Roku (NASDAQ:ROKU) on Tuesday announced its intent to buy DataXu, a demand-side platform that lets marketers buy over-the-top (OTT) video ad campaigns via automated bids, for $150 million in cash and stock. The deal was approved by the boards of both companies and is expected to close in the fourth quarter.

In a statement, Roku CEO Anthony Wood said, "TV advertising is shifting toward OTT and a data-driven model focused on business outcomes for brands," and that the acquisition of DataXu would "accelerate our ad platform while also helping our content partners monetize their inventory even more effectively."

Roku states that the integration of DataXu into its own ad platform will offer marketers a "single, data-driven software solution to plan, buy, and optimize their ad spend across TV and OTT providers." Roku also notes that OTT platforms account for 29% of TV viewing, according to Magna Global, but only capture about 3% of TV ad budgets, which indicates that the oft-overlooked market has plenty of room to grow.

A person pointing a remote at a smart TV

Image source: Getty Images.

$150 million is a significant figure for Roku, which ended last quarter with just $387 million of cash, cash equivalents, and short-term investments on its ledger. Therefore, investors should take a closer look at the DataXu deal and how it could strengthen Roku's fastest-growing business.

Understanding Roku's business

Last quarter, Roku generated 67% of its revenue from its platform business, which makes money from OTT ads and content partnerships. The rest of its revenue came from its hardware business, which sells devices like set-top boxes and streaming sticks. Here's how those two businesses performed over the past year:

 

Q2 2018

Q3 2018

Q4 2018

Q1 2019

Q2 2019

Player revenue (millions)

$66.5

$73.3

$124.3

$72.5

$82.4

Player growth (YOY)

24%

9%

21%

18%

24%

Platform revenue (millions)

$90.3

$100.1

$151.4

$134.2

$167.7

Platform growth (YOY)

96%

74%

77%

79%

86%

Data source: Roku quarterly reports. YOY = year over year. 

The bears once believed Roku's hardware business would be crushed by rivals like Alphabet's Google Chromecast, Amazon's (NASDAQ:AMZN) Fire TV, and Apple TV. Yet Roku consistently remains the most popular streaming device maker in the U.S., according to Parks Associates' latest numbers.

Between the first quarters of 2017 and 2019, Roku's domestic share of streaming devices rose from 37% to 39%, while its closest rival, Amazon, grew its share from 24% to 30%. However, the gross margin of Roku's player business also plunged from 22.2% to 5.5% between the second quarters of 2018 and 2019 as it sold cheaper devices to maintain that lead. It expects that figure to remain in the low single-digits for the rest of the year.

During the same period, the gross margin of Roku's platform business fell from 69.8% to 65.4% as it shifted toward lower-margin video ads and ramped up its premium subscriptions feature, which let users access premium content for Showtime, Starz, EPIX, and other channels from its OTT platform. Securing those deals weighed down the business' margins. Roku expects those two ongoing headwinds to reduce its platform gross margin to the low 60% range for the full year.

An ad for a Roku Streaming Stick+

Image source: Roku.

That's why Roku needs DataXu

Roku realizes that as it monetizes its OTT platform with new features (like interactive pop-up ads during broadcast and cable TV commercials on smart TVs), its gross margins could keep dipping. Scaling up that business could help the company lock in more advertisers.

That's why it's buying DataXu, which expands the platform's advertising ecosystem with automated ad buys and analytics tools for marketers. Roku could also use those tools to sell a larger quantity of cheaper ads -- which could stabilize the platform unit's revenue growth and gross margin and offset the impact of its lower-margin player business. That expansion could appeal to advertisers that don't want to be tethered to big tech ecosystem players like Amazon, Google, and Apple.

Buying DataXu can also be considered a counterattack against Amazon, which recently opened up its connected TV apps (integrated with Amazon Publisher Services) to marketers working with DataXu and The Trade Desk. Roku didn't say anything about DataXu's new relationship with Amazon, but it wouldn't be surprising if it severed those ties to slow down its top rival.

It's unclear how much revenue DataXu actually generates, but The Wall Street Journal reported that it was exploring a potential sale for about $300 million last year. Assuming DataXu's business didn't deteriorate significantly, Roku seems to have gotten a pretty good deal at $150 million.

The key takeaway

Roku's purchase of DataXu won't move the needle right away, but it's a significant investment in the platform business' advertising ecosystem. That growth should boost the platform unit's overall scale, stabilize its gross margins, reduce Roku's dependence on lower-margin hardware, and widen its moat against Amazon, Google, and Apple.