By Ophir Gottlieb
Roku Inc (NASDAQ:ROKU) is a Spotlight Top Pick, one of the riskiest we have in the portfolio, and a wave of downgrades has pushed the stock lower. Let’s review the downgrades, the bullish thesis, and what may be coming for the stock.
ROKU was added as Spotlight Top Pick on 11-28-2017 for $47, and as of this writing, it is trading at $46.28 after rising to over $58. The company, already, has a bizarre history as a public company, even though it just IPO’d on 28 Sept. 2017.
The IPO price was set far too low – this is a trick the large banks do to enrich their wealthiest clients and steal money from unwitting founders.
The company [read “the banks”] priced its 18 million share offering at $14 per share, and on the very first day, it rose 67%. That means the founder shares that were sold in that IPO were set too low, while the bank’s clients that bought in for $14 made a killing.
As of today, we’re looking at a $46 price – yet more evidence of a wildly underpriced offering.
Now, it’s of no real consequence to us as investors except for one stark reality – when a stock is underpriced so wildly at IPO, a wave of buying comes in, which inevitably leads to a wave of short selling and that’s exactly what we see with ROKU right now.
ROKU’s short interest started at 4.1 million shares on 10-13-2017 and rose all the way up to 7.7 million shares by 11-30-2017. Here is a little table from NASDAQ.com:
Now, we do see a slight dip as of 12-15-2017, but still, with float of just 17.44 million shares, we now see a short float as a percentage of total float of over 40%. That is a “wow.”
For a little bit of perspective, Nvidia has a 2.82% short percentage of float, and even Shopify, with that huge bearish call from Citron Research has a 1.21% short percentage of float.
So, yes, 40%+ is enormous.
Wall Street Downgrades
While Wall Street was actually fairly bullish this name for $14, with price targets coming out in the $25-35 range, with the stock at $46, the banks are chirping.
On January 4th, Morgan Stanley analyst Benjamin Swinburne cut his rating on Roku from equal weight to underweight, and, now read this carefully, while increasing his price target from $25 to $30.
On January 5th, Citi joined Morgan Stanley with a downgrade of Roku’s stock from Neutral to Sell, with a price target raised from $27 to $28.
So, we see two price target increases, while still seeing necessary downgrades given that the targets are well below the current price.
Morgan Stanley had this to say about its downgrade while increasing the price target (our emphasis is added):
Two of the content partners generating the greatest engagement and monetization, such as Netflix and YouTube, have historically not generated material revenues for Roku. This is presumably because these services have the leverage in their negotiations with Roku and other hardware platforms to keep it all to themselves.
If market share on consumer time spent increasingly shifts towards these larger scale players (e.g. Netflix, YouTube) and away from the long-tail, we believe Roku’s monetization opportunity could be more limited than the stock is pricing in today. Already consensus assumes platform revenues roughly triple from ’17E to ’20E.
So, again, it’s not a matter of growth potential or even growth expectations, but it is very much a case of the stock, in their opinion, having risen too far too fast.
Citi’s coverage was similar, in that it simply noted the valuation, while also noting that ROKU is “one of the most well-known” brands in the over-the-top video streaming space and its ad revenue growth rate could grow by 82 percent in 2018.
We also note that the company itself said out loud, “Further, we receive no revenue from YouTube, the most viewed ad-supported channel by hours streamed on our platform for fiscal 2016 and the nine months ended September 30, 2017.”
The bullish thesis behind ROKU is well laid out in our Top Pick dossier, The Tech Gem Looking to Dominate Streaming Video.
We follow themes, and one of the most powerful we research is that of streaming video on demand or SVOD. This theme has also given rise to the cord-cutting phenomenon.
The SVOD theme really became possible with the advent of the DVR – the ability to pause and record live TV and save it for later. The inventor of the DVR is none other than Anthony Wood, who is also the founder and CEO of Roku.
Here is a look at the SVOD theme:
Worldwide revenue from just this segment will grow from $12.4 billion in 2015 to nearly $27 billion within five years.
The reality is that the penetration rate – that is actual users – is still low and has room for tremendous growth. This is again from Statista.
We are below 25% in the United States, with the trend growing:
Just to show how crowded the field is, here is a chart that shows the share of viewers who use selected video streaming and download services in the United States in 2017.
