For Now, Watch out for Valuation Risks on Roku Stock

ROKU stock is a long term winner sprinting into some near term valuation turbulence

It’s been a record rally for streaming media platform Roku (NASDAQ:ROKU). Year-to-date, ROKU stock is up more than 430% as investors have realized that this company truly is transforming into the “cable box” of the streaming world.

For Now, Watch out for Valuation Risks on Roku Stock
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More than that, Roku is setting itself up to win big as millions of consumers and billions of ad dollars flow from the linear TV world, into the streaming TV world over the next decade.

This enormous linear to streaming TV pivot will continue to power ROKU higher in the long run. but, over the next few months, valuation friction could ultimately put a lid on this record rally.

My concern with ROKU here is simple. I’m very bullish on the company’s long term growth prospects. Arguably, I’m as bullish as one could be. Yet, even under my most aggressive long-term growth assumptions, ROKU stock doesn’t deserve a price tag much higher than $160 today.

As such, it appears that above $160, ROKU stock is supported by hype and not fundamentals. That makes ROKU unnecessarily risky at current levels, and investors should take steps to avoid this unnecessary risk (i.e. don’t chase the rally in ROKU stock up here, and do some profit-taking if you can).

Roku Has a Very Bright Future

There’s no denying the simple fact that Roku has a very bright future as the “cable box” of the streaming TV world.

Long story short, everyone and their best friend is gong from linear TV to streaming TV. Every media company is making a similar transition to capture shifting demand.

At the end of the day, you will have a streaming TV landscape that looks a lot like the linear TV landscape. You will have a bunch of streaming subscribers (akin to pay-TV subs) accessing multiple streaming services (akin to pay-TV channels). Much like the cable box did in the linear TV world, some platform needs to connect all those subscribers to all those streaming services.

Roku is that platform. It connects streaming subscribers to streaming services through a streamlined, curated, frictionless, and cheap ecosystem that is importantly content-neutral so it doesn’t favor any single streaming service over the other.

Also of importance, Roku is the biggest player in this market by far. In this market, size matters for two big reasons.

First, consumers like consistency, so if most consumers are used to the Roku operating system, most consumers will want to see that operating system everywhere.

Second, streaming services need distribution, and Roku has the widest distribution, so every streaming service needs to launch on Roku (whereas they don’t need to launch on other aggregation platforms). This means that Roku will always feature every streaming service. That will naturally lead to more consumers choosing Roku as their preferred aggregation platform, which leads back into point one.

In other words, Roku is powered by a virtuous growth cycle which ensures that it will maintain favorable competitive positioning in the secular growth streaming TV world. All that growth will ultimately power ROKU stock higher in the long run.

The Valuation Is Concerning

In 2019, Roku has reported a series of quarters which have made the aforementioned long term bull thesis seem like a foregone conclusion. Investors have piled into the stock hand over fist, hence the 430% year-to-date rally.

Unfortunately, all this piling into ROKU has created a near term overvaluation problem.

I’m about as bullish as one could be on Roku. I think this company will be the de facto streaming service aggregation platform at scale, and that most consumers globally will one day access their streaming services through the Roku ecosystem. I also think that this company will consequently win over the lion’s share of advertising dollars that are pivoting from the linear to streaming TV channel.

As such, I’m cautiously optimistic that Roku can grow to well over 100 million active accounts by 2025 (versus just 30 million today) and generate revenues north of $5 billion (versus under $1 billion today).

I’m also optimistic that the Platform segment’s 70%-plus gross margins and significant positive operating leverage will drive huge gains in the profitability profile over the next several years.

Under those aggressive assumptions, I think a best-case scenario for Roku is for the company to net earnings per share of $7.50 by 2025. For comparison purposes, the company is unprofitable today.

Still, that huge profit ramp isn’t enough to justify much upside in ROKU stock from $160 today. Throw an application software sector-average 35-times forward multiple on $7.50 in EPS. That equates to a 2024 price target for ROKU of more than $260. Discount that price target back by 10% per year. That implies a 2019 price target of about $160.

Bottom Line on ROKU Stock

Roku stock is a long term winner. But, this stock has come very far, very fast, and on the heels of a 430% year-to-date rally, the stock looks positioned to run into some valuation friction up here.

This valuation friction will pass. Once it does, that’ll be the time to buy more for the long haul. But, in the interim, caution is warranted at these levels.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2019/12/watch-out-valuation-risks-on-roku-stock/.

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