Roku Inc (NASDAQ:ROKU) stock has had a solid run on Wall Street so far. Things started with a bang. The Roku IPO was huge. Roku stock popped 70% in its first day on Wall Street. That represents the highest single-day return for any U.S. IPO in 2017. Then the stock followed up that record performance with a 13% gain the following day.
Make no mistake. With the cord-cutting trend still gaining momentum, appetite for companies in the over-the-top entertainment space is huge.
But how long can the good times last for Roku stock?
My bet is not very long.
Roku is employing a genius business model, but competition and profitability concerns loom large over this richly valued company. All in all, valuation risk appears elevated while the operational growth outlook is clouded by big competition. That isn’t a healthy combination for a strong investment thesis.
The Roku Business Model Is Smart
I’m a big fan of the Roku business model, which is essentially take a hit on one-time, low-margin hardware revenues to reap the long-tail rewards of repeating, high-margin software revenues.
Here’s the 30 second run-down.
Roku gets money from two revenue streams: player and platform. Player is the hardware side of the business. It’s the money Roku makes from selling devices. Platform is the software side of the business. It’s the money Roku makes from advertising sales and subscription plus transaction revenue share.
Roku’s strategy is simple. Sell a whole bunch of Roku devices at really low average selling prices. Gain a whole bunch users. Monetize that user base through ad sales and revenue share. Because software revenues are repeating and higher margin, the net result is more predictable and higher-margin revenue.
The strategy is working so far.
Hardware revenues declined 2% in the first half of 2017, but that doesn’t mean Roku is selling less hardware. The number of players sold increased 37%. The decline in revenue is simply due to a 29% drop in average selling price. Essentially, a drop in ASPs is fueling huge unit growth.
The huge surge in unit growth has led to Roku adding 1.7 million new active accounts so far in 2017. In the first half of 2016, Roku added only 1.4 million new active accounts, so user growth is actually accelerating.
On top of this accelerated user growth, Roku is squeezing more money out of each user through increased transaction shares and ad sales. Last quarter, average platform revenue per user increased 35% year-over-year to $11.22.
The net result is that so far in 2017, platform revenues are up 91%. Platform revenues carry higher margins, so the focus on platform revenue growth is allowing 23% total revenue growth to turn into 52% total gross profit growth.
That is a tremendous recipe for financial success.
But Competition and Profitability Concerns Loom Large
Despite Roku’s genius business model, the company isn’t guaranteed any success in the rapidly growing and intensely competitive over the top entertainment market.
Roku is going up against three of the biggest names in consumer tech in Amazon.com, Inc. (NASDAQ:AMZN), Apple Inc. (NASDAQ:AAPL) and Alphabet Inc (NASDAQ:GOOG). Roku is currently the market leader, but so was Fitbit Inc (NASDAQ:FIT) when the wearable device maker went public. The intense comp from much larger players with much deeper pockets makes it tough to believe that Roku will still be the market leader in three to five years.
In other words, much like FIT, ROKU has proven a concept. Now that the concept is proven, bigger players are starting to move into the market.
Granted, ROKU is fundamentally different than FIT because ROKU has a steady, high-margin software revenue stream. That means that ROKU doesn’t have to sell a whole bunch of new devices in order to grow. The company can simply grow its user base at a modest rate while continuing to ramp up its ARPU. That combination will lead to modest revenue growth.
But modest revenue growth means profitability is a long ways away. Without explosive user base growth over the next several years, the company won’t see explosive revenue growth. Without explosive revenue growth, the company won’t be able to achieve tremendous opex leverage. And Roku needs big opex leverage in order to make this business profitable (the opex rate is around 50% while gross margins are hovering just under 40%).
Bottom Line on ROKU Stock
The market cap on ROKU is now $2 billion. Revenues over the last 12 months totaled $436 million. That means this unprofitable company is trading at 4.6-times trailing sales.
GPRO and FIT trade around 1-times trailing sales. ROKU shouldn’t trade that low due to the company’s strong software business, but 4.6-times trailing sales still feels rich. AAPL trades at 3.7-times trailing sales, and that is a company with a surefire future and strong software revenues to complement a stable hardware revenue stream.
All in all, a 4.6-times trailing sales multiple for a hazy growth outlook clouded by competition and profitability concerns seems too pricey. Don’t be surprised if this stock goes the way of GPRO, FIT, or Snap Inc (NYSE:SNAP).
As of this writing, Luke Lango was long AMZN and GOOG.
