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Why Roku's Platform Profitability May Decline

By Evan Niu, CFA – May 9, 2019 at 6:40PM

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And why investors shouldn't be concerned.

Roku's (ROKU -0.97%) ongoing shift to its platform segment has been key to its booming profitability. For example, overall gross margin in the first quarter was 48.8%, up from 27.7% three years ago, back when hardware sales accounted for nearly 90% of revenue. However, the platform business continues to develop, with Roku recently adding premium third-party subscriptions as its advertising offerings keep evolving. Platform gross margin has been moving lower, a trend that is expected to continue in the foreseeable future.

Here's why investors shouldn't worry about contracting platform margins.

Chart showing gross margins for Roku's segments

Data source: SEC filings. Chart by author.

The evolution of the platform segment

The platform business has quite a few moving parts and is only getting more sophisticated over time as it evolves. Historically, Roku would take a pretty standard 30% cut of digital sales (subscriptions and a-la-carte purchases), but advertising has always been a much bigger proportion of sales.

Channels that use the Roku Audience Network to serve up ads keep 60% of ad revenue; channels that use their own custom ad servers are able to keep 100% of the ad revenue they generate, although Roku reserves the right to keep 30% of ad inventory for itself to sell ads with. The Roku Channel's growing prominence also affects profitability, because as a first-party channel Roku gets 100% of the ad revenue that the free channel generates.

Premium subscriptions shown on a Roku TV

Premium subscriptions will weigh on gross margin but still help grow the business. Image source: Roku.

On the earnings call yesterday, CFO Steve Louden reiterated that analysts should expect platform gross margin to be in the low 60s percentage for 2019. "For modeling purposes, you should continue to model full-year platform gross margin in the low 60s as a percent of revenue driven by continued mix shift to video advertising and the introduction of premium subscriptions," Louden said. The finance chief also added, "Continued mix shift to video advertising is expected to remain a drag on platform gross margin." Gross margin in the video ad business is above 50%, according to Louden.

Adding premium subscriptions to the mix will also hurt margins due to the way that Roku accounts for those sales. Louden said that it will account for premium subscription revenue on a gross basis and then classify what it pays those content partners as cost of goods sold. While the company hasn't disclosed the exact revenue-sharing percentages, keeping 30% is pretty standard. If that's the cut that Roku ends up taking, that would mean premium subscriptions carry a gross margin of 30% -- meaningfully diluting platform gross margin.

The premium subscription business is so new that it's not really moving the needle one way or the other, and Roku did not disclose any metrics around these subscriptions, such as how many it may have sold to any of its 29.1 million active accounts thus far. But premium subscription sales will matter more going forward as that part of the business ramps up.

Most importantly, investors shouldn't be concerned about the gross margin percentage getting diluted, since the platform is growing rapidly and gross profits are soaring in dollar terms: Gross profit just jumped 60% to $100.9 million.

Evan Niu, CFA has no position in any of the stocks mentioned. The Motley Fool recommends Roku. The Motley Fool has a disclosure policy.

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