Roku: Growing Through Structural Shifts In The Ad Landscape

Summary

• Streaming adoption has accelerated in these times; Roku's April 13th Press Release saw a raised revenue guidance for Q1 while profitability estimates remained in-line.
• The lockdowns haven't just decreased TV Ad demand, but also TV Ad Inventory value. Roku and Connected TV stand to potentially capture ad spending from this dislocation.
• Buy Roku at an NTM EV/Sales of 10.2x for its long-term market potential. It is still undervalued despite the rally.

Roku (NASDAQ: NASDAQ:ROKU) makes for a solid growth pick based on its long-term potential. With a rapidly growing total addressable market, even faster top-line growth, and an excellent management team, there's further upside at a Fwd EV/Sales of 10.2x. The company's growth runway is extremely long and Connected TV Advertising offers immense potential, with programmatic advertising trends to help. This article is focused on discussing the pandemic-related structural shifts in the television advertising landscape and how they might influence Roku's growth trajectory.

Image Source: Q4 2019 Shareholder Letter

Premise

Roku's April 13th Press Release provided a reason for optimism, as the company guided higher revenues for Q1 and in-line profitability margins. Management remarked on the acceleration in user account growth and streaming hours on their platform which they experienced in the two weeks leading up to March 31st.

We know that cord-cutting is an inevitable trend, and we have established that Netflix (NFLX) and streaming services have enjoyed a boost out of this environment. I believe that users of traditional broadcast/cable television will conclude that they don't need to pay over a $100 a month for their Cable TV subscription, especially with the lack of live sports content on it. The current situation will continue to meaningfully accelerate cord-cutting, not just the adoption of streaming.

User engagement, accounts, and streaming hours are however one side of the coin when considering the top-line impact for Roku. The other side is whether advertisers will spend more or less than expected through their platform. The prevailing forces in the economy point to businesses cutting ad budgets significantly. To evaluate the impact on Roku, one needs to investigate the TV advertising inventory available and the transition from linear/broadcast to Connected TV advertising. I attempt to do this and draw inferences in the coming sections after positing some broad hypotheticals given the uncertainty.

Television Ad Markets and Ad Inventory Value

Source: E-Marketer (TV Ad Spending in the US) (US Connected TV Ad Spending)

Pre-pandemic forecasts from E-marketer estimated the total ad spend opportunity in the US at $72B and Connected TV Ad Spend at a rapidly compounding $8.88B for FY 2020.

Let us focus on the larger of the two markets. If $72B was the estimated spend in 2020, let's assume that advertisers would have allocated capital efficiently and there was $72B in intrinsic value in the advertising inventory for the year from broadcast and cable. Now with the current situation, what value does the same market represent?

This is where I think the consideration of sports advertising becomes a huge factor. Sports accounts for roughly a third of total television advertising spend in the United States. In a non-pandemic scenario, that would have accounted for $24B of the $72B over a full year. It is hard to imagine that the now sports-culled inventory is offering the same intrinsic value to TV-advertisers. Imagine all those AT&T, Verizon, Autos, and Food and Beer commercials that amassed viewer engagement during the commercial breaks at NFL halftimes because you could not wait to see what happens in the game. All sports have come to a unanimous halt. My guess is it will at least take a few months for them to return after a definitive recovery is underway. This quality entertainment has been replaced with re-runs and content that is spread too thin. We might add a discount to the $72B of 25% and put it at $54B, which isn't as far-fetched an assumption. For a two-quarter period, which is the current likelihood, that's $27B down from $36B.

While it is broadly understood that the overall demand for TV ad inventory has reduced as budgets are slashed, so has the supply (and such the value) of ad inventory available. This should leave businesses with otherwise predetermined TV ad budgets (or even drastically reduced budgets) to be searching for the right deployment for maximum impact.

Ripples in Some Markets can Cause Waves in Others

This is where Connected TV appears to be shining brighter than ever, offering more value to be unlocked with efficiency through programmatic tech and granular user data to be exploited. For the companies that typically advertise on regular television, and still have ad budgets, there are alternative means to invest in for ad campaigns. Do those otherwise sports commercial budgets go to Google (NASDAQ: GOOG) or Facebook (NASDAQ: FB), or do they even just try Roku? Surely, CTV is the closest thing to pushing television designed ads on the bigger screen for home viewers. If billions in broadcasting/cable advertising inventory value have been evaporated and billions in ad budgets have been cut, it only takes a small fraction of the traditional TV ad budget to move towards CTV to have an outsized effect on the overall CTV market. What we essentially have is a reduction in the quality of broadcast/cable TV inventory and an increase in the quality of connected TV inventory due to the pandemic. This should add fuel to CTV Ad Adoption trend and prepared companies will stand to benefit greatly. Capturing this dislocation can potentially manifest in a revenue/earnings surge in Q2.

These broader structural mechanisms are how innovative smaller markets can potentially grow right through macro headwinds, even in recessionary environments. From Netflix's earnings and Roku's guidance, CTV is winning user attention. Wherever user attention is, advertising will follow. Despite the pandemic uncertainty, the streaming trends leave me optimistic for Roku's capture of the dislocated advertising spend.

