Sitting Down With Roku's S-1

Streaming company Roku is generating a lot of buzz with its plans to go public. In this week's episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu dive into the company's S-1 filing to tell investors what they need to know about the soon-to-be-public company's prospects -- especially some of the many significant risks facing the company.

Find out what kind of competition Roku is up against and why it's so alarming, some of the biggest concerns we're seeing on the hardware side so far, what kind of market niche Roku seems to want to tap into and some of the biggest risks associated with it, and more.

A full transcript follows the video.

This video was recorded on Sept. 8, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Sept. 8, and we're going to run through Roku's S-1. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com senior tech specialist, Evan Niu. Evan, what's going on?

Evan Niu: Not too much. A little tired, but I think I'll make it.

Lewis: Up late looking through the S-1 from Roku?

Niu: [laughs] Yeah, some nice nighttime reading.

Lewis: I love doing S-1 shows. I love looking through soon-to-be public company prospectuses, because very often, it's kind of a first glance at this company. I think it can be very easy to be swayed by what other people are saying about a business once it's been public for a while, but I think looking at a prospectus, it's kind of your opportunity to create your own opinion of a company before a lot of media and a lot of coverage is out there.

Niu: Yeah, it's always interesting to get a first look at some really deep, detailed financial information about these companies that, a lot of the times, you're familiar with, you've heard about them for so long but they've been private. I think there's so much interesting stuff in there.

Lewis: I don't want to say it's like opening presents on Christmas morning, because I think that's a bit of a stretch, but that's the feeling for me. It's nice to discover all these things like, oh, I was wondering how much of their streaming hours are coming from Netflix (NFLX 1.53%), or something like that. All these little tidbits that for a while have been private. So it's really fun to do these shows. I love doing them. Why don't we just start out by explaining exactly what Roku is?

Niu: Sure. Everyone knows they're synonymous with these small streaming media players, either set-top boxes or streaming sticks. They have a wide range of different products in their lineup, five or six different types of devices that offer different levels of functionality or features for different price points. I think the prices are $25-$100. They also have integrations with some smart TVs that are made by third-party TV manufacturers. Those TVs start at $130. But those are not Roku products themselves. That's more of just Roku integrating the platform into the TV. They actually earn a little bit of money in terms of licensing fees from the TV manufacturer. Then, on the other side of that, they have the platform that they offer for all the TV content. And they have about 5,000 channels, I believe.

Lewis: Something like that. And this company, we talked about all the different things they do, they're looking to centralize what has become this very segmented online streaming cable substitute space. They integrate stuff like Netflix, Amazon (AMZN -2.30%) Prime video, YouTube, some traditional cable providers, they're trying to create this central dash, this hub, for people to consume all these disparate content sources.

Niu: Right. And on the platform side, they get a cut of revenue from subscriptions they sell or content they sell through other people's apps. They get a 20% cut. They also offer a lot of ad-supported channels, which, in those cases, they share the ad inventory, so they can ask the channel to give them up to 30% of their video ad inventory. For smaller channels, they don't really get much of an audience, they don't really do this, because it's kind of pointless. But for larger channels, that's how they work for shared ad revenues. They basically get to summon the inventory and then sell ad for themselves.

Lewis: So you can really think about this as a company that has their traditional hardware, their devices, which is what they call their player revenue, and then they also have this platform business, and they call it their platform revenue. To look at how that breaks down for their top line, if you look at the first half of 2017, player revenue was roughly 59% of revenue total, and then the platform revenue made up the remaining 41%. I think when you look at that revenue mix, there are a couple of things that you want to keep in mind, one of them being that the device revenue, player revenue, was actually down 2% year over year for the first half of the year. And I saw that management seemed to attribute that to something with the product mix shifting a little bit, shifting toward some of their cheaper, lower-end devices. But I generally don't think that's a good sign.

Niu: Right. They're very clear that their strategy is to pretty much price very aggressively, which naturally hurts average selling prices, it hurts gross margin. But, the point that they're trying to get across is that they want to grow their number of active accounts, which is currently at about 15 million. They are making progress. Active accounts are definitely up quite a bit over the past couple of years. So on the hardware side, it's kind of that old time tested razor and blade model, where they're trying to sell the upfront hardware very cheaply in order to make ongoing revenue later on, either through recurring revenue or just getting a cut of the platform sales.

