Roku, Inc. Investment Thesis

Roku, Inc.

Ticker: $ROKU

Sector: Communication Services

Market Cap: $45.0 billion

Overview

Roku is the leading TV streaming platform in the U.S. by hours streamed. The company pioneered streaming to the TV and was founded on the belief that all TV content will be streamed. The re-platforming of the TV ecosystem is underway and is creating more options for consumers, content publishers, advertisers and other industry participants. TV streaming is now mainstream and consumers are spending more time watching TV streaming services, with many ‘cutting the cord’ from legacy pay TV services entirely. 

Over the past number of years, many of the biggest names in media have transitioned toward streaming. Advertisers who are looking to reach and engage with streaming audiences, are increasingly taking advantage of the benefits associated the digital advertising capabilities of TV streaming platforms and are re-allocating their budgets accordingly. These trends continued to gain momentum in 2020 as consumers spent more time at home due to the COVID-19 pandemic.

The Roku mission is “to be the streaming platform that connects the entire TV ecosystem of viewers, content publishers and advertisers”. Through their TV streaming platform, Roku is focused on connecting consumers to the entertainment they love, enabling content publishers to build and monetize large audiences, and providing advertisers with unique capabilities to engage consumers. 

Central to the platform is the Roku operating system (“Roku OS”). The Roku OS is purpose built for TV and designed to run on low-cost hardware which allows them to manufacture and sell streaming players that are affordable. The Roku OS also powers Roku TV models that are manufactured and sold by TV brand partners who license the Roku OS and leverage smart TV hardware reference designs. Roku TV models and Roku streaming sticks enable consumers to access a wide selection of content by connecting their Roku device to the streaming platform via a home broadband network.

Consumers can discover and access a wide variety of streaming content. Content publishers can reach a highly engaged user base of over 50 million active accounts and utilize billing services and data insight tools. Advertisers can serve targeted and measurable ads to the TV viewers that they want to reach. Roku TV brand partners can build market share by offering high performance smart TVs in a range of sizes and price points. Retailers can offer customers Roku’s highly-rated streaming devices on-line and in stores. Something for everyone.

Customers

At the end of Q1 2021, Roku had 53.6 million active accounts representing a 35% increase year-over-year. Roku management defines active accounts as “the number of distinct user accounts that have streamed content on our platform within the last 30 days of the period. Users who streamed content from The Roku Channel only on non-Roku platforms are not included in this metric”.

Whilst you might assume that COVID-19 accelerated the growth in active accounts, Roku was already growing active accounts by 36% pre-pandemic.

At the end of Q1 2021, Roku reported streaming hours of 18.3 billion representing an increase of 49% year-over-year. Streaming hours represent a really important user engagement metric. Roku management defines streaming hours as “the aggregate amount of time streaming devices stream content on our platform in a given period. Hours streamed on non-Roku platforms are not included in this metric”

Roku reported streaming hours of 9.4 million in Q2 2019 meaning that it has almost doubled streaming hours in less than two years. Increasing user engagement should lead to greater platform monetization because Roku earns platform revenue from various forms of user engagement, including advertising, revenue shares from subscriptions and transactional video on-demand.

Roku measures its platform monetization with Average Revenue Per User (ARPU). At the end of Q1 2021, ARPU grew to $32.14 representing an increase of 32% year-over-year. Roku management defines ARPU as “our platform revenue for the trailing four quarters divided by the average of the number of active accounts at the end of the current period and the end of the corresponding period in the prior year. ARPU measures the rate at which we are monetizing our active account base and the progress of our platform business”

The Roku OS remains the No. 1 OS for smart TVs sold in the U.S. Roku also continues to make good progress in international markets and is the No. 1 OS in Canada where more than 1 in 3 smart TVs sold are a Roku TV model. Roku is now the No. 2 OS overall for smart TVs sold in Mexico.

Roku consumers now have more choices than ever for premium direct-to-consumer (DTC) services via the Roku platform, including Discovery+, Disney+, HBO Max, Paramount+, Peacock, Amazon Prime Video, AppleTV+, Hulu, and Netflix. Media companies are bringing their best TV and film content to their DTC services to attract and retain viewers. 

Capitalisation

Roku went public on the 28th September 2017 through an IPO raising an initial $242 million valuing the company at $1.3 billion. Today the market market cap is $45.0 billion meaning if you had invested at the IPO date you would have over 34x your initial investment in less than 4 years. Despite this performance the company is still very much a growth stock.

Revenue and Margins

Roku has been growing revenues at an impressive rate over the past couple of years whilst also improving its gross margins. During its most recent financial results for Q1 2021:

  • Revenue was $574.1 million, an increase of 79% year-over-year. 

