Perhaps that is due to the fact the company went the direct listing route, instead of lavishing millions on a Wall Street IPO.

But Wall Street ignoring this company is a boon for us investors. The stock price has not yet soared on this unique company that threatens not only video game developers but also social media companies.

What Is Roblox?

If you’re not familiar with Roblox, it is not a video game. It is a platform that allows people to create and publish their own video games using Roblox’s suite of tools—in effect outsourcing game development to its users. By the end of last year there were more than 20 million Roblox games available to play.

With its reliance on user-generated content, Roblox employs a very different business model from traditional video games developers such as Activision Blizzard (ATVI), which depends on a steady stream of expensive blockbuster releases. Instead, Roblox is something of an industry gamechanger. Think about how YouTube revolutionized the broadcasting of videos. Roblox is doing the same thing to game publishing.

There is no blockbuster Roblox game. Instead, the platform offers everything from puzzles to shooter games to just about anything else you can imagine. And they are available to play across computers, gaming consoles, and smartphones.

Roblox’s most popular title is Adopt Me!, a children’s game in which players look after virtual pets. So far, Adopt Me! has been played more than 20 billion times.

Roblox’s games are free to play, but users can enhance their experience through in-games purchases made using Roblox’s currency, Robux, which can be converted into real currency. Game developers get to keep 70% of the Robux spent within their games, with the rest going to Roblox.

This model has made Roblox a lucrative business for some game developers. In 2020, out of 8 million developers, more than 1,250 earned at least $10,000 in Robux. And more than 300 developers earned at least $100,000!

Roblox and the Pandemic

Founded in 2004, the company’s popularity has taken off recently, supercharged by the pandemic-driven videogame boom. Daily active users (DAUs) on the platform soared by 85% in 2020 to 32.6 million. Users spent a total of 30.6 billion hours on Roblox last year, an average of more than two-and-a-half hours per day.

Roblox is a smash hit with younger audiences. Some say it became a de facto pandemic playground. Some 54% of its DAUs are under the age of 13. And more than half of the children under 16 in the U.S. are on its platform!

This popularity also means Roblox is in play as a competitor to social media firms.

Roblox to Replace Social Media for Kids?

Roblox is more than just gaming. It increasingly is overlapping with social media. Management has said their ultimate goal is for Roblox to become part of a series of interconnected digital worlds in which people gather to learn, work, and socialize. Users can already host private parties on the platform. And Roblox has pushed into virtual concerts—four shows by rapper Lil Nas X in November attracted more than 30 million viewers.

Community building is at the heart of any successful social media venture. That’s why professor of marketing at the NYU Stern School of Business, Scott Galloway, believes that “Roblox could be to Facebook what Shopify is to Amazon, the non-social media social media firm.”

And consider this: from a brand engagement perspective, Roblox looks as though it could be more attractive to advertisers in the long run than Facebook and Twitter. Companies can create their own branded games and experiences on the platform. For example, AT&T’s (T) Warner Bros and DC Comics created a Wonder Woman game, which offered access to special avatar accessories in exchange for Robux. This is much more engaging than an ad that most users would ignore and scroll straight past.

The one drawback of the model so far is that the spending power of Roblox’s young user base is still low. But Roblox is starting to draw in older audiences. These older users are also why Roblox’s spending rose two-thirds in 2020, to $264 million, to install further safety measures to protect young users against predators.

Roblox’s Future

The company has yet to turn a profit as it invests in growth. Its operating loss widened from $76 million in 2019 to $266 million in 2020.

However, Roblox’s strategy seems to be a clever one. Its asset-light business model results in a virtuous circle: additional content attracts more users, who in turn drive more revenue, which encourages more developers to create games. It’s a sort of financial perpetual motion machine.

And let’s not forget that as more and more users encourage their friends to join the platform, this free word-of-mouth advertising keeps sales and marketing costs very low.

The result of Roblox’s strategy can be seen in its cash flow growth. It came in at $411 million in 2020, up from just $14.5 million in 2019. Revenues are also jumping. As more players spent more money on Robux last year, Roblox’s revenue grew by over 80% to $924 million, of which $329 million was paid out to developers.

But Roblox’s growth is likely to slow this year, as children go back to school. The company anticipates that hours spent on the platform could fall by up to 3%, although revenue is still expected to rise by up to 64% to $1.52 billion.

Longer term, Roblox faces the challenge of how to keep children within its ecosystem as they get older. One way to offset the loss of these users in the U.S. is through international expansion. More than two-thirds of DAUs are already outside of North America. And now, Roblox is looking to tap into China, the biggest gaming market in the world. Foreign gaming companies must partner with a domestic publisher in order to enter the Chinese market. Roblox has formed a joint venture with Tencent (TCEHY), the world’s largest gaming company, receiving a publishing license in December.

With a forward price-to-sales ratio of 19, Roblox is more expensive than its gaming peers. But I believe its unique business model justifies the premium valuation—especially because the company has the potential to grow and be both a content marketplace like YouTube as well as a social network like Facebook…with the money-making engine of a game publisher.

I will give Roblox a 5-star rating because I love its unique business model. You can buy the shares at any price up to $85 a share.

— Tony Daltorio

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Source: The Growth Stock Advisor