Roku Inc (NASDAQ:ROKU) stock has lost its momentum after an early pop. The ROKU stock price rose 68% in the company’s first day of trading on September 28, and another 13% the following day. Since then, however, Roku shares have steadily pulled back, dipping below $20 as of this writing.
The decline makes some sense. I wrote soon after the IPO that I thought the stock was overvalued, given some of the challenges facing Roku going forward. Ahead of the company’s earnings report next week, I still believe that’s the case. There are three distinct and significant issues that Roku must deal with. And with ROKU stock still unprofitable and highly valued, even after a ~20% pullback, I still don’t think the company’s potential problems are priced in.
Competition and Pricing
The most obvious concern facing Roku is competition in the device market. Giants Alphabet Inc (NASDAQ:GOOGL), Amazon.com, Inc. (NASDAQ:AMZN) and Apple Inc. (NASDAQ:AAPL) all have their own devices on the market.
For what it’s worth, I personally think Roku is head and shoulders above those peers, having tried all four in my own cord-cutting efforts this year. But the problem for the ROKU stock price is that the competition isn’t just about market share or unit sales.
Rather, pricing pressure has been a big problem. According to the S-1, gross profit dollars from Roku players fell 28% in the first half, despite a 37% increase in volume. The Roku Express was rolled out to compete with the $39 (or lower) price points at Amazon and Google. As a result, gross margin fell to just 12% from 16.6% in the first half of 2016.
When accounting for other expenses, like advertising and support, the player business probably is in the range of breakeven at best. Q3 earnings will give more color on pricing pressure and gross margins, and it will be a closely watched metric coming out of the report.
But assuming there’s no change in Q3, profits have to come from what Roku calls “platform revenue,” which is fees from advertisers and content publishers. That revenue stream totaled just $140 million over the past 12 months, however, while ROKU stock still is valued at roughly $1.6 billion. And there’s a big problem on the platform side as well.
Netflix and YouTube
In the U.S., the two most successful streaming services are Alphabet’s YouTube and Netflix, Inc. (NASDAQ:NFLX). But Roku, per its S-1, gets zero revenue from YouTube and no “material” revenue from Netflix.
That’s a pretty major problem. Alphabet recently announced that YouTube viewing on TVs is up 70% year-over-year. Netflix is the leader in the space. And yet Roku isn’t monetizing either platform in the U.S. and has basically no international presence, either.
So Roku needs platform revenue to grow substantially to turn profitable, yet it’s not generating that revenue from two of the leaders in the space. That’s a tough combination.
The TiVo Problem for ROKU Stock
The problem for ROKU stock is that the device can be a success, and the stock still can wind up overvalued. From that standpoint, TiVo Corp (NASDAQ:TIVO) is a cautionary tale.
After all, TiVo’s DVR product was successful enough that it actually became a verb. But that success did little for TiVo stock. Cable operators ran the company over, and though TiVo had great success in winning patent infringement suits against the likes of Verizon Communications Inc. (NYSE:VZ) and DISH Network Corp (NASDAQ:DISH), that’s basically all it did. The company wound up selling itself for $1.1 billion to Rovi, who took the TiVo name and stock ticker.
I fear the same outlook for Roku. The hardware business has short-term competition problems and long-term fears about a hardware-free environment, with content accessed to versatile screens via the cloud. Platform revenue growth needs cooperation from bigger players, with whom the company has little or no leverage.
There’s little doubt Roku will grow revenue in the near term. But the long-term outlook is a question. Roku is simply so much smaller than its rivals and its suppliers. And that seems like a tough spot to be in a changing market.
Roku is a great product, and I use it every day. But as TiVo and so many other tech hardware plays over the years show, a great product isn’t good enough. This remains an unprofitable business valued at over $1.5 billion. It needs not only a great product, but great profits. And I question whether Roku can ever get to that point.
As of this writing, Vince Martin has no positions in any securities mentioned.