Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Going public at $14 a share, streaming video device maker Roku (ROKU 3.69%) closed its first day of trading up 90% -- then proceeded to rise from there. Within just two days of its IPO, Roku stock had officially doubled.
Now admittedly, the stock has given back some of its gains in the weeks since, as investors cashed in their profits. But here's the thing: Roku's recent weakness came during a period of time known as the IPO "quiet period," a 25-day stretch when investment banks traditionally refrain from commenting on an IPO they have underwritten, and give their new creation no public support. But that quiet period expired this morning...
And now the buy ratings are coming.
Who's saying what about Roku?
This morning, RBC Capital, Morgan Stanley, Citigroup, Oppenheimer, Needham & Co., and William Blair all rolled out new ratings for Roku stock -- the same stock they underwrote at its IPO last month. Of the six, however, only Needham and William Blair are rating Roku stock a buy at this point. All four of the other analysts who helped bring Roku to market are settling for variations of hold ratings for the time being.
Now, this doesn't mean they don't like Roku stock, exactly. As Oppenheimer, for example, makes plain, Roku skeptics are mainly skeptical of the stock's rapid run-up in price. According to a ratings round-up carried on TheFly.com (requires subscription) this morning, here's what the other underwriters are saying about Roku stock:
Morgan Stanley: Media are shifting "from traditional distribution to Internet delivered video" via devices such as Roku. That said, Morgan Stanley is uncertain whether the multiples awarded to Roku after its run-up are entirely justified. Morgan Stanley values the stock at $22.
Citigroup: Although valuing Roku stock at $24, Citigroup, too, worries that after its run-up, Roku stock has limited near-term upside.
RBC Capital: Citing its 50% share of "device streaming hours" in the U.S., RBC calls Roku "a leading over the top ecosystem," and the values the stock at $26.
Bulls beg to differ
Meanwhile in the bull camp, analysts at Needham and William Blair are less concerned with where Roku has been and more with where it's going. Blair puts its emphasis on the overall growth rate of the over-the-top (OTP) streaming market. William Blair says the OTP market is forecast to grow 11% annually through 2021. With Roku offering a pure play on this market, William Blair believes the stock deserves an outperform rating.
Needham agrees, but goes a step further, arguing that Roku could even be undervalued. Comparing Roku stock to Netflix (NASDAQ: NFLX) stock, Needham argues that Roku stock is currently selling for about three times the revenue it expects to collect in 2018. That's less than half the seven times sales valuation of Netflix stock for that same year. Additionally, Needham points out, Netflix needs to spend heavily on content to participate in the OTP video revolution. Roku, on the other hand, "has no risks related to content."
In Needham's estimation, Roku stock that currently trades for less than $22 a share could easily go to $28 -- a 27% gain.
Investors are confused
So how are investors reacting to these ratings? Not well. So far today, Roku shares have already lost more than 4% of their value, as investors recoil in horror, and no wonder. Of the six investment bankers who commented on Roku this morning, each of which helped to bring Roku to market one month ago, only two are endorsing the shares today. What's more, three of Roku's four biggest backers on IPO day, accounting for about 76% of the shares floated on IPO day, are among the banks sitting on the sidelines.
Hardly a ringing endorsement, but should it frighten investors?
Maybe, maybe not. Here's how I look at Roku's valuation today: Although currently unprofitable under GAAP, according to data from S&P Global Market Intelligence, Roku has generated nearly $25 million in positive free cash flow over the last six months. Run-rate that out for a full 12 months, and Roku looks on track to be generating about $50 million in real cash profits annually.
Weighed against the company's $2.1 billion market capitalization, that gives Roku stock a price-to-free cash flow ratio of 42 -- expensive, but perhaps not too expensive to justify if Roku can put up hypergrowth-type numbers over the next few years.
Where might that growth come from? Needham & Company gives us one clue. According to Needham, Roku service or "platform" sales will grow to provide 80% of the company's profit stream by the end of this year. S&P Global data shows that currently, platform accounts for approximately 64% of Roku's $121 million in annual gross profit. For platform to provide 80% of profits, that segment of Roku's business would have to grow at least 25%, and probably even faster. At 73% gross profit margin, such rapid growth in the platform business might be fast enough to justify Roku's premium valuation.
As today's readings indicate, not all of Wall Street is convinced that this is the way things will play out. For the time being, Needham's and Blair's bullish opinions are the exceptions, not the rule. But if Roku succeeds in growing as fast as its fans think it can, there's still time for the company to win over its former backers and make fans of Citigroup, Oppenheimer, RBC Capital and Morgan Stanley.