Lewis: And I wonder if, in some ways, it's kind of a response to what's out there in the market right now. You look at what Google's Chromecast costs, and it's a fairly low-end device. It's pretty similar to the Roku in a lot of ways, where it's just a little dongle that you can plug in and get going. It doesn't have that same hub element to things where you have all these integrated apps, but you can take what is on your laptop and immediately throw it onto your TV. And I think it costs somewhere in the neighborhood of $30 to $40. And when that's out there, there's higher price point products on the market as well, but when there's something low priced like that, you have to respond to it and make sure that you have something in that level of the market.

Niu: Oh, absolutely. Like you mentioned, Chromecast is a really good example. Then, Amazon followed up, responded to Chromecast with the Fire TV stick, which is like $35 and generally gets pretty good reviews. I think the Fire TV stick is one of the best-selling low-end streaming sticks where you just plug it straight into an HDMI port and then you have all your content, and it's nice and easy.

Lewis: Probably doesn't hurt that they have the distribution network of Amazon to help them out on the best-selling side. Looking over at the two different businesses that they have, too, I think it's worth noting that the margin profiles for Roku's main revenue sources are totally different. Not a huge surprise, given that the nature of the device world is very different than the platform world. But the platform revenue has gross margins of over 75%, and the device business has 12% margins. So that is something you want to keep in mind as you see the revenue mix start to shift. They are clearly emphasizing what you'd consider more platform and services revenue, and that should grow in the coming years. And you want to see that, because that probably means that their overall gross margin should expand.

Niu: Right. That's really the whole play here. From an investing standpoint, that's going to be part of the story, is how well are they able to really shift this business to focus more on the platform side and actually grow that business. They are having some encouraging signs in terms of hours streamed, active usage, average revenue per user, which is based on their platform side. So they're definitely making a lot of progress. But I think that's going to be the key thing for investors to want to invest in this company, the No. 1 thing to watch.

Lewis: I mentioned that player revenue was down 2% year over year for the first half of 2017. That was largely compensated for by the fact that the platform business is doing very well. All in all, revenue was $199 million for the first half of the year, which is up 23% year over year. So, in spite of some of the issues on the device side, they are clearly growing the business. They did post a net loss of $21 million. They are not profitable. Although, I believe the gap is narrowing there. Did anything really pop out to you on the financial side, other than that, Evan?

Niu: Not really. Looking at the different margin profiles for the different businesses was pretty interesting. But as far as the rest of the income statement, really standard stuff here. It's very common for these companies to be losing money. They've had one profitable quarter in the past two years. They're investing very heavily in research and development, which really drives up your operating expenses. But, none of this is too surprising. It was pretty much what you would expect to see from a company going public.

Lewis: And on a quarter-to-quarter basis, not a huge surprise. But as a device company, they are typically very heavily weighted toward the calendar Q4. So I think roughly about 40% of their business is done in that period, because you have people buying devices as gifts, and very often their release calendar will sync up to that the ramp into the holiday season. So as you're looking at the results as they go public, that's obviously something to keep in mind. Beyond those standard financials, the company also includes a bunch of other key performance metrics in its S-1. We hinted at active accounts before. I think it might be good to check in on the overall growth trajectory of it. Evan, you said the platform had 15.1 million active accounts. What's going on there in terms of general trajectory?

Niu: That's up quite nicely. A couple of years ago, they were only at about five or six million. So, they have grown this user base quite a bit over the past couple of years. So there's definitely a lot of progress. At the beginning of 2014, they had 4.4 million active accounts, and now they're at 15.1. Over the course of two and a half years, they've tripled that user base. One thing that is weird is, they don't disclose their unit sales, so it's kind of hard to gauge the hardware side, player business in that sense. But if you look at the installed base, it's definitely growing. 

Lewis: And they also don't include average selling price as a metric, in the S-1, at least. Maybe they will down the road. But, that would be a way to back into unit sales. So we're forced to use active accounts as a proxy for what's going on there.

