Roku: Conquering the Streaming Wars.
Roku: Conquering the Streaming Wars.
Deep Dive
Edited by Brian Birnbaum.
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1.0 Seeing Through the Narratives
The market is likely underestimating Roku.
The market has spun a series of yarns about Roku stock. These stories, while perhaps entertaining, circumvent the company’s fundamentals. As the Street’s tall tale goes:
Roku is and will continue to be unprofitable because:
Roku faces life threatening competition from Amazon and Google, as evidenced by its recently slowing growth.
Roku has to spend a lot of money on originals to stay competitive, like Netflix.
Indeed, the above narratives are neither totally true or totally false. But I believe they are sufficiently false for the stock to present an asymmetric opportunity.
In a nutshell, I think it is fairly likely that Roku continues to do well over time because of its spend on originals and despite its tight competition with Amazon and Google. At a P/S ratio of 3.5, I think Roku has considerable upside.
Before dissecting each of these narratives in depth, however, some context.
Roku is essentially a smart TV operating system, which people in the US, Mexico and Canada love to use due to its simplicity. It allows you to manage and navigate through all your favorite streaming apps, like Amazon Prime and Hulu, for example, in an easy way.
As more users watch TV via Roku, it holds more attention which it can then sell to players downstream, like Netflix and Disney+.
These players invest large amounts of money to create engaging content in order to acquire attention, so Roku is a logical place for them to distribute their content. Roku thus monetizes in this manner, by taking a share of the subscriptions it generates and by selling ads.
Roku’s exclusive focus on its smart TV operating system, especially on the UI (user interface) side has led it to being the number one smart TV OS in the United States. In Q2 2022, nearly four out of eight hours streamed per US household happened through Roku.
Further, Roku has 75.8M active accounts worldwide, most of them in the US. The data is fairly blurry, but it seems that Roku has more active accounts in the US than Amazon and Google combined.
Roku plays an important role as the world transitions from linear to smart/connected TVs, which distribute content via apps rather than channels. In fact, I was initially drawn to the company because I get fairly upset whenever I go somewhere on holidays and there is no smart TV.
As with other platforms, there will be a small number of winners. In the case of streaming platforms, Roku is looking like a serious contender.
For Roku to succeed from here, it must proliferate levels of attention at a marginal cost. The business fundamentally consists in acquiring attention for cheap and selling it dear, by luring folks in with a delightful UI.
For this to happen, Roku’s OS must be head and shoulders above that of Amazon and Google and so must its distribution ability. In the digital space, however, superiority looks slightly different than in the analogue space.
When dealing with free offerings, one that is marginally better than the rest will receive a disproportionate share of the traffic. This is because for users the cost of picking one offering over the other is zero.
Now that you know what Roku is, in the next few sections I invalidate the aforementioned tall tales and instead paint a picture of the company’s excellence.
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2.0 Roku’s Profitability
The market is focused on profitability, when the true indicator of financial health is cash flow.
Roku has a fair amount of non-cash expenses which make the income statement look poor. But with a rapidly rising cash from operations (up 67.1% QoQ in Q3 2023) the company is much healthier than it seems at first glance.
Roku is a typical growth company that does not print profits, but does print plenty of cash. I tend to like this sort of company, because this decreases the tax bill and frees more capital for reinvestment.
Note that the delta between net income and cash from operations was particularly widened in Q3 2023 because of an asset write down of $230.8M.
Further, the company stepped up its level of investments during 2022, just before moderating it going into 2023. Together with the rising top line, this moderation explains the increased cash flow production over the last few quarters.
But it also reveals that the company is now stronger.
In Q3 2023, OpEx was only 12.9% lower than in Q4 2022 and revenue was only 5.1% higher over the same period, but cash from operations was 33 times higher. Cash from operations came in at $7.4M in Q4 2022. Despite the small base, the delta is more than tangible.
Roku increased its investments in 2022 with a weakening ad market, which speaks to management’s focus on long term value creation. Reading through the quarterly conference call transcripts and per the price action, the market put plenty of pressure on the company to decrease investments.
Nonetheless, Roku’s cash flow production ability seems to have been enhanced throughout this time. More on this in Section 5.0.
For now, allow me to take you through arguably the most pressing issue: the “existential” competition with Amazon and Google.
3.0 Competition with Amazon and Google
The market is likely confusing a temporary, generally waning attention environment with a reversal of otherwise very stable competitive dynamics. I see no signs of Roku’s competitive edge fading.
