3 Green Flags for Roku's Future | The Motley Fool

2022-06-11 00:14:56 By : Mr. Henry Feng

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Roku's (ROKU -10.46% ) stock closed at an all-time high of $479.50 last July. But today the streaming media hardware and software company's stock only trades at about $100 per share.

Roku's stock was crushed for four main reasons. First, its year-over-year growth in active accounts, streaming hours, and average revenue per user (ARPU) all decelerated over the past year as its stay-at-home tailwinds subsided in a post-lockdown world.

Second, its hardware business struggled with rising component costs and supply chain disruptions, which throttled its revenue growth and squeezed its gross margins. Third, the company ramped up its spending on original shows for its ad-supported Roku Channel as its core growth engines cooled off.

Lastly, Roku's stock had simply gotten too expensive. At its peak last July, the company was valued at $63.9 billion, or 23 times the revenue it would actually generate in 2021. Rising interest rates subsequently drove investors away from pricier growth stocks, and Roku's slowing growth and rising expenses made it an easy target for the bears.

However, Roku's stock now trades at less than four times this year's sales after that brutal sell-off, and three green flags indicate that brighter days might still be ahead for its long-suffering investors.

Anthony Wood, Roku's founder and CEO, briefly worked at Netflix (NFLX -5.10% ) in 2007 to develop a set-top box for the company. That project was eventually spun off and became Roku, and Netflix retained a stake in the new company until 2009.

However, Roku and Netflix have gone in very different directions since then. Roku embraced integrated ads on Roku OS and free ad-supported content on its Roku Channel, and that shift transformed its higher-margin platform business -- which generated 88% of its revenue and all of its gross profits in the first quarter of 2022 -- into a much larger business than its lower-margin player business. Netflix shunned ads and stubbornly stuck with its subscription-based, ad-free model.

But in late April, Netflix changed its tune after it experienced its first sequential loss of subscribers in over a decade. It said it would roll out a cheaper ad-supported tier for its "ad-tolerant" viewers, which strongly suggested it was losing ground to free and cheaper ad-supported streaming video platforms like the Roku Channel, Comcast's Peacock, and Disney+.

Roku also continued to gain active accounts and streaming hours sequentially over the past four quarters, which suggests its ad-supported platform is a lot more resilient than Netflix's premium model.

Speaking of Netflix, several recent reports claimed the streaming giant might be interested in buying Roku. These rumors were largely based on Roku's temporary suspension of employee stock trades, which suggests a big deal or announcement might be right around the corner. 

Investors should be deeply skeptical of those claims, but a takeover of Roku makes some strategic sense. Netflix would gain a dedicated hardware platform, which it had originally hired Wood to develop, to counter similar devices like the Apple TV and Amazon's Fire TV set-top boxes. It could also complement its own planned ad-supported tier with Roku's ad revenue.

If Netflix actually makes a bid for Roku, it could pay a steep premium. A 50% premium at these levels, which would bump Roku's market cap to $20 billion, would still merely value the company at about 5.4 times this year's sales.

Roku's future is tightly tethered to the long-term growth of the connected TV (CTV) advertising market. Therefore, the recent numbers from The Trade Desk (TTD -6.17% ) -- an ad tech leader that serves up a lot of CTV ads -- are very encouraging.

The Trade Desk is the world's largest independent demand-side platform (DSP) for digital ads. It enables ad agencies, advertisers, and trade desks to bid on programmatic ad inventories and manage their own ads campaigns. In 2021, The Trade Desk's number of advertisers that spent more than $1 million on CTV ad campaigns nearly doubled from 2020. During the company's first-quarter conference call in May, founder and CEO Jeff Green also reminded investors that he spent "many of the last ten years publicly predicting that Netflix and nearly everyone else would eventually show ads."

The growth of the CTV advertising market seems to directly coincide with Netflix's slowdown. That market has also supported the stable expansion of Roku's platform business over the past few years.

Analysts expect Roku's revenue to rise 34% this year and grow another 29% in 2023. However, its earnings are expected to stay deep in the red as it grapples with higher supply chain costs and content creation expenses for the Roku Channel. That imbalance makes it a tough stock to recommend right now, even if it looks cheap relative to its projected sales.

Investors shouldn't hold their breath for a Netflix buyout, but the green flags for the CTV advertising market indicate Roku's business could recover quickly as the macro headwinds wane. But until that happens, investors should stick with more reliable stocks to ride out this choppy market.

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