Roku's (NASDAQ:ROKU) stock recently plunged after the streaming device and platform company posted its third-quarter numbers. Its revenue rose 50% annually to $260.9 million, beating expectations by about $3 million.

However, it posted an adjusted EBITDA loss of $0.4 million, compared to a profit of $2 million a year earlier. Its GAAP net loss widened from $9.5 million to $25.2 million, or $0.22 per share, but it still beat expectations by six cents. Roku's headline numbers looked decent, so why did investors head for the exits?

A young woman watches TV in a dark room.

Image source: Getty Images.

Roku's key challenges

Roku generates its revenue from two businesses: its older player business, which sells various streaming devices, and its newer platform business, which makes money from over-the-top (OTT) ads and content partnerships.

Roku is still the top streaming device maker in the U.S., according to Parks Associates. Its market share rose from 37% to 39% between the first quarters of 2017 and 2019, while its closest rival, Amazon (NASDAQ:AMZN), grew its share from 24% to 30%. 

However, rising competition in the streaming device market is forcing Roku to launch cheaper, lower-margin devices to maintain its lead. The integration of OTT operating systems (like Amazon's Fire OS) into smart TVs also threatens to render stand-alone streaming devices obsolete.

Therefore Roku's main goal is to pivot away from its slower-growth, lower-margin player business toward its higher-growth, higher-margin platform business. The bulls believe that it can pull off this balancing act, but the bears don't.

The key numbers

Roku's platform revenue rose both annually and sequentially during the third quarter, but its player revenue declined sequentially.

Revenue (millions)

Q3 2018

Q4 2018

Q1 2019

Q2 2019

Q3 2019

Platform

$100.1

$151.4

$134.2

$167.7

$179.3

YOY growth

74%

77%

79%

86%

79%

Player

$73.3

$124.3

$72.5

$82.4

$81.6

YOY growth

9%

21%

18%

24%

11%

YOY = Year-over-year. Source: Roku quarterly reports.

Roku's revenue growth still looked robust, but its gross margins declined annually and sequentially to 45.4%. The most alarming drop occurred in the platform business, which indicates that its aforementioned "balancing act" is failing.

Gross margin

Q3 2018

Q2 2019

Q3 2019

Platform

70.5%

65.4%

62.6%

Player

11.5%

5.5%

7.6%

Total

45.6%

45.7%

45.4%

YOY = Year-over-year. Source: Roku quarterly reports.

Roku doesn't expect its margins to improve anytime soon. It expects its platform gross margin to stay in the low 60s for the full year due to its ongoing shift toward lower-margin video ads. For the player business, it anticipates a gross margin of 0% for the fourth quarter (due to heavy holiday promotions) and a low-single-digit gross margin for the full year.

Murky guidance and an unclear path toward profitability

For the fourth quarter, Roku expects its revenue to rise 38%-44% annually and for its adjusted EBITDA to decline 51%-71%. For the full year, it expects its revenue to rise 48%-50% and for its adjusted EBITDA to come in between -1% and 15% growth.

A major weight on its bottom-line growth is its planned acquisition of the data-driven ad platform Dataxu for $150 million in cash and stock. Dataxu's tech will strengthen its platform's ad capabilities, but it will also exacerbate the margin pressure it's already experiencing from the shift toward video ads.

A person uses a remote to control a smart TV.

Image source: Getty Images.

Roku is still growing and monetizing its user base at a healthy rate. Its number of active accounts rose 36% annually to 32.3 million, its number of streaming hours surged 68% to 10.3 billion, and its average revenue per user (ARPU) increased 30% to $22.58.

However, its account and ARPU growth trail overall revenue growth as the company's gross margins at both businesses contract -- which indicates that it still lacks a path toward sustainable and profitable growth.

This wouldn't be worrisome if Roku were trading at lower valuations, but the stock still trades at about 10 times next year's sales. That premium valuation doesn't leave much room for error -- so Roku's contracting margins and murky earnings outlook clearly rattled the bulls.

The key takeaway

Roku is still a solid growth stock, but I think too much growth has already been baked into its shares. Investors should wait for the smoke to clear and for Roku to report improving gross margins before starting a position.