Shares of Roku (ROKU 0.34%) soared over 100% after the recently public company reported better-than-expected earnings. That's catapulted the company up to a lofty valuation of eight times price to sales.
In this episode of Industry Focus: Tech, analyst Dylan Lewis and contributor Evan Niu, CFA, discuss the company's earnings report, and explain what's behind this outsize market reaction. Listen in to hear why Roku is switching over to a platform-based business model, and how they're executing on that change so far; just how much short interest is affecting the share price right now; what huge obstacles to growth Roku still has to figure out; and more.
A full transcript follows the video.
This video was recorded on Nov. 17, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Nov. 17, and we're talking Roku and eating a little crow. 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 much. It's a big earnings release here for Roku. It's the first one as a public company.
Lewis: I can't remember anything quite like what we've seen with Roku over the past week and a half. Can you?
Niu: It's pretty wild. The stock doubled in three days.
Lewis: It is by far the hottest tech stock on the market right now. They dropped their first earnings report last week, and since then the stock is up over 110%. That rise is absolutely baffling, it puts them in just under a $4 billion company. We're going to do our best to explain what's going on on today's show. I guess, maybe, to start, we should run through the top line numbers from the earnings report?
Niu: Sure, go for it.
Lewis: The company clocked in with $124 million in revenue, for the quarter, which handily beat Street expectations of $110 million for the top line. The company is not yet profitable. Lost $8 million during the quarter. And that's not surprising, given the phase that they're at as a company. You look over at some of the key metrics, and this is really where you get a flavor for what's going on for the business for them. One of the big ones is active accounts, and these are accounts that have streamed in the last 30 days. That number was up 48% year over year, which is now just under 17 million, which is some pretty incredible growth.
Niu: Right. Hours streamed is also up quite nicely. I forget the percentage, but it was 2.8 billion hours during the quarter. Unit sales are up. They don't disclose unit sales in absolute numbers, but they said unit sales are up 35%, so putting up some strong growth figures in a lot of the big metrics there.
Lewis: The thing I was particularly impressed with on the active accounts side was, that's actually an acceleration in the growth that they've been seeing. I think they had been somewhere in the low 40% range prior to, and being up around 48% year over year this most recent quarter, there's an acceleration there. Not surprisingly, they're also showing good growth on the average revenue, per user, that's up 37% year over year to $12.68 on a trailing 12-month basis. So, you mentioned units. Maybe it's worth going back and talking about how this company makes money, the different segments here. There's a lot of numbers being thrown around. This is a device company. And typically, you think of a device company as being very reliant on their unit sales to really make money, and that's not quite the case with Roku.
Niu: Right. They're doing this really aggressive shift toward the platform business. They mentioned on this release that this is the first time they've ever had, over half of all new accounts during the quarter came from licensed sources. So, they have this Roku TV program where they license their platform out to TV manufacturers. This is a pretty important notion and trend that's happening, because this whole idea is to shift from the player business to the platform business. Roku has explicitly said that they're not really interested in growing hardware revenue or gross profit anymore. And through this licensing program, they get to earn revenue, and they license it out to the manufacturers. Then, they also get to grow active accounts. So, it's really the best of both worlds for them. I think it's this interesting idea, if you extrapolate this idea, imagine, theoretically, in five or 10 years, if Roku can really pull this off and, theoretically, what if they no longer sell hardware in five or 10 years, and it's really a streaming TV platform pureplay? What do margins look like? How much better can it scale? They eliminate all these fundamental risks of hardware operations, which has really hard logistics around it. What kind of valuation multiples can they justify if they can pull off this type of pivot? It's a really interesting thing to think about if you fast forward what this could look like in a few years.
Lewis: A lot of device companies have tried to make the switch from being a hardware manufacturer to being a platform play. We've seen that with Fitbit, we've seen that with GoPro. In the past, it hasn't been done all that gracefully. But it does seem like Roku has something here. Either they're getting it at the right time with digital streaming, or perhaps that experience just lends itself a little bit more to this integrated platform. But, it's working. It's being borne out in the financials. So, there's a lot that's going on there. This is something that they've prioritized for quite some time, the MO for the company. And I think this is a testament to the management having a finger on the pulse for where the industry will be going, where the company should be going, is, we're not going to be making money on the devices long-term, we're basically going to be coming in as low as we can price point wise because we want people to be using the platform. And, actually, in the past, in the first half of 2017, that resulted in them having year-over-year declines in their device segments. They actually showed growth in the device segment for this most recent quarter. So, even with that strategy, they were able to show some low single-digit growth there.
