Justin Sullivan
Calling $100 on a stock that just plunged from $87 to $65 in a single day is going to raise some eyebrows, I know. After two articles advising against buying Roku, now I am writing a third to buy when it just delivered its worst results in years. But Roku (NASDAQ:ROKU) is now in a fundamentally different place than when I shunned buying it earlier this year. While Amazon (AMZN) and Alphabet (GOOGL) (GOOG) certainly aren’t going anywhere and Apple (AAPL) seems to be heating up its TV business as the widely-expected winner of the NFL Sunday Ticket, I believe Roku’s underlying strengths remain … and they are now available far more cheaply.
My History With Roku
I wrote my first article on Roku all the way back in 2018, when it was selling for a meager $40 per share. I advised against buying it.
Given that Roku wound up surging to almost $500, there have certainly been times in the past when I felt foolish. I’d like to defend myself by saying that was at the height of an unforeseeable pandemic, but the truth is even prior to COVID-19 Roku was trading at $130 and far ahead of the general market since my initial article.
Still, I’ve never owned Roku. I didn’t quite understand the bullishness, for the reasons I described at the time. How exactly was this advertising business going to work for Roku? But I’ve also always been intrigued by it, and I outlined some of the reasons why in my second article.
Now, following second-quarter earnings, Roku is all the way back down to $65. Comparing the stock’s rise since my initial 2018 article to the S&P, Roku is now “only” up 63%, compared to 52% for the broader market.
I’m a little tempted to wait until they even out to buy in, to say I didn’t miss out on anything by waiting, but even I know that’s nothing but pride and vanity talking. Roku’s plunge following earnings has put it low enough that it is now almost certainly undervalued, so I am shifting to a Buy recommendation.
But I still say, advertising won’t work.
The Red Herring Of Advertising
There are two big problems with advertising on Roku. The first, as I noted in my first article, is that Roku simply doesn’t have a strong base of data on which to achieve superior targeting. This isn’t to say Roku can’t generate revenue from advertising; it most certainly can and will. But in the long run it is unlikely to generate substantial profit from doing so.
Because advertising delivered to an uninterested party is essentially wasted money, all advertising money can in a sense be considered paying for the “successful” or well-targeted recipients. When someone spends $20 CPM (a CPM is 1000 views) on an untargeted TV ad about makeup, and only half of the viewers are women, they are really paying $40 per one thousand female viewers, not $20 per viewer.
I won’t dwell on this point because you can read all about it in the original article I linked above.
Limited Reach
The second problem is the lack of revenue sharing Roku sees from some of its senior partners. Roku often insists on receiving a 30% share of the ad slots from its more junior content partners who advertise on the platform. But when it went public Roku received no payments from YouTube and almost none from Netflix, its two biggest streaming services. These services remain the two biggest services today, and there’s no reason to think its leverage over them has gotten any bigger.
Not to say that Roku hasn’t tried. It’s spat with Alphabet over YouTube was particularly well-publicized. But that dispute was reportedly about YouTube trying to push Roku around, and get favored treatment for its apps. It was not over ad revenue, which Roku presumably already knew it was never going to get.
It also possible that Roku did try to get an ad cut and simply didn’t want to admit it, but they usually haven’t been shy in that regard: when a similar dispute broke out with Amazon, Roku more explicitly targeted its FAST service, IMDBtv – now called Freevee – as the reason for the ruckus.
It eventually resolved both disputes, of course. No word on what accommodation Amazon and Roku reached, and it’s YouTube dispute ended with a joint announcement that told us nothing, but it seems highly unlikely to me that YouTube ceded any significant revenue. So figure that Netflix and YouTube, which according to Nielsen constitute close to half of all streaming on Connected TVs, still aren’t paying anything, and won’t be even when Netflix starts running ads, which has now been pushed to 2023.
Roku’s Real Potential
I spelled out Roku’s far more demonstrable path to profit in my second Roku article, published at the beginning of this year: Roku also has the potential to generate a significant amount of income from subscription commissions.