In Roku's case for preparation, they added about 9 million active users from a year ago, onboarded Apple TV+ and Disney+, and acquired Dataxu to accelerate their in-house ad capabilities. The company looks very different from where it was just two years ago. And to understand the true power of targeted advertising done right, one only needs to look at Facebook and Google that do it at mass scale. The value of Roku's ad capabilities lies in the data they've collected from their users that linear TV just cannot match for efficient actionable insight. That data's value compounds across users, streaming hours, and channels. Roku is a leader in all three.

Financials: Accelerated Growth and Cash Burn

Source: Author, data from Seeking Alpha; "FCF = Operating Cash Flow - CapEx"

Roku's performance continues to be top-line driven, as it burns cash to capture as many viewers as it can. At under 40 million active accounts, there is a far greater market to capture both domestically and internationally. Market saturation for Connected TVs won't be reached for a few more years. As of FY 2019, the company is on an accelerated growth trajectory clocking at 52.0% yoy on an LTM basis. This level of growth justifies some cash burn and an FCF margin of -5.62% is not unreasonable. I don't expect profitability to be a reliable indicator for the financial health of the company and won't be surprised with higher cash burn to boost the top line going forward. As the revenue base expands, the revenue growth rate will naturally decelerate but I expect it to stay above the 30% range for the coming 2-3 years.

Valuation

Source: Koyfin

At an NTM EV/S of 10.2x, the stock is significantly more expensive than it was a month ago but is cheap when compared to historical multiples from six months ago. As I discussed, I see the shakeup of the broader TV advertising industry as an opportunity for more ad spend to find its way to the Roku platform and stay there. Roku's value proposition will continue to grow with programmatic trends, a stronger Dataxu integration, and as they continue collecting data from their expanding user base. With an enormous market opportunity ahead, Roku is a buy at this price in my opinion.

Risks

• CTV Ad Spend Contracts Significantly. This would render most of my assumptions misplaced in this article and the stock could see some significant drawdowns as a result.
• Competition from Amazon's (AMZN) Fire TV could threaten Roku's expansion. Amazon has a similar number of active Fire TV devices. Their Ad-Tech capabilities don't appear to have the same maturity but hey, it's Amazon! They can throw cash at the problem and stress Roku through a pricing war.
• Investors may have to deal with share price dilution which would reduce returns.
• Roku is a high-growth stock, it is susceptible to volatile swings and offers a poor margin of safety as dynamics can change swiftly; investors should consider it appropriately within their risk appetite.

Conclusion

Many investors are concerned about a drop in ad spending, but few have investigated the supply of high-quality inventory in the first place. I view the shake-up of TV advertising as a likely catalyst for Connected TV adoption in this environment, despite it being ad-revenue dependent. Regardless of near term headwinds/tailwinds, Roku is strongly positioned to capitalize on its long-term market opportunity as the go-to television platform/operating system. It is a buy at the current price in my opinion.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Comments

[Michael Clark]

BOTTOM
63.84
05/07/20
ROKU

Target Gain
333.88
230.46<— NEXT TARGET

127.68<— CURRENT RESISTANCE
103.29<— cURRENT SUPPORT

95.76
88.10
79.1616
73.416

[Michael Clark]

BUY ROKU NOW.

seekingalpha.com/...

[RR investor]

If it is but why is it down today after increased revenue

[JP24]

It’s definitely going to be an interesting report. Since we’re now six weeks into Q2, ROKU should have a good enough sense of the business trends to provide at least Q2 guidance. If they don’t provide guidance, I’ll be concerned. If they do provide guidance and it indicates that growth is not being significantly impacted, then I think the shares will run higher.

[The Abstract Investor]

Looking forward to it. It'll be interesting to see how the market grapples with the balance of short-term hits and long-term growth. The sell-side analysts have predicted 30% growth for FY 2020, and re-acceleration to 38-40% in FY 2021 heading into this earnings from KoyFin data. Strange times. Other stocks I track such as SQ and AYX as of today seem to be relatively unfazed with guided growth hits.

Analysts could be way off, and so could my loosely informed predictions of new revenue flowing to CTV in coming quarters. It's best to focus on the long-term rather than attempt to play swings IMO.

[GreenPirate]

Thanks for your well thought out article.

From what we have found, analysts est. an ESP of -$45 and Est. 39.8 million users, streaming hours 13.2 billion and: Total net revenue $307 - $317 Total gross profit $139 - $144 Net income (loss) ($60) -($55)

The question is: Should ROKU beat these estimates, will the share price rise from the $134 where it is at the moment? Is that going to be a reflection of public confidence? A response to high spending on set up of foreign operations? Or, should we consider the impact of unemployment?

I've had more of a negative view of ROKU since top executive and founder James J. Woods sold off vast amounts of options and shares over short periods of time. He also handed himself a gigantic raise of over 99%.

Also, the Coronavirus pandemic has altered the landscape and reduced investor confidence, in general. And we are not immune! As elderly Americans we are being told to be extra wary.

Given all of this, I think many people will want to hold on to a large amount of cash rather than wait out hoped for increases in share prices over the long term.

