Roku - The Age Of Accepted Unprofitability Is Over (NASDAQ:ROKU) | Seeking Alpha

2022-05-29 10:33:24 By : Ms. Nicole Wang

Justin Sullivan/Getty Images News

Justin Sullivan/Getty Images News

I've taken a look at Twilio (TWLO) and Palantir (PLTR) over the past few months, which is somewhat outside my sphere of value-investing - my comfort zone, if you will.

However, as the market has turned, many of my readers have contacted me and asked me to give them my take on what they view as superb investments (which many of them own and are currently in the negative on).

I am, of course, always happy to do just that for my readers.

Roku (NASDAQ:ROKU ) requires some time to get a grip on - so let's get going.

Roku, with the name actually coming from the Japanese number "six", indicating it was the founder's sixth business, was founded 20 years ago in the year 2002.

Anthony Wood, a very knowledgeable player in the media space, including being the former president and CEO of ReplayTV and being in the space for decades, founded the company. He's the Chairman and CEO of the company and has been the chairman since 2008.

Anthony Wood has an interesting past, where he in 2007 was named a VP of Netflix (NFLX). However, after Netflix decided to go software, not hardware (in that they wouldn't be building their own players), a new Roku company was incorporated and part-funded by Netflix (with $6M) in order to build a player of content. This company moved to Saratoga, CA in 2008.

The company IPO'ed in 2017 - prior to this, it was private and held a number of venture capital funding rounds.

The company has been building technology for a long time. Its legacy products include things like the Roku PhotoBridge HD1000 (Streaming video and photos on high-def TVs using card readers), the Roku SoundBridge (a network music player), and SoundBridge Radio, a similar network music player with more features. All of these products were capable legacy competitors 15-18 years ago.

Today, the company sees and describes itself as a leading TV streaming platform in North America - including the US, Canadian and Mexican markets. The company's products are now also available in Germany, Brazil, Chile, Peru, and the UK, meaning the expansion into international markets has started.

The company believes that all TV content will eventually be streamed and believes that this creates an opportunity not only for consumers but also for publishers, advertisers, and other industry participants.

Roku, through its products and services, wants to be "the" global TV streaming platform connecting and benefitting the entire TV ecosystem of consumers, publishers, and advertisers - your 1-stop platform for everything. To this end, the company owns and operates a TV streaming platform that connects consumers to entertainment while enabling publishers to monetize large audiences through advertisements.

The core of this concept is the Roku operating system and environment, built for TVs and designed to run on very cheap hardware (which, let's face it, most TVs have, and which allows Roku to build cheap streaming devices). So, not only does the company build its own streaming players, but it also provides TV manufacturers with the option, through licensing, to offer the OS built into Its design.

Either through the TV directly, or the Roku player, this then allows consumers access to content by connecting it to the Roku network.

The company, as of FY21, has over 60 million active accounts, which apart from offering plenty of consumers of course gives Roku tremendous and expansive data insights, meaning Roku, and its publisher and advertising partners can target consumers with personalized advertisements and content ideas.

Roku's idea to deliver growth and profit can be summarized into 3 steps.

So, the company is both hardware and software. It's both licensing, and it even does co-branded products, and we might see Roku televisions going forward.

Whenever I think of manufacturing, I want to know at least the basic specifics. Roku outsources its manufacturing to contract manufacturers and thankfully does not own any capacity itself. Manufacturing is done in China, Southeast Asia, and Brazil.

Payments from content distributors to the platform owners (such as Netflix to Roku) are a business with a lot of moving parts. Generally speaking, platform owners like Roku are compensated by distributors like Netflix collect a rev share as a first-party fee. But with subscription services, such as Netflix or Hulu, this gets messy quickly. Early in the business, Netflix paid Apple on a per-sub basis driven explicitly from the platform (Apple TV), while subscribers that just installed the Netflix app and already owned the sub, did not cause for any payments from distributor to platform owner.

Platform owners do deals for driving subscribers by paying sub-bounties to the platform, usually with sub-requirements and so forth.

