Roku (ROKU 2.72%) is best known for its set-top boxes and streaming sticks, but its advertising business is what's really driving revenue growth and a move toward profitability.
Last year, Roku sold $287 million worth of its devices, but it generated a gross profit of just $29.3 billion. Roku's platform business generated about $225 million in revenue, about two-thirds of which came from advertising.
But investors shouldn't expect much growth in the player business, as Roku shifts its focus to licensing its operating system and lowering prices to compete with bigger companies like Amazon (AMZN 1.21%).
Meanwhile, the ad business is booming. Advertising on Roku's platform will reach about $290 million this year, according to estimates from market researcher eMarketer.
So, what's driving this shift in the business, and what does it mean for investors?
A bigger focus on licensing
Roku's top focus for 2018 is on licensing its platform to hardware makers. The company made excellent progress last year growing its share of the U.S. smart-TV market from about 12.5% to 20%. Look for that number to improve even further this year.
Working directly with television manufacturers allows Roku to lock out competing device makers like Amazon since there's no need for consumers to buy an extra device. It also means Roku can focus on other parts of the business instead of worrying about its player sales.
With Amazon willing to sell Fire TV devices at a loss in order to support Prime and its digital video platform, Roku has seen margin erosion on its players. Player gross margin fell nearly five percentage points year over year in the fourth quarter, reaching 9.5%. The player business is likely unprofitable at those levels, and Roku is better off licensing the operating system to manufacturers for free.
Roku is even breaking out smaller product features such as the Roku Channel, and enabling consumers on other devices to stream content from its free streaming video service. It's starting with Samsung smart TVs this summer.
With a greater focus on getting its operating system in other manufacturers' hardware, Roku may see a decline in hardware sales. On top of that, hardware pricing will be further challenged by competition from Amazon and others willing to take a loss on their hardware, but with other significant revenue sources to support those losses. The trend is already starting to take hold, as Roku's player revenue declined 7% year over year in the fourth quarter.
Growing advertising with better targeting
As a television platform, Roku has some unique data on its users that other digital advertising platforms don't have access to. For example, on Roku-powered smart TVs, there's an option to let Roku listen to what you're watching, so that it can show you other ways to watch a show. That's pretty useful if you tune in to the middle of an episode and it's available on Netflix without commercials. Roku calls the technology Automatic Content Recognition (ACR).
In the fourth quarter, Roku started testing ad products that use ACR technology to target incremental audiences for television advertisers. Using ACR, Roku can determine whether a user has seen a television commercial, and if not, deliver that commercial to the user. That's tremendously valuable for advertisers, especially as cord-cutting becomes more prevalent.
In January, Roku introduced new suite of tools called Ad Insights. The ad suite allows marketers to measure ad reach across various demographics and video platforms, as well as how effective those ads are at getting viewers to tune in to whatever they advertised. It also gives marketers the option to target cord-cutters.
Roku has some of the most applicable data for traditional TV advertisers. It knows what content you're watching, when you're watching, and how you're watching it. As marketers shift their budgets from television to digital, Roku stands to be one of the biggest beneficiaries.
A simpler, more profitable business
If Roku can shift away from selling hardware and focus more on selling advertisements, investors stand to see a big benefit to the bottom line. Not only is advertising a much higher margin product than hardware -- the platform business gross margin was 74.6% in the fourth quarter -- but Roku can reduce overhead by shifting away from building its own hardware.
Indeed, analysts expect Roku's loss per share to fall from $0.44 this year to just $0.06 next year. Roku could easily turn a profit in 2020.
A focus on advertising will allow the business to grow even more quickly. In fact, Roku may surpass Hulu as an ads platform as soon as next year, according to eMarketers' estimate, as it moves toward $700 million in ad revenue in 2020.