Rocky Road for Roku?
Despite tremendous subscriber growth, there may not be enough leverage in the current business model.
Roku (ROKU) is the leading streaming platform in the United States by hours watched, with over 40 billion hours of content streamed in 2019. The Roku platform provides its users with access to streaming services such as Netflix, YouTube, and Disney+. The company also offers its own ad-supported content channels that feature licensed third-party content. Roku’s eponymous operating system is used not only in Roku-branded hardware but also in cobranded TVs and soundbars. Roku generates revenue from advertising, distribution fees, hardware sales, and subscription sales.
Despite operating in a highly competitive market, Roku has grown rapidly over the last five-plus years as it has benefited from the secular trend toward more over-the-top viewing as well as smart TV adoption. The company had 46 million monthly active users as of September 2020, up sharply from 6 million at the end of 2014. Streaming hours on the platform have similarly exploded from 2.5 billion in the first half of 2015 to 26.9 billion in the first half of 2020. Like the streaming services that it offers, Roku has benefited from the coronavirus-driven stay-home trend, but the secular shift toward streaming should provide a tailwind to both user growth and hour growth over the next few years.
The majority of Roku’s users and revenue are in the U.S., where the company’s penetration is over 40% of broadband households. While we expect the service to continue to gain users in the U.S., most revenue growth will come from higher ad rates and subscription sales. The larger growth opportunity for Roku will be overseas, where the company still faces fierce competition from Google (GOOGL), Amazon (AMZN), and Apple (AAPL) along with consoles from Sony (SNE) and Microsoft (MSFT). Another impetus behind Roku’s growth has been a neutral approach to services. Unlike Amazon or Google, Roku had historically been open to placing any service on its platform. However, some media companies have been pushing back on the company’s terms, leading to newer services like HBO Max and Peacock not being available at launch. This more confrontational stance could cause users to look for other platforms for their streaming needs, as we believe switching costs for consumers are modest.
Competition Is High, and Barriers to Entry Are Low
We assign Roku a no-moat rating. While the company is the leading streaming platform in the U.S., the streaming device marketplace is highly competitive, with numerous competitors and relatively low barriers to entry. Despite its lead in the U.S., Roku is one of the smaller players in terms of total revenue and financial resources as it competes with not only other streaming devices but also smart TVs and video game consoles. Larger companies in the device space include Amazon (Fire TV), Apple (Apple TV), and Google (Android TV, Chromecast). Amazon and Google both also license their operating systems to TV, smart device, and soundbar manufacturers such as Toshiba, TCL, Insignia, and Xiaomi. Two of the largest smart TV manufacturers, LG and Samsung, have their own operating systems. These devices also all compete with the original streaming leaders, PCs and game consoles, which are backed by massive companies like Apple, Microsoft, and Sony.
We believe that the company’s potential network effect is two-sided, with viewers/users on one side and content providers and advertisers on the other. Roku players originally gained acclaim and recognition in part for being neutral in terms of content providers as a result of the company not having any content tie-up. In contrast, both Google and Amazon battled over allowing their competing services on each other’s platforms. The openness to any provider, willingness to add new entrants, and lower-priced hardware have attracted users to the Roku platform. The growth in users helps to attract more services as well as advertisers. Roku can offer advertisers display ads and ad space on its own ad-supported video on demand, or AVOD, service (The Roku Channel) and the other AVOD services on the Roku platform. While the addition of advertisers is generally not considered a boon to users, the attractiveness of the Roku platform and users to advertisers does help to attract more free AVOD services like Pluto and Tubi.
Roku also monetizes its network effect via content distribution fees for subscription video on demand service like Netflix or Disney+. Like Apple’s App Store or Google’s Play Store, the company only receives a cut of this revenue when the subscriber signs up for the service via the Roku platform. Roku historically took 20% of this revenue on an ongoing basis versus Apple’s take rate of 30% in the first year and 15% beyond that. However, some of the larger media companies have been rumored to be pushing back, with Disney+ reportedly only paying 10% of revenue acquired via Roku and Hulu only 15%. We believe that Netflix is likely also paying a lower take rate. In addition to distribution fees, these large streaming providers also pay for a specific button on Roku remote controls for both the Roku devices and TCL TVs.
As result of the network effect, the company’s revenue growth has become increasingly driven by its platform segment, which generates revenue from advertising, platform and distribution fees, and licensing. As a result, the player segment (hardware sales) has fallen from 84% of total revenue in 2015 to 34% in 2019, a period during which total revenue increased from $320 million to $1.1 billion. We estimate that most of the platform revenue is derived from ad sales. We project that platform revenue growth will continue to outpace hardware growth, leading to an 88% share of 2024 revenue for the service-oriented segment. Despite the growth, we remain cautious about the potential for partners like TCL or Hisense to switch some or all of their TV lineup to other platforms, which would severely hamper platform revenue growth.
