Two of my esteemed colleagues at InvestorPlace have just issued warnings about Roku Inc (NASDAQ:ROKU). Both make valid points about ROKU stock you shouldn’t ignore.
First, Vince Martin suggested Dec. 4 that ROKU stock doesn’t have the growth potential it needs:
“The valuation here looks stretched, with ROKU stock much more expensive than even a nearly 9x EV/revenue multiple suggests…. Valuation matters, even for a growth stock like Roku that clearly is running on all cylinders. And I’d expect the market will remember that problem soon enough.”
A day later, Luce Emerson said ROKU stock doesn’t deserve to trade for over $40:
“With the stock currently trading in the forties, valuation for a company that has yet to turn a profit seems lofty — or at least not particularly cheap. Investors are paying up for the growth now and, from a value investing standpoint, that’s not what one wants to do.”
Hey, I get it.
Deserve’s Got Nothin’ to Do With It
But as Clint Eastwood’s character Will Munny said in Unforgiven, “Deserve’s got nothin’ to do with it.”
Of course, Munny was talking about killing Little Bill Daggett, played by Gene Hackman, and not a stock valuation, but sometimes a stock price doesn’t make sense, and that’s okay.
As a rule, I’m not a fan of investing in money-losing stocks, but at least Roku has all the makings of a profitable business five years from now.
Right there on page six of Roku’s IPO prospectus are the company’s three main growth strategies.
Grow active accounts: By delivering greater depth and breadth of content and continuously improving the user experience, ROKU intends to attract more active accounts.
So, it had 15.1 million active accounts on Jun. 30, 2017, the quarter end before its Sep. 27 IPO. At the end of September, it had 16.7 million active accounts, a sequential increase of 10.6%.
That may not seem like a big deal until you bring its other two growth strategies into the discussion.
Growth hours streamed: Roku grew hours streamed by 8.7% in the third quarter to 3.8 billion. Two years earlier in Q3 2015, hours streamed were just 1.4 billion or less than half what they were at the end of September.
Roku’s seen the hours streamed rise in 10 consecutive quarters since Q1 2015. That says a lot about user engagement, which is essential because that increases gross profits.
Average revenue per user (ARPU): Like any good business, Roku wants to see its key performance metrics moving higher.
In Q3 2017, ARPU was $12.68; in the same quarter two years earlier, it was $6.11 or just 48% where it is today.
However, the critical point about the higher ARPU is that it’s multiplied by 16.7 million active accounts, not 7.6 million active accounts from September 2015.
Platform’s Gross Profits
Two years ago, Roku’s platform segment, which are the fees it receives from advertisers and content publishers, had a gross margin of 78.7%. In the same quarter two years later, the gross margin was 120 basis points lower.
Not good, right? Wrong.
I’ll trade 120 basis points of margin every day of the week for a 436% increase in revenue over the same period.
Now extrapolate the same loss of gross margin and growth of revenue over the next two years. We’re talking about $250.8 million in Q3 2019 revenue, gross profits of $191.4 million and an operating profit of $91.5 million. I calculated this by multiplying total operating expenses of $57.8 million in Q3 2017 by 72.9% growth over previous 24 months.
So, if I told you in 24 months that Roku would have a quarterly operating margin of 29.6%, including a player segment whose revenues didn’t grow over those 24 months, would you still have a valuation concern?
I don’t think so.
Bottom Line on ROKU Stock
As I said in my Nov. 22 article about Roku: “The more accounts Roku gets, multiplied by higher streaming hours, equals higher advertising rates. The economies of scale are tremendous.”
Maybe deserve’s got something to do with it after all.
As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.