What You Need To Know About Roku Before You Invest
August 9, 2022
Roku, Inc. (NASDAQ: ROKU) is the leading TV streaming platform in the United States, Mexico, and Canada. TV streaming is now the main form of TV entertainment as many consumers are ‘cutting the cord’ from cable TV services.
Similarly, advertisers looking to reach and engage with streaming audiences are allocating more budget to digital advertising. This is because the targeting, measurement, and optimization delivered by TV streaming create a superior return on investment compared to traditional TV.
Roku’s ecosystem involves four key players: consumers, content publishers, advertisers and Roku TV brand partners
What Roku does
The Roku OS is a purpose-built operating system for TV and is designed to run on low-cost hardware. This allowed Roku to manufacture and sell affordable streaming players. The Roku OS also powers Roku TV models that are manufactured and sold by its TV brand partners who license the Roku OS.
From the Roku home screen, users can easily find and access the 500,000+ free and paid movies and TV episodes, as well as live TV, news, sports, hit movies, popular shows, and more, that are available from the thousands of channels on the streaming platform. The majority of the content on Roku is licensed from third parties, saving the huge capital costs needed to produce its shows.
Its customers have the option to control their budget by choosing content that is available on an ad-supported (hence free), subscription (similar to Netflix/Disney+), or transactional basis (“a la carte movie purchases or rentals”).
Roku’s first-party data collected about users and their behaviour on the platform enables it to develop actionable insights such as content recommendations to improve users’ experience and also serve advertisers better.
Business Model – How does Roku Make Money
Roku makes money from selling streaming players and audio products. For example, the Roku Streambars with a streaming player built-in enable the soundbar to connect to the streaming platform.
Roku’s revenue generation strategy is based on selling its streaming players near cost price and then profiting from much more lucrative advertising revenue.
Roku also licenses its OS (operating system) to smart TV manufacturers. In exchange, the company receives a licensing fee. Currently, Roku provides these services to over 15 brands such as Hitachi, Philips, and JVC.
The Roku Channel is Roku’s streaming channel that provides users with free, ad-supported access to third-party movies and shows on-demand as well as original content that is exclusive to the Roku Channel. The channel displays licensed content from media companies such as Warner Brothers, MGM, Lionsgate and Paramount.
In 2021, the total number of advertisers on Roku grew by more than 20%. Roku retained over 95% of its advertisers who spent more than $1 million. Its advertising model is working well as returning advertisers are spending an average of 50% more than in the prior year.
The above photo shows an advertisement placed on Roku by HBO Max to drive signups and promote Season 3 of “Succession”.
Content publishers also have access to Roku’s tools to help them attract and retain viewers. Content publishers can use a variety of ad placements, including native display ads on the Roku home screen or a screen saver to promote their channels in order to drive subscriptions and viewership.
Roku is also expanding its total addressable market for its advertising services to direct-to-consumer and small/medium businesses (“SMBs”) that currently spend primarily on digital and social media platforms. In 2021, Roku announced a new tool that will allow Shopify merchants to easily build, buy, and measure TV streaming advertising campaigns on the Roku platform.
The Roku Channel offers Premium Subscriptions from dozens of content partners, giving users the ability to browse all available content before signing up, obtain free trials for subscriptions, sign up in one-click, and enjoy simple subscription management with a single monthly bill.
Roku also takes a cut of the subscription fee as commissions when users subscribe to other streaming services (e.g. Netflix) via Roku TV.
In 2021, the company launched its Roku Brand Studio. Through this studio, the company produces branded content for advertising partners. The company receives money from the partners in exchange.
Investment Thesis/ Growth Drivers
1. Switching Costs
Once a user has selected Roku OS to be the OS for his/her smart TV, Roku will have a captured audience for its advertisers.
Furthermore, the Roku OS does not require a subscription fee, giving customers even less reason to switch. Thus once the company reached a sizeable scale, it will have a network effect of bringing in more advertisers due to its growing audience size.
2. Market Differentiated Product
In 2020, Roku-enabled smart TVs reached a market share of 38 per cent in the United States, making them the de-facto market leader. Likewise, the company has a market share of 31 per cent in Canada. Its platform is content-agnostic; Amazon’s Fire TV platform almost always promotes Prime Video content, and Android TV is similar. This gives the Roku platform a slight edge over rivals Amazon’s Fire TV and Google TV.
However, Roku still faced strong competition. At the end of 2020, Amazon reported having more than 50 million users on Fire TV, while Roku had 51.7 million users. This goes to show that competition is fierce and there is still a high possibility that Roku may lose its market leadership in the future.
3. Industry Growth
OTT is short for “over-the-top” and refers to the delivery of film and television content via the internet, without the need for a traditional cable or satellite subscription.
The US OTT market is expected to reach a value of USD 123.67 billion by 2028 at a CAGR of 15.5 % over the forecast period (2022–2028).
The growth of the OTT market can be attributed to the rising focus on flexibility to watch any show at any time, which is not the case in traditional cable services.
For the first time, TV streaming devices surpassed legacy pay TV devices in weekly reach in the U.S., with 65% of adults aged 18-49 streaming TV vs. 63% watching legacy pay TV. Being the market leader, Roku should benefit considerably from this growing trend.