The genesis for that article was Amazon’s Channels program – which works almost identically to Roku’s – was losing HBO Max after the two companies were unable to come to a deal. HBO, at the time still owned by AT&T (T) – and still owned 71% by AT&T’s former shareholders following the merger – wanted to bring sales under its own roof and exclusively on its own platform … or maybe was just sick of paying Amazon’s commission.
As I noted at the time, it didn’t work. By my calculations, roughly 68% of consumer revenue Amazon was generating for HBO was lost when HBO left the Amazon Channels program. Consumers seem to value the convenience of paying for multiple subscriptions through one platform, and may also value the chance to experience the content they prefer through the user interface they prefer, when the content providers own UI is so universally despised as HBO Max’s is. Roku, on the other hand, regularly wins plaudits for an outstanding user experience.
Even HBO Max now seems to concede its experiment is a failure. With the transition to new management under CEO David Zaslav following the merger of WarnerMedia with Discovery, Warner Bros. Discovery (WBD) is now reportedly in negotiations to re-enter Amazon’s Channels program. So it seems that this revenue is durable, and not easily yanked back by content creators.
Roku’s Hidden Potential
Roku also could operate a video rental store on its platform, if it wanted to. Although it is unclear why it currently doesn’t it certainly has the potential to become a significant contributor to revenue, and again it doesn’t depend on Roku developing information about its customers it doesn’t already have like ads do. If someone wants to offer their title for rental, Roku, as the platform customers buy and use, is in an excellent gatekeeper position to demand a cut. Even if Roku continues to allow other apps like Vudu, Apple TV+ and Prime Video to be the primary mechanism for rentals, it could insist on taking a cut for itself.
This is not currently revenue Roku is making, but it seems reasonable to believe that it could, either through its own store or through a preferential deal with another store. And it wouldn’t threaten Roku’s “Switzerland” status as a non-affiliated device company. So I want to calculate what it could get, if it decided to enter the market.
For these figures, I am going to use the report of the US home-entertainment market from the Digital Entertainment Group. According to these reports, excluding PVOD (Premium Video On Demand) spending on rentals and purchases through digital channels came to $4.2 billion in the US last year.
Recently, in my research for my second Roku article, I divided the market of home video streaming platforms into 1/3 Amazon Fire, 1/3 Roku devices, and 1/3 all other manufacturers. This corresponds to the most recent results of my research, but there are different numbers being reported by different research outfits and you may find some other division more credible. So far, however, most of those disagreeing with me have argued Roku’s share is even larger, so this seems a credible conservative estimate.
I will apply a 15% commission rate, since it has been reported to be increasingly becoming the new industry standard. That suggests that for the $1.4 billion imputed share of total spending Roku controls, it paid out roughly $1.2 billion to content producers, leaving $200 million for itself. The only thing that makes me a little uncomfortable about this number is that Roku management itself hasn’t mentioned anything about starting rental/purchase sales. But it seems like easy money if the company’s stock remains under pressure and it needs another revenue source.
Calculating Roku’s Stock Price Target
I will leave rentals out of it for now and just focus on subscriptions. I calculated in my second article that Amazon alone could take in 7.5% of HBO Max’s entire US revenue base, but treating the revenue as a whole and the platforms as constituents seemed to confuse some people. What’s more, I assumed at the time that Roku’s share was much lower and that they would even out a constant pie over time (i.e., Amazon would go down as Roku went up.)
I now believe that was too conservative. We don’t actually know how successful Roku’s Channels program is compared to Amazon’s, but with a similarly highly rated user-interface and maybe a larger device base it doesn’t seem like it should be any lower, at least in the US. And Amazon’s share alone, we know, came to five million subs by itself.
This time, I will assume Roku has an independent base, but make it smaller, as you will see below. And since my direction of travel wasn’t well received before I will reverse it. I will use HBO Max again as a stand-in for the broader streaming market since few other hard numbers are available.
HBO Max Steady-State Extrapolation
Roku, like Amazon, accounts for 1/3 of the streaming device base in the US. That means it proportionally encompassed 15 million HBO Max subscribers at the time of my second article, who paid some $2.7 billion a year (15m x $15 per month x 12 months) for the privilege.
