Google started producing a television operating system based on its successful Android OS in 2010. It was first called Google TV, now it's Android TV, but few people have bought it. Instead, Roku (NASDAQ:ROKU) has emerged as the dominant television operating system despite waiting until 2014 to start licensing its software.
"Whenever new computing platforms have emerged, the operating system has always changed," Roku CEO Anthony Wood explained at a recent investors conference. For example, Windows dominated PC licensing, but couldn't make the jump to phones. Android dominated phones, but couldn't make the jump to televisions. Roku TV is the operating system on 20% of the smart TVs sold in the United States and Canada. And that number continues to grow.
All about active account growth
In Roku's first letter to shareholders as a publicly traded company, management included a Frequently Asked Questions section. One question addressed the fact that Roku isn't exactly a hardware company. "One way we build active accounts is by selling streaming players," management wrote. "But unlike a hardware company that would normally try to maintain higher [average selling prices] and hardware gross margin, we strategically pass along player cost savings to consumers by actively driving down prices to grow active accounts."
Indeed, player gross margin fell to just 7.9% in the third quarter of 2017, down 5.4 percentage points from the same period in 2016. After factoring in operating expenses, Roku is likely taking a loss on its hardware sales.
The good news for investors is that Roku is quickly finding success by licensing its operating system to manufacturers like TCL, Insignia, and HiSense. Not only is it the most popular smart TV OS, the licensed OS now accounts for the majority of its active account growth. Roku TVs are also the fastest growing source of new accounts.
Roku doesn't make money directly from licensing its OS just as Google doesn't make any money from licensing Android. The money is in getting users on the platform and then selling them ads and distributing content. The model is almost exactly the same for Android on phones, except on a much larger scale.
Margins going up
As Roku attracts more and more accounts from licensed sources instead of its own hardware, investors should start to see overall profit margins improve. As mentioned, Roku is almost certainly making an operating loss on its hardware sales. Its platform revenue, however, kept $0.775 of every $1 as gross profit last quarter.
Roku derives about two-thirds of its platform revenue from advertising, and the other third is largely from referring users to new subscription video services. Advertising is growing faster, and it has the most room to scale. Management says ad-supported video accounted for 40% of time spent on Roku devices, and it's growing faster than subscription video. And Roku just unveiled a new suite of tools that help advertisers take advantage of Roku's unique user data.
As player revenue stalls (up just 4% year over year in the third quarter) and Roku gets more of its new accounts from licensed sources, Roku should start producing better profit margins. Google, for example, had an operating margin of 31.8% in the third quarter, as most of its revenue comes from advertising and the Google Play Store (but, you know, mostly advertising). That number represents the potential for Roku's profits as it shifts to licensing its software.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Adam Levy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares) and Alphabet (C shares). The Motley Fool has a disclosure policy.