According to Nielsen statistics, adults aged 18- 49 spent 45% of their TV time streaming, yet it is estimated that advertisers spent just 18% of their U.S. TV budgets on streaming in 2021. This means there is still significant room for Roku to grow its average revenue per user (ARPU), as advertisers shift their budgets from legacy to streaming TV.
4. International Expansion
While Roku is the #1 TV streaming platform in the United States, Mexico, and Canada by hours streamed, it remains far behind other companies across the rest of the world. In 2021, Roku expanded into Germany with its player business and launched new Roku TV models in the United Kingdom, Brazil, Mexico, Chile, and Peru. In international territories, Roku aims to focus on building scale first, increasing customer engagement, and ultimately driving monetization.
Roku has not established a meaningful presence in Asia yet, and it holds single-digit market shares across the other four regions. Therefore, it could be very difficult for Roku to challenge Samsung, Alphabet’s Google, and other entrenched leaders as it attempts to reduce its overall dependence on the slower-growth U.S. market.
As the penetration of the internet and Smart TVs increases in developing economies such as Africa and the Middle East countries, it will also offer immense opportunities for the expansion of Roku’s total addressable market.
Number of Buyers
Roku had 60.1 million and 51.2 million active accounts as of December 31, 2021, and 2020, respectively reflecting an increase of 17%. The number of users has also increased exponentially over the years.
Roku streamed 73.2 billion and 58.7 billion hours during the years ended December 31, 2021, and 2020, respectively reflecting an increase of 25%.
Average Revenue per User
ARPU was $41.03 as of December 31, 2021, as compared to $28.76 as of December 31, 2020.
Roku announces its financial results in two reportable segments: the platform segment and the player segment. Player revenue is generated primarily from the sale of streaming players and audio products. The remaining revenue is all categorised under platform revenue. Platform revenue is generated mainly from the sale of digital advertising, the sale of Premium Subscriptions, and licensing arrangements with service operators and TV brands.
Currently, its platform and player revenue makes up about 83% and 17% of total revenue respectively.
All of the profits, however, come from platform revenue.
Revenue for Roku had an average 52.4% CAGR from 2017 to 2021. For the next few years, Roku is expected to report excellent revenue growth at a CAGR of 24.31% while returning to profitability by FY2025.
Roku recently returned positive net income in 2021.
Free cash flow
Roku has been free cash flow positive since 2020.
The OTT market has become highly competitive. This is because the barriers to entry are low and there are now many companies offering OTT services.
The smart TV OS market remains fragmented into several platforms, including Amazon’s Fire TV, Apple TV (AAPL), Google Android TV (GOOG) (GOOGL), and Samsung’s Tizen, LG’s WebOS, to name a few.
In my opinion, the Smart TV OS remains a relatively commoditised product. While it is true that Roku TV may have slightly better product features, for now, its competitors can easily replicate them. This is further abetted by the massive financial resources established brands such as Amazon and Alphabet have available for R&D and also gives them the ability to cut prices on their hardware streaming devices to onboard customers. Therefore, I am concerned about whether Roku can defend its market share should such big tech players make aggressive moves to penetrate the smart TV market.
2. Portable devices like smartphones, and laptops over smart TVs
Another concern is that people may spend more time watching shows on mobile devices than on traditional big-screen TVs. Roku’s future depends on people spending more time in the living room so that people use the Roku platform to consume content. But if people spend more time on mobile devices for TV watching, they will use Apple OS or Google Android instead for content consumption. The Roku app on mobile devices would lose its moat and attractiveness completely.
3. Concentration Risks
Roku sells its streaming and audio products internationally through distributors and retailers. Amazon, Best Buy, and Walmart collectively accounted for 69% of Roku’s player revenue. If one of the retailers decides to stop distributing Roku’s products, it could result in significantly fewer customers being onboarded to the Roku TV platform.
I like how Roku has positioned itself as the go-to-OS for Smart TVs, just like what Android and Apple have done for Smartphones and Microsoft for laptops. I believe that Smart TV will eventually take up almost all of the consumer’s time spent on TV, and legacy TV will slowly phase out. This also means much more advertisement budgets will be directed toward Smart TV platforms.
However, I am still held back by the concern of competitive threats that endanger Roku’s market leadership. As of now, I am still not convinced that there are significantly greater benefits from purchasing a Roku TV over a Fire or Google TV. Moving forward, besides the obvious need to continually execute well on its primary performance metrics, I will want to see Roku gaining market share in both the North American and international Smart TV markets. By proving that it can continue to onboard customers at a faster rate than its rivals, it will give me greater confidence that Roku indeed has a superior business concept.
Other things I would like to see are new initiatives and product features to enhance the user experience and makes the Roku TV platform more “sticky”.
On the financial side, I would like management to achieve its target of being profitable by 2025, and thereafter operating margins should follow a smooth upward trajectory.
Finance Chicken is passionate about investing and finance. He likes to share his findings on various companies through articles posted on ValueInvestAsia, as well as through his own personal blog https://financechicken.com.