Roku (NASDAQ:ROKU) beat expectations in its first quarter earnings on Monday. This has reset analyst expectations higher and sent the price to an all-time high, up 27% on the day and 190% from its December 2018 lows.
Given these large gains, my first thought is whether shares have gained too much - is Roku still worth holding at this price? To answer that question, I turn to a discount cash flow valuation.
First Quarter: Beat and Raise, As Usual
In the first quarter of 2019, Roku reported $207 million in revenue, $10 million in adjusted EBITDA, and an $11 million loss from operations.
Source: Roku guidance from Roku earnings release.
Roku provides guidance on four metrics each quarter: Revenue, gross profit, net income, and adjusted EBITDA. Roku gives a range for each metric both for the next quarter and for the full year. Roku beat its guidance on each of these four metrics and raised its annual guidance for each of these four metrics.
A beat-and-raise is par for the course for Roku. Roku first provided quarterly guidance for the next quarter in Q3/17 and has beaten the midpoint of its guidance in all four metrics every time since then - a 24/24 success rate for "beat". Similarly, Roku first provided annual guidance in Q4/17 and has raised its annual guidance, on both the lower and upper ends of the range, at every single opportunity with a single exception (the upper end of net income guidance was reduced in Q3/18) - a 31/32 success rate for "raise".
This suggests both that Roku provides conservative guidance and that Roku is growing as quickly as the company expects, if not faster.
Key Operating Metrics
Source: Roku guidance from Roku earnings release.
In their earnings release, Roku singles out three metrics as its key operating metrics: Active accounts, streaming hours, and annual revenue per user ("ARPU").
As shown above, each of these metrics increased in the first quarter, with annual growth rates of 40%, 74%, and 27%.
Each of these metrics is an important measure for Roku and its investors:
- Active accounts tells us whether Roku is attracting new users to the Roku ecosystem and whether Roku is retaining existing users.
- Streaming hours tells us how engaged Roku users are in the Roku ecosystem, especially when streaming hours are divided by active accounts to get streaming hours per account.
- ARPU tells us whether Roku is able to convert its active users into revenue. Having users is well and good, but as an investor, I want to see revenue, and not just a popular platform. For my own projections, I prefer using quarterly revenue per user rather than annual revenue per user. Roku itself does not report this metric, likely because it is "lumpy" - fourth quarter revenue per user is much higher than other quarters.
Note that selling Roku players is largely irrelevant to Roku's value. Selling Roku devices is a low-margin business, and those sales are only relevant to Roku's operations to the extent they affect active accounts. Because of this, Roku splits its revenue into two segments: Player revenue and platform revenue.
In contrast, Roku's ARPU refers to platform revenue. This revenue is earned when a Roku user watches an advertisement on their Roku (in the menu or in apps) or when a user subscribes to a pay service through their Roku device.
During that five-year period, Roku's active accounts have grown at an average rate (geometric) of 46%, while Roku's ARPU has grown at an average rate of 38%. Both growth rates have slowed down during the past five years. During the past years, active accounts have grown at 40%, while ARPU has grown at 27%.
Roku's platform revenue grows at about the product of these two growth rates - multiply user growth and revenue/user growth to get revenue growth. Roku's platform revenue was up 78% YoY in the first quarter of 2019.
As before, Roku's player revenue is largely irrelevant here. Player revenue has been ~flat for the past four years and is likely to remain flat or decline, as more smart televisions ship that have Roku's television operating system built in. During the first quarter, Roku's OS was said to be in one-third of televisions shipped in the United States in the first quarter, up from one-quarter in prior quarters.
Roku is gaining market share in a secular growth market. Roku is also monetizing its users better than it ever has before, generating more revenue per user.
I value Roku shares at $100/share, based on a discounted cash flow using a 10% discount rate.
This valuation is primarily based on two very speculative projections of active accounts and ARPU over the next ten years.
Active accounts: Over the next ten years, I have modeled active account growth to slow down from its current 40% annual growth rate to 37% in 2019 and to further slow down each year past that until settling in on a single-digit growth rate in the far future.
This model results in Roku have 146 million active accounts in 2028. This figure is close to Netflix's (NFLX) paid membership in Q1/19 (148.86 million), but will be much lower than Netflix's size in 2028, provided Netflix doesn't implode along the way.
As with any forward projection, I expect that other investors will have wildly different ideas on how big Roku may or may not get. For example, skeptics may believe that this size is far too high as perhaps competitors will muscle Roku out of the marketplace. Conversely, the dreamers among us may expect Roku's growth to accelerate rather than decelerate, perhaps driving Roku to expand from its U.S. footprint into a strong international presence akin to Netflix.
