Roku: It’s Time To Go Long (NASDAQ:ROKU)

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After receiving a constant bid from the markets throughout 2019, throughout which Roku (ROKU) shares jumped massively from around $30 in January 2019 to an all-time high at $170 in September, shares of Roku have taken a substantial breather in 2020. Initially Roku was a big outperformer in the markets as investors bet that lockdown orders would glue more and more people to their TVs. But at the same time, the declines in internet advertising (especially with recent news surrounding ad pullbacks from social media platforms, though that more directly impacts companies like Facebook (FB) and Twitter (TWTR)) robbed back some of the benefit of increased usage, and also slowed down Roku’s recent progress on gross margins.

Now, the stock is down ~15% year-to-date:

ChartData by YCharts

I’ve been back and forth on Roku stock, most recently recommending caution in mid-April when Roku was trading in the mid-$130s. Since then, however, shares have have dropped 15% while the broader market has advanced nearly 10% – so I’m now reversing my stance to bullish. Roku is a perfect “buy the dip” situation.

As I have noted in recommending internet advertising-oriented stocks like Twitter (TWTR), the near-term decline in advertising is temporary. Despite the charged media updates on advertiser retaliation, most industry observers have actually observed that ad spending began the path to recovery in May. Yes, Roku was hurting in Q1 and will continue to hurt as it reports Q2 results that were heavily impacted by ad pricing declines – but over time, the company will be able to benefit from a substantially larger (and more engaged) user base when pricing returns to normal.

Roku is a tremendous and popular platform that is in the midst of converting its business to become a purely advertising-driven, recurring revenue company. We’ve seen from counterparts in the software sector that companies transitioning to recurring revenues have typically seen huge appreciation in share prices (as investors value that recurring revenue stream far more than Roku’s one-time hardware sales). I like the fact that most of Roku’s hardware is entry-level priced, making it a great gateway to the smart TV world for new buyers.

Keep monitoring share price movements and buy anywhere in the low $110s.

Streaming has been a hot space this year

Before we get into Roku specifically, it’s useful to take a close look at how streaming companies have performed this year.

ChartData by YCharts

On the back of massively expanded user bases plus increased engagement, shares of Netflix (NFLX) have risen 37% this year, while Spotify (SPOT) in the months of May and June caught its first major breakout since going public at ~$150 a share in 2018, and is now up nearly 2x in the year-to-date.

You’ll notice, however, that Roku has been left behind. This is due to Roku’s exposure to advertising driving decelerations in revenue growth and gross margins, but as I mentioned earlier, Roku’s surge in users and engagement is permanent while the decline in ad pricing is rather temporary.

Q1 download

Let’s now see how Roku’s financials played out in the first quarter. As previously mentioned, the disappointments in the quarter came largely from the advertising side – as marketers pulled back budgets to conserve cash, sending ad rates downward. Dynamics in internet advertising are changing again – marketers are pulling back from social media sites like Facebook (NASDAQ:FB) and Twitter (TWTR), at least in the short term – but this could also mean that this budget could be re-diverted onto streaming platforms like Roku, helping to accelerate the recovery to normal pricing.

Figure 1. Roku 1Q20 resultsSource: Roku 1Q20 earnings release

Still, Roku was in growth mode in Q1. The company’s 37% y/y increase in active accounts and 49% y/y increase in streaming hours produced an impressive 55% y/y growth rate in revenues to $320.8 million, of which 73% was derived from platform. And in spite of a negative stock market reaction post-earnings, Roku still managed to beat Wall Street’s expectations of $309.2 million (+46% y/y) by nearly a ten-point margin.

Roku has cited uncertainty as a reason for pulling its guidance for Q2 and beyond, but there will be counterbalancing impacts that will color Roku’s Q2 results. The first is that, as mentioned in Roku’s shareholder letter, user trends continued to accelerate into April, with streaming hours up 80% y/y. We don’t know, however, if this surge in hours will be sufficient to counteract the drop in ad pricing.

We do think, however, that current consensus estimates are very light. Per Yahoo Finance, Wall Street consensus thinks that Roku will generate only $311.2 million in revenue in Q2, up only 24% y/y. The notion that Roku’s revenue growth will decelerate thirty points in Q2 when streaming hours surged from 49% y/y in Q1 to 80% y/y in April is unrealistic – especially when we consider that ad pricing has only fallen about 15-20% since the pandemic, and has seen recovery in May and June.

Here’s some useful qualitative commentary on the Q1 earnings call from CFO Steve Louden on how advertisers have behaved since the pandemic began:

On the other hand, our advertising business has seen cancellations as some marketing budgets have declined. But this has been partially offset by new marketing budgets moving to Roku from traditional TV given cancellation of high profile, live sporting and entertainment events. As more curious followed viewers and increasingly seek targeted, measurable forms of advertising. Ad cancellation levels were most pronounced in late March and have since decreased in early to mid-April. We anticipate that our ad business will continue to grow substantially on a year-over-year basis albeit at a slower pace and lower gross profit than we originally expected for the year.

We believe the behavioral changes by TV Ad buyers are likely positive for us in the longer term and that with more time spent at home in many households curtailing spending in light of economic hardships, cord cutting and the shift to streaming will continue to accelerate. We remain committed to our strategic investment areas and to extending our competitive advantages.”

One of the impacts of lower ad pricing, of course, is that the revenue decline at into Roku’s progress on the gross margin front. Roku’s platform gross margin fell fourteen points in the quarter (roughly corresponding with the estimated decline in ad pricing), though a richer platform-to-player mix as well as a 209bps boost in hardware margins kept Roku’s overall gross margin to decline only 483bps.

Figure 2. Roku gross margin trendsSource: Roku 1Q20 earnings release

I’ll echo the same comments here: we shouldn’t read too much into Q1’s decline, especially as advertising revenues are already on the rebound. Roku has managed to generate impressive mid-60s platform gross margins over the past six years, and additional monetization opportunities in areas like TVOD are additional tailwinds to expansion.

And in spite of these margin declines, we like the fact that Roku managed to grow operating cash flows to $45.9 million in Q1, despite a loss of -$10.7 million in the year-ago quarter:

Figure 3. Roku cash flow trends

Source: Roku 1Q20 earnings release

Roku also maintains enviable liquidity on its balance sheet, with $588.3 million of cash against a relatively minor debt balance of $167.4 million.

Key takeaways

Roku’s year-to-date slide in spite of strong user sign-ups has driven me to revise my previously bearish opinion on the stock. With the rampant demand for at-home entertainment and the surge in streaming hours, I believe Roku is well-positioned to capitalize on its much larger account base as advertising prices continue to stabilize. Right now investors are shying away from internet names due to the negative news flow on advertising cancellations for social media companies, but I think the impact to Roku will be minimal if not even benign.

Look for an entry point in this stock, especially if it continues to dip further.

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Disclosure: I am/we are long ROKU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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