Keep in mind, this is before Disney releases its massive competitor product which will include Marvel, Star Wars, Disney, Pixar, and much more content from ABC, ESPN, etc.
The various SVOD content providers are in a war – to buy content, to buy users, to keep users, to differentiate. Netflix, Amazon Prime Video, and Hulu are at war with each other, as they are with other over the top (OTT) video services like those coming from Apple, Google (YouTube), Disney, and many others.
That battle doesn’t interest us – what we are after is the operating system, the guts, that will house all of it. And this is where Roku exists. Each of these over the top content providers are available with Roku hardware or software.
Many of us know Roku as a piece of hardware, but that is barely scratching the surface of what this company is doing. In fact, if we look at a chart of revenue by source (from Recode), we can see where the company is going – this is hardware revenue:
As of Sep. 2, 2017
Now that looks bad until we look at platform revenue and gross profit:
As of Sep. 2, 2017
And then we can turn to the number of accounts that have streamed content in the last 30 days:
As of Sep. 2, 2017
ROKU is generating an average of $11.22 in service revenue for each one of them, up from $4.65 per user three years ago.
The CEO noted that TV and TV advertising is in a massive shift to streaming and billions of dollars are moving to new platforms and services. When the Internet disrupts large existing businesses, the opportunity emerges to create a new large-scale platform. That is what Roku is, the leading platform for streaming TV in the U.S.
In fact, Roku’s primary driver of gross profit is its advertising, audience development, and content distribution services it reports in its Platform segment. In the letter to shareholders, the company noted that 89% of gross margins come from this segment.
More on ROKU
The last earnings call also gave us some updated data. The CEO described the company on its latest earnings call, intertwined with usage metrics. We start with one startling comment (our emphasis added):
To put a scale on perspectives, if Roku were a traditional cable company or a service operator, we would be the fourth largest in the country.
And then this broad statement that touches exactly on the Roku bullish narrative (our emphasis is added):
If you look back in time, operating systems rarely, if ever, made the transition from leading on one type of computing platforms or leading on another.
For example, Microsoft Windows became the OS for PCs mainframe operating systems, Android and iOS became the operating system for phones, not Windows, we believe Roku is very well-positioned to maintain its lead as the OS for TV streaming.
Streaming is mainstream, and a huge market. We believe every TV will one day run a streaming OS and what we’re seeing now is just the beginning.
And then this:
* Almost 90% of our gross profit comes from our advertising, audience development, and content distribution services in our platform segment. This segment is driving our strong gross profit and revenue growth.
* The platform segment grew 137% this quarter, and our ad business, which contributed two-thirds of our platform revenue, grew even faster.
* Our value proposition to content publishers and advertisers is clear. Roku is a large-scale platform that monetizes the hard-to-reach and valuable TV streaming audience. Many streamers started their OTT experience with ad-free services like Netflix, but ad-supported content is the fastest growing segment on the Roku platform and free is one of our most popular searched terms.
There is a lot more to this company than hardware sales. It is in the fast lane themes of ad sales and platform revenue. Hardware is good, but it is not the growth engine, and will not be.
Wall Street is worried. With the stock up so much so fast, it should be – at least for the short-term. And friends, I am comfortable with a prognostication, this is going to get bumpy for the stock. And oh my, the headlines will read bloody murder.
Downgrades will come – they tend to do this in bunches, so Morgan Stanley and Citi may be the beginning, not the end. It’s perfectly reasonable to reconsider the timing of a new stock position. If ROKU is keeping you up at night, or if it goes down to $30 and that would keep you up at night, maybe it’s not right for your portfolio at the current time. There is no shame in that.
But, we are looking well beyond the next few years with Roku – toward a tectonic shift away from linear TV, where streaming is everything. A world where content is so rich, that Netflix, Amazon, Google, Disney, Apple, and many others will compete for eyeballs, while Roku simply gives them access to the eyeballs.
It’s no certainty that Roku will win, but we try to find companies that are ahead of the curve that play a vital role in the guts of technological themes, and for now, we see Roku as one of those small companies with the potential to grow substantially.
We’re not sure Wall Street understands the company, but when we look under the hood, we see a robust hardware, advertising, and platform business. We see a company that happily gives up gross margin on hardware, because the real gold mine is simply getting people to stream video – because, in the company’s view, there is a very good chance they will be streaming with Roku powering the platform.
Disclosure: I/we have no positions in any stocks mentioned.