Roku: Thesis Is On Track, But More Downside Is Almost Guaranteed

May 09, 2022 10:41 PM ETRoku, Inc. (ROKU)14 Comments7 Likes

Summary

  • Roku just posted its 1Q22 earnings report and I believe the bull thesis is on track as the company delivers on revenue, adjusted EBITDA, and accounts growth.
  • Following the decision to invest heavily into future growth, the company’s path to constant positive earnings has been delayed.
  • As a result, the company became more expensive and the stock will most likely still suffer in the short term especially since we’re navigating through a volatile period.

Roku Shares Slide 25 Percent After Q4 Revenue Drop

Justin Sullivan/Getty Images News

Investment Thesis

I believe that Roku (NASDAQ:ROKU) delivered a good Q1 and the company’s thesis is on track. Below are some qualitative stats extracted from their Q1 earnings report that I believe are important for Roku’s thesis. Still, after the company revealed it will continue to invest heavily during 2022, the stock became more expensive and will most likely struggle in this market environment.

For the first time, TV streaming devices surpassed legacy pay TV devices (Set-Top-Box and DVR) in weekly reach in the U.S., with 65% of adults aged 18-49 streaming TV vs. 63% watching legacy pay TV in March (Nielsen)

Source: Roku 10-Q report

Source: Roku 10-Q report

This just flew under the radar, as I think we’re witnessing a historical moment. Even if this isn’t exclusive to Roku, I think the company benefits from it as it acts as a solid gatekeeper towards the streaming world giving its 60+ million monthly active users.

In Q1, The Roku Channel (TRC) was a top 5 channel on our platform in the U.S. by Active Account reach and, for the first time, by Streaming Hour engagement

As a reminder, Roku built one of the best AVOD (Advertising video on demand) platforms, behind only Hulu and YouTube in terms of advertising revenue and TRC is the most important piece of the platform. This is more significant after Netflix (NFLX) announced it may enter the AVOD segment in a couple of years, which proves the appetite for free or partially free, ad-supported video streaming, where ROKU seems to have a definitive head start.

In Q1 the top 10 broadcast TV advertisers increased spend on Roku nearly 80% year-over-year, while spending 7% less on legacy pay TV.

This proves that the gap between viewers and advertisers is starting to slowly narrow. I expect this trend to continue as more people can be reached exclusively on streaming, in conjunction with a superior targeting for streaming as compared to linear TV.

Key Performance Indicators

Active accounts & Average revenue per user (ARPU), the two most important metrics, showcase how much users can Roku attract on its platform in spite of the supply chain headwinds and how well can Roku monetize them. Both metrics came in above analysts’ expectations, with Roku adding 1.2 million users and ARPU growing 33.5% YoY. This is a good sign considering all the macroeconomic volatility, especially while the TV sales are still below the pre-pandemic level.

ARPU

Source: Roku 10-Q report

Player segment

Player

Source: Roku 10-Q report

Another way in which the inflation and supply chain disruptions affected Roku is on the player segment. This continues to be a negative margin business since Roku makes accounts growth a priority. Roku will take a hit on this business segment for the foreseeable future, with player gross margin sitting at -17%, a small improvement from 4Q21.

Platform segment

Platform

Source: Roku 10-Q report

Most of Roku’s revenue (~88% of total revenue) comes from its platform. This segment contains all the revenue related to Roku OS, including advertising and media & entertainment (revenue from content creators cross-promoting shows). We found in the earnings call that M&E segment is an important piece since around 25% of all advertising time is used to cross-promote shows. This mix of revenue between video advertising and M&E strongly influences the gross margin for platform segment. Video advertising generates a lower gross margin than M&E and had a significant impact in 1Q2022 when gross margin was 8% lower than 1Q2021.

Content creation – an important dilemma

The most important element of the platform revenue is content licensing and creation. So far Roku licensed content for its TRC and starting with 2021, Roku decided to produce its own original content. This major pivot will affect both its platform gross profit, as well as EBITDA margin. For now, we have no official budget for this investment, except for the amortization schedule published at the end of 2021:

amortization

Source: Roku 10-K 2021

The company announced an amortization schedule for the next 3 years that sums up to around $161 million for content licensing and production. Around $91 million will be amortized in 2022. However, around $44 million was already amortized in 1Q22 and it looks like the company might deviate from its guidance. It’s no wonder giving the competitive landscape for original content and how the company only budgeted around $12 million for producing content. Content licensing and creation is essential for Roku, and I will watch this carefully going forward to see if the company’s spending for this segment becomes a major threat for its margins.

Financials – are margins deteriorating?

Roku delivered on both its Revenue ($734 million vs $719 expected) and adjusted EBITDA guidance but missed on Earnings per share (-0.19 vs -0.18 estimated). Here's a summary for Roku's Income statement:

IS

Source: Roku 10-Q report

Still, the Q2 guidance for gross margin is 49%, 3% lower than 2Q2021, as a result of an acceleration in the portion of video advertising (a lower margin revenue stream) for the platform segment, in conjunction with sustained supply chain disruptions on the player segment. Moreover, the company guided for a breakeven adjusted EBITDA in Q2 as it will pursue attractive investment opportunities that will fuel a more solid growth in the subsequent years. On the flip side, adjusted EBITDA guidance for FY2022 remained unchanged (around $150 million).

Free Cash Flow

In terms of Free Cash Flow (Cash from operations – CAPEX), Roku had a strong quarter as the company managed to reenter the positive FCF territory. Moreover, FCF represents around 12% of Roku’s revenue for Q1, which shows a good ability to transfer some of the revenue to free cash flow:

FCF

Source: Roku 10-Q report

Still, considering the company’s investing schedule for the next 12 months, FCF for FY 2022 is expected to be around $110 million, which is lower than the $188 million for 2021.

Valuation

This is an important part of the thesis. Roku proved in 2020 that it can attain Free Cash Flow ($188 million, ~7% of revenue) and positive earnings (~9% net margin). Still, management is confident in the growth opportunities laying ahead for Roku and as a result they’ve guided for only 4% adjusted EBITDA margin in 2022, compared to 17% for 2021. This major investment schedule generated a significant cut in the estimates for EBITDA and Earnings per share.

As a result, Roku became more expensive, trading around 65X NTM Enterprise Value / EBITDA and 111X NTM Enterprise value / Free cash flow. Even after a massive drop during the last couple of months, the stock is actually more expensive than it was in January following its guidance for full year 2022, so I believe there is still a major risk that the stock price will continue to decrease in the near future, more so considering the high volatility experienced recently by the markets:

valuation

TIKR

Final thoughts

I believe in Roku and I do think that the company will do well. However, as multiple compression is undergoing, even if Roku’s execution will be flawless for 2022, the stock might not reflect that on the short-term. Considering its valuation, it seems like the stock might have more downside in the subsequent months, especially giving the high volatility seen recently in the market.

This article was written by

27. Utterly passionate retail investor. I have a Master's degree in Finance & I passed 2 CFA exams.You can follow me on Youtube & Twitter where I post insightful company specific researchHope you enjoy my articles!
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Disclosure: I/we have a beneficial long position in the shares of ROKU either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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