Roku Inc (NASDAQ:ROKU) went public on Thursday, priced at $14. So far, at least, the Roku IPO has been a success. ROKU stock popped 68% on its first day of trading – and followed up with a 13% gain on Friday. Even a pullback on Monday leaves the stock well above its initial offering price of $14.
From a broad perspective, the optimism toward Roku makes some sense. The company seems well-positioned for the current ‘cord-cutting’ trend. While its namesake device still drives the majority of revenue (59% in the first half of the year, according to the company’s S-1 filing), so-called ‘platform revenue’ is growing much faster and provides much better margins. Those revenues, ranging from advertising sales to fees used to process payments for individual Roku channels, better than doubled in the first half of the year.
But there are some concerns here and not the least of them is valuation. Competition is intensifying, and Roku isn’t profitable. The lack of earnings doesn’t doom ROKU stock by any means; it is a growth stock after all. Still, for a number of reasons, the trading since the Roku IPO seems just too optimistic.
The Competition Problem
The intensive competition in streaming devices is a double-edged sword for Roku. On the one hand, the giants trying to take share from Roku seem a real threat. Alphabet Inc (NASDAQ:GOOGL) unit Google has the Chromecast, available for $35. Apple Inc. (NASDAQ:AAPL) just rolled out a 4K version of its Apple TV. Amazon.com, Inc. (NASDAQ:AMZN) launched its well-reviewed Fire Stick 4K as well.
That’s almost two trillion dollars’ worth of companies directly targeting Roku’s core (and sole) business model. And it’s hard to see how that pressure will abate any time soon, if ever.
ROKU stock bulls would argue that Roku’s growth is all the more impressive precisely because of the giants in its space. It’s not as if Apple, Amazon, and Google are new entrants. Roku already is winning, which means it has a pretty good chance to continue doing so.
That said, competition has had a clear impact on pricing and thus Roku margins. Gross margin was 18% in 2015; it declined to 15% in 2016. In the first six months of 2017, the figure dropped to 12% from 16.6% the year before.
Roku basically isn’t making any money off its hardware sales, once SG&A costs are considered. As a business, that’s OK for now given the growth and profits available in platform revenue. This is a classic “razor and blades” model. But that needs to be accounted for in valuing ROKU stock.
ROKU Stock Is More Expensive Than It Looks
From a fundamental standpoint, the pressure on player margins has two impacts. The first is that it could wind up being an impediment to profit growth for a company that has years to grow into its valuations. Player gross profit dollars fell 28% in the first half, with the S-1 citing higher sales incentives and lower pricing. Volume rose 37% – but pricing fell 29% in H1, mostly due to the Roku Express, which sells for $29.99 (and sometimes cheaper).
It’s one thing for the player business to be break-even. But if the pressure continues, and if Roku for instance has to bring down prices on better 4K models as well, the player business could become a loss leader. And that provides a headwind to the profit growth the company needs.
The second is that valuing ROKU stock on a revenue basis includes that player revenue, which isn’t of much value from a fundamental standpoint, given its low margins. On an enterprise value to revenue basis, ROKU trades at about 4.7x trailing twelve-month sales. But 60%+ of that revenue is from the player business.
The platform business has only generated about $140 million in revenue. And it has to support an enterprise value of around $2 billion. 100% growth might be able to do that – but if that growth slows, ROKU stock likely is in trouble.
Stay Away from the Roku IPO
All told, the Roku IPO looks like an ‘avoid’ for investors, at least. (Traders likely will have some fun with early volatility.) With the company still unprofitable, the bull case for ROKU stock largely comes down to its ability to grow platform revenue and maintain its role in the cord-cutting ecosystem.
And I’m concerned on that front. The S-1 discloses that the company gets no “material” revenue from Netflix, Inc. (NASDAQ:NFLX), despite Netflix accounting for roughly one-third of hours streamed. Roku gets zero revenue from Google’s YouTube unit.
Those are the two biggest streaming services, and Roku doesn’t have a piece. That’s in large part because it doesn’t have the market power to dictate the terms. Rather, Netflix and YouTube have that power.
What Roku reminds me of is TiVo Corp (NASDAQ:TIVO), another content pioneer. TiVo was so successful that its name became the synonym for recording shows. But that never translated into real profits for the company. TiVo, a small, single-product company, was run over by larger content providers, despite a series of patent wins against giants like Google, AT&T Inc. (NYSE:T), and Verizon Communications Inc. (NASDAQ:VZ).
Roku could have a similar future. A role in the content ecosystem doesn’t necessarily translate to profits and upside for ROKU stock. And with the Roku IPO leading to big early gains, investors already are pricing in more profits than the company might be able to generate.
As of this writing, Vince Martin has no positions in any securities mentioned.