Since Q1 2021, revenue growth has been stalling.
In Q1 2021, revenue grew 79% YoY while in Q4 2022, it grew 0.20% YoY. This dramatic deceleration has led the market to place particular emphasis on Roku’s intense competition with Amazon and Google as a plausible explanation.
It is well known that a weakening ad market has helped to drive this slowdown. Yet, it is not widely appreciated that since 2021 the world has also gone through an “Attention Economy Recession.”
While we do not have quarterly numbers for Amazon Fire TV and Android TV, we can see how Netflix fared during this period of time. Arguably the king of streaming, Netflix’s revenue grew 16% YoY in Q4 2021, only to slowly stall throughout 2022, to hit a low of 3.7% growth in Q1 2023.
Since, growth has re-accelerated to 8% in Q2 2023 and to 7.8% in Q3 2023. Certainly, Netflix has taken measures to reignite growth, such as launching shared plans. However, I believe that the deceleration and then acceleration curve is more reflective of post-pandemic screen time fatigue.
Similarly, Roku YoY revenue growth has re-accelerated in recent quarters, coming in at 10.83% in Q2 2023 and 19.79% in Q3 2023, somewhat tracking Netflix’s progress.
In the graph below, you will see that the nadirs along the blue curve (QoQ streaming hours growth) have been rising since Q2 2021. I believe this is indicative of the world recovering from screen time fatigue.
What’s interesting is that the relationship between the growth of active accounts and total streaming hours is cyclical. At the midpoint of 2021, streaming hours stopped growing or even receded, only to have resumed growth going into H2.
Active account growth exhibits a similar pattern, without declining quite as much in Q2.
Now, the reason I say the market is not totally wrong regarding the competition narrative is that if you look at the purple curve, it’s not trending up as it usually does in H2. Then again, the H2 uptick going into Q4 tends to be abrupt. In 2021, for instance, the uptick was preceded by a steady decline from Q1 to Q3.
Perhaps the market’s seemingly distorted perception is caused in part by the fact that the uptick in Q4 2022 was preceded by a steady rise from Q1 to Q3.
At this point you’ll notice that I might be splitting hairs.
But that’s exactly how Wall Street analysts cover their buy-side books, over-analyzing short-term data to death. Bandied tales of Roku’s alleged troubles spring, which lead to overwrought analysis, is precisely the sort of market dynamic that leads to potentially asymmetric opportunities like Roku.
While indeed competition from the two titans is heavy, I believe the market is over-fitting. It seems to be confusing a temporarily waning attention environment–what I believe is now an irrelevant data set–for a reversal of the competitive dynamics that Roku has seen over the past decade.
Reversal of what, you may ask?
Roku has been successfully competing in the US with Amazon and Google for over a decade now, and has been around for far longer than that. Roku launched in May 2008, while Fire TV and Android TV launched in September 2014 and October 2010, respectively.
Despite its competitors having much larger resources, Roku remains ahead. Unlike the tall tales spun by Wall Street, we’ve empirically seen this pattern unfold out before.
Notable examples are Crowdstrike, Spotify and Duolingo.
Having studied the company extensively, I now understand that this success has been enabled by Roku’s unrelenting focus on TV viewers and, by extension, on its smart TV OS. Users claim that Roku’s OS is simply “better.”
Framing the situation in a probabilistic context, it seems unlikely that headwinds seen in 2022 have reversed this competitive dynamic. It seems more likely to me that the market is misinterpreting the signals that I dissect in this write up.
If anything, Roku’s focus seems to have only gotten sharper over time.
Roku’s focus on the smart TV space is not only visible in the active account numbers in the US. It’s also visible in a series of iteration curves.
In turn, these curves are indicative of the company’s ability to translate that focus into success in strategic areas adjacent to the draw of its OS.
Further, increased levels of investment in 2022 through to today point to considerably increased focus of late. Over the past decade, Roku has improved across a number of domains, in which it is competing with giants that have been in the game for decades.
Consider TV “channels”, for example.
The Roku channel launched in September 2017. As of Q3, according to management, it accounted for nearly 3% of all TV streaming in September 2023. In July 2023, Nielsen put the number at 1.1%, which is still noteworthy. Here, Roku is competing with companies that have been focused on entertaining people for decades.
Certainly, Roku has a considerable distribution advantage over its peers, but the achievement is nonetheless notable.
Further, Roku entered Mexico in October 2015 and now it is the number two operating system, just behind Samsung. In turn, Samsung has been making TVs since the 1970s–entering the Mexican market in the 1980s–while Roku has only been in the TV game since 2014.