Niu: It's worth noting that they also just refreshed their hardware lineup last month, right at the beginning of the fourth quarter. They still are making these devices, and they're still important as a way to acquire new users. I think it's very good that they're up front with investors in terms of the narrative, like, "We really don't care that much about the financials of the hardware, as long as it can grow active accounts."
Lewis: Which is amazing, because 54% of revenue for the most recent quarter came from their device segment. The platform revenue, which is really where things are going, was $58 million, which is about 46% of revenue. So, it's slowly making that transition. In the first half of 2017, the platform revenue was only about 40% of revenue. For as much as they are not emphasizing it, it's still a pretty big part of their top line.
Niu: You can't ignore the discrepancy in the margins. The platform gross margin is literally 10X as high as the player gross margin. To put numbers to those, 8% vs. 78% on the platform side. It's so much more profitable, and that's exactly why they're really pushing the platform business.
Lewis: And within that segment, ads is making up about two-thirds of the revenue for them. It was basically ads, licensing, and what was the third component? Do you remember, Evan?
Niu: Those were the two biggest. They had a tiny bit of revenue from these little dedicated buttons on the remote. But, the real core is ads, which is about two-thirds, and licensing, which is about a third, like you mentioned. Those are the two big pieces. The other one is a really tiny part of it.
Lewis: So, we look at this massive spike, this 110% spike, since they dropped these earnings. I think this has to be the market reacting a bit to, "This ad business seems to really have some legs."
Niu: Yeah. They're definitely doing a really good job executing. A big part of it is this new Roku channel that they launched, I think it launched at the beginning of September, which really consolidates a lot of content on the platform. They've mentioned that, a lot of this content is already available on the platform, but it's harder to find because it's spread out among a bunch of different types of apps. So, having one dedicated channel, even if it's the same content coming from the same content provider, it gives that content more visibility, and they can monetize it better, and then both Roku and the content owner benefit from that because more people are actually using it, and then they can monetize the usage through advertising and all these other things.
Lewis: And that's kind of addressing something that we were a little wary of when we went through their S-1. We looked at the main drivers of usage for their platform, and it's Netflix (NFLX +2.60%) and YouTube. And they don't really make much money off of those relationships. I think the top five streaming partners or apps for them make up about 70%. I think Netflix is about 33%.
Niu: Yeah, it's still a third. In their recent 10-Q that they filed for the quarter, they confirmed again that Netflix is still about a third of all usage, they still don't really get any revenue from it at all. I think, quite literally, the only revenue that get from Netflix is that dedicated Netflix button on the remote. Because they don't really monetize, they don't sell it through the platform, they can't advertise on it. So, as long as they can monetize the rest of the usage, I think they'll be OK. But, that's a good chunk of the viewership that they're not really making any money on.
Lewis: And this is the kind of move that makes sense, both from a financial perspective and a user experience perspective. It's creating more revenue opportunities for the business, but it's also helping with content discovery for people on the platform.
Niu: Right.
Lewis: So, we're going to talk about, looking forward, what to expect from this business, and, can this company live up to these expectations.
Evan, something that had me scratching my head when I was looking at Roku and their most recent release was the guidance marrying that back to what they just posted. You look at what the company did for the first half of 2017. They posted 23% year-over-year growth. This most recent quarter, they hit 40% year-over-year growth, and they are guiding to be somewhere in the neighborhood of $175-190 million for Q4, which would be somewhere in the mid to high 20s for growth. What's going on there?