ARPU: While I project a gradual slowdown of revenue, I am projecting a much faster decline for revenue/user. In this model, annual revenue per user will quickly decline from a 27% YoY growth rate in Q1/19 to only a 3% annual (and terminal) growth rate by 2023.
This rapid slowdown is based on the slowdown from 2017 to 2018 (from 49% growth to 30% growth) and based on logic. When Roku's video library was unmonetized, and Roku made very little from any streaming user, it was easy to add paths to monetization. For example, the addition of the Roku Channel and other advertising-supported content allowed Roku to provide users with free content and allowed Roku to earn advertising revenue.
However, once Roku has fully monetized its users, through both advertisements and through users subscribing to pay services through their Roku device, there is relatively little Roku can do to further monetize their product outside of major innovations that, frankly, I haven't thought up. (Luckily, it isn't my job to think up innovations for Roku.)
As a result, I am modeling a relatively rapid slowdown in ARPU growth as the platform becomes fully-monetized. Past that point, ARPU growth will be slow and driven by inflation and the rising price of advertising and ad-free content.
This model is built on stable gross margins for both the platform and player segments. Gross margins for each segment are set to be stable at their trailing-year rate, or about 10% for player revenue and 70% for platform revenue.
This model is further built on modeling that operating costs will decline as a percentage of revenue as Roku achieves operating leverage. During 2018, Roku spent 46.5% of its revenue on operating costs, up from 42.8% during 2017. In this model, I have begun with 46.5% operating costs and modeled that operating costs will decline to 38% over revenue over the next five years and will then be stable at 38%. In my view, this is a relatively conservative model, given anticipated revenue growth. In this model, operating costs will increase to $1.8 billion/year in 2028. During the trailing twelve months, Roku's operating costs were $387 million.
This model is further built on declining player revenue. In this model, I have player revenue set to decline at about 7% per year. This decline is based on the idea that set-top or plug-in players will become less relevant for Roku as an increasing proportion of users will be using smart TVs, especially in ten years. In this model, player revenue declines from $326 million in 2018 to $166 million in 2028. Given the low gross margins on player revenue, this decline is largely irrelevant to Roku's value.
After that, I am applying a 25% tax rate and discounting Roku's cash flow at a 10% discount rate. Roku does not have debt and has relatively little non-cash working capital, with accounts payable approximating accounts receivable. Roku's business is not capital-intensive, with only $5 million in capex this quarter (~2% of revenue) offset by $2.8 million in depreciation and amortization.
After adding in Roku's cash and equivalents, summing Roku's future cash flows and terminal value using a 3% terminal growth rate, and dividing by Roku's share count, I come up with a present value for Roku of $90 or a "target price" of $100, based on a one-year forward price.
This was a strong quarter for Roku, to say the least. That feels a bit silly to say, even, given how much share prices are up - the market is well aware it was a great quarter.
Given Roku's ballooning share price, I wanted to do a "sanity-check" to see if I wanted to cash in my Roku gains, or if I wanted to let it ride into next quarter and beyond.
Based on my model of Roku's future cash flows and their present value, I am satisfied in owning Roku at its current price, coming up with a current valuation of $90 and a target price of $100.
To be sure, Roku was a better value back in December 2018 when it traded down to only $27/share on bearish sentiment. But, as investors, we don't live in the past: My only decision today is whether to buy more shares, sell my shares, or continue holding my shares, and not whether to buy or sell more last December.
There are a lot of risks here. Roku is competing with some of the largest companies in the world, including Google (GOOG) (GOOGL), Apple (AAPL), and Amazon (AMZN). Each of those companies is larger and better funded than Roku. But that has always been the case - and Roku is thriving despite that competition.
Similarly, my valuation is highly speculative and relies on projections ten years into the future. None of those projections will be correct, and readers ten years from now will laugh at how far off they were. But my model isn't intended to be a completely accurate picture of Roku's future revenue or cash flows - merely an estimate to determine whether Roku's current pricing is sensible.
In my view, Roku's current pricing is sensible, and I will continue to hold my Roku shares, even after 200% gains since December.
Next quarter, I model Roku to see 30.6 million active accounts, an ARPU of $20.79, and 9.7 billion streaming hours. If Roku hits those numbers, they should beat their guidance once again.
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Disclosure: I am/we are long ROKU, AAPL, GOOGL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.