The above has of course taken place while competing with Amazon and Google across the TV spectrum. Why can Roku compete with companies with very strong track records, across multiple domains, simultaneously?
It’s likely due to excellent organizational properties, which the market seems to be ignoring for now.
This is also visible in Roku’s evolution in the hardware front over time.
Roku has traditionally distributed its OS by selling Roku players - pieces of hardware that you plug into your TV. As smart TVs are becoming the norm, Roku is increasingly focused on selling smart TVs that run Roku’s OS.
Roku started doing this in 2014 by licensing its OS to Walmart’s proprietary smart TV brand onn and a Chinese OEM known as TCL. Back then, TCL was largely unknown in the US and today, it is a very popular brand, thanks in large part to Roku’s OS.
Another sign that indeed, there is something special about the way Roku operates.
Although the market share data is very fuzzy, if you go on walmart.com most of the TVs that show up when you enter ‘smart TVs’ in the search bar are onn, Hisense or TCL, running Roku OS.
This is not quite the case on amazon.com, but one of the two has a bit more of an incentive to push its own TV operating system. This is not conclusive data by any means, but again, why are Roku-run TVs all over walmart.com if they are falling behind?
Note that, in turn, Walmart also has an incentive to not push Amazon’s products.
With TCL and Hisense starting to move towards Android TV, Roku launched its own branded smart TVs early in 2023. I reviewed the technical specs of these TVs in detail to see if Roku was bound to outperform in this domain too.
In essence, Roku seems to have entered the OLED space, redefining the customary price to quality ratio. Roku’s TVs are higher performing than other TVs in the same category that sell for three or four times more, like the Samsung S95C.
While Roku TVs don’t outperform across the board, the value proposal is more than sufficient.
While we are yet to see actual sales numbers of these TVs, the move has Roku DNA written all over it. It seems that, once again, Roku has managed to translate its focus on viewers into a winning value proposal at the hardware level.
The above graph is an apt summary of their success. It depicts Roku’s achievements in distributing (and iterating) its OS, often in the face of much larger competitors, over the past decade.
Roku seems to have the ability to figure out new distribution vectors on the go–evident in the evolution of the Roku Channel and of its branded smart TVs, its two most recent distribution mechanisms.
At first glance, Roku seems to be a bit scattered. However, I had trouble spotting signs of the company straying into unproductive ventures.
Then again, a potential exception has arisen recently.
Roku launched smart home products in Q3 2022. The venture can lead to a loss of focus, but it seems to be right up Roku’s alley in terms of hardware and software expertise. Smart TVs do make sense as a center of control for smart homes in the future and, ultimately, the end users are the same for both.
We unfortunately have no data on just how much the company is investing in smart products at present or how much it plans to do so.
4.0 Roku’s Originals
The Netflix debacle in 2022 merged with one of Anthony Wood’s declarations in Q4 2022 to create the perfect storm. A deeper look reveals that originals are simply part of Roku’s distribution method portfolio.
Netflix’s “fall” during 2022 was a fairly sobering moment for the market, since the consensus was previously that this was an unassailable company. In my Netflix deep dive, written in Q1 2023, I explain why the market was looking at the company incorrectly.
With or without streaming, Netflix is still fundamentally a great company. In essence Netflix is a creativity and franchising engine. Streaming is just the method they’ve been using to franchise their creations.
Although Netflix is now re-surfacing as a winner in the eyes of the market, this has not stopped the market from projecting the “Netflix trauma” onto Roku.
Anthony Wood aided the cause by saying in Q4 2022 that “the Roku TV program is becoming increasingly important [to] active accounts and is now the majority of new active accounts.”
Naturally, the market placed Roku in the same bucket as “dying” Netflix, following the Quibi acquisition in late 2021. This made the market think that Roku was moving full ahead towards original content spend.
However, if you read all the quarterly transcript calls since early 2021, it becomes apparent that the above quote led the market to misunderstand the company.
In the call Wood said that the Roku channel was the primary method of distribution, at a time in which the market thought the Roku channel was primarily driven by original content. In Q2 2023, as I review below, management explains that original content spend is in fact incremental.
I believe Wood was saying that, as device sales stalled during 2022, the Roku Channel was emerging as a dominant distribution vector.
Incidentally, a successful example of Roku’s original content is Kevin Hart’s “Die Hart”, released in 2020.
