Roku (NASDAQ:ROKU) stock gained 13% on June 8 after news reports surfaced that Netflix (NASDAQ:NFLX) was interested in buying the video streaming platform. Just as quickly, ROKU stock lost most of those gains the next day.
Both of these companies have seen better days. In 2022, NFLX and ROKU are down 69% and 65%, respectively.
My InvestorPlace colleague, Luke Lango, believes the acquisition makes zero sense because Roku is an aggregator platform, providing Netflix with no synergies in a buyout. However, he suggests Netflix may be desperate enough to pay up to double its current price to dig itself out of the hole it finds itself in.
I don’t believe Netflix would act out of desperation. That said, I do think there is a legitimate reason that acquiring Roku makes sense.
ROKU Stock Is Cheap Enough
As Lango points out, he doesn’t believe Roku CEO and founder Anthony Wood would accept anything less than 10x sales. Based on trailing 12-month sales of $2.92 billion, that’s $29.2 billion for its equity or almost $215 a share (135.9 million shares outstanding).
As recently as 2020, Roku was valued at more than 26x sales, so accepting 10x sales would seem to be a reasonable line to draw. After all, $215 would be less than half its all-time high of $490.76 in July 2021.
I don’t think it’s crazy for Roku to go this high.
I believe desperation is never a good reason to spend $30 billion of shareholder capital on something that’s not guaranteed to work. But there is a simple reason Roku would be attractive to Netflix.
Roku’s Been Building a Nice Ad Business
I’ll be honest, I’m hardly the only media person suggesting the rumored purchase is ad-related.
“Netflix has been looking to resort to advertising to keep the lights on while it’s losing subscribers left and right, and Roku made $647 million through its video ad platform during the first quarter. So it makes sense for Netflix to look in that direction,” stated the Android Police’s Arol Wright on June 8.
In 2019, eMarketer discussed 10 ways Roku was building its ad business. It projected that Roku’s ad revenues would grow from $57 million in 2016 to $632.9 million in 2020.
How did its prediction work out?
Well, according to Statista, it was $492 million in 2020 and projected to be $1.16 billion in 2021. Roku doesn’t break out its platform revenue, which includes digital advertising, content distribution services, paid subscriptions, etc. In 2021, platform revenue was $2.28 billion. If 50% of that was digital advertising, Statista’s 2021 number would be fairly accurate.
From where I sit, that’s an attractive base on which Netflix could build an ad-supported tier of its service. For this reason, it makes more sense than my colleague is giving it credit for.
Netflix Would Be a Good Owner for Roku
Roku CEO Anthony Wood and Netflix CEO Reed Hastings have a history together. Wood had developed a set-top box for Netflix in 2007, but Hastings scrapped the project, spinning off the set-top business into what would become Roku.
So, they certainly have a past working relationship, which would make negotiating a transaction somewhat easier. That said, I’m not sure that Wood is ready to let go of Roku just yet.
If you’re an aggressive investor, I don’t think it hurts to play a little merger arbitrage. Long term, I’ve always thought Roku would be a big success. Now, it might have to do so under the roof of the world’s largest streaming platform.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.