Roku (NASDAQ:ROKU) unquestionably has had an incredible 2019. Earnings continue to beat expectations. Growth has impressed. The ROKU stock price has soared, climbing 348% to this point. Among stocks with a market capitalization over $4 billion, not one has come close. Snap (NYSE:SNAP) is in second place, with a paltry-by-comparison 184% gain.
Even after those gains, ROKU stock looks reasonably cheap — at least by the standards of this tech market. The midpoint of revenue guidance for 2019 suggests a roughly 14x enterprise value/revenue multiple. In a market where Shopify (NYSE:SHOP) is getting 25x+ and double-digit EV/sales multiples aren’t uncommon, that figure isn’t necessarily out of line.
With Roku’s pole position among cord-cutting and international possibilities, that type of multiple seems merited. But I’m no longer sure that’s the case. The issue isn’t necessarily the headline multiple. Investors mostly have done well by paying up for growth in this market. It’s that, looking closer, Roku’s current valuation for several reasons looks highly questionable — even if, admittedly, I’ve made that argument before.
Player Revenue Shouldn’t Count for the ROKU Stock Price
Again, 14x revenue isn’t that crazy in this market, even if that statement alone makes some investors wonder if the entire market has gone crazy at this point. But it’s important to remember, as I’ve noted before, that not all of Roku’s revenue is worth paying up for.
The company’s guidance, updated after this month’s second-quarter earnings report, is for revenue of $1.1 billion at the midpoint. But roughly one-third of those sales are coming from Roku players — which are actually unprofitable.
Player gross margin in the second quarter was just 5.5%. Gross profit dollars for players over the past four quarters total just $23 million — suggesting 6.5% gross margins. Given that research and development spending alone has been over $200 million during that stretch, the player business obviously is a loss leader for the company’s platform business.
And that’s fine. Platform revenue is growing at an exponential rate: 79% year-over-year in Q1 and 86% in Q2. But investors shouldn’t be paying 14x revenue — or really, anything, for the player revenue.
Back out those hardware sales, and the ROKU stock price now sits above 20x this year’s revenue. That is a multiple that, on its face, looks questionable. It’s a multiple assigned to companies that have the potential for dominance of their market. Roku isn’t necessarily one of those companies, at least not yet.
The Market Share Question
What’s interesting about Roku is that it’s driving growth while facing competition from absolute giants. This is a company going directly against Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), and Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) — three of the four most valuable companies in the world. It has leading market share in terms of streaming devices in use.
But it’s still a relatively fragmented market. And in smart TVs, which is where Roku management itself believes streaming is going to go, its share in the first half of this year was “more than one in three,” according to the shareholder letter.
To be sure, Roku may be able to take share over time. More users means more data, which combined with the company’s machine learning capabilities improves the experience. The Roku Channel increasingly looks like a gateway to streaming. It also looks like a business in which Roku can take dollars from streaming services, take dollars from advertisers and potentially take eyeballs (and maybe at some point dollars) through its own content.
Still, Roku seems potentially unlikely to ever truly dominate the space. Competition is always going to be a factor — and those larger rivals can find a way to undercut on pricing for streaming services and for advertisers. At 20x+ platform revenue, an investor should at least think she’s buying the clear winner in an industry. That’s not yet guaranteed to be the case.
Where Does Streaming Go?
The broader question is that this remains an industry still in the early stages — which means Roku’s long-term role in the ecosystem may change over time. Right now, there are dozens of streaming services of all sizes — with more on the way. Disney (NYSE:DIS), Comcast (NASDAQ:CMCSA), and AT&T’s (NYSE:T) unit WarnerMedia all are launching major efforts within the next 12 months.
But many of the existing services — and possibly one or two of the larger offerings out there — are going to go by the wayside at some point. The glut of so-called virtual multi-channel video programming distributors like YouTube TV, Sling, DIRECTV NOW and others will ease.
Roku’s potential base of advertising customers, in particular, is likely to peak in the next 12-18 months. A less-fragmented streaming universe would give more power back to the winners — and lower overall demand and pricing power for Roku.
From a broad standpoint, there are simply a lot of questions here. Roku certainly is going to grow going forward. This is not the next TiVo (NASDAQ:TIVO). But, again, this is a stock selling at 20x its key revenue stream — and something like 400x 2019 adjusted EBITDA.
It’s a valuation that leaves little room for questions. And it’s a valuation that is likely to recede if, at some point, those questions are raised.
As of this writing, Vince Martin has no positions in any securities mentioned.