Niu: Right. Yeah, exactly. I think one of the things that would be very useful for investors is knowing the engagement of active accounts versus device sales. If you're selling a bunch of these things and no one is using them, that obviously would not be a good sign. And at this point, investors don't have a good way to tell if some of these devices are collecting dust, not being used, not being upgraded, because that directly feeds into how this installed base is going to grow over time. They very rarely have shared unit sales historically in the past, but there's no real current official data point, which is a little disconcerting for investors.

Lewis: If you're trying to get to something like that, I think another thing you can look at is, at least, hours streamed. This is another proxy that the company uses for engagement. Last quarter, it came in at 3.5 billion hours, and that was up just under 60% year over year and 6% sequentially. Generally, this metric has trended up and to the right, everything that you want to see on the engagement side. I think there's this idea that people who have Roku devices tend to really love them. The issue for me is whether they can convince enough people in the market to continue buying them. 

Niu: I was looking at these numbers a little bit closer just now, actually. If you divide out hours streamed divided by active accounts and get to how many hours are streaming per account on a quarterly basis as another proxy for engagement, they are also having some really good numbers here. For example, Q1 2014, it was 159 hours per active account per quarter, and now that's all the way up to 232. If you divide it out on a daily basis, right now people are spending about 2.5 hours a day on this platform on average for the active account. So, up from about 1.8 hours a day back in early 2014. Again, they're definitely making some really nice progress on the engagement front.

Lewis: It's great to see those numbers moving in the right direction. One thing to be wary of is, it looks like a lot of the hours streaming are coming from one or two sources. They talk about how they have thousands of channels available for people to consume content on. One of the risks for me is they are heavily concentrated among a small group of channels.

Niu: Exactly. In the filing, they did note that the top five channels -- and remember, this is out of 5,000 channels -- the top five of them account for about 70% of all hours streamed. That's very heavily concentrated in a very small number of channels, the No. 1 being Netflix. I would assume that YouTube is up there, too. They disclose that they do not receive any material revenue from Netflix, they received no revenue whatsoever from YouTube. So, if the most heavily used channels on the platform, you're not really monetizing very well, that's not a good sign as far as the business goes, even if the engagement side is strong. So you're splitting up the remaining 30% of usage across 5,000 channels, which calls into question the value of all those other channels. Earlier, you made a good analogy here to the cable model where there's tons of cable channels that people hardly ever watch.

Lewis: And that's part of the problem with the cable model. You have all these people who are paying for and subsidizing channels that they aren't using. At least with the a la carte option, you can kind of pick and choose. But it comes back to the overall value offering on the platform, and one of the things that I worry about is, for them to be so reliant and for people to basically be using Rokus as, I think you said it in an article, these glorified Netflix streaming devices, it puts them at a little bit of risk in case Netflix decides to do something on their own down the road.

Niu: Exactly. If the vast majority of usage is concentrated on apps and services that people can get from anywhere, that are completely ubiquitous and there are a million devices that you can access, and Roku is just another one of many devices that you're just using to watch Netflix or YouTube, then broken isn't really bringing a whole lot to the table. They're trying this out, this a la carte option. But in the cable world, like we were just talking about the economics of a la carte channels in cable TV do not work because there's so few people, many channels are very niche, and people aren't going to opt in to pay for it, which is why they're all bundled together. As you mentioned before, these smaller niche channels are effectively subsidized by the popular channels by being bundled in all together. And the economics scale better and make it all work. People have been talking about trying to buy a la carte cable channels for years and years and years, but the economics have never worked out, outside of a couple of big, prominent successful -- like, HBO is obviously a standalone subscription add-on. But, for just basic cable channels, it just doesn't work. And that's essentially what Roku is hoping they can make work. Which, I don't know if they can.

Lewis: And they're not alone in that. There are a lot of big tech companies that have their hand in the pot right now. And I think that's another thing that worries me a little bit about this business. You think about all the other players in this space. Apple (AAPL 0.22%) has TV ambitions, Amazon has the Fire TV, Google has Chromecast, there's a lot going on there. Roku has positioned itself as a platform neutral provider. They're just going to be the vehicle to get people viewing content. They're not going to have their own stake in the content world. And that's great, so long as that dynamic holds. But, look at what happened with Disney and Netflix. Disney decided, we're going to go off and do our own thing, and Netflix lost them. If any of those content providers decide, we're not going to let you do this anymore, that's a risk, one. And on the other side, you have these deep-pocketed competitors where TV ambitions are such a small part of their business, they can heavily invest and out R&D you, and they can sell stuff at very low prices and it really doesn't matter all that much to them.