Niu: I think what we're seeing here is a lot of bumpiness. There's a couple of factors. Obviously, we've talked about, they have two main segments, player and platform. The player business is a hardware business, so it's naturally going to be bumpy, subject to the seasonality that you see with all consumer electronics, and also tied to when you have product releases, which companies differ in when they refresh their products. So, the player business, you do see some lumpiness based on all of these factors, which is all perfectly normal for a hardware business in consumer electronics. Specifically, they did refresh their lineup in September of 2016, which is why they put a really strong Q4 2016 on the hardware side, which is why, for the guidance going forward, they're projecting some 20-24% growth, something like that at the midpoint. It's a tough comparison against that quarter. But, if you look at the platform side of the business, which, again, is where they wanted investors to focus on, we talked about, it's been a steady march up. It's just going up and to the right. Almost every quarter is a sequential increase as they really grow this business and execute well. So, you do have to dig down into the two segments to see what's going on in each segment. And that explains some of the overall bumpiness that you see in these growth rates from quarter to quarter.
Lewis: And that right there highlights one of the huge benefits of being more of a service-oriented business. Your cash flows are going to be far more predictable once you have a good installed base and you can understand what you're going to be able to generate off of that installed base. The problem with being in hardware is that you need to keep churning out hits, and one big miss can really mess up your year.
Niu: Right, exactly. I really do like this transition to the platform business. Like I mentioned earlier, I think it's kind of exciting to think about this long-off goal. Not that they articulated this as a goal, this is just me speculating. But, this idea of, if they actually got to a point where they didn't need to make a hardware anymore, that would be pretty exciting, because then they're really a software services, a platform play, more than a hardware play.
Lewis: I mentioned the focus on growth rates here because, when you look at the current valuation for Roku, it's pretty darn rich. And I think pinning down how exactly you might expect this company to grow over the next couple quarters or years is pretty important if you're willing to pay 8X current sales for the stock. What are your thoughts on that valuation, Evan?
Niu: It's like 8X or 9X sales, and it's just insane. And I suspected that a short squeeze might have driven the run up. But, S3 Partners, which is one of these financial analytics firms that specializes in measuring short selling activity, they have access to a lot more data than public investors like we do. And they actually said that a short squeeze did not drive the run up. It's worth pointing out that short interest is currently about 30% of float. Roku has two share classes, they have class A and class B. The total combined is something like 90-94 million shares outstanding for both classes, but only class A shares are traded publicly, and there's only 17 or 18 million shares. Of that, only 15 or so is the float. So, most of those shares are locked up, either held by insiders, the class B shares -- so, the float is really small. What that does is, that amplifies movements, because anytime you have a lot of interest or trading activity, there's just not a lot of supply to go around. This cuts both ways. The stock is going to jump or tank, it's going to be really volatile just by virtue of that. And it's interesting, speaking about the short stuff, part of the reason I thought there was a short squeeze was because you have such a high short interest, percent of float. The borrowing costs are also really high, which, this is kind of nuts, but I've been checking in on borrowing costs, and last week, I was quoted at 20-25%. Earlier this week, I was quoted at 20-25%. And I called this morning, I was quoted 85%. [laughs]
Lewis: Evan, would you mind walking listeners through borrowing costs? That's actually something I'm not quite as familiar with myself.
Niu: Sure. Any time a stock is hard to borrow, which means the demand for short shares to borrow exceeds the supply by quite a bit. When companies go public, there's not really a lot of share supply available to short in general. So, it's really hard to get these shares. So, if these shares are really hard to get, there's a fee associated with borrowing them if you want to short sell them. And the way this fee works is, it's quoted as an annual percentage. For example, that 85% I mentioned earlier. You take the dollar value that you're trying to short based on current prices, multiply that by 85%, and that's your annual fee. The broker will prorate that down to a daily fee, so divide it out by 365 or something, and that's the fee that you pay for that day. Then, of course, over time, if the borrowing costs change, your fees will fluctuate, too. But, 85% is an insane cost, because if you're looking to short this stock, you have to pay that fee up front, again, prorated down but still very high. Then, when you close out your position, you need to be overcoming that fee in order for your trade to profitable. It's a function of, like all things, supply and demand. There's an incredible demand to short the stock right now. So, even if the run-up was not driven by a short squeeze, then there's still quite a bit of short interest. There's even more short interest now that the stock has doubled, because everyone is like, the stock doubled in three days and it's trading at 9X sales, I want to short this thing. But it's going to be really expensive.