  • Platform revenue was $466.5 million, an increase of 101% year-over-year. 

  • Player revenue was $107.6 million, an increase of 22% year-over-year. 

Gross margin was 57% in Q1 2021 compared to 44% in Q1 2020. The key driver here is the Platform gross margin which is 67% compared to the 14% gross margin on the Player.

This level of growth and margins is not a once off as Roku has a demonstrated track record when we look back over the last 2 years.

Management has estimated Q2 2021 revenue of $615 million which would represent a 73% increase year-over-year. Gross profit is estimated to be $300 million suggesting a gross margin of 49% compared to 41% year-over-year.

Roku is already profitable on the bottom line after posting net income in Q1 2021 of $76.3 million compared to a loss of $54.6 million year-over-year.

Valuation Multiples

Roku is a growth stock and by its nature trades at high valuation multiples. Below are some of the key valuation metrics that I have identified. I have included the PE ratio and while Roku is profitable, this is not the focus for the business at this time. 

The Price/Sales valuation multiple has essentially doubled over the past year whilst revenue has increased by 79% during the same period. 

Balance Sheet and Cash Flow

Commentary

  • Over $2 billion in cash and cash equivalents

  • Total Liabilities as % of Total Assets is 30% 

  • Current Assets to Current Liabilities ratio of 4.38

  • Inventories amounting to just over 1% of total assets meaning the risk of impairment is low

  • Goodwill balance making up just over 3% of total assets which primarily relates to the acquisition of dataux in Q4 2019 and the acquisition of Quibi’s content in Q1 2021. Readers can expect this goodwill amount to increase in 2021 with the acquisition of Nielsen Holdings

  • Free cash flow for Q1 2021 was $92 million compared with $0.6 million year-over-year

Stock Price History 

The share price had been moving along nicely for the first couple of years after it’s IPO before really taking off over the past year hitting an all time high in February 2021. 

Competitors

As mentioned earlier, Roku leads the Smart TV Operating System market with the most sales in North America during 2020. Roku TV held a 38% market share in the U.S. and a 31% market share in Canada, making it the leading Smart TV OS in both countries. 

However, on an international scale there is fierce competition. Samsung Tizen Smart TVs led the market globally in 2020 with 162.4 million units in use, followed by LG WebOS with 93.4 million units. Other notable competitors include products from Amazon, Google, Microsoft and Apple. Samsung’s smart TV market leadership has given it a great foundation to position Tizen as the leading TV streaming platform at this moment in time. 

Alternative devices also offer competition to Roku as they compete for attention. According to the Conviva State of Streaming Q3 2020 report, globally, viewers spend 75% streaming time in front of a TV screen. The breakdown is as follows: 50% connected devices, 15% smart TV applications and 10% gaming consoles.

This is a significant increase compared to Q3 the previous year, when the numbers added up to 69%. The comparable split then was 51% connected devices, 8% smart TVs and 10% gaming consoles. Based on these numbers, smart TVs have been the biggest winner. The global streaming market grew by a whopping 57% last year. Smart TVs outperformed every other category by showing a year-over-year growth of 200%.

Management and Ownership 

Roku was founded in 2002 by Anthony Wood after selling his previous business, ReplayTV, to SONICblue in 2001. Wood has served as the Chief Executive Officer since inception and Chairman since 2008. 

In 2007, Wood briefly served as Vice President of Internet TV at Netflix. Before ReplayTV, Wood co-founded iband.com, an Internet software company later acquired by Macromedia. Wood is also Founder and Chairman of BrightSign LLC, the global market leader in digital signage products that was spun off from Roku in 2010. He holds a bachelor’s degree in electrical engineering from Texas A&M University.

Anthony Wood appears to be well received at Roku with an 82% approval rating on Glassdoor with the company overall scoring 4.1 out of 5 by its own employees. 

In Anthony Wood, Roku meets my criteria of being led by a visionary founder

Risks

1. Competition 

As we have seen earlier, TV streaming is highly competitive. There are many companies, including the big tech, content owners and aggregators, TV brands and service operators actively focusing on this industry. There is a risk that if Roku fails to differentiate themselves and compete successfully with these companies, it will be difficult for them to attract and retain users.

To continue to attract and retain users, Roku needs to be able to respond efficiently to changes in consumer tastes and preferences and to offer users access to the content they love on terms that they accept. Effective monetization will require Roku to continue to update the features and functionality of the streaming platform for users, content publishers and advertisers. The success of Roku will ultimately depend on attracting and retaining users on the streaming platform with effective monetization. 

Companies such as Amazon, Apple and Google have greater financial resources than Roku do and can subsidize the cost of their streaming devices in order to promote their other products and services, which could make it harder for Roku to acquire new users, retain existing users and increase streaming hours.  

