[Editor’s note: An earlier version of this story mistakenly stated that the Roku app comes preloaded in one-in-five smart TVs. It has since been edited.]
It’s not a good time to be a young newly-traded tech company. Despite a Q3 earnings report that in many ways exceeded expectations, investors have pushed Roku (NASDAQ:ROKU) stock into free fall. Since the beginning of October, ROKU stock has lost about 45% of its value. That’s a decline from over $70 to just $43 now.
To be fair, ROKU was trading in the thirties this past summer; the recent losses have largely just reversed previous gains.
That said, it’s still an incredible decline for ROKU especially given that the business’ momentum remains strong. Bears and bulls will make the same points they have done previously.
To the bears, ROKU stock is too expensive given the strong competitive risks to the franchise. Bulls will say that as long as the company keeps growing quickly, it will grow into its valuation and possibly a return to $70/share in the cards.
Which side has the better argument? At least at this share price, the evidence favors the bulls. Here’s why.
Market Volatility Or Bad Earnings?
Roku recently announced its latest earnings. From the headlines, you’d have expected the stock to surge. The company only lost nine cents per share, well ahead of the 12 cent consensus forecast.
On revenues, it beat expectations by several percent. Additionally, the company raised guidance for both its revenue growth and profit margins. Despite the abundance of good news, ROKU stock instead plunged 10% immediately following the report.
What’s going on here? For one, there were a couple of minor nitpicks with the earnings report. This quarter, for example, Average Revenue Per User grew at a more modest 4% rate sequentially (37% year-over-year).
That compares to Roku’s traditional 10% or more growth rate in ARPU. This could be a limitation of Roku’s advertising model, or simply that the company has already found the lowest-hanging fruit in terms of sales opportunities.
The other issue is that while Roku topped estimates, some people had been hoping for even more. These weren’t blowout results, though they were very impressive. But Roku had the misfortune of releasing its earnings report during the worst meltdown in FAANG stocks in years. Investors have shellacked tech companies coming up short of expectations this earnings cycle.
Facing the challenge of huge expectations and dismal market sentiment, ROKU stock was vulnerable to panic selling.
The Growth Story Is Intact
Bears will argue that Roku’s slowing ARPU rate is a sign of problems to come, and to be fair, they could be right. But it’s important to remember that Roku’s overall user growth rates continue to hum along as they have done in this past.
In an ideal world, Roku would be able to achieve a further surge in average revenue per user. But they’re still achieving economies of scale by expanding their overall audience and monetizing it reasonably well at the same time.
Like Netflix (NASDAQ:NFLX), no one should be buying ROKU stock today in the hopes of huge near-term earnings. Roku is building its brand and user base for the future and this quarter gave no indication that the thesis has deteriorated.
Roku should reach the $1 billion annual sales mark in around a year. That puts ROKU stock at 7x price/sales today, and under 5x forward price/sales.
Netflix often has traded at or above 10x in recent times, and is still at 9x now after its own big correction. Other fast-growing social tech companies also tend to fetch price/sales ratios far above the 5-7x range that ROKU will be at in 2019.
Competition Is the Big Threat
I’d argue the most important takeaway from the recent earnings report is that the user base is still growing rapidly. The CEO, Anthony Wood, noted on the conference call that there is still a great deal of upside coming in user accounts going forward.
As the company comes pre-loaded on roughly one-in-four smart TVs, it is well-positioned to maintain its market share even as Roku transitions from making hardware to native operating systems.
That said, I’ve said it before and it’s still true: lots of large tech companies know how to make native user interfaces. Big TV makers such as Samsung (OTCMKTS:SSNLF) could easily build their own products. And Roku should expect to face stiff competition from the likes of Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOGL).
Roku got a big lead in what was initially a niche hardware market. With smart TVs now mainstream, Roku will have to work much harder to maintain its ecosystem lead. And it will do so against strong well-funded competitors.
ROKU Stock: Expect A Bounce
Ultimately, the bears have some fair points. I’m not convinced that ROKU stock will be a compelling buy and hold story. There are many ways it could fail to end up being the next Netflix or other hot growth company.
But in the short-term, the company is executing beautifully. Once market conditions improve, expect it to get some much-deserved recognition.
As the CEO said, they’ve now beaten expectations all five quarters since becoming a public company. And with the company’s newer video ad format doing well, it’s not hard to imagine ARPU growth picking back up either. Keep ROKU stock on a short leash, but for now, the next move should be solidly to the upside.
At the time of this writing, Ian Bezek held no positions in the aforementioned securities. You can reach him on Twitter at @irbezek.
