Read the Fine Print
We have analyzed ROKU’s recent financial results to further illustrate the overhyped overvaluation of the Company. The primary drivers of value for ROKU are Active Accounts and Platform Revenues. Sales of USB sticks and equipment are run at break-even/small loss as ROKU recovers those costs while it generates accounts. Platform Revenues are derived from revenue share for inventory sold to advertisers targeting ROKU accounts, content distribution agreements for the ROKU platform, and license fees for the Company’s operating system.
We used the following data from the Company’s 2Q19 shareholder letter:
- 2Q19 Platform revenues of $167.7MM,
- 2Q19 Gross profit of $109.7MM, 2Q19 Platform gross margin of 65.4%,
- End of period accounts of 30.5MM up 1.4MM sequentially; average accounts during 2Q19 of 29.8MM,
- ARPU (Average Revenue Per User, Trailing 12 Months - TTM) of $21.06 up $2 sequentially from 1Q19,
Low Monthly ARPU and Monthly Contribution Margin; Misleading Metrics
The above metrics generate Monthly Platform ARPU per Average Account and Monthly Contribution Margin per Average Account of $1.87 and $1.22, respectively, or Annualized ARPU per Average Account and Annualized Contribution Margin per Average Account of $22.51 and $14.72, respectively. It is positive that TTM ARPU is up $2 sequentially from 1Q19 levels. However, it is misleading to call this metric “ARPU” and it is not enough to bury it in parenthesis with a dangling “TTM”. In our 25 years of technology research, ARPU invariably is used to refer to a monthly number. We caution investors that may be reading ROKU’s shareholder letters and assuming ARPU is a monthly metric, that they may be failing to read the fine print while they happily bid for or hold the Company’s stock based on potentially misleading information.
Competition Heats Up
Given the rising competition for the home from Amazon Fire (cutting Fire equipment prices heading into its hardware and services technology day tomorrow), Apple TV (cutting prices for packaged content), Google Chromecast (weekly promotions sent for movies and other), Comcast Flex (free equipment for Internet customers), and gaming console provider such as Microsoft and SONY (eSports audience/promotions), ad inventory available to streaming content providers is growing exponentially heading into 2020. As a result, the law of supply and demand is taking hold – there will be significant pressure on advertising revenues, revenue share, and ad volumes for ROKU as a host of competitors push streaming endpoints into the market and they become activated, allowing advertisers to be selective and giving them bargaining power in how much and where they spend on streaming. We think this trend may already be evident in ROKU’s numbers, as illustrated by the 420-430 basis point sequential and YoY decline(S) for ROKU’s Platform Gross Margins in 2Q19.
Bottoms Up Analysis Supports Much Lower Valuation
Assuming all other expenses remain flat and equipment revenues remain at essentially zero contribution margin, the business today runs at 65% margin. We do not believe these levels are sustainable and forecast a decline to below 50% contribution margins over 2020-2021. With an average “account life” of several years (no contract terms), which we believe will prove generous as competition for the home heats up and ROKU is no longer the only game in town, this suggests ROKU accounts are each currently worth $88.34 - $117.80. Multiplying this range x 30.5MM end of period accounts and adding in $387MM in June 30, 2019 cash (which we believe will be consumed by the business) generates an implied valuation for ROKU of $3.1-4.0BN. Dividing this range by 135MM diluted shares (includes roughly 20MM stock options and restricted stock grants) generates a fair value for ROKU of $23-$30 per share today.
It’s About the Real Estate, not Equipment Sales
We have heard that ROKU sell-side analysts, which ran the stock as high as $176 on unfounded and unachievable financial forecasts and zealous and irresponsible statements, are discounting the pricing pressure of Amazon Fire products and the free Comcast Flex program, claiming equipment revenues are immaterial to ROKU’s numbers. We agree that equipment revenues per se are not material to the story. Our concerns are not about ROKU equipment revenues or margins – they center on the valuable real estate in the home captured by that equipment deployment and the rising cost for ROKU to win and retain endpoints/accounts especially in its core market in the United States. The more options consumers have from well entrenched blue chip global iconic companies willing to almost give away equipment or proprietary content to gain share, the more turbulent headwinds ROKU will face. In the “new” streaming paradigm, ROKU is becoming a fringe player with no technology moat for its Linux system, no proprietary content except its scraped basket of channels, and a weak balance sheet of limited cash that it can use to combat the onslaught of giant competition. Almost all TV's have multiple HDMI ports, allowing customers to plug in a competitor's equipment while ROKU is installed at the same time. This marginalizes the value of the ROKU network and there is nothing ROKU can do to stop it. To make matters worse, even with a 16-year head start, ROKU still struggles to generate $1-2/month per customer on its platform. That’s just not going to cut it when the behemoths listed above activate their playbooks.
Bottom Line – ROKU Is Mispriced While the Market Rapidly Evolves
The above analysis confirms our skepticism on ROKU. Investors need to read the fine print of the Company’s forecasts and of bullish analyst commentaries and do a reality check on the streaming market ROKU faces today. Even if the Company were to double its active accounts, based on our anticipation of hyper competition in streaming, ROKU has substantial near-term downside. Swimming with multiple multi-billion-dollar global iconic competitors, the pool is going to run out of room for ROKU. We reiterate our STRONG SELL recommendation and $25 target price.
Footnote on Tomorrow’s Amazon Event:
Tomorrow (09/25/2019), Amazon will host its annual invitation only hardware and services event in Seattle, WA to showcase new and refreshed wares for the world.
At the IFA show earlier this month in Europe, Amazon introduced a refreshed Fire TV Cube, a new OLED Fire TV Edition, Fire TV Edition Soundbar, and a new 65-inch Toshiba Fire TV Edition with Dolby Vision HDR. During last year’s event, Amazon announced 15 Alexa-enabled products, including a microwave, new Amazon Echo products, a wall clock with Alexa built-in and more.
In advance of the event, Amazon is running promotions for Firesticks targeting existing and trial Prime members, cutting prices to $24.99 from $39.99 for the devices to over 100 million Prime households (38% discount). For those accounts that load $100 credit, pricing drops to only $14.99, an industry leading price point (62% discount).
On the margin, these Prime Firestick prices combined with a vast array of products and services, including free shipping, and proprietary content that costs billions of dollars per year, should assign a disproportionate share of growth in the streaming market to Amazon at the expense of fringe player ROKU, in our opinion.
We expect the Amazon event to provide another substantial negative data point for investors as new technology, bundled services and lower price points offered to Amazon’s substantial Prime base and trial customers provide “sweet chin music” to ROKU who has nothing to offer to counter Amazon’s offering. Amazon has the triple-threat of technology, proprietary content and global distribution that only a few companies in the world can match. It just so happens that some of these companies include other giant competitors in the streaming market recently offering their own variations on the service – Comcast Flex, Facebook Portal, Apple TV and Google Chromecast.
Disclosure: I am/we are short ROKU.
Additional disclosure: We intend to provide additional commentary in our ongoing coverage of ROKU.