Lewis: I think you could have made a really great drinking game out of that segment, by having to take a drink every time Evan said short. This discussion, we talked about this company when they dropped their S-1. We weren't really all that bullish on it, frankly. I think we basically wrapped that episode by saying, it's an OK business, but it's one that neither of us are particularly excited about. I think a lot of people looking at the recent returns have to be like, what do you guys think now? Do you think you were wrong about this? Our big concerns back then, I think many of them still hold. You have competition from Apple, Amazon, Google in the streaming space. We were worried that users were spending a lot of time on apps that don't make Roku any money, like Netflix. What you see in the financials here, and maybe what we've seen on the consumer side in the last couple of months, anything change your mind here, Evan?
Niu: I think, last time we talked about this, the main concern is that we hit on were, A, the transition to the ad business and being able to execute, and B, the valuation. And on the execution side, I think they put up some great numbers. This quarter was really strong. The fundamentals, they're really executing very well with this transition. I think that address is our first concern. But now, the stock has doubled, and the valuation looks even more ridiculous. So, that part looks even worse now, in my opinion. I do think they're putting up really good financials, but I can't justify a stock trading at 9X sales when... they executed really well this quarter, but execution is a long-term thing, and you have to keep executing. There's still a lot of uncertainty and risk. Not to undermine how well they did this quarter. But, I can't get past the valuation. I'm still going to sit on the sidelines on this one.
Lewis: Something I'm kind of interested in with this platform is, what does ad load look like? And how much can they continue to increase that? The two big levers for an ad business are going to be what you charge, and I think they mention they had $30 CPMs or something like that, and how many times you can give people ads during their experience. I was talking with Vince Shen, CG host, who owns a Roku and loves it. And he said, "I don't feel like I'm being shown a lot of ads right now." I wonder if that's because he's spending all of his time on Netflix and he's in experiences that don't allow him to be shown ads, or because there's a big ramp that they still have available to them to roll out ads on the platform. I'm not sure which one of those that is yet. I think I need to look at the Roku experience from the user side a little more and understand what's going on on the platform. I will put out to listeners, if any of you own Rokus, I would love to get some perspective on this, because I don't have one and I need to spend some time in front of one to really understand this business a little bit better.
Niu: We should just go buy one, they're like $30. [laughs]
Lewis: I know. Maybe I'll put it on my holiday list. My mom was asking me the other day if there was anything I wanted for Christmas. So, that might be perfect. Cool. Evan, anything else before I let you go?
Niu: I think we covered it.
Lewis: I do want to spend a couple of minutes talking with Austin Morgan, because Austin spent the other day and some training for our audio stuff, and there's a little bit of an update on the sound of Industry Focus.
Austin Morgan: As a multimedia team, we went through some training from a professional sound mixer, who taught us more in depth about EQ-ing and compression and mastering and all of that good stuff. So, if it sounds better, let us know. If it sounds worse, also let us know. In theory, it should sound pretty good.
Lewis: One thing I will say -- I'm glad you guys went to the training, but you guys were already very good at your jobs. And one of the funniest things, we recently had Foolapalooza, our annual business meetings where everyone hangs out and has a day away from work to focus on what's going on at The Fool, and we had a coupleof members there for this member panel, and one member said she loves the podcast and she particularly loves how the podcasts are mixed. Which, I don't have an ear for that, but I guess some people do. So, you're clearly doing something very well, Austin!
Morgan: She's currently my favorite member.
Lewis: [laughs] I can understand why. If I got that kind of praise ...
Morgan: A full company shout-out of the audio mixing of the podcast.
Lewis: While you guys were also running an event that required livestreaming and mixing.
Morgan: Yeah, it was great.
Lewis: That was the cherry on top. Listeners, if anything sounds funky with this episode, or if it sounds particularly great, also write in and let us know because we would love to know more about that on your end. Otherwise, I think that does it for this episode of Industry Focus. If you have any questions, or if you just want to reach out and say hey, you can 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. For Evan Niu and Austin Morgan, I'm Dylan Lewis. Thanks for listening and Fool on!