So, the marketing and deals between content companies and platform companies like Roku are fairly complex and depend on grandfathering in the subscribers versus not. They are also shifting. Previously, for instance, you could use Roku billing to pay for Netflix - that is no longer possible at this time.

So, Roku can be bought as low as $29.99 (€14.99 sale currently in Germany) for a device - or directly on your TV, if you buy a Roku-compatible TV. There are no monthly fees to watch free channels or use a Roku device or account.

However, there is a mix of one-time charges (such as for renting a movie or show), or recurring charges (through subscriptions, added through Roku). The Roku channel also comes with a premium subscription option.

The ad services offered by Roku are things like ad-supported channels, OneView (and ad platform), and the "Brand Studio", a Roku option that offers the creation of new ad formats and branded content on the Roku channel itself.

So, the company generates revenue by:

We could simplify by saying Roku is an ad-enhanced library of TV and movie content, offering physical devices. The business model hinges on the company getting its viewers and subscribers to spend more sub/content money and hours/watched the time on its services (and products).

Let's look at the numbers.

In terms of revenue, both net and platform, as well as gross profit, the numbers are actually very good. The same is according for Active accounts, which have also been growing.

Roku FY21 Results (Roku FY21)

Roku FY21 Results (Roku FY21)

Streaming hours are up to 73.2B, and Roku is the no.1 TV streaming platform by total hours streamed in each of the three largest NA markets. 2021 was a record year, exactly because streaming hours more than doubled YoY for the full year. The company is also starting to produce original content, such as Zoey's Extraordinary Christmas.

The outlook for the company remains intact, along with the company's stated competitive advantages, driving 2022 and onward. As a company with physical products, Roku is obviously impacted by current supply chain issues., both for its players and for Roku-branded/licensed Television sets and Audio products. The company expects further pressure in TV sales, impacting account growth, but also impacted ad spend in some of its verticals due to supply/demand imbalances.

But all of this is secondary for the time being. The results, as revenue, and gross profitability goes, are good, despite missing a few expectations for 2021, and the market crushing the stock as a result of this.

But the rest of the results?

Well, the excellent set of news here is that Roku is actually a profitable business from a profit perspective.

Not just on any sort of adjusted results either - the company has a positive net profit, $242M for the year 2021, coming to a net profit of $1.71 on a diluted per-share basis. Now, net income isn't always a perfect metric for a company like Roku, because rapidly developing companies can report consistently low net income as they invest and expand, while long-time positive operating cash flows bring a potentially stable increase in net income.

However, the company has issues similar to other "growth" companies such as this. Specifically, stock-based comp is growing at a rapid pace. While the company generated positive operating income during 2021, SBC also continued to grow.

Roku SBC/Operating income (

Roku SBC/Operating income (

When I review these sorts of companies, critical commenters usually take the stance of either "you look too much at net income/GAAP" or "You don't talk enough about cash flows". However, when I engage with these valued readers, I often don't get a feeling that they understand the intricacies or differences between these two company measurements.

So, what's more important, then? Cash flow or profit?

The relationship between profit and cash flow is highly correlated in the long term. Eventually, a consistent negative profit will have detrimental effects on cash flows. The absence of a profit will have destructive effects on cash flows, which is why when I look at businesses such as these, I tend to give profit at the very least an equal amount of attention, if not more.

A crucial difference between cash flows and profits, and one of the reasons I completely understand why tech investors love focusing on cash flows, is that positive cash flows can be easily bought.

All you have to do is get a loan, issue equity, or as is very relevant for our case, issue SBC. Because in accounting and similar to depreciation, no cash is actually paid out. Because of this, SBC, Equity issuances, and debt improve cash flow - at least in the short term.

So, I argue that a focus on profit is crucial. And specifically, we don't want to just look at gross profit, but at operating and net profit, because in the end, the bottom line is what's important in the long term. Profit includes these non-cash expenses, which can otherwise give cash flow an unfair "advantage" if you don't understand it.

4Q21 and FY21 numbers were disliked by the market, despite that positive net profit. Why was this?

