Wall Street’s IPO honeymoon with Roku Inc (NASDAQ:ROKU) is over. After a huge first few days on Wall Street which underscored massive demand for companies with growth potential in the over-the-top streaming space, ROKU stock has gone in reverse. ROKU stock price has dropped 25% since peaking it late September.
But Roku still has a market cap of about $1.9 billion. Trailing twelve month sales are $436 million. Trailing twelve month operating profits are negative. That means ROKU stock still trades at around 4.3-times trailing sales despite running an operating loss.
Overall, ROKU stock is still richly valued ahead of its first earnings report as a publicly traded company (due next week). That is a really dangerous place to be. Here’s why.
Roku Is Still Overvalued
First, lets look at the positives.
Roku is in a great space. Everything is going over-the-top. The tremendous success of Netflix, Inc. (NASDAQ:NFLX) has convinced companies from all industries that over-the-top is the way of the future. Consequently, traditional cable giants like Walt Disney Co (NYSE:DIS) are making a push into this space. As a result, over-the-top streaming will only grow dramatically over the next several years.
Roku also has a great business model. They essentially give away hardware at really low prices to convince a bunch of users to buy a Roku device and join their platform. Once those users sign on to a Roku platform, Roku starts making money through ad sales and revenue sharing. Because a majority of this revenue stream is recurring and higher-margin, Roku is left with a steady stream of high-margin, predictable revenue.
That is where the positives end. On to the negatives.
The big concern is competition. 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. Fitbit buckled under intense competition from Apple.
Consequently, intense competition 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.
The other big concern is profitability. Without robust user growth, Roku won’t be able to acheive robust revenue growth. Without robust revenue growth, profitability becomes a big question mark because operating expenses currently stand at around 50% of revenues. Gross margins are under 40%.
The question, then, becomes whether or not a company running an operating loss and with a bleak profitability outlook should trade at 4.3-times sales?
The answer is no. Apple trades at 4-times sales, but trailing operating income is nearly $60 billion. Roku should be more in the ball-park with Fitbit and GoPro Inc (NASDAQ:GPRO), both of which run an operating loss. Those stocks trade around 1-times trailing sales.
Beware of Earnings
ROKU’s first quarterly earnings report as a public company is just around the corner, and history says that could be a big downward catalyst.
ROKU’s closest comps, FIT and GPRO, smashed estimates in their first earnings reports as public companies. But due to expectations that were way too high and valuations that were way too rich, both stocks got hammered.
That has been the trend of notable tech IPOs this year. Snap Inc (NYSE:SNAP) tanked after its first earnings report as a public company. Same with Cloudera Inc (NYSE:CLDR) and Blue Apron Holdings Inc (NYSE:APRN).
Given its rich valuation and big expectations, ROKU stock will likely be subject to a similar fate.
Bottom Line on ROKU Stock
The stock is overvalued and there are a bunch of risks to the growth narrative. Plus, earnings are around the corner, and that could be a big downward catalyst for this stock.
All in all, I say sit this one out. Wait for earnings to bring the valuation down to a reasonable level, and then consider starting to take bites.
As of this writing, Luke Lango was long NFLX, AMZN, and GOOG.