The company in fact has a portfolio of distribution initiatives, as I allude to in the previous section. It seems to be focused predominantly on improving the UI of its OS, as this is its key competitive advantage.
Although Roku has indeed invested in originals, its content strategy is fundamentally licensing.
In Q3 2023, President of Media Charlie Collier clarifies this:
And to sort of summarize or prioritize for you, originals are a key part of our strategy and I'm proud of the team and our efficient and impact driving efforts.
But the foundation of Roku's content spend is third-party licensed content that we service for viewers through Roku's unique UI advantages. Our position as the platform is extremely powerful, probably, I would say, more powerful than I anticipated even coming in when we first spoke.
To Wood’s credit, he was very clear about this in previous earnings calls. In Q2 2023, he said that the primary TV distribution mechanism was “licensing". In the same call, he also said that Roku branded TVs were “incremental,” since the focus on the hardware side continues to be to license the Roku OS to partners.
Way back in Q2 2022, he also said the following:
[…] when we talk about content spend the majority of the content spend and the foundation of the spend from the RO channel from day one has been third party licensing.
Of course, the rapidly rising OpEx throughout 2022 did not help squelch the market’s fears about spend on originals. But, going back to Section 2.0, in which I briefly discuss the company’s financials, the investment seems to have improved their cash machine.
Wherever the investments went, the company seems to be structurally sounder now. It thus is unlikely that, as the market has been pointing to, the spend went towards a content production black hole.Or perhaps process improvements have overshadowed any waste.
My impression is that Roku is using its OS/UI superiority as a platform from which to launch incremental distribution bets that are fundamentally enabled by the company’s obsessive focus on TV viewers.
It’s from this improvement that, in my belief, Roku’s seeming structural improvement emerges.
For instance, Roku has used its large active account base to launch its own streaming app, the Roku Channel. Every time it licenses content or makes its own, the overall cost per bet is lower.
Why? Users subscribe to Roku for the UI, not the content. Bad content thus has a lower impact on Roku’s retention than on an app like Netflix, in which the only reason for people to be there is great content.
Conversely, this means that good content is more accretive in Roku, because it’s an add-on.
This is true for TVs too. If Roku’s smart TV falls short among sector competitors, the user is still incentivized to stick around for the OS. This is not true for Samsung or any other smart TV OEM, for example.
All within limits, of course. If the content or smart TV in question is bad enough, it can break the user’s affinity to Roku.
Within normal operational ranges, however, Roku’s OS superiority is likely to act as a sandbox for iteration at a lower marginal cost. Over time, this should statistically equate to better unit economics at scale, giving the company more capital to reinvest per unit of scale.
5.0 Network Health and Financials
Meanwhile, the network continues to grow just fine, with management highly focused on long term value creation. Declining platform gross margins are a source of concern, but I believe it is likely noise.
Despite declining gross margins, it seems fair to say that Roku’s continued growth is not largely dependent on original content production and that its competitive edge has not dissipated.
If anything, the company seems stronger than a few years ago, before the ad weakness and waning attention environment.
In absolute terms, although growth has certainly slowed, the network is progressing adequately at a high level. Active accounts and total hours streamed continue to move up and to the right, with no signs of reversal.
Management has consistently made it clear that their strategy is to obtain scale first and then monetize. So long as accounts and hours continue to trend in the right direction, I think the company will be well positioned for the future.
Indeed, Roku buys attention for cheap and sells it dear. Despite all the narratives about just how Roku deals with DSPs (demand side partners) or not, the company will continue to do fine so long as they stick to this equation.
In my studies of ad-tech companies, like Digital Turbine, I have seen that even though they may offer superior attribution granularity to their analogue counterparts, it takes advertisers a while to evolve.
When the world fully moves to smart TVs, Roku will be well suited to capture advertising dollars fleeing from linear TV. In this sense, the thesis is very similar to Spotify versus radio.
Income Statement
Roku’s TTM (twelve trailing months) revenue is up 10.5X since 2015.
ARPU (average revenue per user) has dwindled since Q2 2022, but this is no surprise with the background ad market weakness. In Q3 2023, we saw ARPU accelerate 0.8% QoQ, the first positive move since Q2 2022.
If the macroeconomic conditions do normalize, I believe Q3 2023 will be the beginning of a trend reversal. Indeed, the network’s health seems rather improved compared to Q2 2022, when ARPU was 7.4% higher than in Q3 2023.