Part of it was probably that results came in well below consensus estimates in revenue. More importantly, some of the profit indicators, despite positive net profit, came in at substantially reduced numbers to earlier periods. Adjusted EBITDA margins went down to 10%, and gross margins declined below 45%, which are numbers that are some of the lowest ever recorded by Roku for the past several years.

The company booked a gross loss for its players for every single 2021 quarter except 1Q21, and a decline in player revenue, derived from supply chain issues and challenges related to sourcing and manufacturing.

So, while the active accounts, streamed hours and the ever-important ARPU were up - and significantly, gross margins across both platform and player were down, with Platform GM down to almost 60% down from almost 68-70% historically.

Furthermore, R&D and SG&A were up between 33-70% over the year, and total operating expenses were up 49%, which lead to declined operating income on a 4Q21 YoY basis of 67%.

The company has issued guidance for 2022, expecting a 35% revenue growth and a reversion in adjusted EBITDA to 2020. However, the gut-punch was the EBITDA margin, which is now expected to decline to 4% on an adjusted basis due to significant investments into Roku OS, the channel, and the ad platform.

Oh, and that adjusted EBITDA?

Roku Adjusted EBITDA (Roku 4Q21)

Roku Adjusted EBITDA (Roku 4Q21)

It, of course, includes SBC added back in. It's not a problem if we understand it, and understanding it, in this case, means that Roku is overstating its payment ability, in that payroll would need to be a lot higher if this wasn't the case. In short, despite everything, cash flows are overstated.

Companies can offset this by buying back shares on the market (which would make this essentially a net neutral), but over the past year, Roku hasn't repurchased any of its shares despite the price going down significantly.

This leaves investors with the full, future dilutive impact of these SBCs, and to see when exactly the company (if they do) decide to offset this expense by repurchasing shares.

And obviously, when a company in this situation reports to the market that not only are profits down, margins down and they're seeing manufacturing and sourcing challenges - now they're also going to be doubling down on pushing cash out the door, they're going to be punished.

And that is exactly what happened with streaming darling Roku.

When I say "new", I mean new to the market. Earnings have always mattered to me - but they haven't mattered to everyone for the last couple of years. However, in a world where earnings now once again matter, companies are no longer able to get by on artificially-adjusted cash flows and enhanced numbers.

The valuation framework has shifted, and investors not only want to see revenue growth, but they also want to see a profit and unencumbered, positive cash flows.

The question is, can Roku deliver this?

First off, I see the thesis of Roku being able to deliver increased revenues and customers as solid. Streaming is bound to increase. I'm a cord-cutter myself. None of my television sets are hooked up to the cable network anymore. All they have is an HDMI cable and WiFi. I don't want any more than that.

I don't personally have access to Roku, but if I did, I would probably buy the player. It seems like an excellent way to converge my services and offerings in a way that doesn't require me to use built-in TV OS offerings.

I'm not alone either. I'm convinced that as a content and service aggregator, Roku will probably continue to grow. It already owns large parts of the TV users in the US, and its dominance in the NA market is a good sign to me.

Furthermore, 1Q22 provided a good insight into the company's near-term future - and that future was positive. Revenues, active accounts, and ARPU were up.

For most Roku bulls, there are no more important metrics than ARPU, as it's a financial representation of the company monetizing its very impressive user base. It suggests that there's strong internal growth, and a success in convincing users to spend more on company services even after the pandemic.

The pandemic was a boon to internet-based companies. Streaming has overtaken Pay-TV in the US in 1Q22, and there does not seem to be an end to it because the pandemic is over. Rather, the trend is stable.

I would agree with this. I see no reason why the growth in revenue and users wouldn't continue to grow, albeit at a somewhat reduced pace. While the company's top-line growth rate is no doubt slowing down, it's still seeing growth. As a platform matures, it's natural that a company's margins are compressed, and the business becomes less profitable. This is also, especially true when a business starts expanding, as Roku has.

Expansion always comes with OpEx.

The bullish case hinges on the company's 70%+ decline being enough to make the valuation attractive, given the backdrop of extremely attractive revenue growth, user growth, and its market expansion into new geographies.

