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Bull of the Day: Roku Inc (ROKU)

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In 2007, streaming giant Netflix (NFLX - Free Report) made the decision not to produce the hardware for a video and audio player device and instead invested $6M in a spinoff named Roku (ROKU - Free Report) that was already producing hardware for streaming entertainment options over the internet.

Netflix cashed out just two years later for a small gain, and by 2017, Roku had a wide range of consumer products, a dedicated advertising product for businesses and over $500M in annual revenues. The company went public in September of that year at $14/share, implying a valuation of $1.3 billion.

Thanks to huge revenue growth across all segments, Roku is now has a market capitalization of nearly $10B and increased optimism about revenue and earnings forecasts going forward make it a Zacks Rank #1 (Strong Buy).

The engine for that revenue growth is the sale of advertising. Taking a page from Apple’s (AAPL - Free Report) playbook, the Roku business model is the creation of a “sticky” ecosystem in which customers purchase a device and then the ownership of that device encourages the customer to continue to make more purchases – often of higher margin products.

Roku makes a decent margin on stand-alone hardware that turns a TV or Computer into a streaming media device and they also license their operating system to manufacturers of smart TVs to be included in those products, but once a customer purchases one of those items, they’re unlikely to buy more hardware anytime soon.

Roku intentionally took a platform-agnostic approach and it’s systems can be used with the equipment of almost any manufacturer. This has made Roku ubiquitous in the content-aggregation market, growing the number of active users of the platform more than 40% over just the past year and the number of hours of programming viewed by 75%.

This gives Roku the opportunity to offer advertisers access to highly targeted audiences, maximizing their ad spending by having their ads shown to potential customers who have already shown some interest in the goods or services being offered - as evidenced by their entertainment choices.

Just as print advertising has been decimated by technology over the past few decades, broadcast advertising is largely being replaced by targeted digital ads on streaming services. Digital ad spending has been increasing at better than 20%/year lately and Roku promises advertisers dramatically higher rates of customer purchasing intent than broadcast ads.

In their most recent quarterly report, Roku reported gross revenues of $207 million, nearly 10% higher than analyst expectations. The increased revenues came primarily from what the company calls “platform revenue,” which is mostly advertising fees and Roku’s gatekeeper-like cut of third party sales through the platform.

The difference in gross margins is dramatic. Hardware sales net Roku approximately a 10% profit margin – which is pretty typical for the industry. Platform revenue earns close to 70% in gross margin, and because many of the costs are fixed, those margins increase as sales increase. The more ads Roku sells, the more they net from each ad.

Net earnings were also better than expected with Roku posing a loss of ($0.09)/share, much narrower than the expectations of a ($0.24)/share loss. Roku management also raised revenue  guidance for the full year to a range of $1.03B to $1.05B, more than double the previous year.

Though the company has still yet to turn a net profit, analyst estimates for losses have been shrinking lately with 5 upward revisions since the last earnings report.

The beauty of the Roku business is that is has virtually unlimited scale. Unlike devices which can only be produced and sold in finite numbers, the revenue potential of aggregating content and selling advertising is basically infinite.

It’s that sort of scalability that makes Roku such an exciting opportunity. There’s no reason they can’t keep growing revenues at the same torrid pace well into the future.

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