Wall Street isn’t sure Roku can lead cord cutters to the promised land

Can the king of cord cutters continue to flourish?

Roku’s latest results, out last week, have reignited a debate about the company’s future. Is the streaming platform doomed to be overrun by bigger, more diversified tech players? Or can it make the leap beyond the commodification of its boxes and embedded interface to expand into more profitable businesses of online services and digital advertising? Investors seem to be turning from euphoric to cautious.

In 2019, following the popularity of pioneering online streaming services like Netflix and Amazon, a host of newcomers jumped into the market, led by Disney and Apple. Meanwhile, Roku’s stock shot skyward 337%, as the company’s valuation hit almost $20 billion, buttressed by the streaming service’s users wanting to watch all these hot new shows on their TVs.

Now two months into 2020, Roku’s stock is down 5%, mostly after Roku released its fourth quarter results, which offered ammunition for buyers and sellers alike. Roku’s revenue jumped 49% to $411 million in Q4 2019, as the number of active accounts on its platform increased 36% to almost 37 million. Annual revenue for 2019 was up 52% to $1.1 billion. The company also projects its revenue will grow more than 40% this year. Those results were pretty much as expected, but potential problems lurk deeper.

One of the secrets of Roku’s success has been its expansion beyond its roots as a set top box maker (a term the company tries to avoid). To do this, Roku CEO Anthony Wood built a loyal customer following by moving the company away from only selling its own boxes, instead now licensing its software to TV makers, so they can ship screens with the company’s streaming TV platform built-in. This is a much higher margin business than selling streaming hardware, and almost one-third of so-called smart TVs sold last year included Roku’s software.

Roku has also developed and licensed streaming programming of its own, backed by advertising. The Roku Channel, available on all its platforms, was 2019’s most popular ad-backed streaming channel, ahead of rivals Pluto TV and Crackle, according to market research firm Parks Associates. That’s another business that yields higher margins than producing set top boxes. 

Together Roku’s licensing and advertising businesses brought in $741 million in 2019, up 78% from the year before. Gross profit from the segment totaled $478 million, up 61%. The set top box business, by comparison, brought in $388 million, a 19% increase, with gross profits of only $17 million, down 52%, as higher sales were offset by deep discounting. 

As Roku’s non-hardware business has grown, its growth has started to slow, notes Morgan Stanley analyst Benjamin Swinburne, who expects Roku’s stock to lag this year. “The law of large numbers for Roku’s high-growth advertising business points to decelerating gross profit growth ahead, potentially faster than the market expects,” he wrote after the fourth quarter results came out.

After all expenses are included, Roku still loses money, which should be a growing concern for investors, Wedbush analyst Michael Pachter adds.

“Roku’s path to profitability is unclear, as Roku continues to expand its workforce to support its next leg of growth,” Pachter writes. “Achieving profitability in Roku’s international markets will take time, in our view, which will likely rein in Roku’s lofty valuation once this becomes clear to investors.”

But Roku’s customer base should continue to grow, as it cuts prices on its own hardware boxes and signs more deals to get its software into more smart TV worldwide, argues Oppenheimer analyst Jason Helfstein.

“We believe Roku can leverage its advantage in pricing and merchandising to remain the market leader in consumer-facing connected television solutions,” he notes.

Though an eMarketer report this week predicted that the number of cable-free households will grow 50% in the next five years, there aren’t many other ways for investors to bet so precisely on the continued growth of cord cutting. Plus all of those new streaming video services will need to rely on Roku to bring in eyeballs, explains RBC analyst Mark Mahaney.

“We see Roku benefiting directly from the Streaming Wars,” he wrote last week. “We continue to view Roku as one of the best plays on ad-supported (online TV services), with the company being one of the best positioned to take share of the very large, under-penetrated $70 billion TV ad spend opportunity.”

But then again, the stock market is littered with the collapsed shares of independent hardware makers that once had a hot niche, from GoPro to Arlo to Palm. Will Roku similarly run aground? It’s not yet clear. In the words of traditional television: Stay tuned.

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