But I will argue that this is only half of the truth.

The sentiment on Roku is centered around the slowing account growth. It's an accurate depiction that the US, and even the NA streaming market, has reached a "mature" state. The company's domestic growth rate will likely not replicate historical results.

This means that future growth will likely come from international markets where Roku may have a harder time monetizing users prior to reaching scale. A second problem in the international markets is the perception that Roku does not offer a unique product.

I spoke to several acquaintances across most age categories and explained the product. Their response?

We have Mii devices, Amazon (AMZN) devices, Google (GOOG) devices, LG, SmartCast, and even Samsung. At home, my 73-year-old father uses a Mii. While you can argue with me and say these things are not the same - and I would agree with this, it does not change the fact that international, specifically EU users, feel that their needs are being met in the aggregation/media/content space.

It's unclear enough at this point whether Smart TV and device markets will see any meaningful amount of OS/service consolidation to where Roku could come out of this profitably.

What's more, Roku just announced a massive year of investments in their platform, channel, and services. This represents a massive cash outflow to capture consumers I'm uncertain that they will actually be able to reach, convert or acquire as effectively as they did in the US legacy market.

The shift from a content-focused revenue model to a more advertising-based model also brings with it the risk of viewer exhaustion due to Ads. I fear that the company may be overstating the appeal of its ad offerings, especially as ad budgets are being scaled back to account for the current macro.

The company already forecasts low-single-digit adjusted EBITDA margins due to massive spending. I fear that margins, across the board, maybe the victims as Roku goes on its investment and R&D crusade, and I am uncertain the return that the company will get in the near term from such investments.

Given rising interest rates, increased debt, lower valuation, and a higher focus on a new valuation framework in an expected recession, I question the assumption that Roku has "reached the bottom".

I'm more positive on Roku than I've been on any of the two previous growth stocks I've reviewed. The reason?

I actually see a clear path to profitability here.

The company literally just (2021) announced that it intends to offset this path by more spending and investments.

Even if you argue that a south-of 4X P/S multiple is as low as we've seen the company in a long time, I argue that this does not necessarily qualify the company as being "undervalued".

Roku P/S (

Roku P/S (

It's closer to logical levels, but it's nowhere near legacy content company P/S levels of 5-year means around 1.8X for businesses like Discovery (WBD) or 1.9-2X for businesses like Comcast (CMCSA). Why would I use these as public comps? Because they are legacy businesses in a similar/adjacent space that have actually been around for enough time to matter.

Company EBITDA/EBIT/Earnings multiples are skewed, due to the long periods of negative earnings. We have a hard time in any way using these. Also, the only way Roku generates returns for its investors at this time is through capital appreciation. It does not have a dividend, nor does it currently plan to introduce one. At current share prices and positive profit, the company still trades at EBITDA multiples of over 33X, and EBIT of over 73X. Diluted P/E multiples are down from the somewhat optimistic level of 525X in 2021 but are still at 88X at this time.

The company also wants 4-5X to book multiples.

Roku Book Multiples (

Roku Book Multiples (

So, I don't view Roku as being valued at a "fair" level yet. I also view the aforementioned companies as better, because unlike Roku they don't suffer from excessive SBC and have excellent earnings - and cash flows. Some of the bulls are calling for Roku to go "back to $400 and above".

What is their apparent justification for such a reversal?

Increased revenue growth and profitability, usually, and depressed NTM revenue multiples that supposedly are "low" at sub-3X levels, and justification that Roku, given its growth, should be trading at 5-7X sales.

That's the thing though. Growth is slowing. None of these multiples are "low" on this, and the visibility for profitability and positive CFs are very low, given the company's recent shift toward massive investment.

I see absolutely no justification for a bullish thesis that involves Roku going back to a $400-$500/share price. That's a pipe dream. Neither the growth prospects, the current market, nor the fundamentals justify Roku going there.

Disagree? Let me know, and why.

