For stocks like Roku (NASDAQ:ROKU), growth has beaten valuation almost every time in this market. Whether it’s ROKU stock, or Shopify (NYSE:SHOP), or (for the most part) the likes of Amazon.com (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX), investors have proven that they will pay almost any price for solid growth.
And so, for the most part, investors who have worried about valuation have missed out on big gains. In some cases, they’ve lost a lot of money trying to short growth stocks.
In that context, it’s too simplistic to argue that a stock is “overvalued” based on a single fundamental metric. That’s been true for a name like AMZN, and it’s true for ROKU as well.
After all, it’s not as if the market is unaware that Roku stock trades at roughly 16 times this year’s revenue or that ROKU is unprofitable. In fact, it actually takes more due diligence to understand the bull thesis. That requires long-term modeling and a long-term focus.
So I’m sympathetic to the bull case. ROKU has a real opportunity as new streaming services come online. It will be profitable at some point. Anyone who has bet against Roku stock so far has lost; ROKU stock price has nearly quintupled so far this year.
Even considering all that, however, I still think the shares are overvalued above $150, and they may be disastrously overvalued. The issue isn’t necessarily that ROKU stock is expensive right now, but that the growth priced in by the current valuation may not materialize.
The Case for Roku Stock
In this market, a 16 revenue multiple doesn’t seem that outrageous. Of course, that fact alone might concern investors who see tech, or even the market as a whole, as overvalued at the moment.
But at least on a relative basis, ROKU’s revenue multiple isn’t necessarily out of line. SHOP stock is trading at 28 times this year’s revenue, while Okta (NASDAQ:OKTA) has a price-revenue multiple of roughly 27, and Zoom Video Communications’ (NASDAQ:ZM) multiple is closer to 40.
And Roku’s growth story can arguably match that of almost any other stock in the market. Its revenue should grow close to 50% this year, and analysts’ average estimates suggest a 40%-plus increase in 2020. Both figures are roughly in line with that of SHOP, whose revenue multiple is substantially higher.
From that perspective, the ROKU stock price isn’t necessarily outrageous. In fact, it might even be cheap.
The ROKU Stock Price is More Expensive Than It Looks
But there are two problems with those comparisons. The first is a point I’ve admittedly made in the past; not all of Roku’s revenue is all that valuable. Its 2019 guidance suggests that roughly one-third of its revenue will come from Roku players. To be blunt, selling players is not a good business for ROKU.
Over the past four quarters, gross profit for the player business has totaled only $20.7 million, or just 5.7% of the revenue from players. Over the same period, ROKU as a whole spent $214 million on R&D; a good chunk of that spending no doubt was used to enhance the players.
And so it’s clear that the player business loses a great deal of money. The player business is a loss leader for advertising and other sales, what Roku calls “platform revenue.” So the player business and its revenue shouldn’t be assigned much, if any, value. In fact, investors should assume that the player business will continue to lose money.
Platform revenue is the important metric. And ROKU stock is valued at roughly 24 times that figure, based on its 2019 guidance. That’s an enormous multiple which is more in-line with the market’s most expensive stocks. And yet platform gross margins, which were 63% in the third quarter, are lower than those of several other high-growth software names (though, to be fair, they are higher than Shopify’s gross margins.)
That issue alone doesn’t mean ROKU stock has to pull back; even valuing the stock based only on platform revenue, an investor still can make the case that a price above $150 is reasonable, if not likely. And it does seem like the stock has a path to at least fill the gap created on Monday, when the shares plunged after Morgan Stanley downgraded Roku stock.
Still, ROKU is one of the most expensive stocks in the market. That alone suggests some very real risk.
Are Competitors Coming?
The second issue is that Roku has more, and more intense, competition than other stocks with similar valuations. Admittedly, Roku has achieved dominant market share against the likes of Apple (NASDAQ:AAPL), Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL), and Amazon.
But its role as the primary gateway to streaming services is far from guaranteed. Comcast (NASDAQ:CMCSA) and other telecom companies can and will provide their own streaming boxes to existing internet customers. Amazon has partnered with TV manufacturers to install its Fire TV software; Roku has done the same, but a lack of new agreements with TV makers was one reason for Morgan Stanley’s downgrade.
So the argument that Roku is the primary play on new streaming services from Disney (NYSE:DIS), AT&T (NYSE:T), and Comcast itself seems too simplistic. Over time, the very need for a player is going to fade away as all screens come embedded with the necessary software. New delivery mechanisms may spring up. Roku isn’t necessarily the next TiVo (NASDAQ:TIVO), but any hardware-based business is at risk of being disrupted.
This is not to say that ROKU stock should be shorted or that its growth is going to come to a screeching halt in the next couple of years. Rather, Roku stock has one of the highest valuations in the market but has very real risks. That’s the point that Morgan Stanley made this week — and it’s probably a good one. ROKU stock price suggests that the company’s growth will last for years, and I’m simply not quite sure that will be the case.
As of this writing, Vince Martin has no positions in any securities mentioned.