Additionally, active accounts have exploded from 6 million at the end of 2014 to 46 million at the end of September 2020. We assume that Roku has over 40 million active accounts or households in the U.S. While some households may have other options to stream content, the 40 million accounts imply a roughly 40% penetration against the 100 million U.S. broadband households. Streaming hours per quarter on the Roku platform have similarly expanded from 1.2 billion in the first quarter of 2015 to 14.8 billion in the third quarter of 2020. This expansion of viewing hours has helped average revenue per household reach $2.39 in third quarter of 2020 from $0.45 in the first quarter of 2015.
One of the methods that Roku has used to gain share in the U.S. has been the lower price of its branded hardware and smart TVs using its OS, mainly from TCL and Hisense. Roku currently offers four players with prices from $30 to $100. In contrast, Apple offers three players with prices ranging from $149 to $199. While these lower-priced devices have helped Roku gain market share in the U.S., we don’t believe that this advantage is either strong or long-lasting. Amazon has been equally aggressive on pricing its Fire TV devices from $40 to $120 with constant sales, and Google launched its new Android TV dongle at $50 in the fall of 2020. Roku does not charge or charges very little for its OS, but its hardware partners receive little to no upside from advertising revenue. While the manufacturer partners like TCL will continue to price their smart TVs aggressively, both TCL and Hisense have added Android TV to their U.S. product lineups in 2020. We expect partners like TCL to leverage their increasing scale and ability to substitute Android TV to attempt to claw some of the economics back from Roku.
Audience Data Is Valuable
This large audience does contribute to Roku’s potential intangible asset moat source. Like its online counterparts, Roku can provide advertisers with a wealth of behavioral information about users including location, time watching, type of content, and other specifics to make the advertising more valuable. This data helps to attract viewers and make the platform more appealing to AVOD services. The content-neutral standpoint of Roku also helps as the service attracts new services and retains older ones. According to Parks Associates, Roku offers roughly 65% of the over 225 on-demand services that the company tracks, well ahead of Apple TV (52%), Chromecast (47%), Fire TV (42%), and the average smart TV (34%). While many of the smaller services have few viewers, the services outside of the five largest (Netflix, Disney+, YouTube, Hulu, and Amazon) actually accounted for 23% of the streaming viewing time in the second quarter of 2020, or about 12 billion minutes. Many of these services are ad-supported and have to be on Roku, which takes roughly 30% of their ad revenue.
The Roku OS is designed to be relatively easy to navigate and require only modest processing power. Many of its competitors are scaled-down versions of full-scale mobile operating systems. The relatively low requirements for the Roku OS help make the user interface feel snappy and fluid even on the low-powered processors in cheaper TVs. Roku invests heavily in research and development, with over half of its employees allocated to the function and average spending of 23% of revenue over the last three years.
Unlike Apple, which has adherents with Apple-only homes, we do not think there are many Roku-only households. Roku customers also do not need to have the Roku OS on every screen to watch content seamlessly as the underlying app or service takes care of that. As a result, we believe that many households use numerous platforms including Roku to interact with OTT content. Additionally, as most viewers use both small and large screens to view online video, the account information and passwords for the OTT services are saved in multiple places, negating the need to stay with Roku when purchasing a new device or TV. There appears to be little to no cost to switch from Roku to one of its competitors for most users, unless Roku is billing the customer for most to all of its online services. As a result, we do not believe that Roku benefits from switching costs.
Long-Term Growth Depends on International Expansion
Roku operates in a highly competitive marketplace against companies with considerably more financial and development resources. If these companies allocate more resources to their streaming platforms, Roku could be at a significant disadvantage. As a potential example, Apple could either create its own dongle to compete on the low end or replicate its phone and offer older versions of Apple TV at lower price points.
Roku’s subscriber growth over the past few years has been supercharged by smart TV with Roku OS from TCL and other manufacturers. These producers have begun to diversify to other streaming platforms such as Android TV. In order to hold onto TV producers, Roku may have to give up some its platform revenue. Roku’s long-term growth depends on international expansion as the majority of its subscribers are in the U.S. But the company has little brand recognition in many overseas markets, while Amazon and Google do and have been willing to price at similar levels to Roku. These factors may impede international expansion.
While Roku has historically benefited from its openness to services from any providers, it has begun to enter into carriage disputes with large media companies like WarnerMedia and NBCUniversal. If these disputes linger or reoccur, users may migrate to other platforms.
We believe Roku’s financial health is solid. The company ended the third quarter of 2020 with $1.1 billion in cash and less than $100 million in debt. While the company still does not generate positive net income, the free cash loss in 2019 was only $63 million and free cash flow was positive through the first three quarters of 2020. Roku has generally benefited from the stay-at home trend, so an extended shutdown due to continued outbreaks should not hurt it.
We don’t expect Roku to institute stock repurchases or a dividend, as it will remain in its growth phase for the foreseeable future. We project cash flow allocation over the near term to be balanced among R&D, smaller acquisitions, and debt repayment.
Neil Macker does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.