Motley fool | Think Roblox Makes Its Money by Making Video Games? Think Again -- Here's What the Real Business Is

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Roblox (NYSE: RBLX) is a global digital platform with over 70 million daily active users as of the company's 2023 third quarter. This large (and growing) user base logged 16 billion hours on the platform during the quarter (with my own kids contributing to the cause).

In its annual report, Roblox says that it operates a "free to play human co-experience platform." I don't think the company is trying to be cute with this description, but rather it's trying to capture some nuances in the changing video game world.

Traditionally, video games have included various levels, plenty of bad guys, and a final obstacle in order to beat the game. Other games have been points-based. But nowadays many video games simply allow users to explore, build, and interact. There's no clear way -- or even need -- to win. Roblox is capturing this nuance by using the term "experience" instead of "game".

Still, I believe it's fair to call these digital experiences from Roblox just modern iterations of video games. Therefore, from here on I'll refer to these as video games for simplicity.

With 70 million people on its platform every day, one might think that Roblox is making some exciting video games for its users. But that's the surprising thing about this company: It doesn't actually make the games that bring it profits. Its real business is something else entirely.

Here's what Roblox's real business is

Almost everything on Roblox's platform is generated by users -- that is, independent developers and creators. The company simply provides these people with the software tools they need to build on the Roblox platform. The developers and creators handle the rest.

Therefore, in some ways Roblox is more similar to Alphabet's YouTube, Etsy, or Airbnb than it is to other video game companies. Content creators post to YouTube, crafters upload listings to Etsy, and hosts supply Airbnb with properties. In the same way, third parties create the experiences and the in-game items on Roblox.

This kind of business model is intrinsically high-margin, which is why so many investors believe Roblox stock is a promising opportunity. The chart below shows how its gross margin is high and improving with higher revenue.

Show me the money

Roblox provides software tools to developers. But investors might still be wondering how money flows into its pockets. Some of the video games on Roblox's platform aren't free to play. Other free-to-play games have in-game purchases available. If the company's 70 million daily active users want to buy these things, they have to use its on-platform currency called Robux.

Users start by buying Robux. Then as they spend it, Roblox can recognize revenue. If users spend Robux within an experience, Roblox takes a 30% cut. If users spend Robux on the platform's Avatar Marketplace, Roblox takes a 70% cut.

Certain developers and creators can cash out Robux through Roblox's Developer Exchange Program. This is one of the company's biggest operating expenses, having paid out $519 million in the first three quarters of 2023.

What it means for investors

Once you understand the business model, you can build a proper investment thesis for Roblox stock. The company needs to grow revenue and profits. And to do this, it needs more users spending more money on Robux. This could happen if more compelling experiences are developed -- especially experiences that appeal to older demographics with more spending power.

But remember, Roblox isn't necessarily in the business of attracting users, but rather it's aiming to attract the developers who will build the compelling experiences. Therefore, the company needs to invest in these developers so that they're financially successful on the platform.

This is a harder thing to measure than just user growth. But it's possible to find clues with a little digging. For example, Roblox is actively working to improve its search and discovery within the platform so more games are recommended to the right users.

In Q3, the company's recommendations increased 85% year over year -- that's a bullish data point. Improved recommendations can give developers more confidence that if they put forth the effort to build something compelling, Roblox will work to make sure it's found by users.

There's plenty more that goes into choosing a stock to buy, and personally I'm not interested in Roblox stock today because of its high valuation and ongoing losses. That said, this stock could be a market-beater with enough long-term growth and operational discipline to turn the corner on profitability.

For those interested in Roblox stock, watch its investments in the developer and creator communities. The success of those key stakeholders will in large part determine whether or not Roblox can live up to its potential.