Niu: Exactly. And I think it's important that all the bigger companies that you're referring to, like Apples, Amazons, Googles, they're also competing on both sides of this business. They're offering hardware as well as a platform. Apple has Apple TV, we've already talked about the Fire TV stuff. They're going to be facing competition from these bigger companies on both fronts of the business. It's not just one or the other. So I do think there's a lot of risk there.

Lewis: And I was talking to Austin Morgan, our producer, before the show, and I said, what do you do for streaming purposes? And he said, I have a smart TV that I've had since college, and I have my video game consoles, and those are perfectly good me-too devices, and that gets the job done. So, when you think about a company that specializes in something that's essentially getting people content and there are all these other delivery mechanisms for that, it worries me a little bit. It feels a lot like some of the other dedicated hardware devices that we've seen out in the market that haven't done particularly well. I think of Fitbit and GoPro.

Niu: Yeah, exactly. And that's going to be the challenge, how can they differentiate if their devices are really just being used to stream Netflix, which accounts for a third of all usage on the platform, and they get very little money for it. Specifically in terms of the hardware, with all be bigger companies competing on the hardware front, can Roku keep up just strictly in terms of hardware product? A lot of these companies are dabbling in voice assistance, better search capabilities, etc. So, even in terms of hardware development, Roku is going to be facing an uphill battle. And that says nothing even on the platform side. So there are definitely lots of challenges going forward, I think.

Lewis: It sounds like you and I both agree that this is not a long-term business that we're particularly excited about. Something to add to this is, we obviously don't know what valuation is going to be yet. We're not sure what the issuance will price at, we're not sure exactly when it will begin trading, either. This is more of an exploratory show because the news dropped and we were able to get our hands on this. Are there any other big things that you want to hit, Evan, before I let you go?

Niu: No. I think you got it there. I'm not really a huge fan. I think they're posting some nice improvement and some progress in some of these key metrics. But looking further out, I don't really see a long-term advantage, sustainable differentiation between what they're trying to do. Like you mentioned, this market for streaming devices is so overcrowded. There's gaming consoles, smart TVs, these things can also play all of the big services themselves through different apps. On the platform side, it's like, is there really value in their platform for content that is primarily accessible on Roku? I don't think the answer is yes. I do like some of the numbers they're putting out, but I'm going to sit on the sidelines on this one.

Lewis: In the interest of full disclosure, I have to ask, how do you stream stuff at home? Do you have a device for that?

Niu: I have two Apple TVs, and I have a gaming console. I don't have a Roku. And obviously, my house is full of Apple stuff. So we have the Apple TV. It's already built into my TV, I can stream through my gaming console, I can stream through my phones, tablets, I can stream from anywhere already, so there's no real purpose, at least for me, to go buy another device.

Lewis: And Austin, what about you? You mentioned that you have the smart TV and the gaming console. What do you wind up using more?

Austin Morgan: I'll use the gaming console when I'm on the TV that has a gaming console.

Lewis: Which gaming console is that?

Morgan: PS4. But, the other TVs are smart TVs, and I just stream through that. Until one of these companies can give me live sports, I'm not buying.

Lewis: In the interest of disclosure, I am a loyal Chromecast user. I will say that Consumer Goods host Vincent Shen is a Roku owner and absolutely loves it, so I'm sure he'll be doing some coverage on the company down the road as well, because this is kind of one of those flex companies that seems to fall between tech and consumer goods. Guys, anything else before I sign off?

Niu: No, I think we're good.

Lewis: Listeners, that does it for this episode of Industry Focus. If you have feedback or questions for us, just shoot us an email over at [email protected], or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes, or check out The Fool's family of shows over at fool.com/podcasts. 

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Big ups to Austin Morgan for all his work behind the glass. For Evan Niu, I'm Dylan Lewis. Thanks for listening, and Fool on!