2. Relationship with TV Brand Partners

Roku licenses its OS to Original Equipment Manufacturer (OEM) brands. These licensing arrangements can be complex and time-consuming to negotiate and complete. Current partners include TV brands, cable and satellite companies and telecommunication providers. In recent years Roku has shifted the focus of international growth to the sale of Roku streaming players and Roku TV models.

The loss of a relationship with a TV brand or service operator is a risk to the overall operations and reputation. Further to this, there is a risk of increased pricing and promotional pressures from other partners and distribution channels, or increased marketing costs. If Roku is not able to maintain existing relationships and create new relationships with any of these third parties their ability to grow the business could be adversely impacted.

In addition, many TV brands offer their own TV streaming solutions within their TVs. If consumers of TV streaming content prefer alternative products to Roku streaming players and partners' Roku TV models, Roku may not be able to achieve our expected growth in active accounts, streaming hours, revenue, gross profit or ARPU.

Opportunities

1. Over-The-Top (OTT) and Connected TV (CTV) Advertising

OTT advertising refers to individualized content provided to the viewers' TV sets while they watch the same TV show. OTT advertising is a targeted ad delivery on a CTV enabled by programmatic technology. CTV relates to any television set used to stream video over the internet. These are most often videos that are streamed via apps that are downloaded.

As a result of OTT, advertisers can expand their audience reach that previously was only available on traditional TV. Experts predict that the money coming from OTT ads will increase anywhere from 45-60%.

One of the reasons why OTT is on the rise is because there is an increasing amount of unhappy paid TV customers. While there are many reasons why people are not happy with the cable or dish network provider, there are gradually more and more options becoming available to consumers who want to get rid of the traditional TV. OTT can provide them with a wide variety of payment and viewing options which allows the viewers to free themselves of contracts that their cable providers locked them into. 

So, where does Roku fit in? Roku enables content partners to publish streaming channels, quickly and easily, which makes it an attractive platform for content publishers to partner with as they seek to reach TV streaming, or OTT users. Content publishers can deliver content directly to large and relevant audiences and reach those users who no longer use or those who never used legacy pay TV or paid TV subscriptions. As consumers shift to TV streaming, content publishers that use their platform are able to reach these streaming audiences at scale and engage users directly.

2. Roku Originals

Earlier I mentioned that in Q1 2021, Roku completed the acquisition of Quibi’s content. Roku has since re-branded this service as “Roku Originals” which launched on 20th May 2021. Roku Originals will also be the brand name for future original programming for The Roku Channel, the home of free, ad-supported entertainment on the Roku platform. 

The Roku Originals launch lineup featured 30 titles, including award-winning and scripted series such as Die Hart, #FreeRayshawn and Reno 911!, documentaries such as Blackballed and Big Rad Wolf, plus alternative and reality programming, including Punk’d and Chrissy's Court.

The acquisition and rebranding of Quibi is a clear move towards original content by Roku. When The Roku Channel originally launched, it was a place for media companies to put the content they couldn't ultimately monetize on their own. In exchange for letting Roku stream and monetize this content, the media companies got a cut of ad revenue.

The shift to acquiring and producing original content is important because Roku directly monetizes each piece of content it licenses with video advertisements. For Roku to break even, each piece of content needs a certain number of viewers. The more viewers on The Roku Channel, the more likely any single piece of content will break even. It would appear that Roku has now reached the minimum audience threshold to produce an original series to ensure it can be profitable.

Investment Strategy

Roku is the top TV streaming platform in the U.S. market and continues to maintain robust platform adoption as cord-cutting continues. Despite how limited the offerings are still here in Europe, I am a Roku TV customer and my experience has been really positive so far. I believe that there is scope for significant international expansion as the service gets fully rolled out in Europe and further afield.

As consumer adoption of CTVs increases, advertisers will be able to use this data to identify audience segments to enhance linear and programmatic strategies. CTV data will allow media buyers to optimize their CTV ad spends with this optimization going as far as enabling buyers to expose their audiences to ads at times where viewers are most likely to absorb and engage with ads. Ultimately, CTV ads will offer greater bang for your buck compared to linear TV ads meaning increased monetization for Roku.

Finally, if you look at the operating systems of computers, you see that Microsoft and Windows OS have done much better than hardware producer IBM. The Roku investment thesis can be summarised as it becoming the ultimate operating system of CTVs.

At the time of writing, the author holds a long position in Roku.


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Wolf of Harcourt Street

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Disclaimer: I am not a financial adviser and I am not here to give specific financial advice. The opinions expressed are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The information is based on personal opinion and experience, it should not be considered professional financial investment advice. There is no substitute for doing your own due diligence and building your own conviction when it comes to investing.