Roku Stock Has Surged 180% Since its IPO
Today I want to talk about Roku (ROKU), the company that makes those small streaming players that connect to your TV, and which has seen its stock rise by 180% since it went public at 14 on September 27.
But before I assess Roku stock, I want to briefly talk about the TV streaming market to give investors a sense of how the market is evolving, and how Roku fits in.
Roku is essentially a play on the same phenomenon that has powered shares of Netflix (NFLX), which is up nearly 17,000% since it went public 15 years ago. Call it cord-cutting, streaming, or over-the-air (OTA) TV, it doesn’t matter. The point is that there is a strengthening wind at the back of companies that offer TV services that are delivered via the internet. So much so that traditional media and cable companies are entering the market with offerings of their own.
I think it’s safe to say that almost everyone that watches TV uses at least one streaming service at this point.
Our family has a Roku player, but we also have a Sony smart TV with Google’s Android operating system, so we’re not tied to one hardware or delivery platform. We go with what’s most convenient for getting to the shows we want to watch, which are usually on Netflix, Hulu, Amazon Prime, or every so often, the ESPN app on Roku if the Patriots are playing on Monday Night Football.
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As the TV streaming market evolves, there appears to be room for many players, and many winners, with a wide variety of business models.
Some companies generate revenue purely from hardware sales, whereas others are dependent on subscription revenue, like Netflix. There are players in the market that provide original programming, such as Amazon Prime and Google’s YouTube. And there are players in the market that generate revenue from a mix of advertising and subscriptions, like Hulu.
So how does Roku fit in?
The Switzerland of Streaming TV
Most people recognize Roku as the company that makes the streaming devices that plug in to a TV. In the early days, people bought them to turn their dumb TVs into smart TVs, so they could access streaming apps like Netflix and YouTube.
Roku still sells a range of these streaming devices, but it also sells much smaller streaming sticks, and has partnered with TV manufacturers to provide its Roku TV operating system on a number of their TV models. OEM TV partners include Hitachi, Insignia, TCL, Sharp, RCA, Hisense and, as of this week, Philips. The company has a market cap of $3.8 billion.
Revenue from hardware sales and TV partnerships are accounted for in Roku’s Player segment, which generated 73% of total revenue in Q3 (reported on November 8). Player segment revenue was up 4% (to $67.3 million), reflecting the push and pull dynamics of 35% player unit growth, but 23% decline in average unit selling price.
It’s worth mentioning that the company’s stated strategy for the Player segment isn’t to drive revenue growth, but to drive the number of active accounts. And Roku appears to be exectuting the strategy well through price discounting; active accounts grew by 48% in Q3, and now total 11.3 million users. The Player segment had a gross profit margin of 13.3% in Q3.
The company’s strategy is that active account growth drives more profitable revenue growth through Roku’s other segment, the Platform segment, which had a gross profit margin of 71.8% in Q3.
The Platform segment generates revenue through three vehicles: (1) advertising, typically on free channels like The Roku Channel, (2) content distribution services, including streaming services like its two new offerings, DirecTV Now and Hulu Live, and (3) audience development, which means Roku tracks what users watch (if they opt-in) and then sells the data.
Platform revenue was up an impressive 137% in Q3, illustrating that, so far, Roku’s business model is working.
The 48% growth in active accounts drove another critical metric, streaming hours, up by 58% to 3.8 billion hours. More streaming hours means more users exposed to ads, and more data collected, which helps drive Platform revenue.
Roku also tracks average revenue per user (ARPU), which rose by 37% to $12.68 in Q3. Side note: at that ARPU, is there any question that Roku is a cheaper alternative to cable, even if you’re paying for a number of streaming services!?
Lastly, it’s worth mentioning that the Platform segment’s higher gross margin (more than 5X that of the Player segment) drives the majority of its gross profit, even though Platform revenue is a much smaller slice of the pie. Platform segment gross profit was $17.4 million in Q3, versus $8.6 million for Player segment gross profit.
It all boiled down to adjusted EPS of -$0.10 in Q3, which was $0.19 better than expected. Based on the company’s annual revenue growth trajectory of just under 30%, and blended profit margin profile, Roku could be profitable in 2020.
Should You Buy Roku Stock Today?
The business model appears to be working and growth is impressive. But the mid-cap stock seems like a risky bet right now. A week ago, Roku stock traded near 20. A couple of days ago, after reporting earnings, it traded as high as 48, a better-than 100% increase! Trading volume is high, there is a battle going on between longs and shorts, and the stock is incredibly volatile. It traded down 13% on Tuesday, but was back up 5% yesterday.
If you have the discipline to average in over several months to help moderate the risk of buying during a speculative spike in value, your chances of generating a decent return are probably better. I don’t know what your target blended cost should be exactly, but common sense suggests something under 25 per share.
I base that on peer valuation comparisons. And that’s a little tricky, since it depends on how you assign value to Roku stock.
Its blended business model means that, based on Q3 results, it’s 73% a hardware and software company (based on Player segment revenue) and 27% an online-media company (based on Platform segment revenue). If you base your analysis off Q3 gross profit, it’s closer to 33% a hardware company, and 67% an online-media company.
The distinction is hugely relevant because online-media companies enjoy much higher valuations. For instance, a peer group of hardware and software stocks, including GoPro (GPRO), Apple (APPL), Netgear (NTGR) and Garmin (GRMN), among others, currently trades with a 2019 enterprise-value-to-sales (EV/sales) multiple near 1.6.
A peer group of online-media stocks, including Netflix (NFLX), TiVo (TIVO), Facebook (FB), Google (GOOGL), Grubhub (GRUB), and others, trades with a 2019 EV/Sales multiple of 4.8. That’s almost three times higher than the hardware and software stocks.
Roku should probably be valued at about 40% hardware/software and 60% online-media to balance its revenue and gross profit profile. That assumption means it should trade with a 2019 EV/Sales multiple near 3.5. If we assume 2019 revenue of $840 million, then we get to a price target near 25.
You can make whatever assumptions you want, of course, and this peer-based analysis is far from perfect. But it’s a starting point, and it suggests Roku stock isn’t a great buy at today’s price of just below 40.
But many other stocks are!
In Cabot Small-Cap Confidential, I cover a number of high growth stocks that are great buys at today’s prices. And my reports on each one walk you through the strengths and weaknesses of the company’s business model, growth potential and risks.
Our stocks are up an average of 40% right now. And with most rated Buy, there are plenty of opportunities for subscribers to choose from.
You can find out more, and start a subscription to Cabot Small-Cap Confidential, here.
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