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Background
By writing this article, I want to continue a series of articles (the previous ones were about Netflix, Uber) about lucrative opportunities in the technology sector. Today, I want to highlight the investment opportunity in Roku (ROKU). The company’s shares were sold along with all the fast-growing stories in the technology sector. Then, the fall accelerated on the 4th quarter results. The fall of more than 70% from the highs certainly attracts attention, as it suggests the possible attractiveness of this company if something critical has not happened to the company’s business. Of course, there are some questions about the growth that was during the pandemic. Despite the company being a beneficiary of the pandemic, the part of that growth was fundamentally unjustified. However, looking ahead, I note that such a fall in recent months is excessive and creates an opportunity to open positions. But before moving on to my valuation, let’s go over the financial statements to understand the current state of the company’s business.
The 4th quarter results
Revenue was $865 million (+33% YoY, 3% below expectations). The number of active users (MAU) amounted to 60.1 million. Streaming hours increased by 25% to 72.2 billion YoY. ARPU was $41.03 (+43% YoY). Adjusted EBITDA was $87 million. GAAP earnings per share were $0.17, $0.13 above expectations. Cash at the end of the year was $2.1 billion.
The slowing down of user addition
The number of active users for 4Q increased by only 3.7 million to 60.1 million, which, along with the forecast, I single out as the main negative factor in the financial statements. For comparison, the closest competitor (PlutoTV (Paramount Global)) added 10 million users over the same period and became number 1 in terms of the number of MAUs among AVOD services. Management cited supply chain issues as the main reason for the slowdown in user acquisition. Let’s take a closer look at each segment to understand how supply chain problems have affected the company’s business.
The Roku Player segment overview
Player margins continue to deteriorate due to supply chain issues. Revenue from the sale of players and licensing of the Roku OS operating system to TV manufacturers amounted to $162 million (+9% YoY). Segment gross loss amounted to $47 million (margin -29%), below 3Q (-14%), and the level of 2Q (-6%). Gross margin continued to deteriorate due to the higher costs for components and logistics. Let me remind you that the company decided not to shift to consumers the growth of component costs through increased prices for the player, which puts pressure on margins in the short term, but, in my opinion, will allow maximizing the acquisition of new users. The strategy is paying off as unit sales of players were down just 4% YoY.
As a reminder, the company manufactures smart TV players and licenses the Roku OS operating system to TV manufacturers. That makes its business complementary and sensitive to the sale of TVs. Problems in TV supply chains have led to shortages of panels and increased shipping costs for TVs. Transportation of smart TV players has also risen in price, but since they are smaller in size and more convenient to transport, the increase in logistics costs is smaller. The price of TVs increased in 4Q by 33% YoY, which significantly reduced the demand and sales of TV. The drop in TV sales has resulted in a loss of revenue from Roku OS licensing to TV manufacturers.
I see the company as the beneficiary of the trend for TV manufacturers to switch to third-party operating systems. Many TV manufacturers are switching to third-party software. We saw that before with operating systems for computers and mobile phones. With time, only a few dominant OS operating systems are left (Windows and macOS for PC, iOS and Android for mobile devices). The Roku operating system is now number 1 in the US in units sold (one in three TVs sold with Roku OS) and hours watched, and number 1 in Canada and Mexico in hours watched. Management expects it to become a leader in other countries as well. In support of the thesis, I can cite an agreement signed with Sharp, according to which Roku OS will be installed on Sharp’s TVs, whose sales will resume in the US this year.
The Roku Platform overview
Revenue from the Platform was $704 million (+49% YoY). Gross profit was $426 million (61% gross margin). The slowdown in revenue growth (+118% YoY in Q2, 82% in Q3) is due to the pressure of supply chain problems on several advertisers (consumer goods and automotive), which reduced their advertising budgets. That led to pressure on ARPU. Some of the budget cuts from automotive and consumer goods companies were softened by higher spending from such industries as finance and restaurants. The additional source of company revenue is the commission for subscriptions through Roku Player to other streaming services (Disney, Netflix, etc.). That revenue is highly marginal, and therefore, the shift in the segment’s revenue mix towards higher advertising revenue led to a decrease in gross margin from 65% (a quarter earlier) to 61%.
In addition to streaming advertising, companies from the media and entertainment industry can pay extra for advertising their services. For example, Roku offers the placement of a promo banner in the Roku welcome window. The effectiveness of such advertising could be well measured. That may make it more attractive to some advertisers in comparison to advertising through social networks. Due to changes in the IDFA policy, targeting and measuring the effectiveness of advertising in social media has become problematic.
I highlight the prospects for further growth of the advertising market in streaming. Among the US population, aged 18 to 49, streaming accounted for 45% of TV viewing time in Q4 (40% a year earlier). However, ad spending on streaming accounts for only 18% of the total TV ad budget. I believe that this gap will close in the coming years.
I also underscore that Roku shows good numbers in terms of growth and retention of advertisers. In 2021, the number of advertisers on the service (adjusted for political ads) increased 20% YoY. 95% of advertisers (with advertising budgets over $1 million) stayed with the company in 2021.
The disappointing forecast
Investors were disappointed with the forecast for 1Q and 2022. The 1Q revenue is expected to be $720 million (+25% YoY, 5% below consensus). The management expects a gross profit of $360 million (50% margin). Adjusted EBITDA is expected at $55 million (8% margin), better than Q4 (4%) but worse than a year earlier (15%). Net loss is expected to be $30 million. The company expects supply chain issues to continue to weigh on the company’s performance in Q1. Total revenue growth for 2022 is expected to be around 35%. Management also expects costs to rise (hiring, salary increases, and investment in the Roku original content).
Valuation
In my valuation, I use the DCF model since the valuation by multiples, in this case, is very sensitive to the choice of the multiplier value and the expected revenue in the coming years. I expect total revenue to grow with a CAGR of 18% to 11.8 billion by the end of 2030. I expect the total adjusted margin to be 33% in 2030. I forecasted a 4% revenue CAGR and 0% gross margin in the terminal period for the Roku Player segment. I expect a revenue CAGR of 19% and a gross margin of 64% for the Roku Platform segment. In my model, I used a WACC of 10% and a terminal growth rate of 3%. With these inputs, my DCF model target price is $187 (December 2022 timeframe). That represents a 69% upside at the time of this writing. In my valuation, I used a TGR of 3%. I think that is quite conservative. If I use the growth rate of 4% in the terminal period, the target price will be $209. 4% can be broken down into 1% user growth and 3% revenue growth per user (ARPU). However, I lean more towards the $187 valuation.
Risks and final thoughts
Despite a decent upside, I will note that it suggests a scenario in which the company will retain its leadership position in the US among smart TV operating systems and in terms of sales of smart TV boxes. However, the competition in the smart TV segment is growing. Amazon (AMZN), Alphabet (GOOGL), and Apple (AAPL) have big ambitions in this area. However, there is no evidence yet that Roku is starting to lose the competition. The appearance of such facts in the future may lead to my reassessment of the company’s investment case. But at the moment, the ratio of potential return/risk looks attractive to start building a position. Since supply chain problems may weigh on the company’s business for several more quarters, I plan to open only half of the positions in the coming days. An additional risk for the shares is the high concentration (about 4% of Roku’s shares outstanding) of the ARK family funds in the company’s shares. If the funds start selling shares, it will put additional pressure on Roku’s shares.