If, like Amazon, five million of these were selling through Roku, and only 32% of their revenue could have been retained without Roku’s help, Roku would generate a value of 68% of 1/3 of $2.7 billion. That is roughly $612 million. But we will assume that Roku is only half as good at it, and multiply down 1/2 to $306 million.
The Broader TAM
But HBO Max is only one portion of the broader streaming market, so now we need to multiply up. This exercise implies a US revenue base of around $8 billion for HBO Max, at a time when pay-TV as a whole has gone over $100 billion.
But that’s an unnatural monopoly that may be about to accelerate its collapse, so we will pencil in a $50 billion mature US streaming market and multiply by six. Call it $1.8 billion per year in Roku revenue.
To be conservative again we will assume International, where Roku is only just now getting started, will generate only half as much worldwide as the US, which is just ridiculous but as you’ll see doesn’t hurt our conclusion. That puts it at $2.7 billion.
With operating expenses (R&D, SG&A) of $465 million per quarter as of now, call it $1.85 billion per year, Roku is poised to generate some $850 million in operating profit just from subscriptions. At a 20 P/E that would have an Enterprise Value of $17 billion, and Roku has well over $1 billion in net cash on its books. With its current share count, that comes to a target price of roughly $130 per share.
Risk Factors
The primary risks to my thesis, since I’m not basing my decision on advertising, has to do with the two prongs of the strategy I’m outlining: selling devices and charging commissions.
Device Sales
Device selling is most likely to be threatened if the other major players with far larger balance sheets decide to go for an all-out price war on streaming boxes, for essentially however long it takes to force Roku out of the business. Roku does have $2 billion and change on its balance sheet, but this pales in comparison to its mammoth competitors. If Amazon and Google – probably not Apple, which doesn’t believe in low-priced products – suddenly start selling boxes for $10 instead of $40, they won’t notice nearly as much as Roku.
Against this risk must be set two things. First, it is technically illegal to engage in predatory pricing in this way, and though courts have shown little inclination to enforce antitrust laws these days – my interpretation – any effort to engage in this practice would still carry some risk.
Secondly, and perhaps more importantly, is that Roku’s fellow streaming box makers don’t really show any indication of doing this. It’s not in anyone’s interest to sell devices at such a low price that customers cease to value them and have no compunction about losing or breaking them. We saw something similar with Amazon’s kindle e-readers, which consistently fell in price from $400 to $70 for the basic model by 2012, but haven’t gone any lower since. It’s not that component prices didn’t continue to fall; Amazon just knows it isn’t prudent to go much lower.
Partner Pushback
The other main risk to Roku’s bull case is if streaming services themselves actively seek to undermine Roku’s ability to secure commissions. Apple regularly argues with even some of its most important digital partners about its commission, and has lost a few court cases over the matter.
But the mechanics of how Roku gets paid matter less to me than the fact that as long as Roku is a leading streaming platform, it will be a gatekeeper. As an economist, I believe that gatekeepers get paid. Perhaps instead of commissions, Roku will one day charge for related services like a Buy Now button, or every time a service is included in search results, or any of a dozen other ways.
Roku occupies a critical place in the streaming infrastructure. As long as that doesn’t change, it can generate enough profit to support the current price and even get back to $100 per share.
Implications For Other Stocks
Just very briefly, these basic principles are absolutely ones you could apply to an Amazon, Alphabet or Apple analysis as well. Their own platforms and streaming boxes are presumably producing very similar value chains and effects. But since it is such a smaller piece of their overall businesses, they won’t see quite the boost in share price if things go as well as I hope. In any trending upward sector, the pure-play is the best bet.
Investment Summary
The fall in share price seems an opportunity to me because it was driven largely by concerns of a coming recession and falling advertising. Advertising never seemed to me a very likely path to profit for Roku, so I am basically getting the same profit potential I was being offered before, now for half of the $130 price it was trading for in April. While I could wait and see if more Fed rate hikes drive it even lower, I don’t like to try to time that precisely. I am going to buy now.
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