In turn, gross margins have risen over the last decade, as platform revenue has accounted for a growing share of all revenue. Roku initially made most of its money selling devices (via which it distributes its OS), but this is naturally a lower margin business.
For instance, gross margin in FY2015 was 28.07%. GM peaked in FY2021, coming in at 50.95%, yet has since been in decline. However, a trend reversal can be seen starting in Q4 2022.
It is fascinating to see how Roku has opted to shield customers from price increases in the last few years. The hardware business (player, above) has gone from having a positive gross margin to a negative one.
Q4 devices margin was negative 32% which was down roughly 6 points year-over-year as we prioritized account acquisition and insulated consumers from higher prices caused by inflationary pressure and supply chain disruptions that continue to elevate certain component costs.
- Roku CEO, Antony Wood, during the Q4 2022 ER conference call.
This decision has taken a meaningful toll on Roku’s gross margin profile, which demonstrates management’s commitment to achieving scale first. Much like the increased investments in 2022, with a weakening ad market, this shows that Wood and co are focused on long term value creation.
Most notably, however, platform gross margin has been trending down fast. According to the company, this has been driven by the sale of premium subscriptions and video advertising accounting for a larger percentage of overall platform revenue.
[…] you've seen some year over year degradation that's largely has to do with the mix shift toward more video.
-Roku CFO (at the time) Steve Louden, during the Q2 2022 ER conference call.
Both business lines have relatively low gross margins, although management seems to believe that they are important to drive top line growth. However, the above graph does scream “competitive pressures.”
I look forward to tracking the evolution of gross margins quarterly.
Additionally and as previously mentioned, Roku is nearing saturation in the US. In Q2 2022, nearly four out of eight hours streamed per US household happened through Roku.
To grow over the coming decades, the company needs to expand internationally.
Roku’s success thus far in Mexico is the best set of evidence we have regarding the company’s ability to move internationally, but this is still a country that is relatively close to the US - in more ways than just geographically.
Although Roku has a lead in the US versus Fire TV and Android TV, these two platforms have large worldwide presences. Roku has to have truly exceptional organizational properties to thrive internationally.
I believe it does, but I need more time to make a thorough assessment.
Cash Flow Statement and Balance Sheet
As previously mentioned, Roku’s cash production abilities seem to have been enhanced over the last few years.
However, it must be noted that much of Roku’s investments over the last few years have been non-cash. For instance, they hired and paid much of their compensation via SBC (stock based compensation).
And in terms of OpEx, a reminder when we look at our OpEx, the single biggest bucket is headcount growth or headcount related expenses.
-Roku CFO (at the time) Steve Louden, during the Q2 2022 ER conference call.
Below you can see how SBC has trended. The increase over time is particularly appreciable in the annual graph, in which we can see Roku stepping on the gas.
SBC increased 39.8% from 2020 to 2021, while it increased 91.1% from 2021 to 2022. Even more notably, the increase from 2021 to current TTM has been just over 108%.
Since it predominantly onboards content by closing deals with production companies, Roku needs to hire a lot of sales people. It also needs to hire more engineers to continually improve the platform.
It’s not to say that the SBC increase is purely profligate. SBC is definitely required for the business to grow. But SBC accounts for 11% of total revenue in the TTM, which makes the metric quite worth watching.
As always, with this sort of company, SBC is the price investors pay for a pristine balance sheet. Roku ended Q3 2023 with $2B in cash and equivalents and no debt. Although, interestingly, the company did have $600M in capital leases and $52M in “other long term liabilities” by quarter end.
Despite the relatively high levels of SBC, the positive cash flow and the healthy balance sheet afford Roku a sustained runway.
6.0 Conclusion
At a $12.57B market cap, for the thesis to play out Roku has to remain one of the top few smart TV operating systems in a decade’s time.
I believe the company has the required organizational structure and capabilities to get there. Not just because of the way it has competed with Amazon and Google in the US, but because of the way it’s simultaneously competing with other giants across the hardware and content fronts.
I believe the market is underestimating the company, motivated by the narratives dissected herein. Roku is not going all in on content, and it seems that its competitive dynamics with Amazon and Google remain an extrapolation of the last decade’s.
Its OS advantage is and will continue to serve as a launching pad from which to take on much bigger players, like Netflix and Samsung and have that success feed back into the quality of the OS.
Assuming normal economic conditions, I think Roku’s key metrics will accelerate in the coming quarters. In time I believe the market is likely to assign more generous multiples to the stock.
I need to reflect further before starting a position, but this is a serious candidate for my portfolio.
Until next time!
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