Let's talk about one of Cathie Wood's favorite stocks – one that is sitting in the top 3 holdings by weight in the ARKK fund... ROKU. It's only behind Tesla and Teledoc in her ranks. Given the stock has formed a double top and come down nearly 80% from its highs (wow!), I think it's worth diving into this to see if it's in oversold territory or if there's more blood to be shed.
Let's, first, take a quick trip in history of the company...
Anthony Wood, who's still CEO, founded the company in 2002. He successfully exited previous startup ReplayTV just a year earlier. Initially, Netflix CEO Reed Hastings brought on Wood as vice president to develop the Roku player in secret "Project Griffin". But, they later spun off Roku, and Wood dedicated his full-time efforts there to develop the first Roku player in 2008. Naturally, there were many updates in models throughout the years; and they've come a long way from being a "Netflix player". Most notably, as you'll see when we dive into their current model, they've made a near-full transition to being a dominant operating system (OS) for smart TVs.
Smart TV Market
What I found really surprising about the tv industry in general, was how many households are still using linear TVs. I thought it was a thing of the past, and everyone had smart TVs... but, I was wrong.
In fact, it seems like the shift away from linear TVs is still happening. According to Statista, the smart TV penetration is at 70% of the US household. It's been increasing at a rapid rate, especially during 2020 – the start of the pandemic, which makes sense. It also surpassed connected TVs (CTVs) recently. ARKK predicts linear TVs will continue their decline, as sports league end contracts with networks and move to a streaming-first model. I was also surprised to see Smart TV market CAGRs being forecasted as high as 17-20%.
How does Roku make money?
Ok, so where and how does Roku fit into all of this today? Their business operates in two segments – Platform and Player.
Player revenue is generated from the sale of streaming players and audio products – which is the root of how their business started. It's pretty much hardware sales of the R0ku stick, Streambar, and other devices.
Platform revenue is generated from digital advertising sales in its OS, content distribution ads on its Roku Channel, and licensing arrangements with TV brands for using its OS. These are all revenues driven from the Roku TV OS, which is the real growth-driver for them. Platform revenues contributed more than 80% of revenues in 2021. But, more on this in our valuation & forecast – which we'll get to shortly.
Key Operating Metrics
Roku's key operating metrics are active accounts, streaming hours, and average revenue per user (ARPU). As you can see, they all had double digit growth in Q4'21, but slowing down since the pandemic – which was likely peak growth for Roku (i.e. making it a pandemic beneficiary). Investing in pandemic darlings, if it wasn't obvious is risky business. But, let's not deter us from the rest of the fundamentals. Looking at multi-year periods, these metrics have all grown substantially.
Valuation & Forecasts
As a reminder, all valuation sheets are available to premium members of The Hawk Letter and Discord. I highly recommend you join, to make your own assumptions and investment thesis :)
For our valuation & forecasts, in this case, I didn't bother forecasting accounts and ARPU, but rather just forecasted the operating segments directly as it was the easier approach.
The first thing I noticed is how Player revenue has been significantly trending downwards. This is due to supply chain issues and headwinds the entire industry has been facing. Over the past year, Player revenues have had negative contribution margins; and nearly a -30% operating margin in Q4'21. So, that's quite the headwind dragging performance! Not only have player growth been impacted, but also margins... again, a 30% impact to margins is significant! Because these issues are also impacting partner TV manufacturers, it's fair to assume that, although still growing, Platform revenue is also impacted since manufacturers are now selling less TVs. So, although Roku has benefited from the pandemic, they're also getting screwed on the other end now with supply chain issues.
Roku anticipates supply chain issues to continue onto 2022, and has forecasted total revenue growth at 35% (which I find optimistic) and Q1'22 revenue up 25% due to seasonality. But, overall, they appear to continue down the path of margin contraction, given their negative net income guidance – which I don't like.
For my forecasts, I gave them a CAGR of 13% until 2025 – where I was more conservative. But, I think the real opportunity here is with margin expansion past supply chain issues, if they can focus on the Platform business, and get more adtech margins. This is where I would like to see Roku pivot the business. This is where the real opportunity lies. As an investor, I'd personally want to see them scrap the player business and focus entirely on creating the Windows for PCs or iOS for phones.
But, this is a tough bet to make, because the Street and analysts are really negative on their outlook... but, I think this is where the opportunity lies.
If we assume a 20x P/E on my EPS, we're at $80/share, which means more downside to go. Assuming a FV per share equal to it's price, and a 6x P/S (which gives it some price expansion), and giving each of these variables an equal weight, I get a 30%+ upside.
However, as you can imagine, there's a lot of risks with these assumptions... but, I do think that Roku can make a good investment, or probably a good acquisition target.
Risks & Competition
The biggest risk to Roku is its lack of moat, and competitive threat. At a worldwide level, Roku still has lots of ground to cover against competitors like Tizen (Samsung) who lead the way. But, they have a significant advantage in North America. They have lots of ground to cover in Asia against dominant Android TV. Google's Android TV and Amazon Fire are slowly picking at market share from Roku in North America as well. This concerns me.
Roku primarily grew by riding along cheaper OEMs like TCL and HiSense – who have picked up quite a bit of market share lately. However, many of these manufacturers have been diversifying to other OSs like Android TV lately. This is pretty scary as a Roku investor. Roku (and bulls) argues that manufacturers developing their own OS is too expensive, and Roku has an advantage over other tech giants (i.e. Google, Amazon, Apple) since their OS is primarily designed for TV and can be run with lower performing chips. But, in reality, there's nothing stopping these other players from redesigning.
Overall, I do believe that consolidation in the TV OS market will occur. And, I don't know if Roku will be able to do it alone. I think the way forward will with Roku being acquired. I would buy Roku at the levels where I think they make a good acquisition target. There is a lot of negative sentiment lately, and Roku is facing significant headwinds, so now might be the time to start accumulating.
I haven't fully made up my mind yet. I don't think the levels are attractive here yet, given the risks and lack of moat. They will likely have to give up platform revenues and ARPUs will decline with international market share.
I'm keeping this on my watchlist for now.
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