As a company, there’s not much debate about Roku (NASDAQ:ROKU). Thanks to an excellent product lineup, the company has fought off giants to become an integral part of the streaming landscape. The debate, rather, is over the valuation assigned ROKU stock.
I’ve generally leaned toward the cautious and skeptical side, even if I’ve been too cautious on occasion. Overall, though, my primary concern has been valuation.
Yes, Roku has excellent products, and a large opportunity. But particularly as its price twice cleared $160 last year, ROKU stock was one of the most expensive in the entire market — when properly understanding its business model.
However, that has changed. The lower ROKU stock price and an impressive top-line outlook for 2020 actually make its shares look somewhat cheap. That’s obviously on a relative basis, as the company still is generating losses and trades at a hefty multiple to revenue. Yet, in the context of its near-term growth, there’s a solid, tempting and fundamental case that didn’t quite exist even a few months ago.
That said, risks remain — both short-term and long-term. And there’s one risk in particular that investors need to be comfortable with before buying this dip.
The Case Against ROKU Stock
One of my long-running worries toward ROKU stock has been that it’s simply not as cheap as it looks. On an enterprise value to revenue (EV/Revenue) basis, shares always looked reasonable — even at the highs.
At $170, for instance, ROKU stock was valued at about 18 times 2019 revenue. That’s obviously not cheap. But Shopify (NYSE:SHOP) long has traded over 20 times, and other names like Zoom Video (NASDAQ:ZM) and Slack Technologies (NYSE:WORK) merited even higher multiples.
Meanwhile, few companies were posting the growth that Roku was: 2019 revenue growth wound up coming in at 52% year-over-year. So the case at the highs was that, yes, Roku stock was expensive. But, its performance suggested that it should be.
However, there was a catch. A decent chunk of that revenue came from hardware sales, or what Roku calls “player revenue.” Hardware generated a little over one-third of 2019 revenue, and that figure was unprofitable.
Gross margin for player revenue in 2019, in fact, was around 5%. Given operating expenses for Roku as a whole totaled $560 million last year, those products clearly are a loss leader for platform revenue (advertising, subscription fee, and other revenue). Therefore, investors shouldn’t be valuing player revenue all that highly — if at all.
Focusing solely on platform revenue, Roku’s EV/revenue multiple suddenly was as high as 28 times. That, at times, was above that assigned SHOP, perhaps the most expensive large-cap stock in the market. And it seemed unsustainable.
Nonethless, Roku stock now has pulled back by about one-third from late November highs. It delivered guidance for 2020 with its fourth-quarter report earlier this month. And as a result, the fundamental picture looks more attractive.
Roku is guiding for 2020 revenue of about $1.6 billion, and roughly three-quarters will come from the platform business. With the pullback in its stock price, the EV is currently under $13 billion.
Even zeroing out the player business, Roku now trades at a little over 11 times revenue. However, guidance implies that platform revenue should rise over 60% year-over-year.
There are not a lot of stocks in this market growing revenue at a 60% clip in 2020. Those that are even in that ballpark often trade at 15 times revenue or more. And so there’s now a fundamental case that — again, on a relative basis — Roku actually is cheap.
To be fair, the model probably is a bit simplistic. It might be too aggressive to value player revenue at zero, but the products are costing Roku money, and will do so for years to come.
Additionally, overall losses have to be considered as well. Roku’s outlook for this year included higher spending than analysts and investors had expected, and likely led the stock to reverse after an initial post-earnings bounce.
Meanwhile, it’s certainly possible that growth stocks as a whole are overvalued. Being cheaper than SHOP or ZM might not be of much good if broad markets continue to plunge and valuation expectations shift dramatically.
Still, there’s a nice case to be made here. Streaming is a business that’s only going to grow. Disney’s (NYSE:DIS) 2019 launch of Disney+ will be followed this year by new services from AT&T (NYSE:T) and Comcast (NASDAQ:CMCSA). That said, Roku has barely scratched the surface of its international opportunity.
This is one of the better stories in the market, but it’s not quite priced as such. Near-term margin and profit considerations need to be taken into account, but they probably aren’t enough to derail the attractiveness of that story; But competition could.
The Key Long-Term Risk for ROKU Stock
So far, Roku has outsmarted much larger companies in hardware. Its market share leads the likes of Amazon (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOG,NASDAQ:GOOGL). And it’s why Roku has 37 million active accounts, an enormous base to drive platform revenue going forward.
However, that competition is not going anywhere. And the worry for Roku is that its new customer acquisition channels are going to migrate from players, where it leads, to TVs, where it has less of an edge. The likes of Comcast and AT&T’s DIRECTV can and will create their own boxes to keep their customers in-house.
It’s not necessarily a bad thing that players eventually will go away. Again, Roku loses money on those sales. But Roku isn’t guaranteed to have the same success in smart TVs that it has had in players.
This is the key risk to ROKU stock., and it’s why the narrative that Roku is a “play on streaming” is a bit simplistic. Roku’s growth, over time, will not match that of the industry if it can’t keep its share intact as customers migrate away from players. That said, this shift likely is already happening, as it’s increasingly difficult to find a TV that isn’t a smart TV.
For investors who believe Roku can win going forward, the selloff here is an opportunity. Personally, that risk still seems large, and a “falling knife” stock chart suggests little need to rush in. But at the very least, I see Roku much more favorably than I did just a few months ago.
Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. He has no positions in any securities mentioned.