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.