We have happily sold a percentage of shares this AM at a return of over 450%. They were the highest priced shares we had. We thought that a big negative share price number would set a limit on share price in spite of otherwise sensational data.

As to the rest, we agree with your view about taking a long-term view.

[67Mistral]

Thanks. Interesting article on a too-often-overlooked growth metric.

You're right to focus on the increasingly detailed data analytics that Roku is compiling with respect to its growing and broadening user demographic. These detailed cross-channel usage profiles are of great value to ad targeting. They will also help Roku build a data moat around its ecosystem that will protect it as one of a few leaders in OTT advertising.

But note that the value of the usage data isn't limited to ad sales. Abstracted, such data also provides insight into high-level user behavior, which aids Roku's international expansion. Such data is valuable to persuade new (local) streaming channels to join Roku, and also to part with a greater ad split or revenue share.

Moreover, these usage data acquisition trends will accelerate as streaming continues to replace linear TV, and as theatrical film releases shift to streaming releases (or as theatrical release windows are shortened in compromise).

[The Abstract Investor]

Good points! I agree.

[GreenPirate]

"Roku's performance continues to be top-line driven, as it burns cash to capture as many viewers as it can. At under 40 million active accounts, there is a far greater market to capture both domestically and internationally. Market saturation for Connected TVs won't be reached for a few more years. As of FY 2019, the company is on an accelerated growth trajectory clocking at 52.0% yoy on an LTM basis."

--As to ROKU burning cash I would hope they keep on spending on content. That's how they will grow and the advertisers will come back strong as they continue to show more numbers.

For those who are home streaming more TV than ever, they will not replace their low cost ROKU systems if the content is good. Regardless of your level of wealth, it hurts to pay for cable or satellite TV after using low cost ROKU.

But ROKU's problem, their Achilles heel, is overpaid executives, especially CEO James J. Wood, who continues to sell shares in 35,000 increments. His 99% raise to himself in 2019 leaves him with $8.3M a year.

In 2018, five ROKU executives received on average a compensation package of $5.7M, a 155% increase compared to previous year. www.execpay.org/... They are ALL getting far too much pay given that the company has not been public for very long and shares remain very volatile. Gigantic tear outs of shares will do that.

Shareholders, let them know your thoughts. US corporations are out of control in general when it comes to executive pay, and this is the kind of moment in our history when all overpaid execs should be giving back to the economy that has enriched them. Coronavirus has caused real hardship for Americans. Its time for them give something back to their users by surrendering a percentage of their salaries.

If Wood slams shareholders with another massive sell off of shares, I'm not going to stay with the company based on the enough is enough rule.

[nerd_rage]

How many of those 40 million "active accounts" are like me and never use Roku for any ad-based apps? I avoid anything ad based like the plague. Roku may make money from people who sign up for Netflix and Disney+ through Roku, but what if they're like me and already signed up via the companies' portals?

[wantedtoretireearly]

I’m like you. I’ve been a happy Roku user for probably 6 years now but have never seen an ad except for what is on the home screen. I have never watched the Roku channel. Where else are there ads on Roku they can sell?

[GreenPirate]

Its pretty tough to avoid all of the ads on ROKU's platform. Every time you go to the main platform there are ads. That large space around the icons for channels are filled with ads.

But let me suggest another try on ROKU's free channel. They have had some good stuff there. And unlike some free channels they don't place them so close together that there is no enjoyment in watching.

Give it a try. The latest round of content additions have been impressive, even though not all appeal to old retired folks like me.

[Plain Vanilla]

"What we essentially have is a reduction in the quality of broadcast/cable TV inventory and an increase in the quality of connected TV inventory due to the pandemic"

Wouldn't ctv inventory not suffer from the same problems? Why would they still hold the inventory, because of more breadth in content?

Thanks and good article.

[The Abstract Investor]

Breadth in content, but primarily the growing user base and increased streaming hours.

[nerd_rage]

Discount that 40M number by some % to account for Roku users who don't bother with the ad-based apps. I've sampled some, they are pure junk and not worth suffering through ads for. My time is worth money so I'll pay Netflix to let me dodge ads.

That's the problem ad-based platforms face, the people with money who are prime advertising targets, value their time because they have money, and the people left over watching ads like the free apps because they have no money to spare, but why bother advertising to a broke audience?

[SeanLo]

People can stream NFLX on their Roku. I feel like most people will shuffle between different streaming sites, netflix, disney+, hulu, hbo max, etc. Doesn't roku ads only appear on the Roku Channel?

[GreenPirate]

Thanks, we agree and will hold our ROKU shares in spite of a current extreme profit. Let's all see what happens. With ROKU it makes sense to continuously reposition with some profit taking along the way. We hold shares purchased at an optimal price while taking profits for those shares that were bought at a higher price. That way one builds a fund that is easier to hold long term and also has the benefit of cash on hand for any drops in price. It may not work forever. Nothing does.

[FringDook]

Long $ROKU and I agree with your strategy. It is too volatile to not take profits when it is clearly overbought. A little risky, as at some point it will go up and not come back down again.