- 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
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
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.
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.
- 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.
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.
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