S&P Global calls for a $157/share valuation average, coming from an $80 low to a $240 high. 20 out of 23 analysts are either at a "BUY" or "outperform" rating. These analysts have said their piece. Of course, these are the same people that called for Roku to back to $400-$500/share less than 4 months ago - so I wouldn't personally put that much faith in them.

Still, Roku trades with an 86% upside to S&P Global averages.

Unlike Palantir and Twilio, I do have a target for Roku. Profitability, even momentary ones, has its rewards, as I see it. Sales and revenue multiples are good valuation metrics to look at here. Going by what other peers see in this, I would personally want to see a sub-2X P/S multiple before going very deep into Roku. This would imply a share price of below $50/share, depending on what sales you're looking at.

One of the problems of P/S multiples is it doesn't take into account whether the company makes any profit - or if it ever will. Given that we have seen positive earnings, I would say Roku has the theoretical and historical possibility of making a profit, but it's still a high-risk prospect at this time.

I would want to see consistent profitability and margins for no less than 2-3 years before taking a step into such an investment. Given that we've seen profit in 2021, and if the company wasn't weighed down by player profitability issues, we'd likely see a positive pre-tax operating income, I say that Roku is on a good pace towards profitability, even if looking at the 10-K, Roku struggles with getting its costs in line (though this is also due to the investments).

What's more, 1Q22 saw an increase Q-o-Q in increased SBC - almost 75% to ~$70M.

So, I'd say things are "mixed".

I'm unwilling at this point to go into the company. But I do see a point where Roku becomes potentially interesting as an investment.

For now, I put that point at $50/share.

Roku is a risky investment, and I have a hard time seeing a massive upside at this price. I don't see any easy accelerant for the company to generate massive international sales.

International sales of either its products or its services compete with different and more players than domestic ones. Watch how Netflix has struggled in certain markets. Roku doesn't enjoy the same brand awareness and mover advantage it might be argued as having in the USA.

In order for Roku to push its products and services in Europe and other areas, I see the company having to push SG&A further, which is already at high levels, coming at 61.4% of gross profits for 1Q22, which is a high number, not even considering that including R&D, the company's operating expenses for 1Q22 were 106% of gross profits. Even if the company delivered profits in its player sub-segment, this would turn the company "barely" profit-positive on an operating income basis.

To those people calling for a $500 price target for the business, in a way where that is 100% higher than the highest S&P Global target, I pose the question - how do you reconcile this target with the company's operating expenses? How do you expect the company to eventually deliver the profits and scale worth such an increase?

If the company, through an already-achieved scale, can't deliver better gross or net profits, then I don't really see a unique accelerant able to deliver that magic 10-20% margin increase.

Ads? Really? Ads alone? I don't think so.

Revenue growth alone is not an argument to me for why the company should trade higher, because revenue without profit does not matter. With increasing debt, higher interest rates, and more complex markets to get into, I don't see enough upside to value the company any higher than a trough valuation here.

The company discussed in this article is only one potential investment in the sector. Members of iREIT on Alpha get access to investment ideas with upsides that I view as significantly higher/better than this one. Consider subscribing and learning more here.

This article was written by

36 year old DGI investor/senior analyst in private portfolio management for a select number of clients in Sweden. Invests in USA, Canada, Germany, Scandinavia, France, UK, BeNeLux. My aim is to only buy undervalued/fairly valued stocks and to be an authority on value investments as well as related topics.

I am a contributor for iREIT on Alpha as well as Dividend Kings here on Seeking Alpha and work as a Senior Research Analyst for Wide Moat Research LLC.

Disclosure: I/we have a beneficial long position in the shares of CMCSA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment. Short-term trading, options trading/investment and futures trading are potentially extremely risky investment styles. They generally are not appropriate for someone with limited capital, limited investment experience, or a lack of understanding for the necessary risk tolerance involved. I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles. I own the Canadian tickers of all Canadian stocks I write about. Please note that investing in European/Non-US stocks comes with withholding tax risks specific to the company's domicile as well as your personal situation. Investors should always consult a tax professional as to the overall impact of dividend withholding taxes and ways to mitigate these.