Editor’s note: This column is part of our Best Stocks for 2020 contest. Left Brain Investment Research’s pick for the contest is Roku (NASDAQ:ROKU).
Bill Gates recently said “I’ve paid more than anyone in taxes.” One big reason for that is because Microsoft (NASDAQ:MSFT), the company he co-founded, became enormously successful as the dominant personal computer operating system, at a time when many people barely understood the concept of a PC. In other words, Gates has made a lot of money.
Similarly, Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) and Facebook (NASDAQ:FB) have ballooned to gigantic market capitalization companies. Many people still barely understand how they make money (the answer is largely targeted advertising). And as competition in the streaming industry continues to heat up — between Netflix (NASDAQ:NFLX), Disney (NYSE:DIS), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and others — a relatively unknown company, Roku (NASDAQ:ROKU), is on track to benefit enormously by becoming the operating system for smart TVs. Then, it can use the smart TV data it gathers to offer invaluable personal data, on an enormous scale, to targeted advertisers. Roku’s opportunity is huge.
What Is Roku and How Does It Work?
If you don’t know, Roku makes streaming players that connect to your TV, as well as Roku TVs that have the streaming experience built in. Users simply connect them to the internet, set up a Roku account and start streaming.
Importantly, Roku has developed powerful search features and a powerful advertising platform that are solving the complications of television advertising in a streaming world. Specifically, Roku is ahead of the competition in value-added services and quantifiable insights offered to advertisers. This gives the company a huge advantage. More specifically, Roku has incredible pricing power at a time when competition may commodify leading content providers, thereby pressuring their margins lower.
Roku will gain on the backs of growing content providers such as Netflix, Disney, Apple and Amazon.
Roku Has a Head Start and Momentum
Unbeknownst to many, a third of all smart TVs sold in the U.S. come with the Roku operating system already installed. This may not sound like a big deal considering so many people consume content through smart phones, tablets and PCs. However, smart TVs are far less expensive than those other devices. This makes them a much more cost-effective platform for content consumption for many Americans.
In fact, the reason so many smart TVs come with the Roku operating system is because it’s cheaper for manufacturers to use Roku’s platform than to create their own. Keeping the cost of smart TVs low is paramount in this cost-competitive space (i.e. the price of the smart TV would go up if the manufacturer didn’t use Roku). And importantly, Roku is gaining momentum. For example, according to Strategy Analytics, Roku is stretching its lead as the No. 1 streaming TV platform in the U.S.
Roku’s founder, chairman and CEO is entrepreneur Anthony Wood. Roku is his sixth company, and he has already climbed to No. 195 on the Forbes 400 (his net worth was recently reported to be $3.2 billion). And encouragingly, Wood recently reported owning a 34.3% share of Roku at a $2.1 billion market value. This shows he is significantly in alignment with shareholders.
Prior to founding Roku, Wood was vice president of internet TV at Netflix. Also interesting, Roku means “six” in Japanese (it’s his sixth company). And for a little more perspective on Roku, here is how Wood concluded his latest shareholder letter:
“Consumers are reaping the benefits as the biggest and best names in TV programming embrace the transition to streaming. Investment in content is soaring and free options are proliferating. Just as advertisers are hungry to reach consumers who no longer watch linear TV, they want to measure campaigns and have access to tools that automate them. Roku is well positioned as a neutral party that helps the whole ecosystem build value in [over-the-top media].”
Streaming Market Opportunity Is Massive
If you couldn’t guess, based on the fact that Amazon, Disney, Apple and Netflix are investing heavily in the space, the streaming content opportunity is truly massive. According to data from Statista, total revenue for the video streaming industry is already almost $25 billion annually. And, it should exceed $30 billion by 2024. However, those stats don’t do justice to Roku’s unique operating model. Roku does an excellent job explaining its value proposition in this quote from its most recent shareholder letter:
“The growing number of major streaming services, increasing investment in original programming and related high-profile marketing campaigns are likely to reinforce consumer interest in moving from traditional pay TV to streaming — and to the Roku platform.”
Traditional Valuation Metrics Miss Disruptive Growth
Even though Roku’s revenues continue to grow rapidly (up 50% year-over-year in the third quarter), estimates call for net income to be negative for 2020. We like the near-term negative net income because Roku is focusing on long-term value creation by investing heavily in its operating system through research and development. For example, last quarter Roku generated over $260 million in revenue and then spent over $68 million on research and development. The core technology supporting the Roku operating system offers a critical competitive advantage. And Roku is working hard to grow that advantage and maintain pricing power — both very good things. Also encouraging is that Roku’s total gross margin sits at over 45%.
On a price-to-sales basis, Roku currently trades at around 10.4 times 2020 estimates, according to data compiled by FactSet. This is down from over 12x at multiple points in recent months. And, the number falls to under 8x as compared to 2021 estimates.
However, in our view, Wall Street tends to focus too much on near-term results. These estimates chronically underestimate the long-term growth potential of disruptive growth companies like Roku. For example, the shares now trade 145% higher than the average analyst estimate at the start of 2019. Analysts have continued to update their price targets in lockstep with changes in the share price. We agree with Wood (as quoted earlier) that cord-cutting, content proliferation and competition create a long runway for Roku’s platform to benefit from high-margin growth.
Roku is a rare company with many of the exceptional characteristics we look for in a growth stock. And it has an incredible growth trajectory, as it leads the way in becoming the standard smart TV operating system. Roku’s business model allows it to gather invaluable information for targeted advertisers, particularly as competition among content providers grows.
And while that competition may likely put pressure on their own margins, Roku’s margins (and pricing power) should remain strong. Further, Roku’s CEO has tied a significant portion of his net worth up in shares. Roku shares have tremendous price appreciation potential in all time frames.
As of this writing, Left Brain Investment Research has no positions in any of the aforementioned securities. However, affiliate companies Left Brain Capital Management and/or Left Brain Wealth Management are long ROKU, NFLX, DIS, AMZN, GOOGL and FB. Readers can access the team’s full Roku research report here.