Why It May Be Time to Sell Roku Stock

ROKU stock - Why It May Be Time to Sell Roku Stock

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There’s no better way to look dumb in this market than to try to call an end to a rally based on valuation. And so there’s a case to simply hold onto Roku (NASDAQ:ROKU), even with ROKU stock up almost 150% since early April.

After all, there’s a fantastic story here, as I’ve repeatedly argued, most recently last month. And while ROKU stock hardly seems cheap, the shares are trading at a multiple of roughly ten times the company’s 2018 revenue guidance, which isn’t that out of line these days.

Indeed, recent history suggests that investors simply should ride until the proverbial horse bucks. Good growth stories are defying valuation concerns all over the place. Square (NYSE:SQ) trades at 20 times its revenue. In Roku’s own space, Amazon.com (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX) continue to soar. The conventional wisdom is that it’s dangerous to try to time a bottom in a stock. In 2018, it seems nearly as silly to try to time the top of a stock.

All that said, and as much as I like the Roku story, including calling it one of five stocks that could be the next Amazon,  it’s hard to justify $71 for ROKU stock. There are two notable obstacles to the company’s long-term growth story. Specifically, 40%+ of its revenue remains essentially unprofitable, and the competitive concerns that dogged ROKU shortly after its IPO haven’t exactly dissipated. From here, it’s time to step to the sidelines and hope that call isn’t as dumb as it might seem.

The Valuation Issue

Again, ten times revenue doesn’t seem that expensive for a growth story in this market. (Investors can draw their own conclusions about what that says about valuations across the board right now, particularly in tech.) But not all of Roku’s revenue should be valued equally.

The company’s “player revenue,” derived from sales of its namesake device, generated over 43% of its first-half revenue. That proportion is coming down over time, as its “platform revenue” (advertising, fees, and other sales) is growing much faster. Still, for the full year, player revenue likely will drive over 40% of sales, and the Street expects it to account for 30%+ of revenue next year.

And that revenue really isn’t worth all that much. The business appears unlikely to generate a significant profit over the long-term. Admittedly, ROKU’s gross margin did increase meaningfully in Q2, albeit to a still-thin 22.2% after a 15.8% print in Q1. That’s a notable improvement, however, from sub-10% levels in Q2-Q4 last year, and suggests that Roku is developing some pricing power against Amazon’s Fire Stick and the Chromecast from Alphabet’s (NASDAQ:GOOGL,GOOG) Google.

Still, even 22% gross margins don’t leave a lot of room for R&D, shipping, and other costs. The player business is unlikely to be much of a profit generator over the long-term, and it could still wind up being a loss leader.

What investors are paying for is the platform revenue. That’s where the growth is and where the company can generate huge margins. But ROKU stock now is trading at roughly 16 times its 2018 platform revenue, based on company guidance. And that’s a huge multiple, even in a market willing to pay for growth and even with platform revenue likely to come close to doubling this year after a 115% increase in 2017. Few stocks are consistently receiving that kind of valuation.

The Roadblocks Facing ROKU Stock

Again, Roku has a great story and a path to growth that can support even the current valuation. But there are two notable roadblocks on that path: Netflix and Alphabet’s YouTube.

Both video services are key parts of the Roku story. The Roku device was designed specifically to stream Netflix to televisions. But Roku still doesn’t generate “material” revenue, per its 10-K, from either Netflix or YouTube.

If the story here is based on Roku becoming an increasingly large part of the streaming ecosystem – and it is – then the lack of agreements with those two giants presents a reasonably substantial problem. Roku can monetize the ‘rest’ of the streaming world, whether through subscriptions to niche services or its own channel. But for at least the “foreseeable future,” as the company has noted in its filings, it’s not going to generate much revenue from Netflix or YouTube. That seems to be a reasonably solid impediment to both its revenue growth and margin expansion going forward.

Is ROKU Stock a Sell?

Obviously, neither of these problems is anything new. And I’ve been happy in the past to recommend ROKU stock despite the issues.

But ROKU stock also has more than doubled just over the past several months. And at a premium valuation, Roku is going to need a premium story. At $35, player margins and the lack of Netflix revenue were considerations. At $70, they look like potential risks.

Again, I’m aware that I may well be – or likely will be – too early in trying to time the top here. And long-term, Roku still has room for explosive growth. But at a certain point, valuation has to matter. And it does feel like we’re getting at least near that point with ROKU.

As of this writing, Vince Martin has no positions in any securities mentioned.

Article printed from InvestorPlace Media, https://investorplace.com/2018/09/why-it-may-be-time-to-sell-roku-stock/.

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